Monday 24 September 2018

Macro and Credit - White Tiger

"Earnings don't move the overall market; it's the Federal Reserve Board... focus on the central banks, and focus on the movement of liquidity... most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets." - Stanley Druckenmiller

Watching with interest the trade war between the United States and China ratcheting up with Beijing cancelling its plans to send two delegations to Washington, given the season of fall is upon us, when it came to selecting our title analogy, we decided to go for "White Tiger". The White Tiger is one of the four symbols of the Chines constellations. It is sometimes called the White Tiger of the West and represents the West in terms of direction as well as the autumn season.  It has been said that the white tiger only appeared when the emperor ruled with absolute virtue, or if there was peace throughout the world. Obviously for those who remember our June conversation "Prometheus Unbound", we argued the following:
"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:
- source Macronomics June 2016 
"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" -
In similar fashion, more recently maverick hedge fund manager Ray Dalio came to a similar prognosis in his recent musing entitled "A Path to War" on the 19th of September:
"The economic/geopolitical cycle of economic conflicts leading to military conflicts both within and between emerging powerful countries and established powerful countries is obvious to anyone who studies history.  It’s been well-described by historians, though those historians typically have more of a geopolitical perspective and less of an economic/market perspective than I do.  In either case, it is well-recognized as classic by historians.  The following sentence describes it as I see it in a nutshell:
When 1) within countries there are economic conflicts between the rich/capitalist/political right and the poor/proletariat/political left that lead to conflicts that result in populist, autocratic, nationalistic, and militaristic leaders coming to power, while at the same time, 2) between countries there are conflicts arising among comparably strong economic and military powers, the relationships between economics and politics become especially intertwined—and the probabilities of disruptive conflicts (e.g., wars) become much higher than normal.
In other words economic rivalries within and between countries often lead to fighting in order to establish which entities are most powerful.  In these periods, we have war economies, and after them, markets, economies, and geopolitics all experience the hang-over effects.  What happens during wars and as a result of wars have huge effects on which currencies, which debts, which equities, and which economies are worth what, and more profoundly, on the whole social-political fabric.  At the most big-picture level, the periods of war are followed by periods of peace in which the dominant power/powers get to set the rules because no one can fight them.  That continues until the cycle begins again (because of a rival power emerging).
Appreciating this big economic/geopolitical cycle that drives the ascendancies and declines of empires and their reserve currencies requires taking a much longer (250-year) time frame, which I will touch on briefly here and in more detail in a future report.
Typically, though not always, at times of economic rivalry, emotions run high, firebrand populist leaders who prefer antagonistic paths are elected or come to power, and wars occur.  However, that is not always the case.  History has shown that through time, there are two broad types of relationships, and that what occurs depends on which type of relationship exists.  The two types of relationships are:
a) Cooperative-competitive relationships in which the parties take into consideration what’s really important to the other and try to give it to them in exchange for what they most want.  In this type of win-win relationship, there are often tough negotiations that are done with respect and consideration, like two friendly merchants in a bazaar or two friendly teams on the field.
b) Mutually threatening relationships in which the parties think about how they can harm the other and exchange painful acts in the hope of forcing the other into a position of fear so that they will give in.  In this type of lose-lose relationship, they interact through “war” rather than through “negotiation.”
Either side can force the second path (threatening war, lose-lose) onto the other side, but it takes both sides to go down the cooperative, win-win path.  Both sides will inevitably follow the same approach.
In the back of the minds of all parties, regardless of which path they choose, should be their relative powers.  In the first case, each party should realize what the other could force on them and appreciate the quality of the exchange without getting too pushy, while in the second case, the parties should realize that power will be defined by the relative abilities of the parties to endure pain as much as their relative abilities to inflict it.  When it isn’t clear exactly how much power either side has to reward and punish the other side because there are many untested ways, the first path is the safer way.  On the other hand, the second way will certainly make clear—through the hell of war—which party is dominant and which one will have to be submissive.  That is why, after wars, there are typically extended periods of peace with the dominant country setting the rules and other countries following them for the time it takes for the cycle to happen all over again." - source Ray Dalio
Because the color white of the Wu Xing theory also represents the west, the white tiger became a mythological guardian of the West on the mythological compass. The White Tiger is as well considered in China as the ruler of the Autumn and the governor of the metallic elementals (hint for you gold bugs out there...) but we ramble again. Will the age of reason disappear with the White Tiger? We wonder.

In this week's conversation, we would like to look at the gradual path towards recession in the US and how does the credit cycle will end.

  • Macro and Credit - Credit cycles die of "old age". 
  • Final chart - Hey Fed, NAIRU this!

  • Macro and Credit - Credit cycles die of "old age". 
While many pundits have been focusing on the continuation of the flattening of the yield curve, as we pointed out in our most recent conversation again, credit cycles die because too much debt has been raised. What the most recent Fed quarterly survey Senior Loan Officers Opinion Survey (SLOOs) tells us is that financial conditions remain very benign still. Yet, no one can ignore the hiking path followed by the Fed and that already some part of the economy such as housing are already feeling the heat and the gradual tightening noose of financial conditions. 

From a "White Tiger" perspective, a full-blown trade war between China and the United States would push US companies to pass on prices increases onto the US consumer. Any acceleration in inflation would lead to the Fed to be more aggressive with its hiking stance. The rhetoric of Fed members in recent week has become decisively more “hawkish”.

First question we are asking ourselves is when does the US consumer gets "maxed out"? We are already seeing credit card usage surging as well as the return of housing equity extraction thanks to the return of HELOC. On this subject we read with interest Wells Fargo Economics Group note from the 18th of September entitled "Consumer outlook in a rising rate environment":
"Executive Summary
Conventional wisdom has it that rising interest rates are bad for consumer spending because swelling financing costs put a squeeze on a household’s capacity for other outlays. What if conventional wisdom is wrong? Our analysis finds that a rising interest rate environment does not immediately snuff out consumer spending growth.
As the current expansion stretches further into its tenth year, the economy is on track to eclipse the expansion of the 1990s as the longest on record. In this report we consider the outlook for consumer spending against this backdrop of a record-setting expansion and consider how long the good times will last. Our base-case scenario, spelled out in this special report, anticipates a modest pick-up in consumer spending, at least in the near term. Eventually, like all good things, the longest economic expansion on record will come to an end and consumer spending will come back down with it. That will likely occur alongside financial conditions that warrant rate cuts by the Fed. The precise timing of these events is tough to get right, but by signaling this drop-off in activity in late 2020, we are essentially saying that while the end of the party is not imminent, no cycle lasts forever.

