Macro and Credit - Respite

"I decided that there was only one place to make money in the mutual fund business, as there is only one place for a temperate man to be in a saloon: behind the bar and not in front of it." - Paul Samuelson

Looking with interest at the strong rebound in high beta in credit markets in conjunction with oil prices, with bad news (European macro) becoming good news for asset prices thanks to central banking intervention and dovish tilt, when it came to selecting our title analogy, we decided to steer towards a legal one "Respite". A "Respite" is a delay in the imposition of sentence but in no way modifies a sentence or addresses questions of due process, guilt or innocence. The pardon power of the United States Constitution has been broadly interpreted to include a variety of specific powers. Among those powers are: pardons, conditional pardons, commutations of sentence, conditional commutations of sentence, remissions of fines and forfeitures, respites and amnesties. Historically, presidents have granted most respites for periods of 30 to 90 days and have renewed (extended) such delays when it seemed necessary. We therefore wonder how long the current "respite" and "rebound" in asset prices will last but we ramble again...

In this week's conversation, we would like to look at the most recent bounce in asset prices in the light of the weakening tone from the macro data coming recently from Europe and indicative of the dreaded "R" word, "R" for recession. So, is good news bad news again?

Synopsis:

• Macro and Credit - Bad News is the new Good News...
• Final charts -  Macro matters again...

• Macro and Credit - Bad News is the new Good News...

With Germany on track for "technical" recession, with Italy and France slowing down markedly and with Industrial Production falling depicting a bleak picture overall for Europe (German Industrial Production fell by 4.7% in December, the biggest decline since December 2009), the rally seen so far this year appears to us as more of a respite than a secular change to the overall picture:

- Graph source Bloomberg

Industrial production has been falling in Europe off the proverbial cliff and regardless of the continuation of the "yellow jackets" movement in France, we continue to believe that France's budget deficit for 2019 could be "North" of 4.5%. The services industry in France has been cratering and people tend to forget that services represent 80% in GDP for France versus an average of 76% in the European Union. So, yes, we do believe there is more downside from there for the European macro picture. We are not the only ones sounding the alarm. We read with interest Bank of America Merrill Lynch Europe Economic Weekly note from the 11th of January entitled "The "R" club is recruiting":

"December PMIs: closer to 50, but risks still to the downside

The final print of Euro area composite PMI came in at 51.1, down from 52.7 in November, and the weakest level in four years. A slowdown was reported in both sectors, with manufacturing PMI down to 51.4 from 51.7 in November and service PMI at 51.7 from 53.4 previously. The decline was driven mainly by core countries: French business sentiment was hit by the ‘gilets jaunes’ protests in December (PMIs for both monitored sectors fell below the 50-threshold), and in Germany manufacturing weakness is spilling over to the services sector. On the flipside, Italian PMIs recorded a small improvement in December, with composite PMI back at 50 (no-change threshold), after two months in contractionary territory. With composite PMI averaging below-50 (49.5) in Q4, growth momentum for Italy remains weak. However this improvement (in particular in the new orders balance) suggests some stabilisation in Q1.

Meanwhile hard data for 4Q is not helping either. Industrial production prints were particularly negative. We insist, the weakness goes beyond one offs. Trade data did not help either, neither in Germany nor in France. External demand lacks traction, consequence of the lagged impact of the NEER strengthening and Chinese weakness.

We still think that the Euro area data trough is only for 1Q19, foreign demand permitting. It is then when our China colleagues expect the region to start improving and, given the usual lags, when the negative impact of the NEER should start fading. But remember that Europe typically lags the rest of the world by a few months, and continued weakness in China and the ugly US manufacturing ISM print in December would suggest that foreign demand input to the Euro area is still a drag (Chart 1).

It is crucial for us to see whether the drop in US PMI was a one-off and when the impact of policy support will materialize in China. Meanwhile, we have to rely on low oil prices as a tailwind helping purchasing power and corporate profit margins in the Euro area (Chart 2).

