Friday, 13 April 2018

Macro and Credit - Dyslipidemia

"You can stroke people with words." -  F. Scott Fitzgerald

While learning that Global debt had reached a record $237 trillion in 2017 which is more than 327% of global GDP and that since 2007 global debt has increased by $68 trillion, when it came to selecting our title analogy for this week's musing, we reminded ourselves of the medical term "Dyslipidemia". "Dyslipidemia" is an abnormal amount of lipids (e.g. triglycerides, cholesterol and/or fat phospholipids) in the blood (such as global debt). In developed countries, most dyslipidemias are hyperlipidemias; that is, an elevation of lipids in the blood such as debt levels in comparison to many Emerging Market countries. This "abnormality" level is often due to diet and lifestyle. "Dyslipidemia" can lead to cardiovascular disease, which can be symptomatic but we ramble again...

In this week's conversation, we would like to look at cracks showing up in the "growth" narrative put forward by many pundits. 

  • Macro and Credit - Mirror global growth beautiful?
  • Final charts -  Confidence can turn on a dime

  • Macro and Credit - Mirror global growth beautiful?
As we concluded our previous conversation about some stretched positioning such as long oil, short US Treasury Notes, to name a few, the recent weakness in macro data seems to point somewhat to a different story painted by the rosy tainted narrative of strong global growth which has been prevailing in recent months. As we also pointed out in our last musing, on top of weakening macro data, fund outflows have been increasing, particularly from credit funds. We also argued that the "goldilocks" narrative which had prevailed in credit markets in general and Investment Grade in particular has been changing since the beginning of the year. This is particularly due to the "technical bid" from central banks which has been prevailing for so long, on top of significant issuance levels. Yet, it seems to us that with the central banking put slowly but surely fading, rising dispersion as pointed out as well in numerous conversations is a sign of the lateness in the credit cycle given investors are becoming much more discerning at the issuer level. This also why we advised for a reduction in beta exposure as well as the need to raise cash levels, moving towards a more defensive position. 

When it comes to global data and our "Mirror Mirror", they have started to turn negative. On this subject we read with interest Bank of America Merrill Lynch's take from their Global Liquid Markets Weekly note from the 9th of April entitled "Synchronized cracks":
"Global data surprises turn negative
Synchronized global growth was the buzzword of 2017 and generally expected to continue into 2018. However, global data surprises have turned negative for the first time since mid-2017, potentially due to forecasts being optimistic in the first place. While trade tensions have been widely cited as the reason for the drop in global equities, the realized weakness in global data may be a more straightforward explanation. Chart 1 depicts the stable relationship between MSCI World returns and global data surprises over the past five years.

Markets are assuming Euro zone data deterioration will be transitory
The immediate focus in terms of weaker data is the Euro zone, where data surprises are now the most negative since the peripheral crisis. There are two unknowns here – how much of this weakness is related to weather disruptions and how much reflects a convergence of soft survey data with the reality of weaker hard data. However, this also means the typical rationale for mean reversion in data surprises (economists revising projections) is unlikely to apply here if the weakness is being attributed to temporary factors. Upcoming data, particularly the April PMIs, will be crucial and the fact that EUR has been resilient to the data deterioration suggests the pain trade for markets will be if the weakness persists.
While seasonal distortions mean China slowdown is a blind spot
The relative blind spot in our view is China. With investors mostly looking past the distortions of the Jan-Feb Chinese data, the March numbers should help provide more clarity. Our economists expect a broad deterioration in the official numbers that begin releasing this week (China Economic Watch: Preview of March and 1Q macro data: Softer activity growth momentum 05 April 2018), while some of the higher frequency indicators warrant caution as well.
• Shipments of iron ore to China’s key ports has been weakening in both annual and sequential terms (Chart 3).

The latest March data show the biggest YoY decline since 2015 in both value and volumes. This may partly reflect the very high level of inventories at Chinese ports but at least partly symptomatic of a weaker demand trend.
• Steel production data, particularly for key factories, is less sensitive to inventory swings and supply adjustments, therefore providing some indication of the state of domestic investment, particularly property and infrastructure. Data including the first 20 days of March shows production is still positive YoY but rolling over recently (Chart 4).

