Monday, 29 January 2018

Macro and Credit - The Twain-Laird Duel

"All you need in this life is ignorance and confidence, and then success is sure." - Mark Twain


Watching the mesmerizing new heights reached by US equities in conjunction with US rumblings and looming threats of trade wars being felt, with ECB supremo Mario Draghi vainly trying to offset the weak dollar rhetoric coming from Treasury Secretary Steven Mnuchin's weak dollar recent stance, when it came to selecting our post title analogy, we reminded ourselves of the famous duel that opposed American writer Mark Twain with fellow country man James Laird. This was one of the most prominent duels in American History:
"While living in Virginia City, Nevada, sharp-witted satirist Mark Twain was up to his usual pot stirring, writing such outrageous editorials for The Territorial Enterprise that locals dubbed him “The Incorrigible.” When Twain wrote a piece erroneously accusing a rival paper, The Virginia City Union, of reneging on a promised pledge to charity, the publisher of the paper, James Laird, made such a stink over the false accusation that Twain challenged him to a duel. Twain’s second, Steve Gillis, took Twain to practice his shooting, only to find that the man’s pen was truly mightier than his pistol; Twain couldn’t hit the side of a barn. Filled with fear, Twain collapsed. As Laird and his men were making their way over, Gillis grabbed a bird, shot his head off, and stood admiring the corpse. Laird’s second asked, “Who did that?” and Gillis responded that Twain had shot the bird’s head off from a good distance and was capable of doing it with every shot. Then he gravely intoned, “You don’t want to fight that man. It’s just like suicide. You better settle this thing, now.” The creative ploy worked, and the men reconciled. Tom Sawyer would have been proud." - source The Art of Manliness
One could opine that in similar fashion to Mark Twain, when it comes to its inflation target, Mario Draghi cannot hit the side of a barn as well. Then again, as history as shown us, many times, sometimes you don't want to fight central bankers, because often their creative ploys work, whatever it takes, until they don't but for now that's another story.


In this week's conversation, we would like to look at the recent rise in the trade war rhetoric, the weakness in the US dollar and what it entails from an allocation perspective.


Synopsis:
  • Macro and Credit - Trade and currencies, gloves are coming off
  • Final chart - Pension rebalancing? Re-hedge this...

  • Macro and Credit - Trade and currencies, gloves are coming off
We won't continue to blow our own trumpet, but as a reminder, in January 2017 in our conversation "The Woozle effect" we indicated our contrarian stance, namely that we were willing to stand against the US long dollar crowd and that we would rather be overweight Emerging Markets (EM) equities over US equities. Obviously with the continuation of the same trend in early 2018 with a weaker US dollar, we continue to advocate being overweight Emerging Market Equities over US equities from an allocation perspective. 

The recent "war" of words between US Treasury Secretary and Mario Draghi, tempered somewhat by the US president as of late has already revealed clearly that when it comes to being in a tight spot, the ECB is in a much more difficult position than the Fed when it comes to winding down its QE program. 

Also in our January conversation "The Woozle effect" we indicated the following:
"Equities pundits like to focus on the asset side, such as the impact of corporate tax rate mentioned above, we credit pundits tend to focus on the liability side which means that rather than focusing on the corporate tax relief effect we would rather side with our friend Michael Lebowitz from 720 Global from his latest note "Hoover's folly" from the 11th of January and focus on Global Trade risk, Hoover's style:
"Ramifications and Investment Advice
Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.
If actions are taken to impose tariffs, VATs, border adjustments or renege on trade deals, the consequences to various asset classes could be severe. Of further importance, the U.S. dollar is the world’s reserve currency and accounts for the majority of global trade. If global trade is hampered, marginal demand for dollars would likely decrease as would the value of the dollar versus other currencies.
From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.
Investors should anticipate that, whatever actions are taken by the new administration, America’s trade partners will likely take similar actions in order to protect their own interests. If this is the case, the prices of goods and materials will likely rise along with tensions in global trade markets. Retaliation raises the specter of heightened inflationary pressures, which could force the Federal Reserve to raise interest rates at a faster pace than expected. The possibility of inflation coupled with higher interest rates and weak economic growth would lead to an economic state called stagflation. 
Other than precious metals and possibly some companies operating largely within the United States, it is hard to envision many other domestic or global assets that benefit from a trade war." - source 720 Global, Michael Lebowitz, Hoover's folly, 11th of January 2016
This makes perfect sense and as we indicated earlier on, we have become more positive on gold / gold miners in late December for that very reason. As we pointed out in our November conversation "From Utopia to Dystopia and back" the trade attitude of the next US administration is the biggest unknown, and the biggest risk we think." - source Macronomics, January 2017
Weak dollar policy is a natural extension of protectionist policies. FX policy should not be ignored in trade policy. They go hand in hand. 