- source Bank of America Merrill Lynch

Obviously given Germany is an export driven powerhouse, no wonder the trade war narrative which has prevailed over most of the course of 2018 has had the desired effect of not only pushing the German DAX index into bear market territory but also has had the effect of plunging Germany into technical recession.

Given the bloodbath experienced during the "Slaughter" Claus bear market of December, it is not surprising to see some sort of strong rebound in "high beta" land and for credit markets to rally particularly on the back of rising oil prices given the exposure of the US High Yield sector we have discussed in recent conversations. 

When it comes to the "Respite" and intensity of the rally in US credit, Bank of America Merrill Lynch in their High Yield Strategy note from the 11th of January entitled "HY Energy: Any Value Left Here?" made some interesting comments:

"Intensity of risk rally reaches historical records

An incredibly strong rally in credit has taken HY spreads down to 450bps from 540bps levels reached in early January. HYG has rallied 5.4% from its low prints around Christmas, the strongest such 10-day rally since Oct 2011 (post-US downgrade rebound) and March 2009 (post-GFC recovery). CCCs have outperformed BBs by 230bps in this move, and Energy was the strongest sector contributor.

As we outlined in our Jan 2 piece, a tactical bounce was likely from the oversold late- December levels as the market has done so in every episode of previous 200bp/3mo widenings. We also noted there that the average rally was 170bps within subsequent three-month horizons in such earlier episodes, and so a 90bp move so far provides a material down-payment towards that. While the market can continue to trend tighter in coming weeks, we think a pullback is possible and even likely here, just given the intensity of the move so far. In the 12 year history of HYG, it has only managed to post stronger 10-day gain in two instances: in 2011 when the market rallied from 900bps levels, and in 2009, when the market was coming out of the global financial crisis (GFC) with 1,800bps spreads. Spreads are not in 900s this time around and this is not 2009.

We continue to think that 500bps is an appropriate risk-neutral level of HY spreads here and the likely trading range around that is going to be +/-100bps. As such we view the current 450bps as somewhat tight and prefer to reduce our risk exposures towards more neutral levels from an earlier overweight. We will be looking to extend this to an outright underweight if the market continues to grind tighter from here towards 400bps levels.

We would be surprised if the index tightening deep into 3-handles in coming months. Similarly, we are inclined to move closer to home with our recent tactical CCC overweight given the move so far, which we viewed purely as a short-term reaction to oversold levels and not a fundamentally-driven position. In rates, the reversal in the 10yr yield from 2.55% low print on Jan 3rd to 2.75% recently makes us more interested in adding duration risk here again. We continue to see decent longer-term fundamental value in rates at current levels as inflation fears of 2018 fade into oblivion.

All changes to positioning described above should be viewed as a tactical reaction to very strong moves in the markets since early January, not as changes to our fundamental view this could be a turn in the credit cycle. No question, the return of risk appetite helps decrease the probability of irreversible tightening in financial conditions, but we think it would be too premature to argue conclusively that this is an all-clear signal.

Tactical rallies are perfectly natural after deep selloffs, but we will need more hard evidence that the damage to economic momentum so far is reversible. What will ultimately determine the course of history here is the direction of earnings growth. Our +10–12% US EPS growth estimate for next year provides us with the strongest argument that this cycle could roll on. However, we remain cognizant that this is a model estimate and models could be wrong. We also know that earnings growth in recent years was largely driven by technology, and recent downbeat outlooks from heavyweights like Apple and Samsung do not help this case. The best course of action here, we think, is to stay open-minded on the question of a cyclical turn." - source Bank of America Merrill Lynch

As we stated in various conversations including our last, we tend to behave like any good behavioral psychologist in the sense that we would rather focus on the flows than on the stock. On that note we continue to monitor very closely fund flows when it comes to the validation of the recent "Respite" seen in the market and it is not a case of confirmation bias from our side. 

