Wednesday 27 June 2018

Macro and Credit - Prometheus Unbound

"Trust my folly then, since it is best for a man truly wise to be thought a fool." - Aeschylus, Prometheus Bound

Watching with interest "risk-off" unfolding with Emerging Markets continuing to bleed thanks to the ratcheting up in the trade war rhetoric, leading to more market turmoil, when it came to selecting our title analogy we decided to go for the Greek tragedy reference namely "Prometheus Unbound", a fragmentary play attributed to 5th century BC Greek tragedian Aeschylus. What is not to like in this title and the tragic element? It seems more and more probable that the United States and China cannot escape the Thucydides Trap being the theory proposed by Graham Allison former director of the Harvard Kennedy School’s Belfer Center for Science and International Affairs and a former U.S. assistant secretary of defense for policy and plans in 2015 who postulates that war between a rising power and an established power is inevitable:
"It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable." Thucydides from "The History of the Peloponnesian War"
"Prometheus Unbound" is as well a four act-lyrical drama by Percy Bysshe Shelleyn Mary Shelly's husband, first published in 1820. In the Act II Asia the daughter of Oceanus and Thetys a water nymph and Prometheus love interest, and her sister Panthea descend in Scene IV in the cave of the Demogorgon, the demon ruler of the underworld. In this scene Demorgorgon promises the rise of a new world, triggered by Prometheus' revolution against Zeus/Jupiter. At the end of this act the revolution is triggered, leading to a new order but we ramble again...

Basically, current face-off between the United States and China, and also with the United States and Europe as well as internal rifts between the European Union mark a tectonic shift and validates our views that we are moving from cooperation to noncooperation. In a certain sense, the old Jupiterian order is being challenged by a new Prometheus. This is of course leading to even more instability and volatility in financial markets.

In this week's conversation, we would like to look again at the evolution of the trade war narrative and the rising instability we are seeing as well as the starts of widening spreads in credit which should put some additional pressure on equities at some point.

  • Macro and Credit - Trade war? It's on like Donkey Kong
  • Final charts - Rollover risk? New debt is becoming more expensive...

  • Macro and Credit - Trade war? It's on like Donkey Kong
As per our previous conversation, the recent turmoil seen in equities markets is a symptom of the prevailing "mercantilism" and trade war narrative:
"Returning to our core subject of "mercantilism" and trade wars, it is looking more and more likely that in similar fashion to the 1930s, we risk seeing tit for tat reactions from China to additional US sanctions. Obviously equities markets are reacting to this. Emerging Markets were the big beneficiaries of globalization and cooperation. Following NIRP and ZIRP implementation by DM central banks, EM have benefited from the high beta chase and massive inflows into funds. With the QE tide receding thanks to QT and with the escalation of trade war fears, obviously EM are coming under much pressure, hence our reverse macro osmosis theory we have been discussing various times playing out." - source Macronomics, June 2018
As we pointed out as well, any escalation of the trade war rhetoric would lead to some stagflationary effects, higher prices and lower growth. If indeed there are additional measures taken for example against China, Chinese President Xi Jinping said last week he will not hesitate to retaliate against the U.S. on trade. This is indeed something to take note of.

On this very subject we read with interest Deutsche Bank US Economic Notes from the 19th of June entitled "The tit-for-tat trade barbs intensify":
"Trade tensions continue to intensify
We recently noted that the Trump administration has intensified trade uncertainties on a number of fronts. Over the past week, this intensification has focused on trade relations with China, where the administration announce plans for tariffs on $50bn of goods imports. The first tranche of tariffs, covering $34bn of Chinese goods, will begin to be collected on July 6. The second set of products covering $16bn of goods will undergo further review in a public notice and comment process, including a public hearing. In addition, the Administration threatened 10% tariffs on an additional $200bn of goods in response to China’s retaliation, and potentially another $200bn if China retaliates again.
In terms of timing, recall that the Trump Administration announced tariffs on the original $50 billion of goods on March 22. The product list was then released on April 3 with public hearings held in mid-May and the tariffs are expected to be collected starting July 6. We therefore assume that it would take around two to three months for the process to proceed to the implementation stage for the next $200 billion of goods. Given that the annual Chinese party meeting will take place in October and the US midterms in early November, we would not be surprised if tensions remain elevated for the next several months.
US businesses and consumers will be the prisoners of the latest dilemma
As we outlined in a recent note in April, the initial list of $50 billion of goods targeted for tariffs was relatively benign with respect to the potential impact on US consumers. In order to expand the list of goods to $200 billion, the US Administration would be hard-pressed to avoid large sectors such as consumer electronics. As Figure 1 illustrates, computer and electronics products accounted for a substantial portion of Chinese imports last year.
In fact, as Figure 2 outlines, the top 10 product codes in the USITC classification system account for a little over $150 billion of US imports from China.
This is important because as we can see at the top of the list, cell phones are the single largest category of Chinese exports to the US by dollar value, followed by tablets and laptops. These sectors combined represent over $80 billion of imports. It is likely that sourcing these products from other countries is not a near-term option for large US companies such as Apple. Therefore, these firms will then have to choose between absorbing the higher tariff costs via lower profit margins versus passing them onto consumers.
Growth implications
In our initial detailed look at possible trade war scenarios, we concluded that a trade war light scenario in which reciprocal tariffs were enacted that target somewhere between $50 and $100bn in goods, or equivalently around $30bn in tariff revenues, would shave -0.1 to -0.2 percentage points off of US growth. The proposed tariffs target a larger sphere of goods but at a lower weighted average tariff rate than we originally assumed, raising about $32bn in tariff revenue, or about 0.16% of nominal GDP. As such, the growth impact of this scenario is likely to be only slightly larger than we assumed in our original assessment, likely on the order of -0.2 to -0.3 percentage points. There is considerable uncertainty around this conclusion, owing to the difficulty in assessing supply chain disruptions and the response of financial conditions and consumer and business sentiment to the introduction of tariffs on a broad swath of goods.
In addition, our colleagues in China have noted that the cumulative impact of an escalation of the trade dispute would subtract -0.2 to -0.3 percentage points from growth in that region. China’s Ministry of Commerce issued a short statement, which promised to retaliate with "comprehensive quantitative and qualitative measures" if the US imposes more tariffs. As they had previously discussed (reports here and here ), US firms sold US$ 448bn worth of goods and services to China in 2017, $168bn through trade and $280bn through local operation by US subsidiaries in China. China has not threatened officially to target the US firms operating in China, but as the trade tension builds up our Chinese colleagues see that risk rising.
Inflation impact
According to analysis by San Francisco Fed economists, imports account for about 13% of the core PCE price index. The $50bn of goods targeted for a 25% tariff rate accounts for about 1.7% of total imports in 2017, while the $200bn in goods targeted for a 10% tariff rate accounts for about 6.9% of 2017 imports. If we assume that the types of goods targeted by tariffs are broadly representative, we find that core PCE inflation would rise by about 15 basis points (bps) in response to the implementation of these tariffs. Importantly, this would act as a one-time increase in the price level and thus provide a mostly transitory boost to inflation that would largely unwind in the following year.
Fed implications
With growth well above potential, the labor market beyond full employment and inflation near the Fed’s target, the Fed may be willing to tolerate a modest negative impact on growth, and Fed Chair Powell’s press conference indicated that he will likely need to see the negative implications in financial markets or economic data for the Fed to respond. However, with some willingness to tolerate above-target inflation, we think the Fed would very likely look through any rise in core goods inflation as “transitory”. Monetary policy makers would be more concerned about the second order effects on growth. Powell noted reports of companies holding off on making investments and hiring due to increased trade uncertainties when queried on the topic at his post-meeting press conference last week. Indeed, in the Fed's May Beige Book, tariffs were mentioned 22 times and business contacts noted that trade uncertainty was contributing to "supply chain disruptions" and have caused some firms to tap "the brakes on projects in the planning phases." Atlanta Fed President Bostic (voter/neutral) echoed these sentiments yesterday, noting that he has shifted his balance of risks to growth on the back of the recent escalation of trade threats.
It may need to get worse before it gets better
How far the trade tensions escalate will be determined by some combination of political and market pressure that is brought to bear on the issue. At some point, the potential economic damage and uncertainty caused by the trade tensions will precipitate a meaningful pullback in risk asset prices, forcing one or both parties to the negotiating table. How much of a drop in risk may be necessary to force the two parties to a negotiated settlement? As our equity strategist, Binky Chadha has often noted, 3% to 5% pullbacks in the stock market are a frequent occurrence. At the same time, 10% corrections are rare and signal up to a 50% probability of a recession, and the market generally drops 20% or more around actual recessions. We surmise that a correction approaching 10% should be enough to terminate the trade conflict unless it has gathered substantial momentum. A smaller correction could be sufficient if it was clearly induced directly by trade policy actions, though we admit that gauging the Administration’s reaction function is difficult.
Given the sound underlying fundamentals for US output growth over the next year, overall corporate earnings growth may be somewhat impervious to escalating trade tensions with China, but only up to a point. It is difficult to come up with direct effects from a tariff on $250bn of US imports from China plus a similar tariff on China’s $130 billion imports from the US ($160 billion including Hong Kong). This exercise becomes more complicated if regulatory measures are implemented that effectively act as capital controls. The book value of Chinese foreign direct investment in the US was over $27 billion in 2016 while that of US direct investment in China was over $90 billion. Our equity strategists estimate that a 0.2 to 0.3pp drag on GDP growth translates to a 1 to 1.5% hit to S&P 500 earnings growth. In the context of 2018 EPS growth which is on track to hit their forecast of 23% and 2019 growth estimated in double-digits, a 1-1.5% drag is not particularly significant. While the indirect effects of uncertainty and hit to business confidence are harder to gauge, they see corporates responding by putting more of their cash flow towards share buybacks, the primary driver of equities in this cycle from a demand-supply perspective.
In the meantime, China's review of Qualcomm’s $44 billion bid for NXP Semiconductors and the US handling of penalties against ZTE could be a litmus test of how this dispute could play out. A related issue concerns the progress of the Committee on Foreign Investment in the US (CFIUS) Modernization Act of 2018, which has been passed in the House but has not yet been debated in the Senate. This bill would provide a broad expansion of the government’s ability to review foreign investment. Further complicating matters is the Senate’s potential challenge to the Administration's handling of the ZTE penalties. Congress still has a busy schedule ahead of the August recess, which the Senate majority leader has threatened to cancel.
Other areas of potential conflict lie waiting in the wings as well. Soundings from the Administration indicate that tariffs on trade in autos could be in the offing, and important negotiations regarding NAFTA remain well short of a satisfying conclusion. Should the Administration choose to move ahead with auto tariffs and withdraw from NAFTA, the potential for an economic downturn will intensify significantly. In short, there will likely be no rest for the weary among trade warriors and their watchers in the months ahead. - source Deutsche Bank
Both Chinese elections and US elections could be seen as a catalyst for more posturing from both countries in the search for domestic political support. This will no doubt continue to create market jitters and increased volatility in the near term. Therefore we continue to see more pain ahead for Emerging Market (EM) and overall US stock markets should continue to outperform on a relative  basis. 