• Chinese asset prices are reflecting a growing sense of unease, with a simultaneous drop in commodity prices, domestic rates and equities in recent months (China – sensing the unease 21 March 2018). While this may partly reflect risk premium associated with US-China trade tensions, the fact that even non-tradeable sectors such as real estate have been hit point to domestic demand concerns as well.
Market implications
If Euro zone and China growth moderate, the assumption of synchronized global growth could be challenged. While US Treasuries are becoming desensitized to equity swings (see Rates section), economic data still matter and would temper the upside for US rates. The US dollar would benefit against high-beta commodity and EM FX, but also against the EUR where the divergence with data is extreme. Finally, we are bearish thermal coal relative to forwards (see Commodities section)." - source Bank of America Merrill Lynch
As we have hinted on many occasions, when everyone is thinking the same (in terms of the consensus positioning being very stretched), one might indeed wonder if everyone is thinking. As the central banking "technical bid" is fading, fundamentals matter more than ever. Given rising geopolitical tensions in conjunction with the trade war rhetoric seen lately, one might wonder whether this is sufficient enough to put a further dent into confidence, which has shown in the past its capacity to turn on a dime. For us the short positioning on the 10 year part of the US curve appears to us stretched. Sure the trade war narrative doesn't seem to provide some support to increase the duration exposure, though we think possible further deterioration of fundamentals could eventually cost the bond bears crowd. 

On the subject of the rates story we read with interest Bank of America Merrill Lynch "Rates" segment of their "Synchronized cracks" note:
"• Levered funds' record short positioning remains, and still a risk for bond bears.
• Unlike 2017, asset managers did most of the buying in the rally; unlike 2015-16, USTs pale vs. cash in a risk-off.
• Looking ahead, economic data hold the key for the direction of rates more than equity markets.
This time is different
In our view, the impact of trade tensions ultimately translates into higher rates. As we detail here, the market is only reacting to the growth impact of tariffs but not the inflation impact with both real rates and breakevens lower since February.
In terms of flows, the two biggest differences in this rally compared to recent history are: 1) most of the UST buying came from asset managers, not short covering from levered funds; 2) the rise of cash as a Treasury alternative in risk-off moves. The former suggests economic data hold the key for the direction of rates, more so than risk-off flows; the latter is a confirmation of our view that cash as the new ‘safe haven’ asset threatens the stock/bond correlation.
Levered funds positioning risk remains
Despite the 10% equity market correction and the 20bp rally in 10y rate from February highs, levered funds community stood firm with their net short positions in the futures market. According to CFTC data, the week following the March FOMC meeting did see some profit taking, especially in the 2-year contract. However, overall positioning among levered funds barely budged from the record shorts reached a few weeks ago (Chart 5).

While we have seen evidence of UST short positioning unwind among European investors, the risk of a rally led by positioning unwind remains.
Asset managers did most of the buying since Feb, unlike 2017
Compared to a year ago, this time is different. Much of the buying over the last two months came from asset managers – Treasury futures market saw about $70bn (in 10y equivalent terms) increase in net long positions from this community, whereas levered funds saw $13bn increase in net shorts over the same period. A year ago, the month after March 2017 FOMC meeting saw over 40bp rally in 10y Treasuries and levered funds bought the most, with almost $40bn reduction in net shorts (Chart 6).

The asset manager demand recently was likely propelled by the volatility in risk assets, whereas the levered funds buying in 2017 was driven by a slowdown in tax reform progress and disappointing economic data after Q1.
Cash is now a competing asset
The other interesting development in this risk-off move was the rise of cash as an asset class, threatening rate/equity correlation. Unlike what we were used to seeing, government bond fund inflows in recent weeks were almost negligible compared to historical episodes, especially funds investing in medium and long maturity securities (Chart 7).

At the same time, evidence from money market fund flows reflects greater interest in cash. Seasonally, Q1 tended to see outflows from these funds largely due to anticipation of tax-related withdrawals. However, February and March saw almost $30bn inflows, compared to the average of $40bn outflows from 2012 to 2017 (Chart 8).

Holding cash in the MMF now seems to be a much better alternative for many investors than holding Treasuries with much bigger duration risk.
Watch what the data say, not just what the stocks do
The fact that levered funds are willing to shrug off the risk-off moves in the equity market and trade discussions suggest to us that the driver behind the market volatility is more important than the volatility itself. While we have seen sporadic weaker economic data prints in the US from the consumer side, it’s not enough to convince investors the growth momentum has run its course. The risk-off move could certainly put pressure for rates to move higher, the ultimate test though comes down to the data." - source Bank of America Merrill Lynch

