Saturday 27 April 2019

Macro and Credit - From Dysphoria to Euphoria and back

"Fear and euphoria are dominant forces, and fear is many multiples the size of euphoria. Bubbles go up very slowly as euphoria builds. Then fear hits, and it comes down very sharply. When I started to look at that, I was sort of intellectually shocked. Contagion is the critical phenomenon which causes the thing to fall apart." - Alan Greenspan

Looking at the very strong rally experienced so far this year in the high beta space nearly erasing the pain inflicted in the final quarter in 2018, when it came to selecting our title analogy, we reminded ourselves about "Dysphoria" being a profound state of unease or dissatisfaction. In a psychiatric context, dysphoria may accompany depression, anxiety, or agitation, whereas the opposite state of mind is known as "Euphoria". As well, this post is a continuation of our November 2016 conversation "From Utopia to Dystopia and back", given the continuing reversal of the 1960s utopian revolutionary spirit towards a more populist and conservative political approach globally which we think will materialize even more in the upcoming European elections next month. But, from our much appreciated behavioral psychologist approach to macro and credit perspectives, we reminded ourselves the wise words of our friend Paul Buigues in his 2013 post "Long-Term Corporate Credit Returns":
"Even for a rolling investor (whose returns are also driven by mark-to-market spread moves), initial spreads explain nearly half of 5yr forward returns." - Paul Buigues, 2013
Returns are related to starting valuations and are more volatile during transitional states  regimes, this is a very important point for credit investors we think going forward: 

"Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates.
As a consequence, spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors."  - Paul Buigues, 2013
Also, "dysphoric and euphoric" moves in markets are regular features we think in late cycles:
"Spreads moves between June 2007 and October 2008 (from 250bp to 2000bp in just 16 months) were a great illustration of this manic-depressive behaviour (which can also be related to Minsky’s model of the credit cycle). " - Paul Buigues, 2013
Another great illustration of this manic-depressive behaviour from credit investors was the very significant rally in high beta credit during the second part of 2016 and in particular in the CCC bucket in US High Yield thanks to its exposure to the energy sector and to the rebound seen in oil prices at the time.

In this week's conversation, we would like to look at the start of the deleveraging in US corporate credit and what it entails, a subject we already approached in January 2019 in our conversation "The Zeigarnik effect" as well as in April 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets".

  • Macro and Credit - Under reconstruction
  • Final chart - In the short term, clearly a dovish Fed marks a return of "Goldilocks" for credit markets

  • Macro and Credit - Under reconstruction
Given "Deleveraging" is generally bad for equities, but good for credit assets, one might wonder if indeed credit might in the near term start outperforming equities with CFOs become more defensive of their balance sheet. This would of course lead to less support to some US equities with reduced buybacks and even dividend cuts in some instances. Obviously buybacks have been highly supportive of the ongoing rally seen in US equities over the years thanks to multiple expansion. When companies turn conservative and start reducing debt, credit holders benefit and equity holders lose out, that simple.

An illustration of the above was pointed out by Lisa Abramowicz from Bloomberg on the 24th of April relating to AT&T:
"What's good for AT&T's bond investors is bad for its stock holders. The company is losing subscribers as it cuts debt, leading to a stock slump. Its bonds, however, are soaring." - source Bloomberg
This is exactly the risks we highlighted back in January 2019 in our conversation "The Zeigarnik effect"
"If there is indeed a slowly but surely rise in the cost of capital, yet at more tepid pace thanks to the latest dovish tone from the Fed, then indeed, this could be more supportive for credit, if companies choose the deleveraging route in the US to defend their credit ratings. In this kind of scenario, it would be more "bond" friendly than "equity" friendly from a dividend perspective we think." - source Macronomics, January 2019
While the rally in high betas have been very significant so far this year with even the CCC bucket for US High Yield delivering around 8.8% return YTD, flows points towards "quality" (Investment Grade) over "quantity" (US High Yield) it seems as indicated by Bank of America Merrill Lynch in their Follow The Flow report from the 26th of April entitled "Reaching for quality yield":
"IG funds flows continue uninterrupted
Another week of the same it seems. Fixed income investors continue reaching for “quality yield” via high-grade paper, while reducing risk in the government bond market. With government bond yields still close to the lows, it comes as no surprise to us that investors are looking to source non-negative yielding instruments. At the same time the lack of clarity on global growth is deterring investors from adding risk in equities.
Over the past week…
High grade funds saw an inflow for an eighth week in a row, extending the longest streak of inflows since 2017. We note that the slower pace w-o-w could be attributed to the short week due to the Easter holidays. Should we adjust this week’s inflow (for only three business days) it is almost at the same level as the inflow seen a week ago.

High yield funds recorded an inflow last week, the third in a row. Looking into the domicile breakdown, European-focused funds recorded the bulk of the inflow followed by Globally-focused funds. US-focused funds saw an outflow.
Government bond funds registered an outflow for the second week in a row. We note that the pace (despite the short week) has more than doubled w-o-w. Money Market funds recorded a sizable outflow last week, the second largest ever recorded. All in all, Fixed Income funds enjoyed their sixteenth consecutive week of inflows.
European equity funds continued to record outflows; the eleventh in a row. Note that over the past 59 weeks the asset class has recorded only two weeks of inflows.
Global EM debt funds recorded a small outflow, only the second this year, reflecting the appreciation of the USD over the past couple of weeks. Commodity funds saw an outflow last week, the third in 2019.
On the duration front, even though there were inflows across the curve, mid-term IG funds saw the bulk of the inflow." - source Bank of America Merrill Lynch
Back in early April in our conversation "Easy Come, Easy Go", we pointed out to the return of "Bondzilla" the NIRP monster and the returning appetite from Japan's Government Pension Investment Fund GPIF and their friends Lifers, shedding hedging and adding more credit risk in their allocation process. Therefore it is not a surprise to us to see an increase in allocation to Investment Grade credit in terms of fund flows.

The appetite for foreign bonds for Japanese Lifers is indicated by Nomura in their Matsuzawa Morning Report from the 23rd of April entitled "Pension funds continue to build portfolios premised on an economic downturn":
"Lifers continued to buy super-long JGBs at relatively high levels in March. Buying generally tends to increase in January-March, but the fact that they are continuing to buy even as yields drop significantly, suggests that their shift to other assets such as foreign bonds is not sufficient. Four of the nine major lifers had released their FY19 investment plans as of yesterday. They are divided on Japanese bond investments, with two lifers intending to increase and two planning to reduce Japanese bonds. Compared with last year, they are not in favor of hedged foreign bonds (particularly USTs). They mention shifting instead to unhedged foreign bonds and, even among foreign assets, moving out of government bonds to credit and alternative investments, but it is not clear how far these can go as substitutions. Most of the lifers forecast USD/JPY rates around 108-110 at end-FY19, with all expecting rates to be about the same as at present or JPY somewhat stronger. The lifers predict 10yr UST yields in a 2.30-2.70% range, anticipating neither a rate hike nor a rate cut. Given these projections for the overseas environment, we believe lifers are unlikely to reduce the amounts left idle in Japan for lack of other options compared with FY18, but they could increase these amounts." - source Nomura
To repeat ourselves, like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments to take on more credit risk.

Also something to take note is that as dispersion is rising (which is a late credit cycle feature) some investors are playing it more "defensive" hence the reach for "quality". As well as pointed out by another Nomura Matsuzawa Morning Report from the 25th of April entitled "Flows return from EMs to US", it is worth noting what is happening in Emerging Markets credit wise:
"Overseas markets were risk-off overall on Wednesday. While flows were concentrated in the US, it looked to us like money was being pulled out of EMs. In the FX market, DXY increased significantly for a second day and USD/JPY reached the 112 range. At the same time, JPY was strong across the board in cross pairs, indicating that the market’s risk sentiment is weak—emblematic of unfavorable USD strength. EM currencies were also weak. Germany’s IFO came in below forecast, forcing investors to unwind their trades made hastily on the premise of Europe’s economic recovery. This makes sense to us, but we do find it interesting that Australia’s weak CPI not only triggered an AUD sell-off, but devolved into a risk-off flow that spilled over into EM and Japanese markets as well. It seems to us that market sentiment on EMs and resource-rich countries is beginning to deteriorate, so that even a small factor causes a major response in the market.
The CDS spread in EMs widened relatively significantly and reached the highest level since 3 January (Figure 2).