From an allocation perspective, we continue to think that any escalation in trade war would be bullish for gold, which recently has been weakening. We also think as well that the US long end is starting to be enticing.

Any escalation in trade war would have various consequences. On this subject we read Bank of America Merrill Lynch's take in their Liquid Insight note from the 20th of June entitled "Implications of trade war on rates and FX":

"Trade wars: near-term lower rates and flatter curve
As trade skirmishes continue to deepen, we see increased risk to our base case year-end outlook of 3.25% 10y rates, while our flatter curve view and wider 5y inflation breakeven view appear less vulnerable. The rates market impact of an escalation of trade tensions will naturally depend on the depth and severity of tariffs and retaliatory actions, but recent rhetoric suggests trade escalation may need to get worse before it gets better.
While views vary across outcome probabilities, our Global and Chinese Economics teams see an increase in trade risks.
Should trade tensions worsen, this would likely contribute to lower levels of nominal and real rates, an initially flatter curve, wider short-dated breakevens, and a stronger USD. The Fed would likely be undeterred from near-term hikes, but increased trade friction would likely force them into a slower medium-term path and lower terminal rate for this cycle. The sharp decline in payer skew (ie, declining cost of higher-rate protection) we think confirms the shifting of market probabilities toward the escalation scenario versus a benign outcome. With 3m-5y payer skew now at its lowest since 2007 (+25bp out vs - 25bp out), contrarian traders could take advantage of historically cheap valuations to position for a near-term benign outcome.
Should trade tensions increase, we would expect rates to initially decline with more severe risk off and the curve to flatten as the Fed likely remains on course for further rate increases later this year. However, over time, we would expect that the Fed will need to react to the weaker global growth backdrop by stopping their tightening cycle and potentially cutting rates, which would allow the curve to steepen. As discussed here, this environment would be supportive of wider short-dated breakevens and we also see risks of lower real rates along with a flatter breakeven curve. We also see risks that a material increase in trade tensions could result in less foreign investor sponsorship of US Treasuries, which would contribute to higher rates and term premiums in the longer run.
Fed’s reaction: flatter curve and lower long-term rates
Overall, we think a trade war escalation is unlikely to deter the Fed from near-term hikes but would likely result in a slower medium-term path and lower terminal rate for this cycle.
We see the Fed’s response to a trade-war escalation as occurring through two phases:
  • Near term: the Fed will likely refrain from overreacting to the increase in trade tensions and aim to continue with two additional rate hikes this year. The Fed has repeatedly indicated it does not see a meaningful impact from trade tensions in the data thus far. Chair Powell responded to a question on trade in his most recent press conference by saying that “we don’t see [trade tensions] in the numbers at all. The economy is very strong. The labor market is strong. Growth is strong. We really don’t see [trade tensions] in the numbers, it’s just not there.” That said, Powell and other Reserve Bank Presidents (ex. Atlanta Fed President Bostic) have indicated risks from trade tensions are rising among their business contacts. We expect the Fed will likely refrain from altering the direction of policy until these tensions are more evident in economic data or through a sustained tightening in financial conditions.
  • Medium term: the Fed may need to reduce the total number of rate hikes over the course of this cycle and realize a lower terminal rate. Although tariffs will likely place near-term upward pressure on inflation, we expect the Fed will look through this dynamic and instead focus on underlying softening global growth and consumer demand. This would pose risks to the number of hikes the Fed delivers in 2019 or 2020 and result in a lower terminal rate for this cycle. This assumes any near-term tariff-induced increase in the price of goods would be expected to be short lived and not spill over into longer-run inflation expectations, which is our base case view. If trade tensions result in a rapid escalation of tariffs and protectionist policies, a severe trade war could suppress growth and potentially cause the Fed to consider rate cuts.
Rates reaction: lower rates, higher breakevens, flatter B/E curve
US Treasury rates would likely decline with a further material increase in trade tensions. Rate declines would be led by risk-off dynamics and lower growth expectations. Based upon our expectations for the Fed, the initial response from the rates market would be to price in a flattening of the curve as the front end responds to tightening while 10y and 30y rates remain low due to declining growth expectations and a lower pricing of the terminal rate. As the Fed shifts their reaction function, we would expect the Treasury curve to steepen due to lower expectations for rates hikes and potential concerns about overseas demand for Treasuries.
Within the composition of the rate moves, we would expect wider near-dated inflation breakevens, lower real rates, and a flatter breakeven term structure. Based on market reactions to tariffs in recent years (Table 1) including Bush’s steel tariff, Obama’s tire tariff, and Trump’s recent washing machine and aluminum/steel tariffs, the clearest market reaction is higher breakevens and a flatter breakeven curve.

This was particularly pronounced following the 2002 tariffs on steel, and on average still holds for the more recent measures. While we intuitively anticipate a decline in real rates in the face of tariffs, on a historical basis the real rate reaction has been mixed: 2y real rates tend to decline, but otherwise real rate levels increased on average following the announcement
of a new tariff.
Given these expectations, we see upside potential in our 5Y breakeven widener view. We originally recommended this view due to the economic backdrop and positive carry dynamics, but also see this position benefitting from an escalation in trade concerns. Any surprise from OPEC later this week to not expand supply would also benefit higher short-dated breakevens.
Reserve manager impact: upward pressure on rates after the initial risk-off
Trade tensions are likely to result in weaker UST demand from foreign central banks due to slower FX reserve build and less likely due to trade retaliation. From a flow perspective, a key channel between trade tensions and rates is reserve manager demand. Foreign investors accumulated roughly $6.2tn of US Treasuries over two decades as a result of international trade and market intervention, and $4tn of them are held by reserve managers. China and Japan are the biggest creditors of the US government, holding about 7% of overall marketable Treasury securities each. According to the latest TIC survey, foreign central banks hold mostly front-end to intermediate maturities (Chart 1).