Mirror, Mirror...indeed, watch the data more and more, because it matters. We do agree with Bank of America Merrill Lynch that it is becoming more important than volatility itself. Sure, investors are not convinced yet the growth momentum has run its course, but, as per confidence, the stretched positioning seen on the long end of the US yield curve has the potential to change rapidly should the growth narrative appears to what it seems to us, namely, slowing. No offense to the bond bears out there but even in this much vaunted global synchronized recovery narrative, yield can and will move lower as shown in the below chart from Bank of America Merrill Lynch The Flow Show note from the 12th of April entitled "Gold-ishocks":
"Buried Treasuries: record pace of YTD US Treasury inflows ($18.6 YTD, $3.4 this week); global synchronized recovery, record profits, low unemployment, massive fiscal stimulus, Fed selling, $70 oil…yet 10-year USTs still unable to break >3% and equities (homebuilders down, utilities up – Chart 3) confirm yields can move lower.
- source Bank of America Merrill Lynch

If you want to play the "bond bears" at some point down the credit cycle road then obviously, you should look at credit markets. As we posited in our previous musing, given the size of the ETF complex in that space and dwindling inventories since the Great Financial Complex, you don't need to be a genius to figure out, that the ETF Fixed Income complex dwarfs the "exit" door. 

As a reminder:
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital
This is what we wrote in our November 2017 conversation "The Roots of Coincidence":
"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" - source Macronomics, November 2017
If liquidity is a coward, then obviously reducing the illiquid beta part of your portfolio would be a sensible thing to do. While we have seen some flows return to High Bonds according to Bank of America Merrill Lynch to the tune of $0.4 billion which has been the first inflow for the last 13 weeks and with some rebound as well in Investment Grade with $3.8 billion inflows (66 fund inflows of past 68 weeks), the narrative we think is slowly changing for "goldilocks" in the credit space. This is probably tied up to lower volatility in interest rate volatility and it remain to be seen if the important Japanese investing crowd will return in the coming weeks to US credit markets shores. So yes we could see short term some sort of "relief rally" but we don't expect this to last medium term.

As we pointed out earlier on in our conversation, the central banking technical bid is fading and fundamentals are starting to matter more again. On that note we read with interest Société Générale's note from the 11th of April entitled "The Sword of Damocles - 2Q18 Outlook - Why spreads should widen and how to protect your portfolio":

  1. The real worry is whether growth will slow in 2019, and defaults rise in 2020.
  2. We see a return to late 2015 levels on this fear.
  3. Avoid high beta credits and cyclicals. Be defensive.
  1. The market is expensive
  2. And valuations are the mother of returns
  3. Asset allocators may switch credit for cash and equities (though it is slow to do)
The worst combination would be higher inflation and weaker growth. Yet it is not impossible.
Conclusion on technicals:
  1. Supply has been low but should accelerate.
  2. ECB demand will decline (as we all know).
  3. Which means Europe will follow the US, and it is too expensive." - source Socété Générale
In our credit book as well, increase dispersion, should eventually drive spreads wider particularly in the light of our recent comments surrounding the rise in leverage and the fall in credit quality overall. For the moment, dispersion are coming from single names rather than sectors such as we have seen in the past with the energy sector credit woes in 2016 and recent credit woes in the retail sector. We expect dispersion to rise and impact more sectors going forward. Of course the usual suspects in the US are where the "leverage" is namely tech and healthcare but, that's not a secret. 

If inflation is indeed accelerating and growth is slowing, then again, the dreaded "stagflation" word comes to mind as we posited also in past musings. Back in October in our conversation "Who's Afraid of the Big Bad Wolf?", we indicated that for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation. Sure the explosion of the pigs' short-vol house of straw was triggered by sudden fear of rising wage inflation, but, we continue to believe that a sudden burst of inflation, would no doubt take down their "credit" houses of straw and twigs:
"If as indicated by Christopher Cole, volatility is the brother of credit, then obviously assessing the longevity of the credit cycle is paramount. We do agree with Christopher that, for the time being, we do not see the credit stress required for a sustained expansion of volatility. It's only when the Big Bad Wolf will rear its ugly face that we will change our "Practical yield pigs" stance. But if indeed the credit cycle matters from an Ouroboros perspective, then obviously one has to wonder how the death of the credit snake comes about" - Macronomics
We pointed out as well in this prior conversation that credit cycles die because too much debt has been raised in the final point of this long conversation. Yet another veiled reference to "Dyslipidemia" one could point out. 

 Some might point out, it could be too early to see the fear of trade wars sapping "confidence" in the growth outlook, but we do think as per our last point, that when it comes to "growth" and "stability" in complex structures such as financial markets, confidence matters.