However, spreads on other instruments that act like canaries in a coal mine for the credit market, such as US high-yield bonds and European financial institutions’ subordinated bonds, are relatively stable, which leads us to surmise that these wide spreads can be attributed to an issue specific to EMs (supply/demand? fundamentals?) rather than to a risk-off flow in the entire credit market. In terms of supply/demand, we believe hedge funds locked in profits during the EM rally in January- March and are timing their return to the US to coincide with US companies’ strong earnings results. We see few factors that would prolong and deepen this flow, unlike the flows returning to the US due to the intensification of the US-China trade dispute last year. In terms of fundamentals, Chinese policymakers’ moves toward a more neutral policy stance could be having an impact. Yesterday, the People’s Bank of China (PBoC) injected liquidity via a targeted medium-term lending facility (see the 24 April edition of Asia Insights). This is seen as an alternative to lowering the reserve requirement ratio, and after this supply was announced, additional easing expectations declined, causing short-term rates (SHIBOR) to rise and Chinese equities to fall. If the PBoC were to rush into a more hawkish stance at this point, we believe risk-off flows in EMs would intensify. In any case, during Japan’s 10-day holiday to mark the imperial succession, we expect EMs to be the focus. In addition to Japan’s holiday, China will have its May Day holiday on 1-3 May, and this could restrain the market’s movements. In addition, the release of China’s manufacturing PMI on 30 April could change economic sentiment.
Ironically, the concentration of flows in the US as economic conditions there improve has pushed down US bond yields as well, and the market reflects higher Fed rate cut expectations. In fact, Japanese investors seem to be playing a role in this, and the International Transactions in Securities released this morning show that they were major net buyers of foreign bonds for a second straight week in the most recent week for which data is available (week of 15 April; Figure 1).

Expectations for a Fed rate cut by end-2019 rose to 63% (56% on the previous day). Given that US economic sentiment has improved since April, it seems strange to us that a rate cut in 2019 should be part of the market’s main scenario, but as noted above, this can also be seen as a sign that investors are preparing for a credit event stemming from EMs during Japan and China’s national holidays. However, in this case, US bond yields would have room for a reactionary rollback once this period has passed without event." - source Nomura 
The overseas support from Japanese investors to US credit markets should not be underestimated. They provide significant support to US credit markets hence the importance of tracking their investment and flows from a credit and macro perspective. as per the chart below from Nomura FX Insights report from the 24th of April entitled "Lifers still look for foreign assets":
- source Nomura

This is chart we think is very important we think from an allocation perspective as explained by Bank of America Merrill Lynch in their Credit Market Strategist note from the 18th of April entitled "Party like it's 2016":
"Party like it’s 2016
During the years 2015-2017 foreigners and bond funds/ETFs bought all net supply of US corporate bonds (Figure 1), creating excess demand and driving spreads much tighter starting in February 2016.

Then in 2018 the Fed engineered a disorderly rate hiking cycle and a yield shock, as they were the only major central bank hiking and at the same engaged in QT. As a result, the corporate bond market lost the foreign buyer and inflows to bond funds/ETFs plummeted – hence the big 112bps increase in corporate yields during 2018 was necessary in order to attract other buyers, specifically pension funds (the majority of which state and local).
Given the Fed’s capitulation on monetary policy tightening this year we think 2019 will look much like 2016 as far as corporate bond demand goes, with foreigners and bond funds/ETFs once again buying all net supply. While the outlook for demand this year thus is similar to 2016, we expect ~$250bn less net supply ($100bn less gross supply, $150bn more maturities). Hence, we are unable to escape thinking that demand-supply technicals will remain positive and supportive for spreads for a while. Just like in 2016, although spreads this time are tighter so the rally cannot continue as long (Figure 2).
2019 vs. 2016
Foreign buying – as reflected in negative net-dealer-to-affiliate volumes – has been running very strong this year at a pace matching what we saw in 2016 YtD (Figure 3).

Given that peak weakness in 2016 was on February 11, i.e. later in the year than the January 3rd wides this time, not surprisingly inflows to IG bond funds and ETFs are running well ahead of 2016’s pace YtD (Figure 4).

However, on adjusting for the difference in timing within each year clearly inflows this year following the wides is ramping up much faster that we saw following peak spreads in 2016. Finally gross new issuance is running at the exact same pace this year YtD as in 2016 (Figure 5).

For 2016 we originally forecast about $1.2tr of supply and ended up getting almost $100bn more ($1.289bn). For 2019 we are also forecasting about $1.2tr, and with the decline in yields and wide open markets, clearly the risk this year is again to the upside relative to our forecast first published in a very different environment in 4Q18. Should we again get about $100bn up upside, keep in mind that net supply will still be down $150bn this year due to more maturities." - source Bank of America Merrill Lynch
Indeed, we could see a continuation of the "melt-up" at least in credit markets thanks to the strong technical support in conjunction with overseas interest from the likes of Japanese investors.

But, returning to our main story of "Deleveraging" by CFOs, this we think could provide even more support to credit markets and translate into more "sucker punches" à la AT&T as illustrated earlier in our conversation. This would favor even more credit investors over equities investors we think. So, yes we are "bullish" credit. On that very subject of "Deleveraging by CFOs, we read with great interest Bank of America Merrill Lynch's take in their Credit/Equity Strategy note from the 22nd of April entitled "The Age of Balance Sheet Repair":
"A formula for growth in a low-growth environment
Low growth, low interest rates and low equity valuations in recent years have pushed US corporations to search for new drivers of financial performance. Many of them gravitated to a formula of tapping their balance sheet capacity to issue cheap debt and fund M&A and share buybacks. In only the last five years, companies repurchased $2.7trln of shares, paid $3.3trln in dividends, all while increasing their debt by $2.5trln. For some perspective, their combined capex budgets stood at $9.6trln during this time.
About 30% of EPS growth driven by gross buybacks
Buybacks have been seen as the savior of a lackluster profits cycle: US stocks (proxied by the Russell 3000 ex-Financials/Utilities/Real Estate) have seen EPS growth of 45% over the last five years, but gross share buybacks contributed 12ppt, ~30% of that growth (with the net buyback impact about half of that, or 6ppt). Over the same period, net debt doubled. An elevated equity risk premium and a low cost of debt encouraged debt-funded buybacks, and a scarcity of real revenue growth made this more compelling.
The age of balance sheet repair is here
Late 2018 was the turning point in this cycle of expanding debt balance sheets, buying growth and rewarding shareholders, in our opinion. Interest rates have risen and the market dislocation in Q4 played the role of a wake-up call to the largest bond issuers. This message was particularly loud and clear as it related to BBB issuers, many of whom saw their spreads north of 200bps, levels normally reserved for HY bonds. Given their sizes – many in excess of $20bn in bonds, higher than any existing HY issuer – the message was also critical: delever, or else expect material risk premiums if downgraded to HY. We include screens for largest BBB issuers, those with greater ability to delever and those with greater degree of dependence on capital markets.
Reset your expectations lower from here
Today, the game has changed. Three times as many investors want companies to pay down debt than to buyback stocks, and the cost of equity capital reflects this: the relative multiple of levered companies vs. cash-rich companies is now at a 7% discount to history. We expect a return to normalcy: recall that buyback-driven EPS growth was largely a post-crisis phenomenon, and pre- 2009, companies were mostly net issuers. Based on these and other considerations, our S&P 500 EPS forecast for 2020 of $180 (7% growth) incorporates no net buyback effect, and we see downside risk to per share growth going forward from dilution, not net share count reduction. Sectors where buyback activity is most likely to continue (Fins and Tech, where leverage is still historically low) may be unduly rewarded as the buyback theme grows scarce.
Strong balance sheets are good for all investors
The key takeaway here is that times are changing. After years of transferring value from bondholders to shareholders companies may now be forced to instead defend their balance sheets at the expense of shareholders. Our findings suggest that initial negative reaction in share prices is often short-lived, and eventually equities benefit from stronger balance sheets too." - source Bank of America Merrill Lynch
You have been warned, the fourth quarter was a wake-up call for many US CFOs and given the euphoria we have seen as of late in high beta, we would rather side with the "cowards" aka credit markets over "equities" in the second half of this year, particularly given Investment Grade is as well a far less volatile proposal.