We also added at the time:
"If indeed the US administration is serious on getting a tough stance on global trade then obviously, this will be bullish gold but the big Woozle effect is that it will be as well negative on the US dollar." - source Macronomics, January 2017
In numerous conversations we have mused around the rise of populism in conjunction with protectionism, which represents clearly a negative headwind for global trade and is therefore bullish gold. The rhetoric of the new US administration has gathered steam and there are already mounting pressure to that effect. Furthermore, in our recent conversation "Bracket creep", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. Protectionism, in our view, is inherently inflationary in nature. To preserve corporate margins, output prices will need to rise, that simple, and it is already happening. 

Productivity in the US has been eviscerated. We feel we are increasingly moving from cooperation to "non-cooperation", a sort of "deglobalization". 

It is a theme we approached in January 2015 in our conversation "The Pigou effect" when we quoted the books The Trap and The Response from Sir James Goldsmith published in 1993 and 1994. Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February 2015:
“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey.

“And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian
Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. He violently criticizes the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.


In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith
Real wage growth has been the Fed's greatest headache and probably the absence of it has been of the main reasons behind President Trump's election. This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":
"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, 22nd of July 2014
The recent "Twain-Laird Duel" between US Treasury Secretary and the ECB clearly shows that there is a heightened risk for global trade thanks to a domestic agenda given low productivity and the consequences the "off-shoring" of labor has had on local communities as warned by Sir James Goldsmith in his great books. On the subject of global trade we read with interest Barclays Economics Research note from the 26th of January entitled "Trouble with trade?":
"Global trade at risk?
Protectionism and its adverse effect on the global trade system has been one of the key concerns in a 'Goldilocks' environment of favourable economic developments and rallying financial markets. The aggressive rhetoric on trade of the US started to turn into action this week, as President Trump's approved 'safeguard' tariffs on imported solar panels and washing machines. Later Secretary Mnuchin and Commerce Secretary Ross indicated at the World Economic Forum in Davos that further such trade measures could be forthcoming, while also criticising the WTO in principle. President Trump's speech at Davos struck a generally conciliatory tone on trade, but also lacked any specificity to meaningfully alleviate concerns. In parallel, the NAFTA re-negotiations entered their sixth round this week, with growing risk of collapse, as the US will present its response to Mexico and Canada's suggestions this Monday
Could this be a turn for the worse in global trade? Pessimists can point to the fact that an already quite 'globalised' world in the early 20th century experienced a collapse of trade openness as a consequence of war and protectionism in 1914-1945; it took many decades to regain such openness, and only since the early 2000s have global trade levels reached new highs.

However, several reasons (beyond the absence of a world war) speak against such gloom: first, leaders from Europe, Canada, China and elsewhere in EM continue to underline their commitment to openness and multilateral cooperations; the UK's apparent growing desire for a 'soft' Brexit could also be seen in this light. Second, undoing global trade has become ever more difficult: as it has transformed from an exchange of final goods between nations into a complex trading network of intermediate goods that cross borders as part of corporations' global value chains. Protectionism would, thus quite immediately backfire on an economy with as many global corporations as the US, likely affecting equity market valuations, etc.

We continue to believe the US administration will want to avoid deterioration into a trade war. However, the coming months will show whether this view could be too sanguine; markets will watch for the next steps in: NAFTA negotiations, additional trade actions by the US (eg, on steel and aluminium) and potential retaliation measures by China, as well as a possible turn of the US towards challenging its KORUS deal with Korea and a looming fight over the refusal of the US to grant China 'market economy' status in the WTO. 
Central banks: managing great expectations
Central banks this week acted broadly according to expectations. Facing market expectations for a more rapid policy normalisation and related appreciation pressures on their currencies, both the BoJ's Kuroda and the ECB's Mario Draghi tried to downplay expectations for policy change. However, both did so with limited success, as they did not deny the robust growth and data-dependence of their future actions. Thus, as long as the favourable economic trends persist, the BoJ and the ECB may struggle to reverse the market's growing anticipation of policy normalisation. We continue to expect the BoJ to shift its yield target in Q3 and the ECB to end QE in September, followed by a first depo rate hike in December.
Next week's meeting of the Fed - whose new chairman Jerome Powell was confirmed this week by Congress - should be relatively uneventful as well. The FOMC statement should remain largely unchanged, with the next hike expected only for March. The FOMC members' assessment will take note of recent developments: Q4 GDP growth at 2.6% was below consensus, but accompanied by strong durable goods orders, broadly confirmed the economy's robust expansion; the sharp USD depreciation contrasts with rising yields and ever highly equity market records; and the more aggressive trade policy moves and continued domestic political tensions (even if the government shut down has been ended this week at least temporarily) mean higher uncertainty.