We think that a continued surge in oil prices will be supportive to US High Yield. As well, any additional weakness in the US dollar will support an outperformance of selected Emerging Markets. Sure we might be short term "Keynesian" but overall, at this stage of the cycle we do remain cautiously medium-term "Austrian".  When it comes to fund flows we read with great interest Bank of America Merrill Lynch Follow the Flow note from the 11th of January entitled "Is the worst finally behind us?":

"Some signs of relief

This year has started on a positive note. Despite further weakness on the macroeconomic data front across the globe, risk assets managed to rebound. Light positioning and the end of year sell-off allowed investors to buy the dip. Flows have shown signs of relative stabilisation with fixed income funds seeing inflows and equity funds suffering the smallest outflows in a while. However, we feel that this rally will be short lived as macro continues to disappoint and spreads need to head wider before they tighten again.

Over the past week…

High grade funds suffered another outflow, making this one the 22nd week of outflows over the past 23 weeks. However, this week’s outflow is the second smallest observed over that period. High yield funds recorded another outflow, the 15th in a row, but also the smallest in a while. Looking into the domicile breakdown, European focused funds recorded the lion's share of outflows while US-focused funds outflow was more moderate. Global-focused funds only marginally suffered.

Government bond funds recorded a large inflow this week, the largest in 27 weeks and the 5th over the past 6 weeks. Meanwhile, Money Market funds recorded another sizable inflow. All in all, Fixed Income funds recorded an inflow, putting an end to 18 consecutive weeks of outflows.

European equity funds saw some relief, recording a very marginal outflow this week. Still, this makes it the 18th consecutive week of outflows. During the past 44 weeks, European equity funds experienced 43 weeks of outflows. Chart 1: Risk assets fund flows managed to record a rebound in the first week

Global EM debt shifted back into positive territory this week with a sizable inflow, thus ending a series of 13 consecutive weeks of outflows. This confirms the improving trend observed recently. Commodity funds recorded another inflow, the 5th in a row.

On the duration front, short-term IG funds led the negative trend by far. Mid-term funds saw a small outflow while long-term funds experienced a decent inflow." - source Bank of America Merrill Lynch.

Following the December rout, it is all about damage assessment we think at this stage. The macro picture continues to display a deceleration in both global trade and global growth, now we think, it is all about the earnings picture and given the large standard deviation moves seen in some instances such as Apple, Delta Airlines, Macy's and many more, we are left wondering if indeed this rally can sustain itself on the back of a more dovish tilt from the Fed.

If indeed from a macro perspective at least in Europe it's the "R" word, for "Recession" in many instances, then we wonder if the "D" word, for "Deflation" when it comes to looking at the savage earnings revisions seen so far at a very rapid pace:

- graph source Bloomberg

On the question of the "Deflation" and earnings we read with interest the latest article on Asia Times from our esteemed former colleague David P. Goldman in his article from the 11th of January entitled "How widespread is creeping deflation in the US stock market?":

"Companies with challenged business models account for nearly two-thirds of the S&P 500's top 50 earners

"Investors are waiting for guidance from the US-China trade negotiations, but most of all they are waiting for indications of how the economic disruptions of the past few months will affect earnings.

The slightest hint of squishier earnings guidance provokes brutal punishment. Wednesday it was telecom providers, today retailers. Fragile business models make most US market leaders risky. That’s why I don’t think a dovish Fed is enough to sustain a market rally.

Department stores led declines today, with Target bringing up the rear in the S&P 100 (-4%) and department stores taking the bottom slots in S&P 500 performance – Macy’s (-19%), L Brands (-7%), Kohls (-7%), Nordstrom (-5.4%).

Airlines took yet another beating, with American Airlines down 6.2%. It’s all about pricing power. Consumers are still spending, with real personal consumption expenditures up 1.9% year-on-year as of November, and more workers are earning a paycheck. Consumer debt service comprises the lowest percentage of personal income since the data were collected.

Yet consumer names have been battered. Apartment real estate investment trusts face falling rents, airlines face passenger pushback on price, aging brands face competition from cheaper generics, and tech companies face resistance to overpriced products, for example, Apple.

Roughly two-thirds of the top 50 S&P 500 companies (ranked by earnings before interest, taxes, depreciation and amortization) face a serious challenge to their business models.

The complete annotated ranking is shown below. Economic growth is not the only issue worrying the stock market. Most of the market leaders are aging monopolies that risk losing their grip on customers.