After an immediate risk-off episode, the medium-term reduction in bilateral trade deficit between the US and China should result in a slowdown in China’s FX reserve build, resulting in lower Treasury demand from China. Lower global trade volumes should result in a slowdown of global reserve accumulation, less central bank demand for USTs and upward pressure on interest higher rates (Chart 2).
We think it is unlikely, however, that central banks would sell Treasuries as a retaliatory measure in trade discussions. It is unclear if Treasury selling would have the desired market impact given the mixed history. From 2015 to 2016, foreign official investors sold over $400bn in Treasuries (per TIC data), yet 5y and 10y UST rallied by 60-100bp. In theory, any sizable selling from CBs may be more concentrated in the shorter duration bucket, where the majority of central bank holdings are located. Given the significant demand in the front end this year (Chart 3, 70% of government mutual fund inflows have been concentrated in the very front end as demand for cash like assets surged), the impact of outright UST selling from CBs may not override the flight to quality bid and the repricing of Fed path, as observed in 2015-16. However, such reserve manager selling would likely serve to tighten swap spreads.
USD: accelerated appreciation
In our view, an escalation of trade war rhetoric would serve to accelerate USD appreciation that is already well underway as a result of cyclical and monetary policy divergence, with the added boost to the dollar essentially a function of the severity of perceived global trade deterioration. Under a scenario of a sharp pickup in trade policy deterioration, we would expect the dollar to sharply appreciate bilaterally against most currencies with the exception of the yen, which despite its substantial export sector tends to be supported in risk-off situations due to its large net foreign asset position. USD returns would likely be highest against the higher beta currencies of economies perceived to be most vulnerable to a slowdown in global and/or US trade, a list traditionally including CAD and AUD among others. Recent sharp deceleration in Euro Area data as a result of rising trade tensions early in the year suggests to us that EUR is also perceived to be included here." - source Bank of America Merrill Lynch
Escalation of trade war would see risks of lower real rates along with a flatter breakeven curve in the near term while obviously a rising US deficit would be negative in the long run for the US yield curve overall as foreign investors might shun purchasing additional US Treasuries.

There indeed mounting signs that in some places global trade and growth are slowing down. The trade war rhetoric is adding to this trend as of late. The risk-off environment can again be ascertained from fund outflows as indicated by Bank of America Merrill Lynch Follow The Flow note from the 22nd of June entitled simply "Cutting risk":
"Trimming longs
With credit spreads been broadly flat over the past couple of weeks, it seems that high grade investors have been trimming risk (chart 1) amid fears that Italian risk will not subside any time soon.

Notably all the major asset classes we track have recorded outflows last week, as trade wars have also supported the risk-off momentum.
Over the past week…
High grade fund flows were negative for a fifth week in a row; note that the majority of the outflow came from two funds.
High yield funds continued to record outflows (32nd consecutive week). Looking into the domicile breakdown, global and to a lesser extend European-focussed funds have recorded the largest outflows, followed closely by the US-focused funds.
Government bond funds recorded a third outflow last week; however the pace of the outflow has more than halved w-o-w.
All in all, Fixed Income fund flows were for a fifth week in negative territory, as the major individual pockets recorded outflows.
European equity funds continued to record outflows for the 15th consecutive week; over that period the asset class has suffered $39bn of outflows.
Global EM debt funds also recorded an outflow last week - the ninth in a row - with the trend deteriorating w-o-w, the dollar strength is heavily weighing on the asset class. Commodity funds recorded sizable outflows, the largest since 2013.
On the duration front, short-term IG funds recorded outflows, reversing last week’s inflow. Mid-term funds recorded their fifth weekly outflow in a row. However, long-term funds have seen inflows after a week of inflows." - source Bank of America Merrill Lynch
What is of course of interest to us from a credit perspective is the developing weakness in credit spreads. We did notice that US Investment Grade has so far clearly underperformed US high beta in the High Yield space, partly because of the Energy sector being a heavyweight in the CCC rating bucket. This disconnect has been highlighted in another Bank of America Merrill Lynch report, their latest Situation Room report from the 25th og June entitled "Let's get back together":
"Let’s get back together
Recently IG underperformance vs. HY in USD credit markets has been remarkable (Figure 1).

Reasons for IG weakness include first and foremost supply pressures in an environment of reduced demand that began in March and extended through last week, plus the Italian situation, which is about systemic risks running through the global IG financial system. Reasons for HY strength include the lack of supply, etc. Trade war risks are probably more neutral across the credit spectrum, as we saw today. We think IG spreads are somewhat predictable based on seasonal supply volumes and that we increasingly will be able to decouple from the Italian risks. That leaves IG spreads currently at the wide end of the range and with our HY strategist, Oleg Melentyev’s, outlook for wider spreads (see: High Yield Strategy: Scarcity of Yield is Now History 15 June 2018), that suggests decompression." - source Bank of America Merrill Lynch
What is of course of interest to us is that the recent in Investment Grade credit in the US in conjunction to a rising US dollar should seduce again foreign investors, and even Japanese investors, given their yield appetite. This is confirmed by Bank of America Merrill Lynch Credit Market Strategist note from the 22nd of June entitled "The return of foreign investors":
"USD corporate bonds now again offering better hedged yields than EUR
A couple of Fed rate hikes later, some spread widening and the USD corporate bond market is now again offering higher currency hedged yields for foreign investors than its EUR counterpart for most relevant maturities (Figure 6, Figure 7).

Specifically higher hedged yields can be obtained in USD credit inside 7-8 year maturities, which includes more than two-thirds of the EUR market."  - source Bank of America Merrill Lynch
Clearly, it appears to us that the divergence between US High Yield and US Investment Grade is not warranted. The recent decoupling to us should correct itself. Although high beta has been performing strongly, we think that in the second part of the year we could see a reversal with Investment Grade outperforming should a deceleration in growth materialize.

As pointed out in our most recent musing, US High Yield has had a much better performance overall than EM High Yield and even against US Investment Grade. But, US High Yield has started to look expensive. On that note we agree with Deutsche Bank's US HY Strategy note from the 26th of June entitled "USD HY looking increasingly expensive":
"In a year that has proved challenging for credit market returns, the USD HY market has proved something of a relative bright spot. In Figure 1 we show YTD total returns across the credit spectrum in local currency terms, ordering performance from best to worst. We can see that USD HY is one of the few parts of the credit market that has provided positive total returns, with CCCs and Bs, the standout performers. This is very much in contrast to the performance of USD IG credit, which has seen the worst of the YTD performance, weighed down by the extra duration and associated impact of rising Treasury yields.
The higher yields available in USD HY, particularly for lower ratings, certainly help to provide higher returns, but as we can see in Figure 2 it is also the only part of the credit market that has seen tighter spreads at an index level so far this year. It is worth highlighting that the strength of this performance is really being driven by CCCs and Bs, with the returns and spread moves for BBs much closer to what we've seen from USD IG credit, even though BBs have still outperformed IG.
Given this relative strength from USD HY we try to assess whether such outperformance makes sense and whether this part of the credit market is becoming excessively expensive.
USD HY broadly in line with volatility
In the left hand chart of Figure 3 we update our analysis comparing USD HY credit spreads against a volatility implied spread series.

(click to enlarge) 
We can see that spreads have continued to broadly track the volatility implied series, although it's clear that the reaction of USD HY credit spreads to the spike in volatility earlier this year was limited. As recently as a couple of weeks ago, the two series were in line but HY spreads have generally remained firm, even as we've seen a rise in volatility around trade tensions. The current differential has USD HY spreads around 70bps tighter than the volatility implied level. So this measure is suggesting USD HY is on the expensive side now. Interestingly, a quick comparison of the same measure with IG credit spreads shows that the opposite is currently true, with USD IG credit spreads actually wider (around 10bps) than the volatility implied level, even after the recent move higher in volatility.
HY vs. IG
We've already highlighted in terms of total returns that USD HY has comfortably outperformed USD IG. In Figure 4 we show the relative spread ratio which shows that at the start of 2018 the ratio was as high as it had been since the GFC.