- Source Bloomberg LP, The Conference Board, University of Michigan and Wells Fargo Securities

As per the below Macrobond chart, the University of Michigan Consumer Confidence turning points tend to coincide with significant S&P 500 12 months return:
- source Macrobond (click to enlarge).

Before we go into more details of Wells Fargo's note, there are a couple of points we would like to make. Despite decreasing significantly from its peak prior to the Great Recession, household debt still remains quite elevated, stabilizing around 77%. Also back in March in our long conversation "Intermezzo", when it comes to consumer credit, as pointed out by famous French economist Frédéric Bastiat, there is always what you see and what you don't see. We pointed out the following from Deutsche Bank's State of the US Consumer report from the 26th of February entitled "Robust Consumer with Pro-cyclical and Seasonal Tailwinds on the Horizon":
"Items to watch
Lower income consumers are more levered than they appear: The aggregate deleveraging post-crisis has largely benefited from mortgage leverage sitting at its lowest level since 2001. However, other consumer leverage (card, student, auto, and personal) continues to grind higher into 2018 and is now at all time highs (~26%). Excluding disposable income for the Top 5% income bracket of US consumers, consumer debt levels are closer to 43% of adjusted disposable income—almost double the reported measure of ~26%. The latest triennial Fed Survey of Consumer Finances highlights this dynamic, with the bottom 40% income households running at ~50% non-mortgage DTI, which is ~10% more than LT averages.
The subprime/low income consumer is stretched: Sluggish wage growth and rising healthcare and rent expenses as a percentage of income (non-debt obligations near 25 year highs) among lower income households have stretched subprime consumers as they look to augment rising expenses with debt. 
Banks have met this increased demand by providing deeper credit access to subprime (increased participation, especially for cards), leading to higher leverage and an increased severity risk of loss as delinquencies start to diverge for lower quality consumers. Like DTI, adjusting debt payment burdens to exclude the top 10% income brackets almost doubles the reported Fed figure (9.6% PTI vs. 5.8% reported PTI by the Fed).
Socio-economic divide driving credit cycle: While aggregate consumer fundamentals remain robust, subprime consumers are seeing rising delinquencies and losses starting to normalize much faster than other credit tiers: +90-day DQs within subprime cards have rose+300bps Y/Y in 3Q17 vs. only~30bps on average for near prime/prime borrowers. ~45% of Americans would have difficulty paying a surprise medical bill of ~$500 (Kaiser Foundation), while ~50% of US consumers live paycheck to paycheck (FITB). Taken all together, a disconnect between the lower credit tier borrowers and the economic cycle is starting to emerge." - source Deutsche Bank
The issue of course for the stretched US consumer would be if Core PCE inflation continues to pick up slightly faster than core CPI if healthcare service price inflation accelerates while rent inflation gradually slows. This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further, not to mention the issue with gas prices at the pump should oil prices continue as well to trend up. Remember that the acceleration of inflation is a dangerous match when it comes to lighting up/bursting asset bubbles.

But let's return to Wells Fargo's take:
"A Consumer Spending Framework in the Context of Rates
As we would at any time in the business cycle, we consider the macro drivers of consumer behavior. Consumer sentiment and confidence, by about any measure, are at or near high levels last seen around 2001; which, not coincidentally, was in the late stages of that prior long-lasting expansion (Figures 1 & 2). We also look at the purchasing power in consumers’ wallets, be it in the form of personal income, which is at last picking up (albeit in only a modest way) or in access to capital through borrowing, where measures of revolving consumer credit growth indicate a levelling off more recently. Finally, we tally the actual spending numbers reflected in the personal income and spending report and the monthly retail sales numbers, both of which have been on a roll in recent months.
In an effort to better inform a consumer outlook, it is essential to have a framework for thinking about these fundamentals and how households will manage finances at this late stage of the cycle. The trouble with considering this period in the context of what has happened in prior cycles is that for a long stretch in the current cycle, from December 2008 until December 2015, the Federal Reserve maintained a near zero interest rate policy (ZIRP), and at various points during those years was engaged in a broad expansion of the balance sheet through quantitative easing (QE), (Figures 3 & 4).

- source Federal Reserve System and Wells Fargo Securities
The Fed has historically purchased Treasury securities to expand the monetary base, although the monetary policy “medicine” applied during that era, including the purchases of mortgage-backed securities and other assets, had not been tried before, at least not in the United States.
Central bank actions, no doubt, are a factor in the remarkable duration of the current cycle, and on that basis any informed outlook for consumer spending ought to not only consider these macro drivers (like confidence, access to capital and willingness to spend) but to consider them in the context of Fed policy.
To that end, we went back to just before the 1990s expansion began in 1989 and divided the years since into four broad categories based on what the Federal Reserve was doing with monetary policy at the time: (1) lowering the fed funds rate, (2) a “stable” rate environment, (3) raising the fed funds rate and (4) ZIRP with QE.
The date ranges for each of these periods is spelled out in Table 1 below.

Most of the time periods are straightforward, although the one period that might invite critique is that we have characterized the time period from March of 1995 through January 2001 as “stable” (revisit Figure 3).
One could reasonably observe that the fed funds rate actually moved up and down during that nearly six-year stretch. Our argument for calling it “stable” is that this period was essentially from the “mid-cycle” slowdown until the end of that expansion. Admittedly, there were adjustments up and down throughout the period, but from the start of the period to the end, the funds rate finished just 50 basis points higher. Reasonable minds could disagree, but in our view, the idea of thinking of that period as four unique rate cycles would unnecessarily complicate our analysis.
With our various Fed cycle dates established, we looked at our macro drivers for consumer spending through the lens of the Fed policy that was in place at the time. For each interest rate backdrop, we calculated the average levels for various measures of consumer confidence, the average annualized growth rate of personal income, the average net monthly expansion in consumer credit and finally the average annual growth rates of both real personal consumption expenditures and of nominal retail sales.
A key takeaway from our exercise, depicted in Table 2 below, is that measures of consumer fundamentals tend to do best in periods of stable interest rates. Interestingly though, a rising rate environment is almost as good for these same consumer fundamentals.

Perhaps that is not altogether surprising, considering that the Fed is apt to raise rates when the economy is at full employment and inflation is heating up beyond the Fed’s comfort zone. Those factors tend to exist when the economy is doing particularly well or even overheating.
The inverse of that dynamic may explain why the worst rate theme for consumer spending is during periods when the Fed is lowering rates. Personal income and spending as well as nominal retail sales all performed worst during periods when the Fed was cutting rates. Interestingly, the lowering of interest rates does not compel consumers to increase their appetite for credit, at least not immediately. The average net monthly increase in consumer credit came in a distant last during periods when the Fed was actively lowering rates.
2020 Vision
So what sort of Fed policy theme should we consider looking forward? To judge from the Fed’s dot plot, a visual rendering of policymakers’ own forecasts for the fed funds rate, the FOMC is closing in on its neutral rate for fed funds. With most dots clustered around 3.00 to 3.25% and the current fed funds rate at 2.00%, there are only four or five quarter-point rate hikes left to go in the current cycle, barring some change in forward guidance from the Fed (Figure 5).

