Thursday, 15 March 2018

Macro and Credit - The Canton System

"The philosophy of protectionism is a philosophy of war." -  Ludwig von Mises

Watching the intensification of the trade war rhetoric, with additional dollar weakness, and a softening tone in US macro data, when it came to selection our title analogy, we reminded ourselves of the 1757-1842 Canton System which served as a mean for China to control trade with the West within its own country by focusing all trade on the Southern port of Canton (now called Guangzhou). This policy arose in 1757 as a response to a perceived political and commercial threat from abroad on the part of successive Chinese emperors. To some extent, one could argue that the Trump administration would like to reassert its control on trade like the Chinese emperors did back then, hence our chosen analogy this week. For the history buffs out there, the 1842 Treaty of Nanking put an end to the Canton System.

In this week's conversation, we would like to look at the relationship between interest rates and the price of credit, in conjunction with the relationship between credit and cycles as well as into the trade war narrative building up.

  • Macro and Credit - Credit relationships and cycles and trade wars should not be taken lightly.
  • Final chart - Deglobalize me...

  • Macro and Credit - Credit relationships and cycles and trade wars should not be taken lightly.
Back in October 2016 in our conversation "An Extraordinary Dislocation" we reminded ourselves of the Wicksellian Differential and the credit cycle (linked to the leverage cycle):
"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." - source Macronomics, October 2016
Also we find interesting that Wicksell used the housing sector to illustrate his theory, particularly in the light of the start of some housing prices weakness seen such as in London for instance. We added at the time of our musing:
"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). This is clearly reminded by Credit Capital Advisors' note from July 2012 entitled "Navigating the business cycle: A new approach to asset allocation":
"The calculation of the Wicksellian Differential is however an ex-post measure, so is unhelpful for investors to use as an investment trigger, hence an ex-ante model needs to be constructed based on the underlying drivers of growth in the Wicksellian Differential, which is of course leverage. However, an ever-increasing amount of leverage is clearly unsustainable and will cause expectations to shift at some point, resulting in a period of deleveraging and falling profits. As a result, an investment trigger can be set up based on the dynamic relationship between leverage ratios and the rate of profit, which requires constant recalibration as new data is made available.
The relationship between each leverage ratio and the rate of profit is unique and dynamic through time. For example, the slowdown and fall in the consumer leverage ratio caused the Wicksellian Differential to reverse between 1990 and 1992. Furthermore, during the tech bubble between 1996 and 1999, corporate leverage fell followed by consumer leverage, causing the rate of profit to fall. This highlights that there was no real basis for rising equity returns during the tech bubble as the rate of profit growth was falling. Thus the dotcom bubble ought to be seen as akin to John Law’s South Sea bubble, which was purely based on a rather large misconception. The extent of the credit bubble leading up to the recent financial crisis is highlighted by the substantial rise in consumer leverage, the rate of which began falling at the end of 2006, highlighting the downturn in the rate of profit growth in 2007, and thus a shift to bonds. Finally consumer leverage rose again in 2009, signaling a recovery in profits, although the recovery was short-lived. In 2011 the trend fell again, and the 2012 signal highlights a continuing slowdown in the underlying trend of profit growth. 
There are of course other factors that impact profits, such as significant changes in the general price level and in output per worker, as well as other known variables such as the tax rate; however, the most important driver with respect to the turning points is the realisation that a period of credit expansion has become unsustainable, leading to changing expectations." - source Credit Capital Advisors, July 2012
And of course dear readers, we have long been warning that the credit cycle was slowly but surely turning thanks to credit "overmedication"."  - source Macronomics, October 2016 
We are starting to feel some keen interest in becoming contrarian again when it comes to a "long US duration" exposure (MDGA - Make Duration Great Again). Once more, it is fairly simple to explain particularly in the light of the most recent Atlanta Fed forecast for Q1 2018 coming at a paltry 1.9% (below consensus) and remember these guys have been right on cue on numerous occasions in the past Q1 weak US GDP prints:
"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data." So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."
With record net short duration exposure thanks to Treasury Futures Net Aggregate Speculative Position at around $3.8 trillion, one could argue that, when everyone is thinking the same, then maybe no one is really thinking. 

