Macro and Credit - Mithridatism

"Many have said of Alchemy, that it is for the making of gold and silver. For me such is not the aim, but to consider only what virtue and power may lie in medicines." - Paracelsus

Watching with interest the tentative rebound in US equities on the back of hope for an agreement between China and the United States on trade, while listening to the "contrition" of French president Macron following the "tax" revolution, promising more spending aka more deficit and more debt, which should no doubt please his technocratic friends in Brussels, when it came to selecting our title analogy given the market gyrations surrounding liquidity withdrawal, we decided to go for "Mithridatism", being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts. 

The word is derived from Mithridates VI, the King of Pontus, who so feared being poisoned that he regularly ingested small doses, aiming to develop immunity. It has been suggested that Russian mystic Rasputin's survival of a poisoning attempt was due to mithridatism, but this has not been proven. It is important to note that mithridatism is not effective against all types of poison (immunity generally is only possible with biologically complex types which the immune system can respond to) and, depending on the toxin, the practice can lead to the lethal accumulation of a poison in the body. 

For example, the Australian Koalas' diet is so much toxic and poisonous that a normal mammal can't survive. It has also come to our attention that finally the long "immune" Australian housing market has come under pressure as of late as indicated by Cameron Kusher on his twitter feed on the 3rd of December:

Sydney dwelling values have been falling for 16 months and are down -9.5%, when Perth started to decline, 16 months in values were -5.3% lower, and in Darwin they were down -4.4% after 16 months. Is this an orderly slowdown?" - Cameron Kusher - Twitter feed 

While thanks to "Mithridatism", Australia's housing market had been spared for such a long time, it looks to us that finally it is coming under tremendous pressure. One of our French friends currently residing in Sydney suggests that the four big Australian banks were displaying classic 2007 US banks characteristics. Our friend Carl Hodson-Thomas Portfolio Manager at Prometheus Asset Management and based in Perth, would probably argue that QBE insurance company should be a prime candidate for a sizable "short" position given it, along with GMA, has the first-loss exposure to the riskiest mortgages in Australia through its lenders mortgage insurance... But, we digress.

In this week's conversation, we would like to look at what 2019 could entail in terms of risk given the most recent bout in widening credit spreads and with the ECB joining the tapering bandwagon on the back of Fed's ongoing QT.

Synopsis:

• Macro and Credit - 2019: When the central banks are no longer your "friends"...
• Final chart -  Did the Fed already break something?

• Macro and Credit - 2019: When the central banks are no longer your "friends"...

As we pointed out in our previous musing, credit markets and fund flows continue to be "wobbly" to say the least. We continue to monitor credit markets as yet another indication we are in the late stage of this credit cycle. As indicated by Lisa Abramowicz on her twitter feed, the recent credit selloff has been vast and furious in the US:

"The recent credit selloff has hit U.S. debt more than emerging-markets notes. Investors are now demanding the most extra yield to own U.S. junk bonds versus emerging-markets credit since April. (This is a comparison of spreads, as per BBG Barclays data)" - source Bloomberg - Lisa Abramowicz - twitter

Furthermore, more and more pundits are taking the short side of the credit markets and it's not only in the illiquid part of the market such as "leveraged loans" which have come to the attention of central bankers and others, as pointed out by the Wall Street Journal on the 11th of December in their article entitled "Investors Bet $10 Billion Against Popular Bond ETFs":

"Bond investors scrambling to protect themselves from losses are increasingly using bets against the largest junk-bond exchange-traded funds and derivatives that rise in value when corporate bonds lose ground. The popularity of such defensive trades could portend more pain for stock investors as corporate bonds, especially those with sub-investment grade, or junk, ratings, often pick up signs of economic stress before other assets.

The value of bearish bets on shares of the two largest junk-bond ETFs hit a record $10 billion in recent weeks, according to data from IHS Markit . Downbeat wagers on indexes of credit default swaps, or CDS, for junk bonds hit a four-year high in November, according to Citigroup .