Our forecast anticipates two more hikes this year and another three next year. After that it stands to reason we would be in a stable rate environment slightly above the neutral rate until the Fed’s understanding of r* changes (favoring another hike) or until conditions warrant a cut. In a separate special report1, we explained our use of an analytical framework we recently developed to inform our view of Fed policy going forward and why we look for the FOMC to raise rates another 125 bps before it cuts rates at the end of 2020.
In forming our outlook for the consumer, we take the findings of our rate-environment study and overlay them with our expectations for Fed policy over the next couple of years. If things play out the way we anticipate, monetary policy is entering an era of transition unlike anything the economy has seen in more than a decade. For a number of factors including the longevity of the cycle, growing fiscal budget imbalances and a potential fallout from the global economy, we indicated in our initial 2020 forecast that by the end of our forecast horizon the Fed would likely begin cutting the fed funds rate.2 A rate-tightening environment is expected to prevail at least through the first part of 2019, which will be followed by a stable rate for another year or so before the Fed begins to signal eventual rate cuts.
For the consumer, this Fed forecast implies a pick-up in the pace of consumer spending in the near term before an eventual slowing the further out we go in the forecast period. Full year PCE growth was 2.5% in 2017. By the time we close the books on the current year, we expect the comparable number for 2018 to pick up to 2.6%, prior to quickening to 2.7% in 2019 and slowing to just 2.2% in 2020 (Figure 6).
- Source: Bloomberg LP, Federal Reserve Board, U.S. Department of Commerce and Wells Fargo Securities
Consumers may be better prepared to endure a slowdown than in the past. The saving rate, currently at 6.7%, is rather elevated given the late stage of expansion, while real median household income surpassed its pre-recession peak in 2017. With the unemployment rate currently matching low levels last seen in the late 1960s, there remains little slack in the economy. The labor market is expected to grow increasingly tight, with the unemployment rate trending to as low as 3.3% by 2020. Similarly, inflationary pressures that continue to gradually build over our forecast horizon will put downward pressure on real income gains.
The length of the current expansion is expected to surpass that of the 1990s, taking the title as the longest expansion on record. While monetary policy changes act as signals to markets about the health of the economy and/or concerns about inflation expectations, we must be sensitive to policy movements and their implication for consumer spending. Our initial 2020 forecast expects the Fed to surpass its neutral rate, prior to beginning to cut policy by the end of 2020. With this signal of a slowdown in activity, we are essentially saying that this expansion will eventually draw to a close. The rate cutting environment will act as a last call announcement – and for the consumer sector it serves as a valuable indication for longevity of this expansion." - source Wells Fargo
Whereas we agree with the timing, we disagree with the perceived health of the US consumer, as per the above points illustrated in a previous Deutsche Bank research note. There is more leverage than what can be seen, not only when it comes to the US consumer but as well when it comes to the distorted balance sheets of many US corporates after years of a buy-back binge and a fall in the quality of the overall rating for the Investment Grade category much closer to "junk" than in the previous cycle.

Overall the timing for the end of the credit cycle could indeed be in the region of 2020. This is as well Ray Dalio's most recent view and also Christopher R. Cole, CFA from Artemis Capital Management as per his July  2018 letter entitled “What is water?”:
“When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents. The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets. Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates.Despite this trend, U.S. equities will very likely escape 2018 without a crisis or volatility regime shift because of the one-time wave of corporate liquidity unleashed by tax reform. Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate.” – Source Christopher R. Cole, CFA from Artemis Capital Management
The whole note written by Christopher R. Cole is worth a read particularly on the subject of passive management and liquidity. His quote from above resonates as well with our opening quote from maverick investor Stanley Druckenmiller.

 As well in his note, Christopher R. Cole indicates when he thinks we will most likely have another crisis on our hands:
“When does this all end? If or when the collective consciousness stops believing growth can be created by money and debt expansion the entire medium will fall apart, otherwise it is totally real… and will continue to be real.
A crisis-level drought in liquidity is coming between 2019 to 2022 marked by a perfect dust storm of unprecedented debt supply, quantitative tightening, and demographic outflows.
Quantitative easing has caused the natural relationship between corporate debt expansion and default rates to break down. U.S. debt is at an all-time high of $14 trillion (45% of GDP) and high yield default rates are near all-time lows at 3.3% (MarketWatch, 13d). This is not sustainable. Years of cheap money has led scores of investors to buy debt at levels that do not reflect credit risk. The poster child is the 2017 issuance of 100-year Argentina bonds (USD denominated) that were oversubscribed 3.6x with a 7.9% yield. It is hard to find a decade where Argentina has not defaulted, much less a century. That medium of bond market demand has already begun to show signs of cracking.” – Source Christopher R. Cole, CFA from Artemis Capital Management
Fiduciary duty anyone? Credit cycles tend to die of old age and too much debt. We have entered the season of the White Tiger we think. Only a few innings left. 

On the current evolution of the credit cycle we read with interest Bank of America Merrill Lynch's take in their High Yield Strategy note from the 21st of September entitled "The Evolution of the Credit Cycle:
"The Evolution of the Credit Cycle
As we continue to study the state of the current credit cycle, the accumulated evidence sides with the argument that it has more room to develop, as long as few more years. Previous cycles have lasted anywhere between 6-8 years, on average, and this observation would make it an unusual development to see the current cycle extend for much longer. However, we also note that more broadly, this economic cycle has been an unusual one in many respects, including how long it took the US GDP to return to trend growth rates, the unemployment to decline, and the inflation to recover. And if those major macroeconomic variables took an unusually long time to return to normal levels, then why should we expect the credit cycle to be an average one?
Away from this argument, we also continue to believe that the commodity episode in 2015-2016 represented a partial cycle in and of itself. Among the most conclusive pieces of evidence in support of this view, we present the charts in Figure 3 for debt growth and Figure 4 for capex.
In both cases, we highlight cyclical turns, as defined by catalyst events as the starting points and subsequent observed peaks in trailing 12mo HY issuer default rates as ending points.
Both graphs suggest that previous cyclical turns have occurred at similar points on each respective line, had similar impact on each measure, and had left them at similar levels after defaults receded. Both graphs also suggest that a cyclical turn at current levels and given their recent trends would be inconsistent with historical experiences going into previous default cycles.
And yet, inconsistent does not imply impossible, particularly in light of trade tariffs that are being threatened and imposed by the Trump Administration. It remains our view that at the end, these policies are unlikely to survive the test of time, however it is difficult to say how much time it would take to prove them wrong and how much damage they could do in the meantime.
The exact timing of cyclical turns is an inherently uncertain exercise and we do not claim to possess superior skills to do so. Instead, our approach relies on using all available data and analytical tools to help us make a judgment on a relatively short next-12mo time horizon, and continue doing so as time progresses and new data becomes available. As such, we made a call that this cycle was unlikely to turn at this point last year. With all the evidence we accumulated since then, we believe this view still holds today.
Our default model continues to suggest low likelihood of a meaningful spike in defaults over the next year, based on its latest inputs. It currently projects a 3.25% issuer weighted rate during this time period, marginally lower than the actual realized 3.41% rate as calculated by Moody’s (Figure 5). A 3.25% issuer default rate would be consistent with 2.0% par-weighted rate. 