The leverage "situation" is described in more details in Bank of America Merrill Lynch's note:
"Low growth, low interest rates, low equity valuations
In the years that passed since the Global Financial Crisis (GFC), many historical norms that were established over previous decades came into question. Economic growth has slowed with the trailing-10yr real US GDP growth bottoming out at 1.5% annualized in 2011-2018, a post-great depression low. This growth pattern also compares to 3.6% 10yr trailing average in the 2003-2006 cycle, and 4.2% in the mid-1990s. Inflation has also dropped to 60-year lows, as measured by core PCE. The Fed responded to this predicament by keeping real interest rates at negative levels for several years in a row.
For US corporations, this backdrop implied two new factors: their earnings were unusually difficult to grow organically, and their debt was unusually cheap (Figure 1).

Their managements have responded to this macro backdrop in a predictable way, by borrowing cheap debt and using its proceeds to buy back shares, thus improving EPS, and funding M&A (Figure 2).

Fast forward to today, and we are looking at corporate balance sheets that are carrying cyclically high levels of debt leverage, a development that usually happens after credit cycle turns and EBITDAs drop.
The large credit expansion over the last decade was supported by both strong demand and ample supply of corporate bonds. On the demand side investors were forced to reach for yield in US credit as a function of inability to achieve their income targets in other fixed income markets. On the supply side companies were put their balance sheets to use by borrowing at the historically low interest rates, while also satisfying the growing demand for their bonds.
While borrowing to enhance shareholder returns and acquire new businesses is not a new phenomenon, it has reached new highs over the past decade (Figure 2). Looking more broadly at US nonfinancial corporate business, corporate bond borrowing covered 58% of net spending on buying equities. This includes both share buybacks and M&A activity (Figure 3).
Reaching the limits of releveraging
The demand and supply dynamics are now turning less favorable to releveraging. On the demand side Fed’s hiking cycle in 2018 made it more difficult for foreign investors to buy US corporate bonds due to higher FX hedging costs. At the same time higher interest rates and the corresponding bond price declines weakened inflows to high  grade bond funds and ETFs. The result was a notable decline in demand for corporate bonds in 2018, although it has improved this year. In terms of supply, higher corporate bond yields mean borrowing costs have increased for US companies.
On top of that after years of cheap credit a number of issuers have reached their balance sheet limits. For US non-financial issuers leverage is currently around cyclical highs (Figure 4).

Based on BofA Merrill Lynch Global Fund Manager Survey, equity investors are now more focused on balance sheet repair that at any other point in this credit cycle (Figure 5).

Investors have grown disenchanted with buyback driven per share growth and are more interested in balance sheet improvement. Almost half (43%) of investors want excess cash used to improve balance sheets, a post-crisis high, compared to just 33% desiring increased capex and a paltry 16% desiring cash return to shareholders. The chart also shows strong cyclicality and previously has reached this level of credit-related concerns only in 2008 and 2002.
A preference for clean balance sheets is evident in valuations, where we find that levered companies within the S&P 500 have de-rated to trade a historical discount to cash-rich peers (Figure 6).
- source Bank of America Merrill Lynch.

If indeed equity investors are getting "Dysphoria" being a profound state of unease or dissatisfaction, and want companies to improve their balance sheets, then indeed it should lead to more "Euphoria" from credit investors we think.

Strong technicals on the back of overseas demand and a 2016 issuance level situation does indeed make us bullish for now on credit markets and in particular for US Investment Grade thanks to a dovish Fed as per our final chart below

  • Final chart - In the short term, clearly a dovish Fed marks a return of "Goldilocks" for credit markets
While a strong source of demand for US credit markets comes no doubt from "overseas" in general and Japan in particular, the dovish tilt from the Fed on the back of strong technicals such as issuance make it very supportive for credit markets for now as per our below chart displaying the fall in interest rate risk coming from Bank of America Merrill Lynch in their Credit Market Strategist note from the 18th of April entitled "Party like it's 2016":
"Crucial ingredient for the rally: Re-pricing the FedWe want to end by discussing the key sources of demand driving the present environment of strong technicals in IG – bond funds and ETFs and foreigners. The key development for both is this major shift in monetary policy expectations. The below chart shows that the Fed funds futures market went from pricing in three rate hikes over the coming twelve months to now pricing in about one ease (Figure 11). 
There are two key consequences of this: 1) dramatic decline in interest rates and 2) a much more benign outlook for dollar hedging costs for foreign investors." - source Bank of America Merrill Lynch
So if indeed we have seen a lot of "Euphoria" in the rally so far seen this year particularly in the high beta space  with the start to year for the S&P since 1987 (+17%) , with Oil up 35%, Small Caps by 19% and High Yield up by 9% (HYG) and Investment Grade (LQD) up a cool 7%, given the current "Dysphoria" feeling about the level of leverage for US corporate balance sheet, rest assured that they are more potential for additional AT&T sucker punches being delivered. One would be wise to trade accordingly and rotate towards the credit part of any US issuer at risk but we ramble again...

"Indeed, bull markets are fueled by successive waves of prior skeptics finally capitulating as their fears fade. Eventually, fear turns to euphoria, and that's the stuff of bubbles." - Kenneth Fisher
Stay tuned!

Wednesday 17 April 2019

Macro and Credit - Showdown

"In every battle there comes a time when both sides consider themselves beaten, then he who continues the attack wins." -  Ulysses S. Grant

Watching with interest the lingering Brexit saga playing on in conjunction with the much commented trade war between China and the United States, when it came to selecting our title analogy, we decided to go for yet another poker card game reference (previous ones being "Poker tilt", "Le Chiffre", "Optimal bluffing", the "Donk bet", to name a few in no particular order). In the game of poker, the "Showdown" is a situation when, if more than one player remains after the last betting round, remaining players expose and compare their hands to determine the winner or winners. To win any part of a pot if more than one player has a hand, a player must show all of his cards face up on the table, whether they were used in the final hand played or not. Cards speak for themselves: the actual value of a player's hand prevails in the event a player mis-states the value of his hand. Because exposing a losing hand gives information to an opponent, players may be reluctant to expose their hands until after their opponents have done so and will muck their losing hands without exposing them. Robert's Rules of Poker state that the last player to take aggressive action by a bet or raise is the first to show the hand - unless everyone checks (or is all-in) on the last round of betting, then the first player to the left of the dealer button is the first to show the hand. 

If there is a side pot, players involved in the side pot should show their hands before anyone who is all-in for only the main pot. To speed up the game, a player holding a probable winner is encouraged to show the hand without delay (Brexit comes to our mind). Any player who has been dealt in may request to see any hand that is eligible to participate in the showdown, even if the hand has been mucked. This option is generally only used when a player suspects collusion or some other sort of cheating by other players. When the privilege is abused by a player (i.e. the player does not suspect cheating, but asks to see the cards just to get insight on another player's style or betting patterns), he may be warned by the dealer, or even removed from the table. There has been a recent trend in public cardroom rules to limit the ability of players to request to see mucked losing hands at the showdown. One would probably think a similar rule should be applied to Brexit negotiations but we ramble again...

In this week's conversation, we would like to look at US consumption and consumers, following the significant rally in the high beta segment of asset classes as we believe monitoring the state of the US Consumer in the coming months will be paramount. 