This would arguably suggest that HY looked relatively cheap to IG at this point and therefore it is understandable that HY has outperformed. That said, the ratio is now towards the lower end of the post GFC range so the same indicator is now suggesting USD HY looks expensive compared to USD IG. If you remain bullish on USD HY you may point to the fact that the more domestic based issuers are less trade war sensitive than say IG companies. However if it eventually leads to a recession, these companies will eventually be hit hardest, so it is very hard to say they are a safe place to hide, in our view.
Last month we published a more detailed note considering the relative value between EUR and USD HY ( link ), and here we provide an update of the simplest part of that analysis comparing broad index spreads for USD and EUR HY. At the time USD HY spreads had been tightening relative to EUR HY spreads but at an index level were still wider. As we can see in Figure 5 that is no longer the case with USD spreads now around 20bps tighter than EUR spreads.
 (click to enlarge) 
That said, the outperformance of USD HY can, in part, be justified by the fact that on this measure in Q4 2017 EUR HY was about as tight to USD HY as it had been since the GFC. However with this differential now back in positive territory and towards the upper end of the post-GFC range, USD HY is now looking fairly expensive on this measure and this does not even take into account the lower credit quality of the USD HY market compared to EUR HY.
We've shown that USD HY has compared favourably, performance wise, to other parts of the main corporate bond markets and that this outperformance has not been entirely unjustified. However there is certainly evidence that it is looking increasingly expensive. We now compare with some other parts of the broader credit spectrum; starting with EM.
DM vs. EM (USD HY vs. USD EM HY)
It's certainly interesting to look at how these two asset classes have performed relative to one another this year. YTD total returns for EM credit are currently less than -5%. This is not only weak compared to the positive total returns produced by USD HY but also compares unfavourably with other parts of the credit spectrum we have already used for comparison.

Interestingly, through Q1, total returns for both HY and EM were around -1%, so all of the divergence has really occurred during Q2. This is fairly well highlighted in Figure 7 which looks at the relative spreads of the two asset classes. 
 (click to enlarge) 
The spread differential had fluctuated in the 20-80bps range from late 2015 to the end of Q1 2018. However over the course of the last few months this has widened from less than 30bps to more than 150bps. Whether this says something about the relative attractiveness of USD HY now is probably a little more complicated. It can be argued that these relative moves are justified by the implications of Fed actions of late. USD HY should benefit from the same growth dynamics that have allowed the Fed to hike rates and therefore it's reasonable for spreads to keep tightening or at least remain tight. At the same time higher rates in the US can have negative implications for EM currencies and expose potential economic weakness and therefore lead to spread widening for EM sovereign credits. We have seen this recently for countries such as Argentina, Brazil and Turkey. We can also look to 2013 when there was also a notable divergence. This occurred around the time of the taper tantrum with the potential for the removal of monetary accommodation a likely factor here too. The EM-DM differential went from around 0bps in Q1 2013 to nearly +200bps by the end of September and as much as +280bps during Q1 2014 before hitting a peak differential of more than 400bps in early 2015. The differential only closed at the height of the recent energy/commodity crisis.
Given the likely drivers of the divergence, we're not sure in isolation whether the underperformance of EM in recent months is a particularly strong barometer. That said, given that other measures are suggesting USD HY looks expensive then it only adds to the story.
Bonds vs. loans
One comparison that is not so flattering for USD HY is the performance compared to the loan market. Figure 8 shows YTD total returns for bonds against loans and highlights that so far in 2018 loans have outperformed bonds by more than 1.5%.

So based on this comparison with broadly similar rated securities, there is nothing exceptional about the performance of USD HY. Clearly the floating rate nature of loans has helped here but we can see that loan returns are also much less susceptible to mark-to-market volatility and have therefore provided a more steady accumulation of carry this year. Looking at relative spreads in Figure 9 we can see that despite the underperformance in returns, spreads for USD HY do not look attractive on a relative basis.

In fact, current bond spreads are tighter than loan spreads at an index level and whilst this has largely been the case for the past 18 months or so, it is actually a fairly rare event historically. So in this instance, the performance of USD HY does not standout but it still looks relatively expensive on this measure.
Based on all of the simple relationships we have analysed, USD HY looks quite expensive. Our expectation for the remainder of the year, as we highlighted in our recent outlook update , is that USD HY is likely to underperform other parts of the credit universe." - source Deutsche Bank
Simply put, there is potential for a reversal of fortune for US Investment Grade credit versus US High Yield particularly in the light of the performance in High Yield being in the high beta bucket with CCCs taking the lead. As liquidity is withdrawn by central banks and financial conditions start tightening, it will become more and more expensive to issue debt for the weakest players. Some might say that the lack of issuance will therefore continue to provide a technical bid to the asset class, given the very high correlation with the S&P 500, we do not think US High Yield will be spared as it was in the second part of 2018. 

If indeed financial conditions are tightening and liquidity is being withdrawn, then again high beta such as EM will continue to suffer as per our final charts, this mean debt is becoming more expensive. 

  • Final charts - Rollover risk? New debt is becoming more expensive...
Many pundits have pointed out the correlation between liquidity being withdrawn and tightening financial conditions. Obviously the credit spigot is being gradually closed by the Fed and it remains to be seen when corporate America's debt binge to finance buybacks will turn. On this subject our final charts come from Wells Fargo Economics Group report from the 20th of June entitled "Corporate America's Debt Binge: An Issue When Rates Rise?":
"Corporate debt has risen to 45 percent of GDP, equal to the peak of the previous expansion. Low interest rates and longer payment periods have kept corporate debt cheap, but these trends are beginning to reverse.
Nonfinancial Corporations Load on Debt
The overall U.S. economy has become less indebted since the Great Recession, with domestic debt outstanding as a percent of gross domestic product (GDP) falling to 330 percent in Q1 from more than 370 percent at the start of 2009. Shrinking debt relative to GDP is mainly due to deleveraging in the household and financial sectors, while debt has grown faster than GDP for government and nonfinancial business (below chart).

Aside from government, the largest debt gains have occurred in the nonfinancial corporate business sector. Corporate debt growth turned positive in 2011 and has averaged 5.8 percent a year since, propelled higher by low interest rates and robust investor appetite for fixed income securities. As a percent of GDP, corporate debt is currently sitting at its highest level of the cycle (45 percent) and is equal to the peak of the previous expansion.
Lower Interest Rates and Longer Payment Periods
The interest rates corporations are paying on their debt remain far below historical levels, which has helped to keep debt servicing costs low relative to the amount of debt corporations are holding on their balance sheets. We look at interest expense as a share of total short-term and long-term debt as a proxy for the average interest rate paid by corporations (below chart).

This measure fell substantially after 2009 as the Federal Reserve cut the benchmark rate, and remains below the lows of the 2001-2007 cycle for retail trade and all major manufacturing industry categories. Also limiting the corporate debt burden is a shift toward more long-term debt, which means lower principal payments due in each period (bottom chart).

Short-term debt (due in less than one year) represented 9.4 percent of debt held by manufacturing and retail corporations in Q1. This compares to over 13 percent at the end of the previous expansion.
In Q1, manufacturing corporations owed $505 billion on their debt in the coming year (short-term debt plus installments due on long-term debt), while large retail corporations owed $73 billion. These obligations amount to 19.1 percent and 12.6 percent of current assets, respectively. Even though interest rates and the short-term share of debt are lower than during the 2001-2007 expansion, high debt loads mean that debt payments coming due relative to current assets have far surpassed levels of the previous expansion.
But… Debt is Becoming More Expensive
In the past year, the short-term share of debt and the interest rate proxy have risen for corporations, reversing previous trends. Therefore, debt is set to become more expensive. Given strong economic growth and profits, leverage is not overly concerning at present. However, should investor appetite for debt wane or benchmark interest rates go up quickly, funding new debt could fast become more onerous for U.S. corporations." - source Wells Fargo.