How it ends?
In our last year’s outlook on the prospects of this credit cycle, we listed three key risks to its longevity: (1) inflation spike; (2) trade contraction; and (3) sector distress. We think all three remain valid and potent sources of known risks going forward as well. In our judgment, the spike in inflation remains a lower probability risk, followed by trade contraction, somewhat higher on our scale of likely developments, and still inside of a tail risk zone.
A contraction in one of the key industry sectors is a higher probability outcome, in our opinion, albeit not an imminent one. Previously, we published our thoughts on capital allocation trends across various sectors, and identified healthcare as the most overextended sector in terms of the amount of capital raised in recent years.
A higher capital formation could lead to higher capex, higher production capacity, higher supply, lower prices, and an eventual need to remove excess capacity. The latter stage often goes hand in hand with a need to eliminate excess debt that was used to finance excess capex.
Other sectors that we found to be overextended on this scale include autos, utilities, and food producers, although these three are relatively small compared to healthcare.
And at the end of this conversation on risks, we think it is also important to remind ourselves that previous cycles have ended with a surprise event, a “black swan” of sorts, which, by definition, was unexpected by the consensus and meaningful in its impact. We do not see any particular reasons as to why the next one would break out of this mold." - source Bank of America Merrill Lynch
From our "White Tiger" perspective, an inflation spike is something very much on our radar, hence our close attention to market gyrations in oil prices and geopolitical risk, the famous known unknowns which have been building up recently in world which has decisively moved from cooperation to noncooperation.

As we have stated above, many pundits are focusing on the flattening of the yield curve, from an employment and non-accelerating inflation rate of unemployment (NAIRU), Monetary policy conducted typically involves allowing just enough unemployment in the economy to prevent inflation rising above a given target figure, we think the Fed will once again be behind the curve as per our final chart.

  • Final chart - Hey Fed, NAIRU this!
In our previous conversation we discussed the great work of American economist Irving Fisher, in relation to NAIRU,  the concept arose in the wake of the popularity of the Phillips curve which summarized the observed negative correlation between the rate of unemployment and the rate of inflation (measured as annual nominal wage growth of employees) for number of industrialised countries with more or less mixed economies. This correlation (previously seen for the U.S. by Irving Fisher) persuaded some analysts that it was impossible for governments simultaneously to target both arbitrarily low unemployment and price stability, and that, therefore, it was government's role to seek a point on the trade-off between unemployment and inflation which matched a domestic social consensus, the famous dual mandate of the Fed. We won't go into more details about our fondness of the Phillips curve, it's a subject we have discussed on this very blog on many occasions. Our final chart comes from Deutsche Bank's US Economic Perspectives note from the 20th of September entitled "How the Powell Fed can make history" and shows that the Fed has never succeeded in returning unemployment to NAIRU from below without a recession ensuing:
"With unemployment now noticeably below standard measures of its natural level of full employment and likely to tighten further and with wage and price inflation returning to desired levels and likely to continue upward, the Fed has a delicate task on its hands. It needs to begin to close the gap between growth of aggregate demand and aggregate supply in the economy — in other words, to slow and eventually reverse the tightening of the labor market before it risks pushing up inflation and inflation expectations excessively. The question is whether it can do so without pushing the economy into recession and causing unemployment to surge upward, overshooting its natural rate.
Many in the market already see the storm clouds of recession gathering in the distance, a narrative that has found an ally in the flattening yield curve. Talk of a downturn by 2020 is increasingly in vogue and for good reason: a soft landing in unemployment from below NAIRU has never been achieved before. In the modern history of US national economic statistics since the late 1940s, every time the unemployment rate has overshot to the downside, policy firming by the Fed has helped drive the economy into recession (Figure 1).
We think the Powell Fed can make history by achieving the unprecedented outcome of a soft landing from below sans recession." - source Deutsche Bank
Contrary to the elements put forward in this very interesting note, we think that once again this time isn't different. On a final note we thought we had run out of arguments against the cult of the Philipps curve as per our conversation "The Dead Parrot Sketch" back in August 2017, we did read additional arguments against the Phillips curve cult in Saad Filali's take on Seeking Alpha in his article "There Is No Inflation: Too Much Supply, Not Enough Unions", which we found of great interest.  It has been said that the white tiger only appeared when the emperor ruled with absolute virtue, it could be said that the white tiger only appeared when the BIS ruled with absolute virtue as per their very interesting most recent quarterly survey, but we digress...

"Liquidity is oxygen for a financial system." -  Ruth Porat
Stay tuned!

Friday 14 September 2018

Macro and Credit - The Money Illusion

"The greatest obstacle to discovery is not ignorance - it is the illusion of knowledge." -  Daniel J. Boorstin, American historian

Looking at the most recent print in US nonfarm payrolls in conjunction with stronger than expected 2.9% wage growth (AHE) in August, with US Annual core-CPI declining to 2.2% in August vs 2.4% expected, leading to a tentative rebound in gold prices, when it came to selecting our title analogy we decided to steer towards a reference to the seminal work done by Irving Fisher in 1928 in his book "The Money Illusion". In economics, the money illusion is also referred as price illusion. It is the tendency for people to think of currency in nominal, rather than real terms. In other words, the numerical/face value (nominal value) of money is mistaken for its purchasing power (real value) at a previous point in the general price level (in the past). The term "Money Illusion" was coined by maverick economist Irving Fisher in his book "Stabilizing the Dollar" though it was popularized by John Maynard Keynes in the early twentieth century. Irving Fisher was the first economist to produce what is now called "The Fisher equation" in financial mathematics and economics which estimates the relationship between nominal and real interest rates under inflation. The existence of money illusion is disputed by monetary economists who contend that people act rationally (i.e. think in real prices) with regard to their wealth. Eldar Shafir, Peter A. Diamond, and Amos Tversky (1997) have provided empirical evidence for the existence of the effect and it has been shown to affect behaviour in a variety of experimental and real-world situations in three main ways:
  • Price stickiness. Money illusion has been proposed as one reason why nominal prices are slow to change even where inflation has caused real prices or costs to rise.
  • Contracts and laws are not indexed to inflation as frequently as one would rationally expect.
  • Social discourse, in formal media and more generally, reflects some confusion about real and nominal value.