  • Macro and Credit - Secular stagnation or secular strangulation? 
  • Final charts - Yes, Europe is turning Japanese

  • Macro and Credit - Secular stagnation or secular strangulation? 

With U.S. consumer prices increasing by the most in 14 months in March to 1.9% thanks to Energy prices climbing by 3.5% and accounting for about 60% of the increase, in conjunction with The University of Michigan’s preliminary consumer sentiment survey falling to 96.9 in April, from 98.4 the previous month, one might wonder what is the state of the US consumer.

On a side note, given the recent rise of the MMT crowd we read with interest Dr Lacy Hunt's take in his latest 1st Quarter review. We highly recommend you read it, for those of you in the "Deflationista" camp. The Keynesian camp might be somewhat part of the "Inflationista" camp given their preference for 2% inflation and beliefs in the much antiquated "Phillips curve" (we have said enough on this subject on this very blog). It seems to us the MMT crowd, as rightly pointed out by Dr Lacy Hunt, could make us all fall into the "hyperinflationista" camp with their monetary prowess and "promises".

As well we have seen many recent conversations surrounding the fact that in many instances in Developed Markets (DM) the "middle-class" has been hollowed out. This has been discussed at length by the OECD in their recent paper entitled "Under Pressure: The Squeezed Middle Class".

Back in December 2014, in our conversation "The QE MacGuffin" we pointed out the following Societe General's take from their FX outlook on central banks meddling:
"It’s broken, and they don’t know how to fix it. It is remarkable that after so many years of super easy monetary policy, the global economy still feels wobbly. On the positive side the US continues to recover and the lower oil price will provide a boost to global growth in H1 2015. Yet the growth multipliers seem to be much weaker still than they have been historically, highlighting a lack of confidence, be it because of post-crisis hysteresis, the demographic shock, the excessive levels of non-financial debt, etc.‘Secular stagnation’ is the buzz word. The theory encompasses two ideas: 1) potential growth has dropped; 2) there is a global excess of supply, or a chronic lack of demand. If true, the implications are clear. First, excess supply creates global disinflation forces. Second, to fight lowflation and to help demand meet supply at full employment, central banks may need to run exceptionally easy monetary policy ‘forever’. In other words, real short-term rates need to remain very low, if not negative.
Life below zero. At the ZLB, central banks do what they know: they print money. But such policy seems to follow a law of diminishing marginal returns. It has worked well for the US, because the Fed had a first-mover advantage, and the support from pro-growth fiscal policy and a swift clean-up of the household and bank balance sheet. The BoJ and ECB aren’t as lucky. Let’s consider three transmission channels: 1) The portfolio channel. By pushing yields lower, central banks force investors into riskier assets, boosting their prices. But trees don’t grow to the sky. And the wealth effect on spending is constrained by high private and public debt. 2) The latter also gravely impairs the lending channel. And with yields already so low, it’s questionable what sovereign QE can now achieve. 3) The FX channel. This is where the currency war starts, as central banks try to weaken their currency to boost exports and import inflation. It however is a zero-sum game that won’t boost world growth.-The battle to win market shares highlights a fierce competitive environment, which tends to depress global inflation. Adding insult to injury, oversupply in commodities, especially oil and agriculture, currently add to the deflationary pressure. That leads central banks to get ever bolder, when instead they’d need to be more creative (e.g. a bolder ABS plan from the ECB would be far more effective than covered and government bond purchases) and get proper support from governments (fiscal policy, structural reforms)."  -source Societe Generale
High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates but, low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." source Macronomics, December 2014
The central banking "Showdown" is still going on we think. The "Global Savings Glut" (GSG), has been put forward by many defenders of Keynesian policies. 

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. But, returning to the wise note of Dr Lacy Hunt, he puts another nail in the coffin of this "Savings Glut" theory put forward by Dr Ben Bernanke:
"Secular stagnation is basically the rebirth of the over-saving theory. However, after WWII the U.S. balanced the budget, contrary to Keynes’s recommendation, and the economy boomed, permitting the U.S. to rebuild and open U.S. markets to the world’s exporters. What Keynes missed is that the national saving rate averaged over 10% during WWII, and the U.S. had a strong balance sheet. The private sector drew down their saving, and this propelled the economy higher. In 2018, the national saving rate was 3%, less than half the long-term average since 1929 and one-fifth the level of 1945. There is no excess saving to be drawn down (Chart 5)."
- source Hoisington, Dr Lacy Hunt

Given the worrying trend for the middle-class in DM countries, you probably understand by now our chosen title of "Secular strangulation". For instance the "yellow jackets" (gilets jaunes) movement in France is an illustration of the fear of downgrade for many middle-class families which have been eviscerated by continuous fiscal pressure over the years. End of our parenthesis on the GSG.

Returning to the paramount subject of the state of the US consumer, with the volte-face made by the Fed, mortgages rates have fallen in sympathy giving some much needed respite to the US housing market. Existing-home sales climbed nearly 12% in February from the month before, reaching an annual rate of 5.5 million, according to the National Association of Realtors, which attributed the growth partly to interest rates. Of course lower interest rates for home mortgages buoy the housing market. In 19 weeks since November, the rate on a 30-year mortgage dropped from 4.94% to 4.06%, the most rapid decline since 2008. But, given "Shelter" comprises 40% of the Consumer Price Index, we might see some erratic readings in the coming months. 

As illustrated recently by Bloomberg, an excess of 7 million Americans were at least three months behind on their car payments at the end of 2018:
- graph source Bloomberg

Given the rapid deterioration in financial conjunctions in conjunction with housing headwinds thanks to rising mortgages rates in the final quarter in 2018, we think that this conjunction of factors on top of falling equity prices managed to spook enough the Fed to generate the aforementioned volte-face.

Obviously this welcome respite has managed to trigger an incredible rally for high beta thanks to global dovishness from central banks overall. Yet, we do think that the current housing bounce we are seeing is only temporary and providing some short term relief to the US consumer increasingly using revolving credit aka it's credit card to maintain his consumption. On top of that, rising oil prices might be good news for US High Yield but, should gas prices continue to surge, it might start again to become a slight headwind for US consumers. This would point to overall weaker growth for the remainder of 2019 in the United States we think.

When it comes to the US Housing situation we read with interest Bank of America Merrill Lynch's take from their Housing Watch note from the 12th of April entitled "A brief housing pop":
"Get ready for some good data…for now
All signs are pointing toward a short term boost to housing activity following a difficult end to last year. At the end of last year, mortgage rates were the highest since early 2011, the stock market was selling off and confidence in the economy was declining. Prospective homebuyers sat on the sidelines, uncertain about their future finances and concerned about affordability.
It has all changed since then. Mortgage rates have tumbled, returning to levels last seen in January 2018, the stock market has recovered and confidence has returned. If buyers were hesitant last year, this environment has lured them back into the housing market. Indeed, mortgage purchase applications have climbed, pending home sales have improved and existing home sales in February were very strong. Survey measures, including our own proprietary survey, show more favorable perceptions around housing with people noting that buying conditions have improved (Chart 2, Chart 3).

Similarly, homebuilders feel more confident with the NAHB housing index improving and realtor confidence surveys ticking higher. In our last housing watch in January, we argued that we would see a “brief period of stronger housing data.” We are doubling down on that view and now revising up forecasts for home sales in 2Q (Table 1).

Why are we looking for just a short-term boost to home sales rather than a more persistent recovery? Importantly, affordability challenges still remain. While the drop in mortgage rates provides a jolt to housing, housing is still overvalued given the strong rise in prices over the past several years (Chart 4). In addition, we see evidence that existing home sales have reached an equilibrium level based on the historical relationship between sales and the labor force. Of the people in the work-force, we are
at a historically “normal” rate of existing home sales (Chart 5).

There are greater opportunities for new home sales than for existing given that the recovery for new construction has been lackluster. Builders have been shifting away from the high-end of the market where inventory is higher toward the more affordable part where there is still incremental demand. This can be seen through the average size of a new single family home slipping lower and a drop in new homes sold over $300,000
(Chart 7, Chart 8).