  • Final charts -  Confidence can turn on a dime
While geopolitical tensions are quite palpable, the increasing trade war narrative has proven in the first quarter to be "bullish" gold as we anticipated. We believe that for a continuation of the global growth narrative to prevail, confidence matters and matters a lot. We continue to see cracks in the macro narrative on both the hard side as well as a weaker tone now in soft data such as consumer confidence. Our final charts come from Bank of America Merrill Lynch Global Economic Weekly note from the 13th of April entitled "Fear factor" and display the reaction of various equity markets since the announcement of steel and aluminum tariffs as well as the Global PMI Manufacturing New Export Orders and Volume of world merchandise trade:
"Fear factor
One of the striking developments in the last two years is how investors, consumers and business leaders have learned to shrug off confidence shocks. The result is not only a steady pick-up in confidence indicators, but a pick-up in growth as well. In recent weeks, however, the markets seem to have found something they can’t dismiss: the prospect of trade wars. Here we argue that the way this “war” is developing, the US is the most exposed, followed by China and then relatively open economies around the world. This is because the US is looking to change its relationship with all of its major trading partners, with a particular focus on China. In other words, while most countries are “fighting” on only one front, the US is fighting on many fronts.
Let’s take a look at signs of confidence effects thus far, and what to watch if the “war” escalates.
First responder: global equity markets
It is much too early for fears of trade wars to impact hard data. In the meantime, equity markets are the best canary in this coal mine. Chart 1 shows the change in equity prices since the day before the steel and aluminum tariffs were announced for the US and the countries the Trump Administration is targeting.

Not surprisingly, the US (S&P 500) and China (Shanghai Composite Index) markets have dropped the most over this period.
Thus far the equity market seems to be pricing in a high probability of a benign outcome, with small drops in response to major threats and then rebounds on more assuring comments. The market response to the US-Korea trade deal is also telling. Korea made concessions on autos, steel and currency manipulation, but there was virtually no response for stock prices of the impacted companies. For example, Korea agreed to raise its quota on US car imports from 25,000 to 50,000. However, the “big three” US companies only shipped 19,911 cars to Korea last year. Not surprising the stock price of US and Korean car companies shrugged off the news.
Second responder: confidence surveys
A similar story applies for confidence indicators. As Michelle Meyer and team show, there are early hints that trade war fears are impacting confidence indicators in the US, particularly for manufacturing firms. Canadians are also growing concerned. The latest Business Outlook Survey from the Bank of Canada found that “while firms’ expectations for US economic growth have strengthened further, some cited rising protectionism and reduced competitiveness as factors limiting the impact on their sales.” The survey also shows a shift toward negative views of US policy overall. Asked how US policies had impacted “your business”: a year ago 11% said favorably and 10% unfavorably while in the latest survey 8.8% said favorably and 20.1% unfavorably. Confidence in Mexico dipped sharply in response to the initial threats to NAFTA, but has rebounded recently on hopes of minor changes to the treaty.
Outside of the NAFTA region, only Germany seems worried. Here are some representative thoughts from our regional economists:
  • Germany: According to the latest IFO survey, “the threat of protectionism is dampening the mood in the German economy.”
  • UK: The local press has generally reported this as something that is happening elsewhere rather than to the UK.
  • Japan: Our equity analysts say firms don’t seem overly concerned about trade wars.
  • Australia: At this stage, the press has focused on the opportunities these frictions presents for Australian exporters, particularly in agriculture. Perhaps the most important hint of global risk comes from Purchasing Managers reports. The global index of manufacturing export orders dipped in February and March (Chart 2). 
Two months does not make a trend, and the level of the index is still healthy, but this bears watching.
The biggest loser(s)
It is not surprising that even a small probability of an outright trade war is resonating in the markets. After all, the main battle involves the two most important economies in the world. It also comes at a time when stronger trade is underpinning global growth. The World Trade Organization reports that the growth in global merchandise trade volumes accelerated from 1.8% in 2016 to 4.7% last year. Hence, after a period of weakness, trade is again significantly outgrowing GDP. Looking ahead, they expect 4.4% growth this year, but also present a downside scenario in which trade volumes drop (Chart 3).
- source Bank of America Merrill Lynch

For us, stretched positioning in conjunction with geopolitical risks are major looming threats. That simple. This could lead to a "hot summer" indeed. Sell in May and go away? As say the old adage, in the current case of "Dyslipidemia", high cholesterol and high blood pressure do not mix well, in similar fashion, high debt level (leverage) and volatility do not either...

"Confidence is contagious. So is lack of confidence." - Vince Lombardi
Stay tuned !

1 comment:

  1. Martin - your missive, it doesn't get any better. Stagnant growth and wages + rising risk premia = accelerating stagflation.

    “You defeat defeatism with confidence. Confidence is contagious and so is lack of confidence, and a customer will recognize both.” - Saint Vincent


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