In the light of our reminder of the "Wicksellian Differential", bond maverick Jeff Gundlach recent webcast caught our attention as pointed out by Zero Hedge in one of their recent post:
"The highlight of Gundlach's webcast, was his remarkable indicator for the "fair value" of nominal 10Y yields, which he calculates simply as the average of Nominal US GDP and the yield on the German 10Y bund. As shown in the chart below, there is an uncanny correlation between the two series, which would suggest that all one needs to trade the 10Y is to know the latest GDP estimate and where the German Bund is trading.
- source DoubleLine - Zero Hedge

If the Atlanta Fed is right again on its call on a weak Q1 2018, (and we have seen this movie before given that since 1980 there have been 15 instances where growth came in below a 2% SAAR in Q1), then again, tactically playing a rally in the long end looks more and more enticing to us from an"asset allocation" perspective" given the huge consensus which has built up in being short duration and the most recent weaken tone in US macro data (retail sales dipping 0.1% sequentially in February for third month in a row). If it was not for the increased deficit spending by the US administration, we would be jumping in and buying US duration at this stage. 

But moving back to the subject namely the relationship between interest rate and credit, and somewhat the Wicksellian Differential, we read with interest Wells Fargo note from the 28th of February entitled "The Evolution of Irrationality" and relates to the relationship between the complex economic relationships that drive the credit cycle:
"The credit cycle, much like the business cycle, is driven by complex economic relationships. Understanding the emotional component in these cycles can equip investors to better identify turning points in the cycle.
“Many liquid assets which are close substitutes for money… [are] only inferior when the actual moment for a payment arrives.” – Radcliffe Report (1959)
For the Radcliffe Commission, the growth of credit rises with euphoria. As animal spirits take hold, investors seek out opportunities, producing more credit in the system. We only have to look at the “” bubble and the subprime housing bubble to see the wisdom that credit risk grows with prosperity. What makes the current scene so challenging is to value new instruments against the administered interest rates of central banks. We know the central bank rates are not normalized, but what do we know of the anticipated market returns for new investment opportunities?
As illustrated in the below graph, when the moment of payment arrived in southern European debt in 2014, liquidity and credit quality came under a cloud. As a result, bond yield spreads tightened considerably within a very short period of time.
Interest Rates and Credit Allocation Over the Cycle
As illustrated in the below graph, credit benchmarks differ significantly over the business cycle—to emphasize the problem, these credit benchmarks are very procyclical.

Initially, both the creditor and the debtor start the allocation process with an apparently economically legitimate project, where risk/return has a sense of balance. However, as the first projects demonstrate success, more projects are financed. Moreover, as credit becomes more available, the expected rates of return diminish. It is no surprise to see an inverse relationship between demand for C&I loans among firms and the credit standards required by banks to offer loans. Credit agencies are certainly aware of the behavior of investors over the business cycle and try to mitigate credit risk by tightening standards as demand soars.
Credit For Income or Capital Gain
For J.P. Morgan, the success of the railroads depended on traffic flow—when he looked at the railroad industry, it was badly overbuilt. But for Jay Cooke, the key concept was the promotional sale of bonds to European investors with limited knowledge of American geography.
Upon what basis is credit advanced? The problem is that at the start of many innovations, credit is advanced in anticipation of an income flow to pay off that credit. The initial investors often get their return. However, as time moves on, credit is advanced in an effort to realize capital gains, but they are less available while the risk rises. This phenomenon is represented in the bottom chart, which depicts the run-up in home prices in the mid-2000s.

Many individuals were under the impression that home prices could not fall and treated the homes as an investment opportunity with little downside. Irrational exuberance coupled with inexperienced investors contributed to the subprime housing bubble, which devastated the global economy. Credit relationships and cycles should not be taken lightly." - source Wells Fargo
Wicksell using the housing sector to illustrate his theory was clearly a good indicator, particularly with US home prices now 6.3% higher than their peak in July 2006 and 46% above their trough in February 2012. In our last conversation we did also put a very interesting chart from Wells Fargo and concluded:
"On a more cautionary note, plans to buy a car or a house both rose much less during the month, although the proportion of consumers stating that now is a good time to sell a house jumped 7 points to 73 percent." - source Wells Fargo
"In this ongoing "intermezzo" period giving us that 2007 feeling, what is really striking to us is that the amount of leverage for the US consumer is not what it seems, and no matter how strong the willingness of the Fed to hike is, it appears to us that much sooner than in previous hiking cycle, the Fed is going to "break" something. As per the above chart, it seems to us that Main Street has a pretty good forecasting record in calling housing market tops it seems, much better than some sell-side pundits but we ramble again..." - source Macronomics
Main Street has had a much better record when it comes to calling a housing market top in the US than Wall Street. Maybe after all, they are spot on and now is a good time to sell in the US, just a thought. As we have stated before, the Fed will continue its hiking path, until something breaks, and we have already seen some small leveraged fish coming belly up when the house of straw build up by the short-vol pigs blew up. We keep pounding this but, Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount this year as the credit noose tightens. 