Watching Wages
More quietly but no less importantly will be the monitoring of inflation and wage growth developments in core economies. This week’s December core CPI print failed to strengthen, suggesting the need for wage growth and higher service prices for more sustained inflation. Next week’s annual wage outlook survey should be a decent predictor for the actual Shunto wage negotiation outcomes in March. Amid a growing labour shortage, the outlook for Japanese wages should finally improve in Germany where unemployment is also at record low levels, the powerful 'IG metal’ trade union has threatened nationwide strikes, as the fourth round of wage negotiations has not satisfied their demand for a 6% wage increase. Again this could possibly signal the beginning of some upward pressure on wages.
For the same reason, attention will be on US core PCE (December) on Monday (we expect 1.5% y/y), as well as on next Friday’s labor market report. Besides some expected improvements in the monthly NFPRs from last month (to 175,000), we expect the pace of m/m wage growth to be unchanged at only 0.3%.

It will show whether some US companies' recent verbal commitment to increase investments, hire more worker and increase wages will be reflected in these aggregates" - source Barclays
Although Barclays continue to believe the US administration will want to avoid deterioration into a trade war, this is akin for us of being "long hope / short faith". For those lucky enough to be on Dylan Grice's distribution list (ex Société Générale Strategist sidekick of Albert Edwards) now with Calibrium, back in spring 2017 in his Popular Delusions note, he mused around the innate fragility of trust and cooperation and how cooperation and non-cooperation naturally oscillate over time. One could indeed argue that "Globalization" has indeed been (as also illustrated by Barclays) an example of a long cooperative cycle. Global trade is illustrative of this. The rise of populism is putting pressure on "globalization" and therefore global trade. The build-up of geopolitical tensions with renewed sanctions taken against Russia by the United States as an example is also a sign of some sort of reversal of the "peaceful" trend initiated during the Reagan administration that put an end to the nuclear race between the former Soviet Union and the United States. Times are changing...


Could the word "stagflation" makes a return? We wonder given corporations which have spread their supply chains across the world in the last ten years could be impacted seriously via a rising cost bases due to protectionism. After all, "globalization" means the world is more connected than before, so are stock markets around the world, and we are not even talking about the ETF "interconnection" risk here (another subject yet an important one).


But moving back to the US dollar, we still think, when it comes to its relationship with oil, that it was the primary driver of the collapse in oil prices in 2014. The sudden vicious surge in the US dollar was an exogenous shock which impacted the oil market. The US dollar has been in the past as well problematic for oil prices when recessionary forces caused a safe haven surge in the US dollar in 2008, leading to oil prices collapsing as per the below FRED chart:
- source FRED

While some pundits would argue that correlation doesn't mean causation, the weakness in the US dollar in 2017 has translated in a surge in oil prices with a continuation of the theme in early 2018 it seems. The risk is that if the Fed reads the US dollar weakness as a sign of the global economy’s heating up too fast with a higher risk of inflation in the future (particularly in the US), then it could shift in a hawkish direction because the dollar weakness goes hand in hand with even looser financial conditions and financial stability matters a lot for these guys. This would mean that the Fed might feel it is once again behind the curve. Yet it seems many investors have not factored in a possibility of more rate hikes coming compared to what is being discounted. This is indicated by Deutsche Bank in their Global Fixed Income Weekly note from the 26th of January entitled "Exogenous currency shock and monetary policy":
"A weaker USD supports easier financial conditions in the US. In turn, easier financial conditions will support growth and inflation. Therefore, one can back the implied “rate cuts” from the currently extremely very loose financial conditions. The work done by our US economics team suggests that the improvement in financial conditions observed since December is equivalent to 15-20bp of Fed fund easing. In other words, to compensate for easier financial conditions, the Fed would need to add close to one additional hike.