Investors are turning to ETFs and derivatives as proxies for actual bonds because debt-trading activity, also called liquidity, has declined over the past decade as new regulations forced investment banks to pare risk-taking. Rising numbers of hedge-fund and mutual-fund managers, for example, are using ETFs to quickly take bearish and bullish positions on bond markets, making them early indicators of investor sentiment." - source WSJ

Over the last 7 days, the US leveraged loans market is down 1.1%. This is the steepest one-week drop since 2011 (per the S&P / LSTA Leveraged Loan Index) according to S&P Global Intelligence.  The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, lost 0.38% on the 11th of December. Loan returns were –0.66% in the month to date and 2.38% in the YTD. You can expect an acceleration in the fall as we pointed out in our November conversation "Zollverein" particularly given their behavior in 2008 and the "illiquidity" premium discussed in our November conversation that needs to be factored in.

Cracks have started to show not only in supposedly "liquid" ETFs but, as well as in the CLO tranches market as pointed out by the Financial Times in their article entitled "Investors signal concerns with leveraged loans" (H/T Lisa Abramowicz):

"The difference between the interest rates on the highest-rated CLO tranches and three-month Libor has hit 121 basis points — the biggest risk premium since February 2017, according to Citigroup. As recently as November 2017, the spread was 90bp.

Lower-rated CLO tranches have also come under pressure. The spread between double-B tranches and three-month Libor rose 70bp in November to 675bp, the biggest monthly increase since early 2016, Citigroup said."

 - source Financial Times

There is more pain to follow we think in 2019. As we pointed out in our November conversation "Zollverein", US High Yield CCC rating bucket is seriously exposed to the Energy sector and to any fall in oil prices. Oil prices and US High Yield are highly connected (15% of US High Yield). As pointed by Lisa Abramowicz on twitter, no wonder some US oil drillers are starting to feel the "heat":

"An offshore driller, Parker Drilling, just filed for bankruptcy because oil prices aren't high enough to sustain its business model. It's bonds:

- source Bloomberg - Lisa Abramowicz - twitter

The big question one might rightly ask if indeed this is a start of a trend. Sure some pundits would like to point out about the current low default rates but that is akin to looking at the rear view mirror. We have indicated in numerous conversations that QT is accelerating the tightening in financial conditions, akin to some stealth rate hikes given the support provided by massive liquidity over the years. With credit spreads widening, so are financial conditions impacted for the leveraged weaker players.

In their most recent blog post on the 12th of December, DataGrapple is asking if indeed PKD is only the first shoe to drop in the Energy sector:

"SRAC (Sears) has been the first name to default in series 31 of CDX HY on October 15th, even though the auction that will help determine the payout of CDS contracts has still not been held. The second default happened overnight, as PKD ( Parker Drilling Company ) voluntarily filed for Chapter 11 protection under an agreement with a group of debtors that will allow it to quickly restructure. Drilling contractors have struggled to recover from a steep drop in oil prices which reached a trough in 2016. The recent step-down in crude levels – Brent lost roughly 30% since early October to close at $60/barrel tonight – threatens to derail a long-predicted recovery for off-shore companies, which typically handle more expensive projects that require higher energy prices to turn a profit. As recently as November, PKD warned its investors it might not be able to repay certain debts. Since then, its obligations have been trading at levels implying a near certain default and today’s announcement did not come as a big surprise to investors. The question is rather whether PKD is only the first shoe to drop and whether they should expect more decompression between the energy heavy CDX HY and other credit indices." - source DataGrapple

In true "Mithridatism" fashion one should indeed start to seriously reduce their credit "high beta" exposure while they can. It's not only a question of what is "illiquid" versus what is "liquid" given than contrary to 2007, dealers inventories are nowhere near to what they used to be.

The story of fund flows is clearly indicative of "crowding out" happening with appetite switching from credit markets towards US Treasury bills and the safety of the US front-end. As shown by Bank of America Merrill Lynch Follow The Flow note from the 9th of December entitled Back to pre-Qe levels, credit markets are under pressure:

"Outflows have now erased the QE flow

Outflows continued for another week in Europe. Cumulative outflows from IG and HY funds have now erased the inflow seen post QE.

The lack of yield and the lack of growth in Europe are pushing assets away. Risks remain to the downside as the buyer of last resort is stepping away and liquidity remains challenging. Spreads are prone of further widening, not due to weak fundamentals, but due to challenging liquidity and weakening macro backdrop.