Of course, housing dynamics are going to differ by region. A good way of understanding the relative strength or weakness in housing conditions is to track migration.

We find that people continue to leave Northeast, the Midwest and the California to move to Texas, Colorado as well as other areas in the West and South." - source Bank of America Merrill Lynch
Given affordability is stretched, we agree with Bank of America Merrill Lynch, namely that the recent fall in mortgage rates is only providing some short term respite. When it comes to Main Street  it has had a much better record when it comes to calling a housing market top in the US than Wall Street. If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising in recent quarters. Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder. Housing activity is leading overall economic activity, housing being a sensitive cyclical sector.

The big question was that rising interest rates were starting to choke the US consumer hence the dovish tilt from the Fed following the horrific final quarter of 2018. 

On the state of the US consumer we read with interest Wells Fargo's take from their note from the 2nd of April entitled "U.S. Recession? How Do We Count the Ways?":
"Are Consumer Finances in Good Shape?
Household leverage generally, and mortgage debt specifically, was at the epicenter of the last downturn. Although the severe repercussions of consumers getting over-extended a decade ago may still be fresh in the minds of borrowers, lenders and regulators, overall household leverage has fallen substantially over the past decade (Figure 1). As Mark Twain said, however, history does not repeat, but it often rhymes. Are there other areas in consumer balance sheets that pose a risk to the economy from an extensive build up in debt and deterioration in lending standards?
While mortgage debt has fallen over the past decade, Figure 1 also shows that leverage of other types of consumer debt, including autos, credit cards, and student loans, is at an all-time high.

 - Source: Federal Reserve Board and Wells Fargo Securities
Yet unlike housing debt in the 2000s, the increase has not been exponential. Leverage for consumer credit is also only a quarter of the size of housing-related leverage at the height of the housing bust. What’s more, debt service remains exceptionally low. Historically low interest rates and longer repayment terms have kept households’ monthly financial obligations ratios near levels last seen in the early 1980s (Figure 2).
- Source: Federal Reserve Board and Wells Fargo Securities
Notably, the most significant driver of the increase in consumer credit has been student loans. Given that educational debt is nearly impossible to discharge and primarily backed by the federal government, we view student loans as a sustained, long-term headwind to other types of spending rather than a mass credit event that could cause the financial system to seize up like the subprime mortgage crisis. In short, we do not think that consumer debt problems will trigger a recession in the foreseeable future.
Corporate Sector Debt: Keep an Eye on This Space
Where leverage may be more concerning is in the non-financial corporate (NFC) sector. As measured as a percent of GDP, debt in the NFC sector is at a record high. With corporate profit growth slowing, the ability to service debt likely will deteriorate somewhat over the next few quarters. At the same time, a shift in investor sentiment could weigh on asset values, which up until recently had been keeping pace with debt.
The financial health of the business sector has deteriorated since 2015, and significant further deterioration would be worrisome (Figure 3).
  - Source: Federal Reserve Board and Wells Fargo Securities
Firms that are stretched financially may be more reluctant to invest and hire. In addition, if companies start having trouble servicing their debt due to slower growth and/or higher interest costs, rising charge-offs and loan losses could disrupt credit growth. However, the current health of the non-financial corporate sector does not seem particularly dire at present when compared to the late 1980s or ahead of what we consider to have been the business-led recession of 2001.3 Interest rates have been rising from a historically low level and are unlikely to rise much further this cycle, while companies have locked in historically low interest rates by holding more long-term debt.
One segment of business sector debt that bears particularly close watch is the leveraged loan market.
  - Source: Federal Reserve Board and Wells Fargo Securities
Leveraged loans are made to companies with high debt-to-cash flow ratios that are typically rated less than investment grade. Loans outstanding in this sector have grown 35% since 2016, twice as fast as total NFC debt. Slower economic growth this year could make servicing that debt more difficult and lead to weaker demand from investors, which would weigh on credit growth to the business sector and therefore the broader economy. Yet leveraged loans are floating-rate instruments, and, with the Fed currently on hold, interest costs are not expected to shoot markedly higher. As a result, we do not see the leveraged loan market as an immediate threat to the economy.
Is There Overbuilding in Construction?
The bursting of the U.S. housing market bubble precipitated the Great Recession but it does not seem that lightning will strike twice, at least not in the current cycle. As noted above, households have de-levered over the past ten years. The value of mortgage debt outstanding among households is down 4% relative to its peak in early 2008. But disposable personal income is up 50% over the past ten years, giving households better ability to service that mortgage debt than they had at the height of the housing bubble. Furthermore, single-family housing starts are roughly 50% lower than they were at the height of the housing boom (Figure 5).
  - Source: Federal Reserve Board and Wells Fargo Securities
Although the level of multifamily starts is a bit higher today than it was a decade ago, apartment vacancy rates are low and rent growth remains solid.
Despite indications of robust activity in commercial construction, we do not think that commercial real estate (CRE) is an accident waiting to happen, at least not in the foreseeable future. As we wrote last autumn, the underlying fundamentals in the CRE market appear to be strong. Despite appearances of robust construction activity, the level of real non-residential construction spending is only 16% higher today than it was before the economy tumbled into recession in late 2007. At the end of the expansion in the 1980s, real non-residential construction spending was more than 60% higher than its previous peak. Commercial banks hold nearly $1.7 trillion worth of commercial mortgages, an all-time high. However, this amount represents less than 11% of their total financial assets, which is not out of line in a historical context (Figure 6).
  - Source: Federal Reserve Board and Wells Fargo Securities

Whereas it might be a little premature to call for a decisive turn of the credit cycle, to repeat ourselves, the next Fed Quarterly publication of the Senior Loan Officer Survey will be extremely important to monitor.

For now the US consumer is still holding on apparently. This is indicated by Bank of America Merrill Lynch in their BofA on USA report from the 11th of April entitled "The consumer spring into Spring":
"Strong consumer spending in March
The long-awaited rebound in consumer spending has arrived. According to BAC aggregated credit and debit card data, retail sales ex-autos jumped 1.5% month-over-month (mom) seasonally adjusted in March, partly reversing the decline over the prior three months. This recovery supports our view that the recent drop was largely due to temporary distortions rather than a fundamental weakening in consumer spending.
We see evidence that the timing of tax refunds pushed spending from February into March, specifically for lower income households. Those households receiving the Earned Income Tax Credit saw a significant delay in tax refunds, resulting in lower spending in February. Once tax refunds were received at the end of February, these households were able to spend, boosting activity in March. We see this notable swing in the data in the Chart of the Month.

It was the most apparent in the “discretionary” spending categories such as clothing, furniture and lodging. Interestingly, we did not see a big gyration in spending in restaurants which is typically sensitive to income changes. To be expected, spending at grocery stores was fairly steady over the prior two months (Chart 2).

We examine our tax refund data to see if the tax legislation, which capped state and local tax (SALT) deductions, altered refunds across the different states and income tiers. We focused on the top 10 states in terms of the SALT deduction and found that tax refunds were indeed down sharply for upper income households in these states – down 10% year-over-year (yoy) vs. an average of 1.7% increase over the three years prior (Chart 4).

In contrast, upper income households in the states with the most favorable tax laws saw little change in tax refunds relative to prior years. How does the decline in tax refunds among the upper income population in high SALT states impact spending? It isn’t obvious that it will have much of an impact since the upper income population tends to have more disposable income and are therefore less dependent on tax refunds to finance expenditures. Nonetheless, it could possibly weigh on confidence and curb purchases of bigger ticket items.
Bottom line: the consumer finally showed up in March, offsetting part of the decline at the turn of the year. We think we should see further improvement in spend going forward as consumers respond to higher wage growth amid solid job creation.
- source Bank of America Merrill Lynch 

While it's difficult to validate yet a bounce as per Bank of America Merrill Lynch's internal data, while University of Michigan Consumer Confidence remains high, it remains to be seen if there is indeed a change in the narrative:

Something as well worth of interest when it comes to US Consumers given they make 70% of US GDP, has been the rise of Millenials and change of consumer habits as pointed out by another interesting report from Bank of America Merrill Lynch BofA on USA from the 17th of April entitled "Consumer, my how you have changed":
"Two numbers: age and income
The Millennials - who are currently aged 23 to 38 – make up 28% of retail sales ex-autos based on BAC internal card data, slightly outpacing the 26% from Baby Boomers. The wallet of Millennials is growing, with the average number of monthly transactions up 16% from 2012 vs. the 5% increase of Boomers. Millennials also live differently, with 51% of food consumption done at restaurants vs. Boomers at 34%.