Apparently "The Money Illusion" influences people's perceptions of outcomes. Experiments were conducted and have shown that people generally perceive an approximate 2% cut in nominal income with no change in monetary value as being unfair, but do see a 2% rise in nominal income as fair where there is 4% inflation, despite them being almost rational equivalents. This result is consistent with the "Myopic Loss Aversion theory" but this will probably be an interesting title for another post. The "Money Illusion" is indeed a cognitive bias which can vary depending on the "inflationary/deflationary" context. Numerous studies have documented a negative correlation between nominal yields and inflation. Modigliani and Cohn (1979) assumes that the valuations of the assets differ from their fundamental values because of two inflation-induced errors in judgment: the tendency to capitalise equity earnings at the nominal rate instead of at the real rate, and the inability to understand that, over time, the debts will devalue in real terms. What does it means? Simply that stock prices are overvalued during periods of low inflation. If indeed inflation accelerates, this will lead to some "repricing" and some reversion to the mean. For a bear market to ensue as we have repeated on numerous occasions on this very blog, you need inflation to "accelerate". Past history has shown, what matters is the "velocity" of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years. So, if QE could be seen as "deflationary" then QT could be seen as "inflationary". If the "money illusion" is "fading" and real wages starts accelerating, then the Fed will have no other choice but to pursue a more aggressive hiking pace. Of course if "inflation" is accelerating in conjunction with real wages, then again this will trigger "Bracket creep" being the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation for those who remember our post from January this year:
"Most progressive tax systems are not adjusted for inflation, as wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect overall is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate. That simple." - source Macronomics, January 2018
Yet another illustration of the existence of the "Money illusion" we think but we ramble again...

In this week's conversation, we would like to look at rising inflation creating therefore a shift in the "Money illusion" and what it entails down the line from a liquidity perspective.

  • Macro and Credit - The Money illusion is fading
  • Final charts - Always remember that liquidity is a coward
  • Macro - The Money illusion is fading
As we indicated back in June 2015 in our conversation "The Third Punic War", bear markets for US equities generally coincide with a significant tick up in core inflation. Also in our January conversation "Bracket creep" we indicated the following:
"As pointed out by Christopher Cole from Artemis Capital in his must read note "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987",  the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion described. But flow wise, as we have pointed out in numerous conversations, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy" so far." - source Macronomics, January 2018
While the latest inflation figure for August is considered as a miss, the Fed has most recently appeared much more hawkish it seems. The big question therefore should be about the strength of inflation. Subdued real wage growth could be one of the reasons put forward for the surprise election of Donald Trump in the United States. The election could be marking a return of Main Street versus Wall Street which has experienced tremendous asset inflations thanks to low volatility and low "perceived" inflation. Yet it seems to us from a "macro" perspective that, indeed the "Money Illusion" is now fading on the back of "QT". 

Is inflation returning? On that subject we read with interest Wells Fargo Economics note from the 12th of September entitled "Inflation not as benign as first indicated by drop in PPI":
"Producer prices came in softer than expected in August, falling 0.1%. The miss stemmed largely from the volatile trade-services sector, which measures margins. The underlying trend in inflation continues to inch higher.

At the Margin

  • PPI inflation unexpectedly slipped 0.1% in August. Goods prices were flat, but the miss came in large part from services, specifically a 0.9% drop in the volatile trade-services sector, which measures margins, not selling prices. Declining margins at machinery and equipment firms accounted for 80% of the decline in services this month and suggest producers may be struggling to pass on rising input costs related to recent tariffs.

Core Inflation Continues to Gradually Climb
  • Our preferred measure of core inflation, which excludes food, energy and trade services, also came in a bit softer than expected –up 0.1%— as transportation & warehousing prices fell. The trend remains upward, however, with the “core-core” measure climbing to 2.9% over the past 12 months versus 1.9% the 12 months prior.
  • Input prices eased a bit in August, but are still running ahead of final prices. Pressure on margins therefore looks to continue.
- source Wells Fargo

Additional escalation in the trade war would as we pointed out in various conversations put additional pressure on inflationary trends and on the US consumer we think. The question on everyone's mind is how are we shifting into a new inflationary state meaning that the "Money illusion" is finally fading?

On this subject we read with interest Bank of America Merrill Lynch's take from their Inflation Strategist note from the 13th of September entitled "Signs of life":
"The old normal shows signs of life
  • Globalisation delivers a fall in price level masquerading as deflation. Both secular and cyclical deflation forces are fading.
  • We update our long list of determinants of the low real rate era. Bernanke's "global savings glut" obviously has a place.
The three big picture inflation supports
Cyclical, secular and survivorship
We can be critical of the different ways output gaps are calculated, the numbers themselves and their usefulness as a single measure for encapsulating spare capacity in economies. Nevertheless, the reduction/elimination of slack that they signal, apart from being encouraging in its own right, should help towards resolving the question over how much of the “lowflation” experienced has been cyclical and how much secular.
Even when it comes to secular, long term trends, these shouldn’t necessarily be misconstrued as meaning a permanent shift to a new inflationary state. Whether it be the deflationary influence of globalization or the internet, to the extent that this means greater competition (so reduced pricing power), then it does perhaps reduce inflationary potential “permanently”.
However, in a shift from closed economies to open economies (globalization) or from weaker price discovery to stronger price discovery (the internet), a large part of the impact on prices is a one-off adjustment in the level not a permanent reduction in the inflation rate. It just looks like the latter because it doesn’t happen all at once. Inflation should firm if the pace of globalization slows.