The biggest exception to this rule is Amazon, which is doing most of the disrupting. But the fact that Amazon is able to disrupt everyone else depends on the willingness of Amazon shareholders to live without earnings. It now trades at around 110 times trailing earnings. Netflix trades at 95 times trailing earnings.

Deflation and value destruction are bad for equity markets. Amazon eats the retail market, and the department stores crash, along with CVS, and the REITs that own the properties from which the retailers rent.

Huawei crushes Apple in the Chinese market. Sprint, T-mobile and even more aggressive discounters erode the earnings of AT&T and Verizon. Proctor and Gamble, Johnson and Johnson, General Mills, Campbell’s and Kraft-Heinz have to sell their products on an Amazon web page that conveniently flashes an ad for a generic alternative.

Taken together, companies with challenged business models generate nearly two-thirds of the earnings among the top 50 members of the S&P 500.

(click to enlarge)

- source Asia Times - David P. Goldman

Now if higher profits were somewhat "juiced" up by stock buybacks, then indeed no wonder earnings revision have been savage so far. Back in October last year in our conversation "The Armstrong limit", we quoted as well another article from David P. Goldman and discussed the "profit illusion". 

In our macro book, the "velocity" in "earnings revisions" regardless of the "Respite" due to "bad news" being "good news" again in forcing the hand of our "generous gamblers" aka our central bankers, mean that the growth outlook for the US is also at risk. This is pointed out by Bank of America Merrill Lynch in their US Economic Weekly note from the 11th of January entitled "Earnings downgrades =  GDP downgrades" and we are not even mentioning the ongoing government shutdown at this stage:

"Earnings downgrades = GDP downgrades

• Earnings estimates continue to be slashed, which suggest that further downward revisions to GDP growth are forthcoming.
• While the direction of revisions is relevant, be careful relating actual earnings growth to economic performance.
• After controlling for oil prices and the services share of the economy, economic and earnings growth become much less correlated.

Resetting expectations

Earnings estimates for 2019 are being slashed. Just this week, Macy's and Barnes & Nobles made news by cutting their profit estimates while American Airlines warned that earnings may fall short of expectations. It seems that analyst estimates may still be too optimistic even after a slew of downward revisions over the past few months. According to Savita Subramanian and team, the consensus EPS growth is 7% for this year, which is down from the 10% forecast just three months ago

What does this tell us about the economy? It is intuitive for earnings estimates to correlate with economic growth as earnings are a function of expected revenue growth. A simple scatter plot of annual EPS growth and nominal GDP growth shows the positive correlation (Chart 1) but with very low significance.

This means there is more to the story. We see three reasons that earnings will differ from US economic growth:

1. S&P 500 has greater sensitivity to global growth with 46% of sales coming from foreign markets. In contrast, only 12% of US growth is from exports.
2. Oil prices have a different impact on the S&P 500 than on the overall economy. There is a clear positive correlation for the market – higher oil prices boost earnings for energy companies. The impact on the US economy is slightly negative.
3. The S&P 500 has a greater concentration of manufacturing

We run a series of models to determine how much these factors influence the relationship between earnings and GDP growth. We first start with a regression of earnings growth as a function of US and global GDP growth which shows a statistically positive relationship between GDP growth and earnings. We then include oil prices which show up as a positive relationship with earnings and reduce the significance of US and global GDP growth. Swings in oil prices can overwhelm the impact of growth. Think back to 2015 when the decline in oil prices led to an earnings recession without an economic one. Adding in the change in services share of the economy ends up leaving US and global GDP growth as insignificant. This tells us that as the economy becomes more services based, the relationship between earnings and US growth weakens.

The sensitivity to global growth and oil prices allows earnings growth to be much more volatile with a standard deviation of 17% vs. nominal GDP growth of 2.5% (Chart 2).

This could also be explained by the fact that the sample for aggregated earnings change overtime, thus creating a bias that does not reflect the whole economy.