- source Deutsche Bank


Also, many pundits have put into the forefront a risk of a repeat of a 1987 event in the making. On this subject we read with interest Nomura's Matsuzawa Morning Report from the 25th of January entitled "Similarities between the strong commodities/weak USD trend and Black Monday":
"Yesterday, USTs and Bunds softened (bear steepened), USD and equities weakened, commodities strengthened and inflation expectations increased. This combination provides a relatively clear message, namely that the Fed is beginning to fall behind the curve. If the US administration takes FX measures favoring US trade, the Fed would lose its freedom with monetary policy and faith in the USD could begin to crumble. This would be a relatively dramatic denouement. We can look back to Black Monday in 1987 and the Tequila Crisis in 1995 for examples. Ultimately, USD did not stop weakening until the G7 issued a joint statement and carried out coordinated interventions. At the same time, the implications for US rates and global rates could be the exact opposite, depending on economic sentiment at that point. In 1987, rates surged globally, but in 1995 they plummeted. Stronger-than-expected economic growth in 1987 led to calls for rate hikes but, in 1995, substantial Fed rate hikes over the previous year sparked fears of an economic slowdown. Opinions will differ on which of these scenarios mostly closely approximates our current situation, but we believe the 1987 scenario is a closer fit. EM equities continued to rise yesterday, demonstrating resilience in the face of higher US yields and weaker USD. Moreover, despite stronger EUR, Europe’s PMI has reached the highest level during the current phase.
We cannot be sure whether the current phase will play out as dramatically as it did in 1987 and 1995, but investors holding USTs will face a trial in the near term, in our view. If the US administration and Fed fail to address weak USD and higher inflation expectations, the support line of 2.75% for 10yr UST yields would lose its significance, and the bear steepening could accelerate (due to higher risk premiums). The outcome with the least damage would be for the Fed to turn hawkish at an early stage, curb inflation expectations, and encourage USTs to bear flatten. We will be watching the end-January FOMC statement and incoming Fed Chair Jerome Powell’s testimony before Congress in mid-February for any hints as to the approach the Fed will take. However, if the US administration continues to take action to weaken USD, the Fed’s efforts alone would not be enough to alter this course. This would create a difficult position for Japan and the EU, which face strong currencies, and for their central banks, for the opposite reasons. They must consider a QE exit given robust economies, strong commodities and higher inflation expectations, but they must also take into account the deflationary pressures arising from strong currencies (Note 1). As a result, the ECB and BOJ would find themselves unable to take action, which could encourage investors to pull their money out of the US and seek refuge in Japanese and euro area bonds instead. However, this flow would reverse as soon as the weak USD begins to wind down, accelerating upward momentum for global yields.
Note 1: In 1987, the Bundesbank gave a greater weighting to strong commodities and higher inflation expectations than to a strong currency and ramped up its rate hikes accordingly. This was one of the triggers for Black Monday. In contrast, the BOJ left its policy rates at a historical low (for that time), creating the most massive stock and real estate bubble since WWII." - source Nomura
In this new Twain-Laird Duel, it could be argued that both the ECB and the Bank of Japan have been effectively cornered. If some feels there is a 1987 risk to the current trend, some others think the period is more akin to the 1994-1995 period which showed significant pressure on bond prices with rising yields. This is what Deutsche Bank has argued in their FX Special Report note from the 25th o January entitled "Yes, it all makes sense":
"The lead market commentator of the Financial Times this morning writes that the dollar sell-off has “stopped making sense”. Viewed with the post-crisis lens of activist central banks and exceptionally tight correlations between FX and rates the dollar is entirely out of line with fundamentals. Take a step back to the 1990s and 2000s however and things look a lot less unusual. Back then, the correlation between US yields and the dollar was very weak. FX market drivers were influenced by the complex interaction of macro variables, politics and valuations. The deviation between rates and FX was the norm, rather than the exception (figure 1).

Currency moves over the medium-term ultimately boil down to one thing: flows. If inflows into an economy pick up the currency strengthens and vice versa. Looked at from a flow perspective, the dollar bear market makes complete sense. The US basic balance – the sum of the current account, portfolio balance and foreign direct investment flows - peaked last year and is on a steadily declining trend (chart 2).

The European basic balance, in contrast, is shooting up (chart 3).