Chart 2 suggests globalization is at least experiencing a pause. It shows the extraordinary shift in the openness of the global economy since the 60s but a leveling off in the trade share of GDP in recent years. And, as Governor Carney of the BoE has warned, “deglobalization” (an ugly word for an ugly concept) would threaten a meaningful build-up of inflation pressures.
Perhaps the last line of defense for inflation, as measured, is “survivorship bias”. If economies open up to trade with each other, production gravitates to their respective comparative advantages and (in principle) output is boosted and prices fall. In advanced economies, we have become used to falling goods prices. But, as Chart 3 illustrates simply, if goods prices fall and services prices rise steadily over time, then the overall inflation rate will rise because the index weighting for goods will fall, unless the relative price change prompts a consumption shift from services to goods.

Whether it be this “survivorship bias” or the tendency of economies to consume proportionately more services as they advance (and as their populations age), Chart 4 shows the mild but meaningful shift from goods to services in CPI baskets. 

We suggest that perceptions of r*, the neutral real policy rate consistent with growth at trend and inflation at target, have been framed by the experience of a prolonged period of economic slack and an even longer period of globalization. The impacts of both on inflation are probably fading and the real policy rate required to keep inflation pressures in check will likely rise gradually to a considerably higher level than currently priced.
Real rate drivers - the usual suspects
It is worth periodically rounding up the “usual suspects” cited as causes of the low real rate world we have been in. Here we list suggestions from a variety of sources and throw in a few of our own. We do not claim that it is exhaustive and readers would no doubt add and subtract from what we have below.
Thinking in terms of potential longer-dated real rates drivers – those shifting the supply and demand for savings and investment – it is perhaps useful to split them into those drivers that might have shifted the savings curve and those that might have shifted the investments curve.
Most items we list are self-explanatory and we do not want to go over well-trodden ground in a lot of detail before getting to our main contentions. However, some of the drivers we identify should actually be broken-down into arrays of sub-drivers. In particular, we suggest that there are many facets to the apparent change in capital/labour preference that has subdued capital investment, so we carve out a sublist for that driver.
Causes of investment curve shift to the left?
  • The long shadow of the crisis – reduced expected real returns, greater uncertainty over those expected returns or greater risk aversion to that uncertainty
  • A decline in innovation, reducing opportunities
  • The cost of equity capital has fallen, but nothing like as much as the risk free rate.
  • Falling prices of investment goods (and inelastic demand).
  • Capital/labour substitution – replacing the former with the latter.
Causes of savings curve shift to the right?
  • The “Global Savings Glut” (GSG), especially imported savings from reserve accumulators.
  • Demographics – a falling dependency ratio. Workers can save more because they are supporting fewer dependents.
  • Precautionary savings accumulated because of crisis.
  • Rising inequality raising the average propensity to save."  - source Bank of America Merrill Lynch
We would like to add a couple of comments to the above  relating to the GSG theory put forward by former Fed president Ben Bernanke relating the reasons for the Great Financial Crisis (GFC). Once again we would like to quote our February 2016 conversation "The disappearance of MS München" on this subject:
"The "Savings Glut" view of economists such as Ben Bernanke and Paul Krugman needs to be vigorously rebuked. This incorrect view which was put forward to attempt to explain the Great Financial Crisis (GFC) by the main culprits was challenged by economists at the Bank for International Settlements (BIS), particularly in one paper by Claudio Borio entitled "The financial cycle and macroeconomics: What have we learnt?": 
"The core objection to this view is that it arguably conflates “financing” with “saving” –two notions that coincide only in non-monetary economies. Financing is a gross cash-flow concept, and denotes access to purchasing power in the form of an accepted settlement medium (money), including through borrowing. Saving, as defined in the national accounts, is simply income (output) not consumed. Expenditures require financing, not saving. The expression “wall of saving” is, in fact, misleading: saving is more like a “hole” in aggregate expenditures – the hole that makes room for investment to take place. … In fact, the link between saving and credit is very loose. For instance, we saw earlier that during financial booms the credit-to-GDP gap tends to rise substantially. This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income." - source BIS paper, December 2012
Their paper argues that it was unrestrained extensions of credit and the related creation of money that caused the problem which could have been avoided if interest rates had not been set too low for too long through a "wicksellian" approach dear to Charles Gave from Gavekal Research.
Borio claims that the problem was that bank regulators did nothing to control the credit booms in the financial sector, which they could have done. We know how that ended before." - source Macronomics, February 2016
Indeed, conflating financing and savings is the main issue when it comes to the GSG theory. From a "Wicksellian" perspective, one would argue that low rates for too long leads to mis-allocation of capital. For instance if one looks at CAPEX expenditures in US High Yield since 1997, one can see in the chart below from Bank of America Merrill Lynch that prior to the onset of the GFC, capital raised through bond issuance went into more leverage thanks to a buying spree with Acquisitions/LBOs. Of course a feature of a late credit cycle does lead to seeing more LBOs and acquisitions:

- graphs source Bank of America Merrill Lynch

As we pointed out in our October 2017 long conversation relating  to inflation entitled "Who's Afraid of the Big Bad Wolf?", we had over-inflation of asset prices and too low inflation thanks to the "Money Illusion". The Fed, subdued inflation expectations and inflation with its various QE iterations. We indicated at the time:
"Credit cycles die because too much debt has been raised
When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are still fairly loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion" - source Macronomics, October 2017
Financial conditions remain very loose and with the fiscal boost coming from the Trump administration, no wonder the Fed is becoming more hawkish. You have been warned. 

But returning to real rate drivers, Bank of America Merrill Lynch in their note highlight what has mattered most for the "Money illusion" to take place:
"What has mattered most?
Over the past ten years, bond market participants would almost certainly cite risk-free bond buying by central bank reserve accumulators and the duration extinguished by quantitative easing, mitigating the impact of heavy government bond supply as the crisis lifted debt/GDP levels.
However, real rates were already in long-term decline well before the crisis. Taking a longer time frame, a Bank of England Working Paper by Lukasz Rachel and Thomas D. Smith (No. 571, “Secular drivers of the global real interest rate”, December 2015) claimed to be able to account for 400 of the 450 basis point fall in long term real interest rates over the preceding thirty years.
Exhibit 1, clipped from their paper, suggests that the global savings glut has only had a small walk-on part in the unfolding real rate drama.

In their analysis, the big four drivers were: lower growth, demographics, an increase in the spreads between risk-free real rates and the real rates experienced in the real economy (including, for instance, the real cost of equity finance), and the falling relative price of capital. For this last to be a driver of lower real rates one must assume that demand for capital goods is price-inelastic.
They concluded that: “most of these forces look set to persist and some may even build further. This suggests that the global neutral rate may remain low and perhaps settle at (or slightly below) 1% in the medium to long run.” In their forecasts, they see demographics delivering most of this increase, as the Exhibit shows. Chart 6 shows how this relates to an end to the downtrend in the world dependency ratio, with upswings well underway in advanced economies.