Looks like Prometheus is indeed "unbound" and that there could be some "revolutionary" changes down the line for financial markets. For many years the Fed had your back. Not anymore. If indeed there is an escalation in trade war leading to a stagflationary outcome, then one would expect US long Treasuries and long duration Investment Grade to start outperforming again in the near term. In similar fashion to Demorgorgon promising the rise of a new world, triggered by Prometheus' revolution against Zeus/Jupiter, liquidity withdrawal should be taken very seriously , particularly for EM. As we stated before, liquidity matters more than fundamentals in many instances as our reverse macro osmosis thesis discussed recently played out which is an illustration of "Sudden Stops: A Primer on Balance-of-Payments Crises" as we were reminded by this excellent article (H/T Alibey Tuncer). Things are starting to get interesting...

"The story of 'Prometheus' is the idea that if you're given a gift from the gods, do not abuse it, and do not think you can compete." -  Ridley Scott
Stay tuned !

Tuesday 19 June 2018

Macro and Credit - Mercantilism

"What generates war is the economic philosophy of nationalism: embargoes, trade and foreign exchange controls, monetary devaluation, etc. The philosophy of protectionism is a philosophy of war." - Ludwig von Mises

Looking at the strong yet short bounce in equities following market jitters on Italian wobbles (while enjoying some much needed R&R hence our lack of recent posting), indicative of our "white noise" previous analogy, given the acceleration in the trade war rhetoric in the G7, soon to be G6 by the look of it, when it came to selecting our title analogy we decided to go for the simple one of "Mercantilism". "Mercantilism" is a national economic policy designed to maximize the trade of a nation and, historically, to maximize the accumulation of gold and silver (as well as crops). Mercantilism was dominant in modernized parts of Europe from the 16th to the 18th centuries before falling into decline, although we would argue that it is still practiced in the economies of industrializing countries in the form of individual rights. High tariffs, especially on manufactured goods, are an almost universal feature of mercantilist policy. Even if mercantilism and protectionism are applied through the same economic measures, they have opposite aims. Mercantilism is an offensive policy aimed at accumulating the largest trade surplus (China, Germany). Conversely, protectionism is a defensive policy aimed at reducing the trade deficit and restoring a trade balance in equilibrium to protect the economy (United States). Mercantilism is the economic version of warfare using economics as a tool for warfare by other means backed up by the state apparatus, that simple. In our previous conversation we reminded ourselves our thought from October 2016, namely that we were drifting towards the inevitable longer-term violent social wake-up calls: populist parties access to power, rise of protectionism, the 30’s model. 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
Hence our "Mercantilism" analogy or basically the reality is that we are fast moving from a cooperative world to a non-cooperative world à la 1930s. It isn't only tensions rising between China and the United States, or United States with Europe, there is as well growing tensions between European country and internal tensions rising even in Germany putting Merkel's feeble coalition at risk thanks to political tensions surrounding immigration issues. We would like to repeat what we we wrote in June 2012 in our conversation "Eastern Promises":
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in "The Daughters of Danaus")."  
Remember, it is still a game of survival of the fittest after all:

"While differences between the Soviet Union and the EU are greater than their similarities, there are parallels that may prove helpful in assessing the debt crisis, historians say. Both were postwar constructs set up in response to a collective trauma; in both cases, the founding generation was dying out as crisis hit and disintegration loomed." - source Bloomberg.
Also in June 2012, in our conversation "The Unbearable Lightness of Credit" we argued the following:
"We do see similarities in the current European "complacent" situation with the Brezhnev Doctrine, first and most clearly outlined by S. Kovalev in a September 26, 1968 Pravda article, entitled "Sovereignty and the International Obligations of Socialist Countries".
This doctrine was announced to retroactively justify the Soviet invasion of Czechoslovakia in August 1968 that ended the Prague Spring, along with earlier Soviet military interventions, such as the invasion of Hungary in 1956. "In practice, the policy meant that limited independence of communist parties was allowed. However, no country would be allowed to leave the Warsaw Pact, disturb a nation's communist party's monopoly on power, or in any way compromise the cohesiveness of the Eastern bloc. Implicit in this doctrine was that the leadership of the Soviet Union reserved, for itself, the right to define "socialism" and "capitalism"." - source Wikipedia.
The Brezhnev Doctrine is interesting in the sense it was the application of the principal of "limited sovereignty". No country would be allowed to break-up the Soviet Union until, the "Sinatra Doctrine" came up with Mikhail Gorbachev.
"The "Sinatra Doctrine" was the name that the Soviet government of Mikhail Gorbachev used jokingly to describe its policy of allowing neighboring Warsaw Pact nations to determine their own internal affairs. The name alluded to the Frank Sinatra song "My Way"—the Soviet Union was allowing these nations to go their own way" - source Wikipedia
"The phrase was coined on 25 October 1989 by Foreign Ministry spokesman Gennadi Gerasimov. He appeared on the popular U.S. television program Good Morning America to discuss a speech made two days earlier by Soviet Foreign Minister Eduard Shevardnadze. The latter had said that the Soviets recognized the freedom of choice of all countries, specifically including the other Warsaw Pact states. Gerasimov told the interviewer that, "We now have the Frank Sinatra doctrine. He has a song, I Did It My Way. So every country decides on its own which road to take." When asked whether this would include Moscow accepting the rejection of communist parties in the Soviet bloc. He replied: "That's for sure… political structures must be decided by the people who live there." - source Wikipedia 
Could Europe allow for the adoption of the "Sinatra Doctrine"? We wonder, but nonetheless, before we enter into the nitty gritty of our long overdue new conversation, we thought it would be interesting to remind ourselves of the above given our take for Europe from our November conversation "Chekhov's gun" is still as follows:
"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…)." - source Macronomics, November 2014

In this week's conversation, we would like to look at the continuous adverse effects of moving from QE to QT, and the impact is having on Emerging Markets with rising tensions as well on the trade war front. 

  • Macro and Credit - The receding QE tide thanks to QT will expose those who have been swimming naked...
  • Final charts - Capital Flows? This time it's really different.

  • Macro and Credit - The receding QE tide thanks to QT will expose those who have been swimming naked...
While the short-vol pigs house of straw was the first casualty to go in the change in the sea of liquidity provided by our "Generous Gamblers" aka our dear central bankers, Emerging Markets have been of course next in the line in the change of the narrative with the return of  "Mack the Knife" aka rising US dollar and positive US real rates. We wrote in our last missive that investors were moving back into assessing the "return of capital" rather than the "return on capital". This is creating rising dispersion thanks to investors being more "issuer credit profile" sensitive with the return as well of US cash in the allocation tool box. The rise in dispersion should continue to make active management benefit from this trend after years of being in the shadow of passive management and consequent fund inflows into ETFs.

With the receding tide of cheap liquidity, there is no doubt an intensification in the competition for capital. When it comes to credit, we have recommended to start moving up the quality spectrum and tone down the high beta game, basically meaning being more defensive that is as the game is changing.

Sure some pundits when it comes to Emerging Markets would like to point out to "fundamentals". Yes they do indeed matter particularly when looking at current accounts, but in the end, if there is spillover and contagion from the "usual suspects" with Argentina, Turkey and now Brazil, then what will matter much more is "liquidity". Right now liquidity is being drained by central banks, this will ensure financial conditions tighten. As many have pointed out, including ourselves, the Fed will hike until something breaks, and in the end, what drives the credit cycle is simply the Fed. On the matter of liquidity, which we think is paramount, we read with interest Morgan Stanley's take from their FX Pulse note from the 14th of June entitled "Liquidity Breaks Correlation":
 "Global liquidity… 
The pool of global liquidity appears to be starting to shrink. Several factors are at play here. First, the Fed's balance sheet reduction is increasing pace while the ECB and BoJ are reducing their asset purchases (Exhibit 8).

On net, global central bank liquidity is likely to turn negative over time when compared to GDP growth. Second, the global economic expansion suggests that capital will increasingly be allocated to 'real' economic uses as opposed to financial assets. A closed output gap suggests rising capital demand as spare capacity is eroded, and investment into new capacity requires financing.
Third, the flattening of the US yield curve has reduced the incentive of local financial institutions to transform short-term liabilities into long-term assets (maturity transformation). If banks are less willing to generate liquidity through the maturity transformation process, another buyer will have to step in to make up for the shortfall. Japanese banks liquidating their FX-denominated assets is evidence that demand for US assets is falling outside the US as well, meaning tighter liquidity conditions as demand for financial assets declines (Exhibit 9).
Tighter liquidity conditions suggest higher volatility as the risk-absorbing capacity of markets declines. When liquidity is ample, all boats tend to get lifted. The reverse effect may be more selective, though. EM volatility has risen sharply, but DM volatility, with the exception of some credit markets, has been relatively muted (Exhibit 10).