Over the past week…

High grade funds recorded another large outflow this week. This has been the 17th week of outflows over the past 18 weeks. High yield funds also recorded another sizable outflow this week, the 10th in a row. Looking into the domicile breakdown, outflows were almost equally split between the three buckets we have: US-focused, Euro-focused and Global-focused funds have all lost similar amount of AUM. 

Government bond funds recorded a marginal inflow this week, putting an end to two consecutive weeks of outflows. Meanwhile, Money Market funds suffered again a large outflow, though half the size of last week’s.

European equity funds continued to suffer outflows for the 13th consecutive week, though this week’s outflow is meaningfully smaller than the ones observed in the 5 previous weeks. Still, during the past 39 weeks, European equity funds experienced 38 weeks of outflows.

Global EM debt recorded a large outflow this week, the 9th in a row, in sharp contrast
with the improving trend we saw during the past 7 weeks. Commodity funds recorded a
marginal outflow.
On the duration front, we saw outflows across the entire curve, though mid-term IG
funds led the trend by far." - source Bank of America Merrill Lynch

So yes, there is a "Great Rotation" from "growth" to "value" stocks in US equities, but, in credit land, there is as well a more defensive stance taking place and this doesn't bode well we think for 2019, particularly it could mean even more bad news for equities if one continues to believe that credit leads equities.

When it comes to the year ahead we read with interest Bank of America Merrill Lynch's take in their "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" that ties up nicely with our "Mithridatism" title:

"The Toxic Brew that threatens near term…

Three market drivers have turned hostile simultaneously. 1) The inflation-adjusted global monetary base was growing 10% YoY at the start of the year, and is now contracting 1%. Based on current Fed balance sheet contraction targets of USD472bn in 2019, and a flat ECB and BoJ balance sheet, it is projected to contract 4.6% by December 2019.

2) The breadth of global economic growth has collapsed – in January 2018, 26 of 38 i.e. 70% countries saw rising leading economic indicators, now only 6, or 16% are. This is close to the lowest decile of global economic breadth in the past 35 years.

3) Global equity market breadth has also collapsed. In January, 46 of 47 equity markets were above their 200-day moving averages, now only 6, or 13% are. Again, this is near the bottom decile. This triple toxic brew has percolated only three times in the past 35 years – in 1990, 1998 and 2001.

Each period was rough for risk assets, followed by central banks capitulating and easing monetary policy. Once the monetary elixir arrived, markets rallied hard, except in 2001, when it took longer to work off the TMT bubble valuations. We expect this time will be no different. While global monetary authorities currently plan to tighten, they are most likely to panic next year, and reverse themselves. Asia/EMs are poised to lift-off when that capitulation occurs." - source Bank of America Merrill Lynch

So global growth is indeed decelerating, credit markets are widening, the Fed blinked and it looks like many are hoping for China to come once again to the rescue and provide more Mithridatism it seems.


While Mithridatism being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts, it seems to us that ng the Fed with its QT is trying to gradually impose to markets more "price discovery" by administering non-lethal amount of rates hike and gradual liquidity withdrawal, a very difficult exercise indeed after years of repressed volatiliy. Our final chart below is asking if indeed the Fed already broke something or not.

• Final chart -  Did the Fed already break something?

Did the Fed recently blinked and December hike will need to a more data dependent Fed? This is the ongoing raging question everyone is wondering about. Clearly liquidity withdrawal has already blown in 2018 the house of straw of the short-vol pigs, the house of sticks of the Emerging Markets carry tourists, and it seems that as of late the house of bricks of the credit pigs have lost a few. The question that remains is if indeed in this cycle the Fed will break something else in 2019. The below chart comes from Bank of America Merrill Lynch "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" and displays the Fed's tightening in this cycle at 5.2% in total:

- source Bank of America Merrill Lynch

Given the above no wonder US based money market funds attracted $81 billion over the weekly period, the largest inflows on records dating to 1992 according to Lipper. It seems to us that some pundits don't believe that much in "Mithrandism" and its potential to protect from the "poison" of liquidity withdrawal but, we ramble again...

 "The true alchemists do not change lead into gold; they change the world into words."- William H. Gass

Stay tuned !