We revise together

While the relationship between GDP growth and earnings growth is complicated, as we argue above, we still can take signal from the forecasts for earnings. We find that the direction of earnings revisions can tell us something important about the direction of GDP revisions. As Chart 3 shows, the consensus forecast for earnings and GDP growth tend to be revised in tandem.

Looking at the evolution of forecast for the current year earnings and GDP growth over the past four years, the direction is consistent. The outlier was in 2015 when earnings were slashed more dramatically than GDP and the latter actually ended up being revised higher at the very end of the year.

Collecting all data

Given the high degree of uncertainty about the outlook, we should look at all sources of information. As Fed Chair Powell has made clear in recent remarks, on the one hand, the economic data continue to point to a solid expansion. But on the other hand, market measures have deteriorated with a sharp sell-off in equities and a flattening in the yield curve. We consider earnings estimates to be a mix of both economic and market signals.

We think they are pointing to a moderation in growth but not a contraction. We should heed Powell’s advice. Have patience until we see who is right – the data or the markets." - source Bank of America Merrill Lynch

Where we disagree with Bank of America Merrill Lynch's take is with the "solid expansion" narrative. A flattening curve in our book is not positive for banks and cyclicals such as housing and autos have already turned.  Also as briefly pointed out, a sustained shutdown is likely to be another drag on US growth which will therefore push the Fed's hand further into "dovish" territory". In that context, and if inflows return into credit markets, then high beta credit as well as Investment Grade could continue to thrive in the near term given Fed Chair Powell indicated in the latest FOMC minutes a willingness to be patient with future rate hikes. 4Q US GDP might disappoint we think.

If 2018, with liquidity being reduced thanks to central banks was volatile, 2019 marks we think the return of "macro" and given the rise in dispersion it also marks the return of active management we think as per our final charts below.

• Final charts -  Macro matters again...

With global liquidity supply on reduction mode and with 2018 marking the return of volatility, with rising dispersion and more and more large standard deviation moves, 2019 will continue to indicate a return of macro as an important factor for returns. This means that active management, should benefit from this trend. Our final charts come from Bank of America Merrill Lynch note Why They Did What They Did from the 9th of January entitled "What's past is prologue":

Macro mattered more than fundamentals in 2018

Based on the ~40 macro factors and ~50 quantitative factors we track, macro factors had higher explanatory power on stocks’ 2018 returns than fundamental factors (average R-squared of 5% for macro factors vs. 1% for fundamental factors).

And the top 10 factors with the highest explanatory power were all macro factors – in particular, credit spreads, commodities, the USD, consumer confidence, and the VIX.
As for fundamental factors, one of the most explanatory factors on returns in both 2018 and 4Q was Beta.

Stocks less sensitive to macro (idiosyncratic stocks) have outperformed

• Some stocks tend to move more with macro factors (i.e. high systematic risk) while others move less (i.e. more idiosyncratic). In our recent report we grouped BofAML-covered US stocks based on their overall macroeconomic (i.e. multivariate) impact using a principal components (PC) regression.

• The results from the screen and a backtest of its performance over time suggested that idiosyncratic stocks (those with a below-median regression Rsquared) have outperformed systematic stocks (those with an above-median regression R-squared) since the crisis (including last year), primarily due to lower annualized volatility of the former with slightly better annual returns.

• Segments of the S&P 500 most exposed to risks around trade – in particular, multinationals with high China exposure and stocks in industries with high import costs—have seen multiples compress most (by ~20%) since trade tensions began to rise last February.

- source Bank of America Merrill Lynch

While investors have been enjoying a welcome respite in the early days of 2019, with "bad news" becoming "good news" at least from a "dovish" Fed narrative, we do not buy the strong expansion narrative put forward by many sell-side pundits, though if indeed flows return to credit markets, Investment Grade credit could thrive again at least in the near term from a "Keynesian" perspective. There is no doubt that growth is decelerating and our concern is that cooler head can prevail avoiding us from moving from the "R" word of recession towards the "D" word of depression, but that's a story for another day. Enjoy the ride while it last.

"The only safe ship in a storm is leadership." -  Faye Wattleton, sociologist

Stay tuned !