No doubts that years of QE, ZIRP and NIRP have turned the market upside down and played with asset prices and grew a large disconnect in some instances from fundamentals. The level of interest rates does indeed matter for the credit cycle and things are slowly but surely turning towards the end of an already very long cycle. On the relationship we read with interest another interesting piece from Wells Fargo from their Economics Group published on the 7th of March and entitled "Interest Rates as the Price of Credit: Altered Fundamentals":
"Interest rates are connecting fibers between the real economy and credit markets. In recent years, the price of credit has been manipulated to spur the real economy, but has altered capital allocation along the way.
Back to Normalization: Administered Rates to Market Rates
Credit allocation has been distorted in recent years in an attempt to spur the real economy. Alterations of market prices, whether in credit or product or exchange markets, creates a tension, an observable disequilibrium between markets that must be resolved over time. For the 1970s, wage-price controls created the disequilibrium. In the early 1990s, the tension in the Exchange Rate Mechanism led to a large, sharp adjustment in exchange rates.
In recent years, the era of administered rates has created a credit disequilibrium and thereby provides little guidance on what should be the proper level of interest rates to price financial capital and thereby judge the viability of real world activity. As illustrated in the top graph, we have moved to a new economic environment since the fall of 2017. We are searching for a new equilibrium in interest rates, exchange rates and real markets.
Altered Fundamentals: Altered Market Prices
Since November, there has been a distinct shift in the fundamentals underlying the search for equilibrium in credit markets. Expectations for economic growth, inflation and exchange rates have moved, so why not market interest rates?
Growth expectations have risen. Inflation expectations have risen. Expectations on the dollar’s value have declined. Net result? Interest rates have risen.

Altered expectations of growth and inflation have moved investor expectations of monetary policy actions.

The probability of Fed action in March moved from 65 percent in January to 99 percent in February.
Modeling Interest Rates: Setting The “Normal” Benchmark
The Great Recession has “added fun” to interest rate modeling. The most widely utilized estimation method is OLS, and one major assumption of OLS is that the underlying data is stationary and has no structural breaks. However, if the data is non-stationary or/and have breaks, then OLS estimations are not reliable. As we have discussed in the past, almost all major macroeconomic variables, including interest rates, experienced structural breaks during the Great Recession. Furthermore, both the 10-year and two-year series have non-linear (declining) trends since the 1980s (bottom graph).

Thus interest rates and the growth rate of the economy, which is also a declining rate, are not constant overtime.
Another major hurdle for modeling interest rates is the fed funds rate’s behavior since 2008. The fed funds rate hit the 0-0.25 percent range on December 2008 and stayed there until December 2015. Unusual fed funds rate behavior, along with structural breaks in interest rates, pose great challenges for modeling. “Add factors” are the best friends of analysts since the Great Recession and it does not seem likely to change in the near future. One thing is very clear for us, and that is due to breaks/altered fundamentals finding a “normal” is similar to “waiting for Godot.” " - source Wells Fargo
The battle rages on between the two camps, namely the "deflationista" who thinks we have yet to see the lows in US yields versus the "inflationista" camp who thinks the secular downtrend in yields is broken and that the only way is up. 

As shown by the burst of the short-volatility bubble in February, there has been a change in the narrative leading to less financial repression which had been a clear sign of central banking intervention in recent years. Now obviously, everyone and their dog are talking about the end of financial repression and normalization of interest rates with the Fed leading the central banking pack. This is leading to renewed real "price discovery" in some segments of financial markets. On that note we read another interesting note from Wells Fargo in continuation of their previous one from the 14th of March and entitled "Ending the Financial Repression Era":
"Markets seek an equilibrium after years of financial repression but the path to equilibrium means backtracking through the minefields of mispriced real and financial assets based upon administered rates.
Back to Normalization: Part II
Economic fundamentals have been moving since 2016 in the direction of higher economic growth, higher inflation, a weaker dollar and larger Treasury fiscal deficits. In this difficult context, central bankers now wish to move away from an environment of administered prices (interest rates and bond prices). However, for investors the problem is policymakers. Financial markets are moving from one disequilibrium point with interest rates held below market values (and below inflation, see below graph) to generate growth, to another nexus of interest rates, growth and inflation that remains undefined given the uncertainty about the equilibrium of real interest rates, the potential growth rate of GDP and the Fed’s commitment to a two-percent inflation target.