Indeed, US equity markets are trading near historical highs, while the 10-year Treasury yield fell back from the recent 3.12% cycle high. It seems the liquidity pool is both shrinking and becoming more concentrated, too. One explanation for the differential in volatility is that we have simply seen a rotation – out of EM and into DM – which explains why DM volatility has been relatively muted compared to EM. This too suggests that a positive outlook for US shares may no longer imply that EM assets will perform well too if they increasingly attract funds at EM assets' expense.
The feedback loop: It is likely that recent market thinking and positioning have been, at least in part, impacted by RBI Governor Patel's recent op-ed where he suggested that the Fed's balance sheet reduction, coupled with rising US public deficits and private debt levels, is leading to an absorption of offshore USD liquidity. Many EM economies experienced recessions following the US taper tantrum in 2013, which in turn resulted in balance sheet consolidation and reduced foreign funding needs. Still, EM countries require capital inflows to keep the economic expansions in place, particularly in the current environment of closed output gaps where spare capacity is increasingly scarce.

Indeed, 2017 saw record inflows into EMs, but this has turned into outflows, tightening local financial conditions and thus their economic outlooks. If not addressed, this issue could create bearish economic feedback loops where liquidity outflows worsen the growth outlook, resulting in more outflows, and leading to even more weakness.
Thus, it may be argued that the US fiscal expansion, implemented at a time when the US output gap was closed and global funding costs were at the lows (and are now rising), may actually reduce the length of the global economic cycle, sowing the seeds for financial asset volatility and investors increasingly seeking safety. Our bearish risk outlook projected for 2H18 has gained traction, we think.
The FX message: Currencies not requiring capital imports and running net foreign asset positions should perform best in this scenario, explaining our bullish JPY call. EUR and Nordic currencies offer value too in this regard. As long as markets only de-correlate but do not fall collectively, CHF should weaken, though. As noted above, the relatively low risk of its asset position suggests that it is not much exposed to waning risk sentiment; otherwise, its income balance would be far higher. Thus, CHF may benefit less than the other surplus currencies should risk sell off. CHFJPY shorts may begin to look attractive again." - source Morgan Stanley
While we got out of EM equities back in January this year following impressive performance in 2017, we continue to believe that US equities will fare much better relative to EM in 2018, contrary to what played out in 2017. Fund flows related wise, in similar to US High Yield, where there is a large contingent of retail punters, Emerging Markets are starting orderly retreat from the asset class at a rapid pace. This is confirmed by Bank of America Merrill Lynch GEMs Flow Talk note from the 14th of June entitled "EXD & LDM outflows continue… 8th straight week down; big blow for EXD":
"EPFR fund flows down: EM debt 8th consec week down
• EXD, LDM and EM Equity were all down, while blended funds were slightly up.
• 8 negative weeks in a row for overall EM debt, outpacing the large negative trend recorded at the end of 2016 (six consecutive weeks down) but still not as bad as the one registered since Oct 15 – Feb 16 (18 consecutive weeks down).
EPFR aggregate EM debt flows were down -0.3% total.
-0.1% for Local Debt (LDM), -0.5% for External Debt (EXD),
+0.1% blended funds and -0.1% EM equity.
• ETF flows were down in LDM but positive in EXD (-0.2% and +0.2%).
EXD outflows are from retail and mild vs 2013
EXD funds now have a small negative total YTD outflow after this week. They are still quite small compared to the large wave of outflows in 2013, at a time when retail investors were a larger part of the EM market (Chart 1).

We do not think they returned.
The outflows reported by EPFR have been almost entirely from small retail accounts who are less than 5% of the EXD market ($66bn AUM of the $2.4tn EXD outstanding). The remaining funds monitored by EPFR are another 5% of the EXD mutual funds in the US, SICAVs in Europe and ETFs. (Table 5).

The rest, who do not report weekly, include mainly large privately managed accounts, pension funds, sovereign wealth funds, insurance companies and banks and who are the mainstay of the EM buyer base. Our institutional managers do not report these sorts of institutional outflows at this time, and we believe there are still EM mandates expected." - source Bank of America Merrill Lynch
In a competitive system for capital allocation, with the receding QE tide thanks to QT, we are much more concerned about the "corporate sector" due to dollar funding and leverage in some instances. We have also voiced our concern in our October 2014 conversation "Sympathy for the Devil" in relation to the particular vulnerability of LATAM and the large part of Brazil High Yield risk representing $30 billion of EM dollar denominated debt issued out of $116 billion with the top sector being energy with $27.7 billion of exposure so watch what oil prices do going forward, not only what the US dollar does. It is not a surprise to see LATAM High Yield down 3.8% YTD compared to Asia High Yield only down 3.3% YTD. Overall in both EM and DM, credit has suffered more than equities when US High Yield has been much more stable relative to EM as well.

One might ask itself that if indeed the short-vol yield pigs house was made of straw, then maybe the EM yield pigs house is made up of wood and the next step could be a full blown EM crisis on our hands. Bank of America Merrill Lynch made some interesting points in their Credit Market Strategist note from the 8th of June entitled "When the tides goes out":
"EM crisis?
Other markets benefiting from QE include EM. With a rising dollar the greatest rollover risk is now for countries that have relied on external dollar denominated financing and are running deficits. Hence, this year’s worst performing countries in terms of currency depreciation and sovereign CDS include Venezuela, Argentina, Turkey and Brazil (Figure 1).

In terms of spillover risk to US credit, we would de-emphasize the EM story and focus on Italy and the European sovereign situation, which has much more cross-exposures to the US and systemic risk to the global financial system. Of course, the Italian story is also partially an outcome of QE that allowed cheap deficit financing, and made worse with the coincident timing of ECBs coming final taper (Figure 2).

Another important contributing factor has been a fixed exchange rate (euro member), which used to be how EM countries got into trouble via large current account deficits." - source Bank of America Merrill Lynch
Sure fundamentals matter, but given the receding tide in liquidity thanks to central banks turning slowly turning off the tap, more and more liquidity will matter. There is as well the L word for leverage and on that point we are worried about US corporate leverage which has been creeping up in recent years on the back of a buyback binge. To illustrate this we would point out towards another point made in Bank of America Merrill Lynch note about the state of credit fundamentals:
"Final update on 1Q credit fundamentals
Based on almost final data for 1Q (covering 97% of companies), gross leverage for US public non-financial high grade issuers increased to 3.04x in 1Q from 2.98x in 4Q, while net leverage rose to 2.67x from 2.54x. Both gross and net leverage are now the highest on record (Figure 36).

For our “core” issuers excluding Energy, Metals and Utilities gross leverage was 2.39x, up from 2.34x in 4Q but below 2.40x in 3Q-17. Net leverage increased to 1.79x from 1.59 in 4Q (Figure 37).

The coverage ratio fell to 8.23 in 1Q from 8.44 in 4Q for the full universe of issuers (Figure 38), and was a bit lower at 10.79 in 1Q compared to 10.91in 4Q for the core set of issuers (Figure 39).
- source Bank of America Merrill Lynch

It's not only the leverage which is higher in US Investment Grade credit, quality as well has been worsening in a market where secondary trading is much weaker than before thanks to low inventories on US banks balance sheet and less appetite in providing "risk" in a context where "passive" management through ETFs has exploded in terms of inflows. It isn't a good recipe for when things will start heating up, but, we are not there yet in this credit cycle. Dispersion is rising still between issuers as the competition to attract capital is ratcheting up thanks to central banks turning the liquidity spigot gradually until it hurts.