There are also differences by income, as we find that 30% of spending is made by the >$125k income cohort while the <$20k group only constitute 10% of total retail ex-auto spending." - source Bank of America Merrill Lynch
Overall, while it is too early to turn negative on US consumers, in the coming months ahead it will be essential to monitor closely the situation we think.

We have long posited that Europe was becoming more and more "Japanese" hence our frequent use of the word "Japanification". Our final charts below goes more into the similarities.
  • Final charts - Yes, Europe is turning Japanese
Looking at the trajectory of policy rates and government bond yields in Japan, it looks to us more and more that Europe is becoming more Japanese and we are not even mentioning the slow pace of resolving the issue of nonperforming loans plaguing the European Banking system. Our final charts come from Deutsche Bank Thematic Research report from the 9th of April entitled "How Europe is looking like the next Japan":
"In February this year, the Bank of Japan celebrated an ominous anniversary: 20 years since it first cut interest rates to zero. Despite a few abortive attempts to raise policy rates, they have never again exceeded 1% and remain stubbornly stuck around zero. Likewise, Europe has seen a few false dawns but again looks set for a long period of short-term rates being stuck at or below zero. More recently, long-term bond yields have fallen as well, with ten-year bund yields dipping into negative territory again over the last month. As such there are ever-growing similarities between the Europe of today and the Japan of the past two to three decades.
The consensus forecast is for the ECB to hike its policy rate from zero by the end of next year but this forecast has been repeatedly pushed back and markets are increasingly sceptical. Much like in Japan, there are now increasing concerns that ‘lift-off’ will never actually happen and Europe will be stuck in a world of ultra low growth and negative yields for years to come. Is this realistic? Well, as we know, it happened in Japan and it is therefore worthwhile examining in more detail the similarities and differences between the two economies with a suitable lag." - source Deutsche Bank
Given in a "Showdown", to win any part of a pot if more than one player has a hand, a player must show all of his cards face up on the table, whether they were used in the final hand played or not and that Cards speak for themselves, it is clear to us that any form of normalization by the ECB will be repeatedly pushed back à la Japan.

"In battle it is the cowards who run the most risk; bravery is a rampart of defense." - Sallust

Stay tuned !

Monday 1 April 2019

Macro and Credit - Easy Come, Easy Go

"There are many harsh lessons to be learned from the gambling experience, but the harshest one of all is the difference between having Fun and being Smart." - Hunter S. Thompson
Looking at the return of the "D" trade, "D" for "Deflation" that is with the return of the strong "bid" for bonds, marking the return of the duration trade on the back of "goldilocks" for "Investment Grade" which we foresaw, pushing more inflows into fixed income relative to equities, when it came to selecting our title analogy, we decided to go for a cinematic analogy "Easy Come, Easy Go". It is a 1947 movie directed by John Farrow, who won the Academy Award for Best Writing/Best Screenplay for Around the World in Eighty Days and in 1942, and was nominated as Best Director for Wake Island. "Easy Come, Easy Go" is the story about Martin Donovan, a compulsive gambler. His gambling habits leave him constantly broke and under arrest from a gambling-house raid. He places bets as well for the tenants of his boardinghouse, who lose their money and ability to pay the rent. Martin, came upon a sunken treasure but his philosophy is "easy come, easy go," promptly squanders all the loot. Looking at the various iterations of QE and the return to more dovishness from central bankers around the world, which lead no doubt to rise of so called "populism" with the asset owners having a field day, particularly the renters through the bond markets, over "Main Street", it is clear to us that the "treasured" support provided by central bankers to politicians has been all but "squandered". For example, French politicians have done meaningless structural reforms leading to unsustainable taxation creating the rise of the "yellow jackets" movement hence our pre-revolutionary stance. As we say in France, c'est la vie.  As in the move, with Martin's daughter Connie not knowing what else to do, she tries to solve her dad's debts by taking bets on a horse race. In similar fashion, central bankers have decided to add more dovishness on more debt, resulting in even more debt being created. Caveat creditor but we ramble again...

In this week's conversation, we would like to look at the return of Bondzilla the NIRP monster made in Japan given Japan's Government Pension Investment Fund GPIF is likely to come back strongly to the Fixed Income party.

  • Macro and Credit -  Once again the money is flowing "uphill" where all the "fun" is namely the bond market.
  • Final charts - The deflation play is back in town

  • Macro and Credit -  Once again the money is flowing "uphill" where all the "fun" is namely the bond market.
In our most recent conversation we pointed out again that we advocated our readers to go for quality (Investment Grade) rather than quantity high yield given rising dispersion. To repeat ourselves, we continue to view rising dispersion as a sign of cracks in credit markets and not as a sign of overall strength. You have to become much more selective we think in the issuer profile selection process.

"Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan" as we pointed out again in our most recent conversation. We also indicated as well:
Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective.
Not only Japanese Lifers have a strong appetite for US credit, but retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years so watch also that space.
For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments to take on more credit risk. " - source Macronomics, March 2019
"Bondzilla" the NIRP monster should not be underestimated in our macro allocation book. On this particular point we read with interest Nomura's FX Insights note from the 29th of March entitled "GPIF: sustained aggressive foreign buying more likely":
"Annual plan for new FY unveiled
The Government Pension Investment Fund’s (GPIF) annual plan for the new fiscal year suggests the fund can manage its portfolio more flexibly. This should allow the fund to continue purchasing foreign bonds aggressively, while reducing exposure to negative yielding domestic bonds. This shift is also likely to lead a higher share of foreign bonds in the updated target portfolio, which will be announced by end-March 2020. Given the significant size of the GPIF’s AUM, this flexible stance will be crucial for Japan’s financial market and yen-crosses. We expect pension funds’ foreign bond purchases to support yen-crosses during the new fiscal year.
The GPIF announced its annual plan for the new fiscal year. In the annual plan, the GPIF noted that it will manage its portfolio according to the basic portfolio, as usual. However, the GPIF added two important points for its portfolio strategy in the new fiscal year, in relation to the allowable range of the target portfolio.
First, the GPIF repeated that automatically reinvesting redemptions from exposure to domestic bonds may not be appropriate in the current market environment. Thus, for now, the fund will manage its domestic bond portfolio more flexibly in relation to the allowable range. The fund will maintain the total amount of domestic bonds and cash within the allowable range of domestic bonds (25-45%). The GPIF has already announced the temporary deviation in domestic bond exposures from the allowable range last September and thus, this point is not entirely new (see “Equity flows supporting yen-crosses”, 26 September 2018). However, flexibility has now been extended into the new fiscal year that commences next week, and the fund can continue to reduce exposure to domestic bonds for a longer amount of time.
Second, the GPIF added a new sentence, stating: “the fund will examine the application of allowable range for asset classes as necessary, as the fund is formulating its new target portfolio (Figure 1).

In April 2014, the GPIF stated that it would flexibly manage its portfolio in relation to the allowance rage, as it started reviewing its target portfolio for the next medium-term plan (see “GPIF: Time for whale-watching”, 4 December 2018). Owing to the increased flexibility, the fund could begin investing in equities and foreign bonds before it announced the new target portfolio in October 2014. Although the communique this year differs from five years ago, this additional comment could provide the fund with more opportunity to manage the portfolio more flexibly in the new fiscal year.
We think these statements are significant for Japan’s financial market and yen-crosses this year. As of end-December, the share of domestic bonds had declined to 28.2%, closer to the lower bound of the current allowable range (25%, Figure 2).