Finally, as the year moves forward, we must ask ourselves if the central bank is committed to market-setting interest rates or are we simply moving from an era of close-to-zero interest rates to an era of slightly higher rates, while still being administered by the central bank?
“John Bull Can Stand Many Things, But He Can’t Stand 2 Percent”
For John Stuart Mill, the problem was that “a low rate of profit and interest… makes capitalists dissatisfied with the ordinary course of safe mercantile gains.” That is, capitalists push the envelope of risk to achieve higher returns commensurate with their perceived target or normal rates of return. For today, the pursuit of yield has taken investors to a very broad range of asset classes where the accurate measure of risk/return has been altered by the low administered interest rates set by central banks.
In recent years, the era of administered rates provided little guidance on what should be the proper level of interest rates to price financial capital and thereby judge the viability of real world activity. As illustrated in the below graph, sovereign yields in European debt appear remarkably low, and in some cases are below U.S. Treasury yields. Some observers see this as odd.

Our view is that these low yields reflect the policy of the ECB in buying both sovereign and corporate debt. But here is the rub. When the ECB normalizes interest rates, what then happens to business finance, real growth and the euro exchange rate? Again, we are moving from an era of administered rates to an era of market rates—or perhaps less administered rates. 
What About Real Interest Rates and Inflation Discounts?
In the bottom graph, we see the pattern of current market pricing for the nominal and real component of interest rates. There is one positive signal here. The rise in the real component is consistent with market expectations for an improved economy since early 2017.

In this case, higher real interest rates would be consistent with higher expectations for the real return on capital—a very positive sign indeed." - source Wells Fargo
Given current positioning, everyone is expecting an acceleration in US growth in conjunction with inflationary pressure from rising wages. What if indeed the growth is not as strong as one would expect? On top of a weaker US dollar, the recent surge in the trade war narrative will continue to weight not only on the US dollar but, can add to the inflationary pressure building up in the US. This indeed is a poor recipe for risky asset prices and for a continuation of the support from the US consumer given we noticed that consumer credit has been slowing in January, undershooting the consensus. Nonrevolving credit accounted for nearly all of the consumer credit growth to begin 2018 according to Wells Fargo. Non-revolving credit rose at a 5.6% annual rate, or $13.2 billion, compared to December's rate of $13.1 billion. Total non-revolving credit is now $2.83 trillion. If the US government is going for the "Canton System and we get an all-out trade war, this could spark more threatening inflation and impact the US consumer in full. This would put the Fed in bind as inflation would be rising above the Fed’s comfort zone while real GDP growth would likely be slowing, pushing some economists to already use the dreaded word "stagflation". The most recent US unemployment and wage numbers have provided additional support to the "Goldilocks environment" narrative yet recent softness in some economic data in conjunction with rising trade tensions could indeed put a spanner into this narrative in very short order. Global growth looks fine until it doesn't thanks to a change in sentiment, and that could come quickly through trade war escalation with the US and the rest of the world as indicated by Barclays in their Global Synthesis note from the 9ht of March entitled "Goldilocks is nervous":
"Global growth still fine, but potential ‘trade war’ poses risk
"Recent data suggest there has been some modest deceleration in global manufacturing. Yet, this comes off elevated levels, following many months of increases. Notably, services PMIs picked up in both EM and DM economies, offsetting the manufacturing weakness. This week's robust US labour market report seems to confirm the Goldilocks scenario of a robust expansion with little underlying price pressure. Next week, February IP prints in the US and Europe, machine orders in Japan and investment numbers in China should provide further signals about the health of the global economy. However, with fiscal stimulus still ahead and financial conditions still supportive, the risks to global growth seems limited. That said, a serious deterioration in global trade relations could change that"

- source Barclays

When it comes to the US dollar, we think it can continue to weaken if US tariffs trigger a broader trade war and global crisis risks. It might be seen as being Goldilocks for the US economy but when it comes to credit markets, it has been "Goldilocks" for a while, but, since early 2018, the price actions and fund flows for both Investment Grade and US High Yield (17th consecutive week) have shown a weaker tone.