Can this continue? In our FX outlook for the start of the year we argued that the answer is yes: US asset valuations are at record highs so it will be difficult to find the marginal buyer of dollar assets in 2018. US twin deficits are widening driven by fiscal stimulus at the wrong point in the macroeconomic cycle pushing the US current account deficit even wider. And the US is reengaging with a weak dollar policy similarly to the 1994-95 period. “Words” in the world of FX do matter – the big turn in the dollar cycle in 1985 was driven by the Plaza accord, and in 1995 by Treasury secretary Rubin’s initiation of a strong dollar policy. The US tax reform does not make a difference because corporates already hold the bulk of their offshore earnings in dollars and there was nothing preventing them from converting into dollars in previous years anyway.
What about Europe? Europeans have spent trillions of euros recycling their current account surplus abroad over the last few years, a phenomenon which we have previously termed “Euroglut”. This flow drove EUR/USD all the way down from 1.40 to parity. As a result, Europeans are exceptionally overweight foreign assets. In the meantime, Europe’s current account surplus has swelled to 400bn EUR a year. As these European outflows begin to normalize, even a small change makes the Eurozone basic balance look a lot more positive. Add the shifting political dynamics in Europe and we have the perfect cocktail for continued euro strength.
Turning points in the medium-term dollar cycle are often marked by material geopolitical events (chart 4).

We would argue the medium-term bear market in the dollar started with the inauguration of President Trump and President Macron in the US and France, respectively, last year. It has coincided with a structural shift in the relative flow dynamics between the US and the rest of the world. We continue to target 1.30 in EUR/USD for this year." - source Deutsche Bank

From cooperation and globalization to un-cooperation and "deglobalization" through "trade war"? One might wonder if indeed there is a definite change of narrative that could lead to a new "Twain-Laird" Duel. So far the "inflationista" camp is racing ahead, but given lackluster productivity growth in the US, automation, robotization and globalization and demographic headwinds, do all this mean that the "deflationista" camp has lost the battle and the reflation trade remains the "trade du jour"? We wonder, but so far, the trend in yield is up and is your friend. We'd rather be neutral on the duration front for now and wait for more clarity from the upcoming FOMC, making us more Laird than Twain on this occasion and not willing to fight these men for now.


  • Final chart - Pension rebalancing? Re-hedge this...
Last week saw for the first time outflows in 5 weeks for Investment Grade funds as reported recently by Bank of America Merrill Lynch Follow The Flow note from the 26th of January entitled "Blame the tail" with a sizable outflow but, according to them there were only a handful of funds to blame for this event taking place. Higher outflows would be tied to renewed bond volatility than current rates levels according to them. Also, we would argue that as we are moving into the end of an extended credit cycle it would be wise for some investors to become more defensive credit wise and we would continue to expect some sort of rotation from US High Yield towards US Investment Grade. In fact their report indicated that High Yield fund flows remained into negative territory, recording 11th consecutive week of outflows. Yet, our final chart from Deutsche Bank US Fixed Income Weekly note from the 26th of January entitled "Easier financial conditions warrant higher short rates" indicates that we could see significant rebalancing or re-hedging needs from the pension community:
"Dramatic equity outperformance relative to fixed income such as that experienced thus far in 2018 can produce very large re-hedging needs. For example, at the time of writing the SPXT had outperformed the Bloomberg Barclays US Aggregate index by just over 7%, which produces an implied “static weight flow” of $87 billion out of equity and into the bond market. This demand is likely to remain a short term impediment to term premium recovery, and should continue to flatten the long end of the Treasury curve and steepening of the swap spread curve. This acute demand has been the third of our four key themes.
Note, however, that punitive hedge costs for yen based investors have the opposite effect, as the yield of hedged Treasuries over JGBs is at or near historically low levels. With these investors likely to look elsewhere for yield, it is pension demand at the moment which is the “swing factor” slowing term premium recovery. What reduces pension demand? Equity stabilization, or more generally tighter financial conditions. Ironically, the Fed will likely have to continue to hike rates to stabilize equities and provide an ultimate release for the long end." - source Deutsche Bank
With US 2 Year treasury now yielding 2.13% it remains to be seen at what level investors will start parking cash again and start paring back on their equity exposure and other risky credit such as high yield. For the time being in similar fashion to Twain and Laird, the duel seems to have been postponed but we ramble again...

"Prophesy is a good line of business, but it is full of risks." -  Mark Twain

Stay tuned !

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