In contrast, the share of foreign bonds increased to 17.4%, closer to the upper range of the current allowable range (19%). The fund has recently been purchasing foreign bonds aggressively, as it likely judges negative-yielding domestic bonds as unattractive (Figure 3). Historically, the pace of foreign bond purchases in Q4 last year was at the highest pace (see “Three important JPY flow stories”, 1 March 2019). Without the two additional points above, the GPIF would need to start liquidating foreign bonds, while accumulating exposures to domestic bonds again.

However, as the fund can manage its portfolio more flexibly in the new fiscal year, it should be able to continue purchasing foreign bonds, even if the share exceeds the upper limit (19%).
As the BOJ’s negative rate policy will be extended further, in our view, we think it would be reasonable for the GPIF to continue reducing the fund’s exposure to domestic bonds, while shifting into foreign bonds. At the moment, both domestic and foreign equity shares central of the GPIF’s target portfolio are at 25%, but the central target for foreign bonds is just 15%. Thus, there is room for the fund to further shift from domestic bonds into foreign bonds.
The GPIF will release its new basic portfolio by end-March 2020, while the announcement could take place by end-2019. We see a strong probability that the GPIF would raise the share of foreign bonds then, and its flow could lead to JPY selling.
As of end-December, total AUM managed by the GPIF was at JPY151.4trn (USD1.4trn), and 5% portfolio shift into foreign bonds could generate JPY7.6trn (USD65-70bn) of JPY selling.
In comparison with 2014, market interest in the GPIF portfolio change seems much lower (Figure 4).

Nonetheless, we believe the annual plan released today shows the fund’s investment in foreign bonds will remain significant this year, and the diversification should support cross-yens well (Figure 5).
- source Nomura

So, from an allocation perspective, you probably want to "front run" the GPIF and its lifers friend, given they play "Easy come, Easy Go" particularly well in adding US dollar credit exposure we think.

When it comes to flows, and all the "fun" going into the bond market, it is already happening as per Bank of America Merrill Lynch's note from the 29th of March entitled "Bonds over stocks":
"Dovish central banks revive the bond market
As global central banks continue on their dovish path, more money is flowing into credit and fixed income funds more broadly.

It feels that this trend is here to stay amid low inflation and lack of growth in Europe, and continued political headwinds (Brexit, trade wars). As macroeconomic data trends are bottoming out and central banks continue to remain dovish, we think that credit gap wider risks are limited.
Over the past week…

High grade funds recorded an inflow for the fourth week in a row, albeit at a slower pace than last week. However we note that one fund suffered an outflow of almost $1bn. Should we adjust for that the inflow would have been more than $2.7bn.
High yield funds enjoyed their fifth consecutive week of inflow. Looking into the domicile breakdown, Global-focused funds gathered half of the inflows, with the other half favouring US-focused funds more than European-focused funds.
Government bond funds saw inflows for a second straight week, while the pace has been ticking up over the past couple of weeks. Money Market funds recorded an outflow last week, the strongest over the last five weeks. All in all, Fixed Income funds enjoyed another week of strong inflows.
European equity funds continued to record outflows; the seventh in a row. Note that the pace of outflows shows no sign of slowing down.
Global EM debt funds recorded their fifth consecutive week of inflows. Note that last weekly inflow was the largest in seven weeks. Commodity funds saw another inflow last week, the fourteenth over the past sixteen weeks.
On the duration front, short-term IG funds underperformed whilst mid and long-term IG funds recorded strong inflows amid a broader reach for yield trend." - source Bank of America Merrill Lynch
Follow the flow as they say, but follow Japan when it comes to credit markets exposure, given that they are no small players when it comes to global allocation.

So should you play "defense" allocation wise or continue to go "all in"? On that very subject we read with interest Morgan Stanley's Cross Asset Dispatches note from the 31st of March entitled "Improving the Cycle Indicator – Countdown to Downturn":
"Cycle inflection argues for more cautious portfolio tilt – pare back exposure in US stocks and HY, add allocation to US duration, RoW stocks
But just because a shift in our cycle indicator is imminent, it doesn't mean that broad asset rotation needs to occur now:
Looking at the optimal allocation for the ACWI/USD Agg porfolio, we find that weighting between global equities and bonds doesn't really change materially until a downturn starts. However, rotation within asset classes occurs throughout expansion and into the cycle turn – for example, US equities see weighting fall throughout expansion in favour of RoW stocks, and fixed income portfolios rotate towards long-duration away from intermediate maturities over the same time. In other words, downturn may trigger the broad cross asset allocation, but investors should still look to tilt more defensive within asset classes throughout expansion.
What would this defensive tilt look like? Examining the optimal allocations for: i) USD Agg/ACWI; ii) Multi-asset; and iii) USD Agg portfolios through various cycles over the past 30 years, using realised next one-year returns, these shifts need to occur for a more defensive positioning:
  • Pare back equity risk, especially US versus RoW: Optimal weight to stocks tends to fall from expansion to downturn as stocks go from seeing a boost in returns to a drag.
  • Reduce US HY to max underweight: Allocation to lower-quality (BBB and HY) corporates typically collapses in expansion, given the unattractive returns profile; downturn only sees performance deteriorate further, taking HY (and BBB) to its lowest weighting in the cycle.
  • Tilt towards long-duration in late-cycle, add cash: UST and cash combined have the largest allocation in downturn.

These are largely in line with our current recommendations, based on our cross-asset allocation framework of which the cycle indicator forms one of the three pillars, along with long-run fair value models and short-run expectations from our strategy colleagues.

With long-run capital market assumptions which are below average for most assets, unenthusiastic 12-month forecasts from our strategists and a cycle model that's about to turn, we reiterate our stance to be EW in stocks, with a preference for ex-US equities, EW in bonds, with a tilt towards USTs, and UW in credit, in particular low-quality corporates. For investors looking for late-cycle hedges, we also recommend vol trades like buying credit puts, USDJPY puts and long Eurostoxx calls versus S&P calls to take advantage of dislocations in the vol space." - source Morgan Stanley.
Of course everyone is looking at the inverted US yield curve as a good predictor of a downturn to show up and markets are already pricing rates cut from the Fed. From a lower volatility positioning, it makes sense to be overweight US Investment Grade and adding duration and somewhat reduce exposure to US High Yield. In Europe, when it comes to financials, credit continues to benefit from the ECB support, financial equities, not so much, regardless of the price to book narrative put forward by many sell-side pundits. We continue to dislike financials equities and rather play exposure through credit markets, even high beta offers better value. 

But what about the cycle? Is it already turning in the US given the inversion of the US yield curve? On that specific point Morgan Stanley in their note pointed out the following:
"New cycle indicator, still same old cycle (for now)
Our revamped US cycle indicator suggests that the market is still in expansion. But our model also says there's a high chance (~70%) of a shift to downturn within the next 12 months.
Our market cycle indicators are a central part of our cross-asset framework, launched with our initiation of coverage nearly five years ago. While prior builds have served us well over this time, generally pointing to continued cycle expansion amid bouts of volatility, we have looked to continually improve these indicators. This is the latest iteration.
The main changes to the methodology revolve around index composition, weighting system and the way we systematically categorise cycle phases, relying on breadth of change across metrics instead of moving averages. The result is, in our view, an improved cycle indicator which can better flag turns in real time, with greater confidence and less lag. Currently, the revised US cycle indicator ('v2019') ( Exhibit 22 ) points to continued expansion, driven by many key macro indicators being above-trend ( Exhibit 23 ).

…but a market cycle peak is imminent
We don't think that this expansion can be sustained for long:
Exhibit 26 shows our real-time downturn probability gauge, which estimates the chance of our cycle model inflecting to downturn from expansion within the next 12 months, based on historical experience.

What this chart suggests is that, given the level of the cycle indicator, the chance of a shift to downturn over the next 12 months is elevated at close to 70%, up from ~60% from end-2017 when we last checked up on the cycle.
What's been behind this prediction? The strong unbroken run of improving data over the last year has been the main 'culprit':
Since April 2010, we've not had a six-month period where a majority of the components of the cycle indicator were not improving; it is, to our knowledge, the longest streak in history ( Exhibit 27 ).