It seems some pundits have decided to quietly exit the credit dance floor. This is indicated by Société Générale in their Mutual Fund and ETF Watch note from the 15th of March entitled "Outflows from credit funds - Another sign that the good times may be over":
"We monitor the flow of funds into and out of mutual funds and ETFs in all asset classes.
  • Exceptional outflows from credit funds. The latest outflows from high yield and investment grade credit funds mark a clear break from previous trends. For US high yield credit (HY), cumulative net outflows started in 2016 (chart below left) but have accelerated over the last month, with HY ETFs also seeing outflows. In the case of investment grade (IG) credit funds in the US and Europe, the turnaround comes after a prolonged period of strong cumulative net inflows. The series therefore appears to be peaking at very high levels (chart below right). So far, these outflows have had little impact on performance.
  • Credit – an indispensable asset... Since 2010, the hunt for yield has turned credit into an indispensable asset, resulting in a fourfold increase in credit funds’ assets under management in the US and Europe (to $1,075bn, EPFR coverage). As a result, most investor portfolios are now heavily overweight on credit versus other asset classes compared to history. Within credit funds, the strongest implied overweight position is for European investment grade. But, increasingly this is a point of weakness. When the wind turns, these OW positions point to potential selling pressure.
  • ... soon to be an undesirable asset? The latest outflows from credit may be a further sign that the golden years are increasingly behind us. In the editorial, we highlight several other reasons to be worried. Risk premiums indicate that credit is expensive compared to almost all asset classes. Rising rates are bringing closer the point at which credit is no longer indispensable for covering contractual obligations. No marginal buyers seem to exist to replace the ECB when it stops purchasing credit (CSPP) in September 2018. Meanwhile, worries about a pick-up in credit defaults seem premature, even if corporate leverage has risen and economic and earnings momentum seem to have peaked. That said, the credit market certainly looks stretched and it may take very little to puncture current complacency. And when credit gets hurt, equity is typically not far behind."
- source Société Générale

All in all it might feel like "Goldilocks" on the macro side for Main Street with expectations of higher wages, for Wall Street it seems, the only "easy day" seems more and more to be yesterday with the "Credit Goldilocks" narrative truly fading as of late...

While on numerous occasions we voiced our concerns for that 1930s with the rise of populism, which has once again been vindicated by the recent Italian elections, it seems that with the US Canton System we are moving from cooperation to noncooperation and lower cross-border capital flows. This could be a troubling development as per our final chart below.

  • Final chart - Deglobalize me...
Back in January this year, in our conversation "The Twain-Laird Duel" we looked at the recent rise in the trade war rhetoric and we argued the following:
"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..." - source Macronomics, January 2018
Our final charts comes from Bank of America Merrill Lynch "The European Credit Strategist note from the 15th of March entitled "NIRP manias - the part 2" and ask the question if globalization is dead, displaying Global cross-border capital flows and the rise of "populist" votes since 2000: 
"Is “globalization” dead?
Draghi’s dovishness comes at an opportune time, as populism has been an all too familiar theme lately. But populism is now becoming synonymous with protectionism. Does this mean that the story of globalization is reversing? Cross-border capital flows are undoubtedly lower than in 2007, but much of this reflects the prudent retrenching by banks from global lending. Other signs are more encouraging, though. World trade is still low, but is forecast to improve relative to world GDP. Foreign direct investment has recovered much of the post-Lehman bankruptcy drop, and global migration rates have noticeably jumped over the last decade. Thus, it may be too early to hail “deglobalization”, we think. Instead, a lesser, but steadier and more fruitful form of globalization is emerging.

“Marginalized” workers around the world want a fresh political agenda that is more inclusive, and prosperous, for them. Understandably, ideas around “Frexit” and “Italexit” play no part in this given their wealth destructive consequences (see here for how Eurozone breakup fears have receded). Instead, the current brand of populist politics is more inward looking and seeks to play on voters’ fears about globalization and migration. Populism, therefore, has become more about protectionism: putting up barriers to entry and reworking free trade."- source Bank of America Merrill Lynch
As a reminder, the Canton System arose as a response to a perceived political and commercial threat from abroad, it seems to us that the US Government under Trump is keen on imposing further restrictions on foreign trade with China particularly in their sight, is Germany next? We wonder and ramble again...
"The United States can't keep a completely open system if the rest of the world is less open. The United States may have to take a leaf out of the book of Japan, China, and Germany, and have protectionism inside the system." -  Robert Mundell

Stay tuned!

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