Later, we will discuss the interaction between risk-aversion, driving the “spreads” component in the Exhibit, and the global savings glut, in order to contend that this can be a force for a bigger upward adjustment in real rates in the future.
The replacement of capital with labour has many aspects
As before, we will list what we see as potential causes of this phenomenon, rather than discuss them in any detail. They should be self-explanatory. We would also stress that the ordering should not be regarded as signalling an attempt to rank them in order of importance.
Drivers of the trend shift from capital to labour
  • Increasing labour market flexibility
  • A global “labour supply glut”, resulting from:
o A falling dependency ratio
o Globalisation
o A post-crisis workforce that needed to re-skill and price itself back
into work
  • A change in firms’ perceived capital-labour risk/cost efficient frontier since the crisis
  • Capital intensive goods production has been driven out of advanced economies (their comparative advantage being in services)
  • Production reflects consumption. Advanced economies consume fewer goods and more (labour intensive) services
  • As a result of the above, the modern advanced economy business is capital-light
Ben Bernanke memorably used the term “global savings glut” to describe excess savings circling the world in pursuit of a return. Admittedly, the world saving rate was a little higher in 2005 (when he coined the term) than now but the overall increase in the world savings rate over time has not been great, while that for the OECD has seen a gentle decline.
The glut that is generally understood to have exerted downward pressure on nominal and real yields refers to the savings recycled from surplus countries to deficit countries as large current account imbalances emerged.
However, there are reasons to be a little uncomfortable with that seemingly axiomatic received wisdom without further elaboration. To the extent that current account surpluses represent the excess savings of countries, there are equal and opposite savings shortfalls in current account deficit countries (notably the US and UK).
Conventional wisdom used to have it that countries with persistent current account deficits needed to pay higher prospective returns to attract and retain foreign capital. Investors have a natural preference for domestic assets, so need to be paid a premium for accepting foreign market risk. Therefore, without any change in global saving, an increase in imbalances would be expected to depress real yields in surplus economies but raise them in economies with savings shortfalls.
Conventional wisdom upended
If the above framework is accepted, then a mild increase in the global saving rate accompanied by the development of large global imbalances would have exerted a downward “income effect” on real yields but an upward “substitution effect” on real yields in economies on the negative side of the global imbalances identity. The net impact on real yields in the US (with the greatest need for imported savings) would have been ambiguous. What has upended this logic has been the change in the risk preferences of the exporters of savings.
When an economy is “self-sufficient” in savings, domestic savers have diverse risk appetites; they invest across the risk spectrum. And when an economy does have a savings shortfall but is financed by foreign private capital, risk appetite also tends to be diverse (FDI, equity portfolio acquisition, etc). Up until the late 90s, this was the norm.
So our contention is that the rise of the reserve accumulators, in pursuit of risk-free government paper, crowded-out risk appetite. The substitution effect became one of increasing risk-free investment appetite surpluses and risk-taking appetite shortfalls. Therefore the nature and sign of the substitution changed.
Chart 9 shows the IMF’s presentation of these global imbalances.

In Chart 10, we regroup and simplify the picture. By unifying European creditors and debtors (which appear above and below the zero line in the IMF layout) we change the outline of the picture a bit.
However, the main thing highlighted by Chart 10 is the surplus share recorded by China and the oil exporters up until the last few years. It’s a major oversimplification, obviously, but these are perhaps the most conspicuous reserve accumulators pursuing risk-free external assets.
But that era appears to be over, insofar as we accept IMF forecasts for the development of imbalances. The present and near future of imbalances looks simpler than the past – Europe will be financing the US.
The flows will be private capital, not public reserves, so have the potential to restore the old regime where a US savings shortfall delivers higher not lower risk-free real rates. This also suggests that even though the spread between US and Euro real rates has widened significantly, there’s more to come.
Was the equity risk premium a casualty of this risk appetite shift?
The BoE working paper discussed earlier discussed widening “spreads” as an important driver of low real rates. No doubt the crisis was a major contributor to a gapping wider in the equity risk premium and a shifting preference towards government bonds will reflect other things, like the aging of the average saver. However, we would suggest that if global imbalances have extinguished risk appetite in the way we have described, then this also played a big part in the late-90s bond-equity “correlation flip” shown in Chart 11 and the widening gap between bond and equity earnings yields.

In this context, the post-millennium US experience of debt-financed equity buybacks (widely pilloried as “short-termism” and “financial alchemy” looks, more objectively, to be a rational response to a dramatic increase in the relative cost of equity finance. It’s been about giving investors what they want.
New normal looking more like old normal than we thought
In this note we have discussed very big picture influences that are likely evolving very slowly. However, the underlying messages seem clear. A closing of the global output gap appears to be coinciding with a waning in the deflationary influence of globalisation, resulting in firming global inflation, or at least a higher r* to keep inflation in check. This would be aggravated if globalisation is actually in retreat.
That a global savings glut depressed risk-free real rates is universally accepted but perhaps the bigger global real yield depressant from global imbalances was the extinguishing of risk appetite – “bad” savings driving out “good” savings. The global imbalances are still with us but the composition is changing in a way that should restore risk appetite and lift US real yields, both outright and (especially) relative to European." - source Bank of America Merrill Lynch
We disagree on the above a GSG was not the reason risk-free rates were depressed, no offense to Bank of America Merrill Lynch but we would rather side with the wise wizards at the BIS than with the reckless wizards such as Ben Bernanke at the Fed and others.

Before we move on to our final charts regarding the "liquidity illusion", we would like to quote the wise words of Irving Fisher from his 1928 book:
"We may now summarize our findings
1. The problem of what to do about our unstable money is one of prime importance
2. It has been all but overlooked because of the Money Illusion
3. This Illusion is the more serious because every man finds it harder to free his mind of this Illusion as to the money of his own country than of foreign money.
4. This Money Illusion so distorts our view that commodities may seem to be rising or falling when they are substantially stationary, wages may seem to be rising when they are really falling, profits may seem to exist when they are really losses, interest may be believed to be rewarding thrift when no real interest exists, income may seem to be steady when it is unsteady, bond investments may seem to be safe when they are merely a speculation in gold. It makes a unit of weight appear to be a unit of value; it hides a chief cause of the so-called business cycle; it has enabled political financiers to employ unsound finance with burdens heavier but with complaints less than if sound finance had been employed; it has led to unjust blame of "profiteers" and of the "money lenders"; and above all it has held back stabilization by concealing the need of it.
5. The present fixity of weight of our dollar is a very poor substitute for a fixity of value or buying power.
6. By actual index number measurement our dollar rose nearly four fold and fell back to the starting point again between 1865 and 1920.
7. Most of the dollar's fluctuations were while the dollar was a gold dollar (1879-1922).
8. They were largely peace time fluctuations; most of them occurred while America was at peace (1879-1898, 1899-1917, and 1918-1922), and much of them when there were no important wars elsewhere (1879-1914 and 1918-1922).
9. These fluctuations through serious shrink into insignificance in comparison with the thousand-fold, million fold, billion-fold, and trillion-fold fluctuations in Europe.
10. The cause of a falling or rising dollar is monetary inflation or deflation and that , in practice, it is seldom or never necessary to specify that the inflation or deflation is merely relative since it is also absolute as well.
11. To go back to the cause of inflation or deflation, the extreme variability of money is chiefly man-made, due to governmental finance, especially war finance, as well as to banking policies and legislation; but also due in part to discoveries or exhaustion in gold mines, and changes in metallurgical art.
12. The tremendous fluctuations of money produce tremendous harm analogous to what would result if our physical yardstick were constantly stretching and shrinking but far greater