If L is for "Leverage" when looking at US credit, L is as well the word for "Liquidity". Liquidity, as many veterans from the Great Financial Crisis (GFC) know is a coward. For EM it is already the case as pointed out in another note from Bank of America Merrill Lynch, in their Emerging Markets Weekly from the 14th of June entitled "It is the "L" word...Liquidity":

"It is the "L" word...Liquidity
  • Near-term liquidity in EM is a big problem. Several factors are having an adverse impact, but some of that is improving.
  • EM EXD technicals are better now, long-term fundamentals are good, spreads have risen far more in EM than in HY and institutional mandates have not ceased, but risks are high.
Dealer liquidity has fallen sharply while the market doubled in 6 years. Compared to last year or even to January 2018, dealers are less able to position the size clients need for three main reasons. First, there are fewer dealers than previously. Several major dealers have substantially reduced the size of their EM business and some have retreated from EM altogether. Second, the higher the volatility, the smaller the size of dealer trading books, making it extremely difficult for the Street to buy large positions. Third, over the last five years, EM-dedicated managers have become so large that the trade sizes that can be done in these illiquid markets are inconsequential to performance of a large fund compared to the market impact for trying.
It is a tale of two markets ‒ before and after April 16 Before April 16, EM debt was a different market, outperforming every other debt asset class, with continued EM inflows (2%) while there were outflows from US (-4%) and non-US HY (-7%). Unlike 2013, EM inflows persisted, even during the first 75bp of the US rate rise from Sept 2017 to April 16, 2018. Since then institutional flows are somewhat offsetting the small retail outflows and EXD ETF inflows have been fairly stable. EM issuance was up 8% through April 16, while that for US IG and HY was lower by 7% and 25%, respectively (EM supply? Relax. It is not as bad as you fear). 
2017 to early 2018 large growth
EM economies are still booming and new markets have opened with new demand. First, GCC sovereign issuance and frontier markets have grown rapidly, offering investment opportunities for high credit quality crossover buyers, as well as higher yielding and promising credit stories offering diversification. In addition, China has become more than one-third of EM corporate issuance and as much as 90% of that is placed in Asia, much in China itself. Fundamentally, most of those markets have not changed in the last 2 months." - source Bank of America Merrill Lynch
Yes, in illiquid markets, size matters. No matter what some sell-side pundits would like to spin, liquidity trumps fundamentals. It is your ability to trade that matters.

Having learned quite a few things from reading over the years the research from the wise Charles Gave of Gavekal research for whom we have great respect, at this juncture from QE to QT we think we needed to reminded ourselves his wise words:
"if there is more money than fools then market rise, and if there are more fools than money markets fall"
Last year rush for Argentina 100 year bond was indeed a case of more money than fools for EM. As the tide slowly recedes and we turn from QE to QT, we will over the course of the next quarters gradually discover who has been swimming naked, given capital will flow more discerningly we think. QE was a period where money thanks to NIRP and ZIRP was chasing anything with a yield without distinction. Now with rising dispersion, there will be truly more "credit analysis" done at the issuer level. Times are changing as pointed out by Bank of America Merrill Lynch in their Credit Market Strategist note from the 15th of June entitled "On the road from QE to QT, redux":
"On the road from QE to QT, redux
We have used this title before (see: Credit Market Strategist: On the road from QE to QT 29 March 2018) and this week’s central bank meetings - Fed, ECB and BOJ - motivate us to recycle it. Quantitative easing (QE) was mostly characterized as an environment with too much money chasing too few bonds, lower interest rates, tighter credit spreads and volatility was suppressed. There is no doubt that quantitative tightening (QT) at times will lead to the opposite - i.e. higher interest rates, wider credit spreads and very volatile market conditions (Figure 1).

However, we are currently in this intermediate phase - i.e. on the road from QE to QT - where things remain orderly although technicals of the high grade credit market have weakened notably this year due to less demand (Figure 2).

Hence, we have seen higher interest rates, wider credit spreads (Figure 3) and more volatility (Figure 4).

Domestic QT+ foreign QE/NIRP=OK
The reason we are not yet experiencing the full effect of QT is that foreign central banks - the ECB and BOJ in particular - are still providing tremendous monetary policy accommodation via QE and negative interest rates (Figure 5).

Thus, if US yields rose too much due to QT and rate hikes there would be large foreign inflows. Hence, US yields would not increase too much and fixed income volatility remains moderate. While this week the ECB announced the end to QE, they came out dovish by promising continued negative interest rates (NIRP) for a long period of time (Figure 6).

NIRP in the Eurozone works much like QE, as explained below, as it encourages companies and individuals to take risk way out the maturity curve or down in quality.
How does the ECB influence the back end of the curve? It is very simple: with negative interest rates, European investors are forced to either take a lot of interest risk or credit risk to earn even a small positive yield of 0.50% for example (Figure 9).

That asserts bull flattening pressure on both rates and quality curves.
We have not seen this movie before
While QT in itself is a rare occurrence we have never been in an environment of QT with a backdrop of major foreign QE/NIRP. Given the clear failure of the ECB and BOJ to meet their policy goals of near 2% inflation (Figure 8) the road from QE to QT may be very long - certainly years.

However, while we consider high grade credit spreads this year range bound - and in fact presently are at the wide end of the range due to supply pressures that will ease and Italian risks we will increasingly decouple from (although they remain severe a bit further out) - we continue to believe that the end to ECB QE means moderately wider spreads next year and in 2020. This is because the ECB presently buys about $400bn of bonds annually, which pushes investors into the US market. Without that we get less inflow from Europe and technicals deteriorate further. Partially offsetting this will be less supply as the relative after-tax cost of debt has risen due to higher interest rates and a lower corporate rate." - source Bank of America Merrill Lynch.
The escape route is somewhat less tricky for the Fed than for the ECB. It remains to be seen if Mario Draghi will rock the boat before the end of his term in 2019. We do not think he will. The Bank of Japan remains so far committed to QE, so there is still some time on the gradual tightening spigot we think.

Returning to our core subject of "mercantilism" and trade wars, it is looking more and more likely that in similar fashion to the 1930s, we risk seeing tit for tat reactions from China to additional US sanctions. Obviously equities market are reacting to this. Emerging Markets were the big beneficiaries of globalization and cooperation. Following NIRP and ZIRP implementation by DM central banks, EM have benefited from the high beta chase and massive inflows into funds. With the QE tide receding thanks to QT and with the escalation of trade war fears, obviously EM are coming under much pressure, hence our reverse macro osmosis theory we have been discussing various times playing out. On the subject of disruption from trade wars, we read with interest Barclays take from their Thinking Macro note from the 1st of June entitled "Trade war in perspective":
"US trade protectionism: Where do we stand?
This year, the US has implemented a number of protectionist trade actions. In March, President Trump announced a 25% tariff on steel (10% on aluminium) imports. The US Trade Representative (USTR) then proposed a 25% intellectual property (IP) related tariff on 1,333 Chinese goods. President Trump then asked the USTR if it was possible to impose tariffs on a further $100bn of Chinese goods. Import tariffs in the automotive sector are also being considered. Some progress has been made in trade negotiations with China (see China: Tariffs on hold, long negotiations continue, 12 May 2018). But escalation risks remain, since the steel tariff exemption will expire on 1 June and the White House said it will impose a $50bn IP tariff on Chinese products, with the list published by 15 June 2018.
We use a VAR model to quantify the potential impact of US tariffs on global growth and CPI inflation. The first year estimates are subject to high model and parameter uncertainty. We thus use second year estimates. These show that a 1% unilateral rise in US tariffs as share of US imports may reduce global growth by 0.3pp and increase inflation by 0.4pp. That said, the impact of the steel tariff, even without exemptions, would only lead to a 0.1pp decline in global growth and a rise of 0.1pp in CPI inflation, as steel is only 0.33% of US imports.
Large economic effects larger require big tariffs. If the proposed 25% tariff of $100bn of Chinese goods is added to the steel tariff, together with tit-for-tat retaliation, our model shows that such a scenario would raise CPI inflation by 1.1pp and cut growth by 0.9pp.
Our model suggests that the adverse effects of US trade tariffs on emerging markets are likely to be much larger and more persistent. This is intuitive, as these economies have been the largest beneficiaries of the most recent globalisation wave. According to our model, a 1% rise in US tariffs leads to a 1.1pp reduction in EM growth in the first year, versus 0.5pp for DM. For CPI inflation, the numbers are +1.1pp for EM versus +0.2pp for DM.
However, there are a number of mitigating factors. In the first age of globalisation, US tariff policy was very active, but large retaliations were rare. Similarly, their 70% success rate incentivises the US and EU to keep the WTO for resolving trade disputes. In addition, President Trump’s drive for deregulation, by removing entry barriers, could encourage more services trade, which may mitigate the negative effect of higher tariffs on goods. That said, any rise in services trade flows is unlikely to fully offset the impact of higher tariffs on EM countries, given the size and persistence of the effects estimated in this paper.
The impact is larger for emerging, than developed, markets
Emerging markets have likely benefitted the most from the trade hyper-globalisation of the 1990s. The abundant and competitively priced labour supply in these countries, together with free trade, led to large FDI inflows, allowing these countries to export their way up the development ladder. Intuitively, this suggests that these countries should also be more vulnerable to a rise in protectionism. In this section, we split our global real GDP growth and inflation variables into corresponding variables for emerging and developed markets, to econometrically examine if EM economies react differently to DM economies.

Figure 8 and Figure 9 shows the results for EM and DM economies, respectively. This breakdown produces several interesting results. First, EM GDP growth is likely to shrink by roughly twice as much as DM. Second, the DM GDP effect is short-lived and not statistically significant after one year, but is much more persistent in EM. Finally, the impact on EM CPI inflation is approximately five times as large as in DM. This could be due to higher USD denomination of financing flows and trade transactions, as well as different monetary policy reactions to external shocks in EM than DM.
Not surprisingly, the effect of the current US steel tariffs is much larger for EM economies (Figure 10.) than DM economies (Figure 11).

We compare first year estimates, because of a lack of statistical significance for the DM GDP response after the first year. With the steel tariff alone, our model suggests that EM (DM) GDP growth could fall by 0.3pp (0.1pp) and inflation rise by 0.3pp (0.1pp). With steel tariff retaliation, EM growth could fall by -0.7pp, with inflation rising by 0.7pp, which are sizable effects. If the US unilaterally implements IP-related tariffs on $50bn of goods from China, then EM (DM) growth could fall by 0.9pp (0.4pp) and inflation rise by 0.8pp (0.15pp). In the case of tit-for-tat retaliation, EM (DM) real GDP growth falls by 1.7pp (0.7pp) and inflation rises by 1.7pp (0.3pp). Overall, DM would only really feel any effects from tariffs in this very last scenario, while the impact for EMs is already sizable if the current steel tariffs are retaliated against.
The return of US protectionism can be disruptive
In this section, we review the main lessons from our econometric exploration of US tariffs. Modelling the impact of US tariffs on short-term global growth and inflation is challenging. Academic work has focused on the long-term effect, and uncertainty about the impact in the first year after the tariff announcement is large. Our estimates are based on a gradual tariff reduction, while the current situation is a rapid tariff rise. The estimates presented in this paper should therefore be interpreted accordingly. However, they nevertheless provide a first econometric view on how President Trump’s tariffs might affect the world economy.
Our results suggest that US tariffs act like a negative supply shock to the world economy, lowering global growth and raising inflation. However, only large tariffs produce large effects: the current US Steel tariff is only 0.33% of US imports and would reduce global growth only by 0.1pp, while raising global inflation by 0.1pp. It is only when $50bn of IP-tariffs are added and retaliated tit-for-tat that growth falls 0.6pp, while inflation rises 0.7pp.
The impact on emerging markets is much greater than on developed markets. The EM GDP growth impact is twice as large as on DM and significantly more persistent. The EM CPI inflation response is approximately five times as large as in DM. While there are a number of mitigating factors that are not accounted for, the analysis suggests that EM economies will be affected to a much greater extent than developed markets.
Overall, US protectionism could be disruptive, especially if tariffs are large and are retaliated. Emerging markets will likely be more affected than developed markets." - source Barclays
So there you go, if you think EM woes are overdone because of "fundamentals" then again you would be wrong if trade war escalates this could lead to a stagflationary outcome. Then of course, there is as well the trajectory of the US dollar and oil prices to factor in. From a liquidity perspective, we think the second part of the year will be challenging as the central banks turn off the liquidity spigot. You should continue to be overweight DM over EM on a relative basis overall. Then again, there are as well different stories and different issuer profiles. In a rising dispersion credit world, you need to go back to "credit analysis" and this is why active management should be favored right now over passive management. It is time to become more "discerning".

For our final charts, given the increasing competitive nature of capital allocation when liquidity is being withdrawn, we would like to highlight how this cycle is unique.

  • Final charts - Capital Flows? This time it's really different.
When it comes to the acceleration of flows out of Emerging Markets and growing pressure on their respective currencies, it is, we think a clear illustration of our "macro theory" of reverse osmosis playing as we have argued in our conversation "Osmotic pressure" back in August 2013:
"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 (which accelerated again in 2015 and in 2018) started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:
"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.
Capital flows react to real interest rates dynamic. Following years of financial repression in this cycle, the reaction and velocity of the moves we are seeing are therefore much larger from a standard deviation point of view. Our final charts come from Wells Fargo Economics Group note from the 13th of June entitled "Capital Flows Part III: This Time Is Different" and highlights the unique nature of the current economic cycle which ultimately affects capital flows as per our reverse osmosis theory stated above:
"The relationship between interest rate expectations and exchange rates has become harder to quantify, largely due to the unique nature of the current economic cycle. This changing dynamic ultimately affects capital flows.
What About Expectations?
As we have discussed in two previous reports,* capital flows respond to relative interest rate and exchange rate dynamics across borders. We now turn to the effect of expectations on our three variables. Expectations have played an increasingly important role in market participants’ reactions to global events. For example, recent Italian political developments led the euro to decline against the dollar, while Italian bond yields rose more than 100 bps (below chart).

While it is too soon to determine any effect these political tensions could have on capital flows, it is clear that expectations play a role in short-term exchange rate and interest rate dynamics. In the long run, these dynamics affect capital flows.
Expectations of central bank actions have also caused unpredictable swings in foreign exchange rates and interest rates. As previously discussed, our currency strategy team has found additional rate hikes from the Fed to be less supportive of the dollar, while at this stage, tightening on the part of foreign central banks has been more supportive of foreign currencies. Throughout much of 2017, short-term rate expectations moved in favor of the U.S. dollar, but the dollar declined (below chart).

This is likely due in part to the FOMC being further along its tightening path relative to other major central banks, and market participants having already priced in future rate hikes to a large extent. Market-implied probabilities of a rate hike are nearly 100 percent for today’s FOMC decision. Market participants likely see the FOMC as only having so many rate hikes left before reaching its terminal rate, and this means the potential for rate hike “surprises” is much lower.
In turn, the effect of interest rate expectations on exchange rates has been harder to quantify. As the Fed began to tighten policy in 2015-2016, one could theoretically identify a more direct relationship between the probability of a Fed rate hike and its effect on the dollar. However, as global central banks have engaged in unconventional monetary policy measures, the focus has turned toward perceived policy stances through actions such as quantitative easing, rather than a pure reaction to actual rate hikes.
Reviewing Past Cycles: All Else Is Not Equal for Capital Flows
The evolving relationship between interest rate expectations and exchange rates confirms why this cycle is unique. We have found that country-specific characteristics lead to volatility in capital flows, and similarly influence expectations. In the U.S. for example, prior cycles may have had a rising rate environment, but lacked a fiscal stimulus. This difference is compounded by unconventional global monetary policy and a deteriorating fiscal outlook during one of the longest economic expansions in recent history (below chart).
These differences influence investors’ relative allocation of capital, and decision makers would do well to pay attention to the unique outcomes that stem from differing market expectations."  -source Wells Fargo
More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike as discussed in our "Mack the Knife" July 2015 musing to repeat ourselves. Why did past Mercantilism failed and will fail again? Just read again Adam Smith's 1776 "The Wealth of Nations" in 1776. In his book Adam Smith's argued that the wealth of a nation consisted not in the amount of gold or silver stashed in its treasuries, but in the productivity of its workforce. He showed that trade can be mutually beneficial, an argument also made later by David Ricardo. In January 2017 in our conversation "The Ultimatum game" we argued:
"The United States needs to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017 
Once again it isn't the quantity of job that matters, it's the quality of jobs. No matter how the Trump administration would like to play it, but productivity matters more than trade deficits but we ramble again...

"It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country." - Adam Smith

Stay tuned ! 
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