  • a. because the money yardstick is used so much more generally
  • b. because it is so much more used in time contracts, because stretching and shrinking are unseen.
13. This harm includes a constant robbery of Peter to pay Paul - amounting to sixty billion dollars in six years in the United States alone - a net loss to all Peters and Pauls taken together, confusion and uncertainty in all financial, commercial and industrial relations, constituting much what is called the business cycle, producing depression, bankruptcy, unemployment, labor discontent, strikes, lockouts, class feeling, perverted legislation, Bolshevism and violence. In short the harm is threefold: social injustice, discontent and inefficiency." - source Irving Fisher, The Money Illusion.

He also added that credit control must always be an important part of any program for stabilization. This is leading us to our final charts relating to the "liquidity illusion" in credit markets.

  • Final charts - Always remember that liquidity is a coward
As a reminder, a liquidity crisis always lead to a financial crisis. That simple, unfortunately. In our February 2016 conversation "The disappearance of MS München" on this subject we quoted Dr Jochen Felsenheimer and Philip Gisdakis from their 2008 book Credit Crises:
"Asset price inflation in general, is not a phenomenon which is limited to one specific market but rather has a global impact. However, there are some specific developments in certain segments of the market, as specific segments are more vulnerable against overshooting than others. Therefore, a strong decline in asset prices effects on all risky asset classes due to the reduction of liquidity.
This is a very important finding, as it explains the mechanism behind a global crisis. Spillover effects are liquidity-driven and liquidity is a global phenomenon. Against the background of the ongoing integration of the financial markets, spillover effects are inescapable, even in the case there is no fundamental link between specific market segments. How can we explain decoupling between asset classes during financial crises? During the subprime turmoil in 2007, equity markets held up pretty well, although credit markets go hit hard." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
Our final charts come from Bank of America Merrill Lynch's Credit Market Liquidity report from the 12th of September and highlights the "buy-side" versus the "sell-side" imbalance after the GFC and seems to be on every credit investors mind these days, rightly so:
"The ECB has been tapering its QE programme, and asset purchases will finish by the end of this year. Credit market liquidity is becoming more challenging with market participants seeing fewer bids when they need them. We think that when bond market liquidity becomes more challenging, the CDS market is the vehicle to manage risk. Bond trading frequencies have slowed down over the past years; trading volumes in the CDS market are rising rapidly, both in the index and the options market.
The “buy-side” vs. “sell-side” imbalance is the largest it has ever been. In a world of growing buy-side assets but lower street liquidity, sharp corrections are more common. Dealer inventories of corporate bonds are clearly way down on where they were in ’07, but banks also appear more nimble in managing their mark-to-market risks and overall exposures on their securities portfolios.

The CSPP has dominated the European credit market in recent years. The ECB has bought more than €167bn of euro-denominated corporate debt (and this is still growing, albeit slowly). The CSPP has been pivotal in improving the credit market’s strength and resilience. But we can see a shift in market liquidity for the worst in recent months amid rising markets volatility.
Liquidity has been challenging according to the findings of our analysis, and credit investors seem to think that it will deteriorate as the buyer of last resort withdraws and they will be the only buyers left in the market (chart 3).

With inflows drying up and possibly continuing to do so as the rates cycle between US and Europe pushes money out of the latter, liquidity will likely become more challenging (more here).
The trend of selling in secondary to participate on primary is the new norm as inflows have stopped. If macro deteriorates further and investors need to replenish their cash balances to cover weaker fund flows technicals, the bid for bonds would weaken more, we think. No wonder that the key concern for credit investors is that “market liquidity evaporates”; the August 2018 survey reading was the highest since H2 2015 heading into the February 2016 sell-off and amid HY market weakness (on the back of a flare-up in the Greek debt saga, EM risks and oil prices tanking).
Our liquidity indicator at the most distressed levels
Arguably it is difficult to quantify liquidity. So many metrics (bid/offer, turnover, volumes and trade counts), but none of these have the ability to measure “illiquidity aversion” and to what extent risk-aversion has dominated the market. We think the volatility market is providing unique and eye opening insight on the current state of the “illiquidity scare” for market participants.
In our Hold your breath for a bumpy ride note, we highlighted an interesting and rather unique phenomenon that recently emerged in the European credit index options market. Amid significant volatility during the Italian BTP sell-off, we have seen an increase in hedging demand. As a result implied vols have moved well above the levels justified by the underlying spread market. But not only that, as not only have vols underperformed (moved more than) the underlying market, but implied vol skews were heavily bid too, steepening to the highest levels we have seen historically (chart 4).

We think we could gain significant insight on risk aversion from examining the correlation between the forward moves of the implied vol skew (payer vs. receiver implied vol differential) vs. the preceded moves in the underlying implied vol market. In simple terms, the higher the correlation the stronger the need for tail hedging going forward post a vol shock in credit. Currently we find that the level of positive correlation (steepening of implied vol skew, post a rise in implied vols) is the highest we have ever seen, according to our data.
In our opinion this clearly reflects the high levels of risk aversion and illiquidity fear during the recent sell-off. It seems that investors hit the “panic” button harder than at any other time in history. A continuation of outflows, a weak macro and declining market liquidity could ultimately push too many investors to the exit." - source Bank of America Merrill Lynch
It seems that some credit investors are getting wary about the "liquidity illusion" in credit markets and some are already lining up for the exit as no one wants to really pick up the tab of the very large credit punch bowl offered by our "generous gamblers" aka our dear central bankers but we ramble again as we are not there yet and equities continue to surge oblivious to the on-going shift in the "Money Illusion". Oh well...

 “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

Stay tuned ! 
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