Historically, such an environment of data improvement breadth and depth (with the likes of unemployment rate and consumer confidence hitting extreme levels in recent months) has meant a high probability of cycle deterioration in the next 12 months – after all, what goes up must come down. Indeed, the latest disappointing consumer confidence data pushes the number of cycle indicator components deteriorating over the last six months to seven now – enough to be considered 'critical mass'. If such deterioration persists, our rules-based approach to identifying cycle phases could very well call a switch from expansion to downturn as early as next month. At any rate, our market cycle indicator and the probability gauge are very clear – an inflection from expansion to downturn is on the horizon." - source Morgan Stanley
As we indicated on numerous occasions, the cycle is slowly but surely turning and rising dispersion among issuers is a sign that you need to be not only more discerning in your issuer selection process but also more defensive in your allocation process. This also means paring back equities in favor of bonds and you will get support from your Japanese friends rest assured.

It doesn't mean equities cannot rally further, there is still the on-going US-China trade spat yet to be resolved. Right now Macro continues to deteriorate, particularly in the Eurozone with its Manufacturing PMI falling to 47.5 (49.3 - Feb). Germany and Italy were notable contributors to the stronger decline:
  • Germany : 44.1 vs 47.6-Feb
  • France : 49.7 vs 51.5-Feb
  • Italy : 47.4 vs 47.7-Feb
  • Eurozone : 47.5 vs 49.3-Feb 

This is a reflection of world trade growth further slowing as highlighted by DHL's Global Trade Barometer from March 2019:
"Key findings:
  • Overall GTB index for global trade falls by -4 points to 56 compared to December, signaling only a slight growth and coming ever closer to stagnation.
  • Prospects weakening for most surveyed countries – but remain above neutral 50, still indicating positive growth, apart from South Korea
  • Outlook for global air trade is sluggish, dropping by -3 to 55 points. Growth of global ocean trade is also slowing down, reflected in an index value of 56, a decrease by -5.

According to the latest three-months forecast by the DHL Global Trade Barometer (GTB) global trade is foreseen to grow only slowly. The overall growth index decreased by -4 points compared to the last update in December, scoring 56 points in March. The slowdown is especially attributed to the significant decelerating growth prospects of India (-18) and South Korea (-12).
Also in the US, trade growth is expected to lose momentum (-5 points), whereas the GTB forecasts for China (-1), Germany (+2), Japan (-2) and the UK (+2) are largely in-line with the previous update.

The outlook for global air trade is sluggish, dropping -3 to 55 points. All surveyed countries are forecasted to slowdown in air trade except for Germany (+9). The largest declines are expected for South Korea (-14), India (-13) as well as Japan (-5). China and US dropping moderately with -3 and -2 points. Moreover, the index for South Korea and UK air trade drops below 50 points, suggesting a contraction of air trade growth.
Global ocean trade outlook is also modest, seeing decelerated growth (-5 points to 56). The largest downturns are found in India (-20), South Korea (-10) and US (-7). German ocean trade further weakened, as the country’s index falls slightly by -2 to 46 points. China (-1 point) is forecasted to decelerate slightly. Meanwhile, ocean trade in the UK (+4 points) and Japan (+2 points) is picking up some steam." - source DHL - Global Trade Barometer, March 2019
With China’s Caixin March manufacturing PMI beating expectations at 50.8 from 49.9 last month (50.0 expected), optimism that China can once again provide the heavy lifting for global growth has been renewed, hence the latest positive tone from financial markets. 

Could it be that we will see weaker growth for longer? In that case bonds could continue to perform in that environment where bad news is good news again thanks to the renewed "Easy Come, Easy Go" stance from central banks.

We can therefore expect US Treasury Notes 10 year yield to fall further in that context. It seems that bond bears were a little bit too hasty in 2018 in the demise of the long duration trade.

We have been asked recently by one of our readers on  the rise in interest rate volatility seen recently through the MOVE gauge index responding by posting its biggest two-day gain since 2016. We replied that it didn't change our recommendation of playing "quality", Investment Grade that is, over "quantity", US High Yield. On that specific point we read with interest Barclays US Credit Alpha note from the 29th of March entitled "Rates Moves Dictates Credit Moves":
Rates Moves Dictating Credit Moves
Interest rate volatility remains high, with consequences for the credit market, as spreads have widened modestly. In addition to the decline in yields, the 3m10y Treasury spread has inverted, and the market is implying a rate cut by the Fed for the first time since the beginning of 2013. The last time 3m10y was inverted and the market implied a significant rate cut was in late 2006, as the prior economic cycle reached maturity. As Figure 2 shows, equities rallied at that point, and credit spreads held in despite concerns about a weaker economy.

An obvious question is whether the current inversion signals the end of the cycle, since, in the past, recessions have occurred on average four quarters after the 3m10y inverts. However, the 2y10y curve has typically already been inverted, which is not the case today. We believe more caution is warranted based on recent curve moves, consistent with our forecast for wider spreads at year-end.
Digging deeper into the relationships of credit markets around the 3m10y inversions in 2000 and 2006, we notice significant differences compared with this year. In both instances, high yield was outperforming investment grade and the BBB/A spread ratio was flat or lower. This seems to support our short-term view that BBBs should outperform their beta.
We had also been advocating owning BBBs versus BBs recently, and the gap between those spreads has moved almost 20bp higher from the recent lows. While a sizable move, it still does not make BBs look particularly cheap. However, we think that differences in trading conventions for the high yield and investment grade markets are behind a lot of the BB underperformance and expect some bounce-back for BBs in spread terms as soon as rates stabilize. Traders are quoting BB prices broadly flat over the past week, as rates rallied and spreads moved 20bp wider. In contrast, BBB bonds are quoted more or less unchanged on spread, but their prices jumped more than a point. Underscoring the technical nature of the move, we note that even within capital structures that have both BBB and BB rated bonds, such as Charter Communications, the basis spiked. As a result, we believe there could be some near-term tactical spread outperformance for BBs." -source Barclays
We could see a continuation in the high beta rally yet it doesn't seem to us vindicated by recent flows, so we would rather stick with our defensive call for the time being.

Given all of the above, we are more inclined towards credit markets and "coupon clipping" and playing it safe through Fixed Income and credit markets as warranted by current fund flows we are seeing and Japanese support coming from overseas. As well our final chart displays the defensive positioning as we enter the second quarter.

  • Final charts - The deflation play is back in town
Looking at the dismal macro data which has tilted central banks towards a much more dovish stance, the positioning and fund inflows for the second quarter appear to be more geared towards "deflation assets". Our final chart comes from Bank of America Merrill Lynch The Flow Show note from the 28th of March entitled "Pavlov's Dog Bites Fed" and shows "Deflation vs Inflation flows":
"Positioning into Q2: consensus starts Q2 long “secular stagnation” & “deflation”; YTD $87bn inflows into “deflation assets” e.g. corp & EM bonds & REITs, and $42bn redemptions from “inflation assets”, e.g. EAFE equities & resources (Chart 4); investors are discounting neither recession (they love corporate bonds) not recovery (they don’t like cyclical equities).
Weekly flows: $8.6bn into bonds, $0.4bn into gold, $12.5bn out of equities.
Credit inflows: $5.2bn into IG, $2.2bn into EM debt, $0.9bn into HY.
Max deflation: record redemptions from TIPs ($1.3bn).
Equity outflows: $7.7bn out of US, $4.8bn out of EU, $2.0bn out of EM.
Cyclical outflows: $1.5bn out of financials, $0.4bn out of consumer, $0.2bn out of
Q2 catalyst: Positioning & Policy were positive catalysts in Q1; Profits will be the catalyst in Q2; we say consensus global EPS numbers remain too high (BofAML Global EPS model forecasts -9% EPS growth in the next 12 months vs. analyst consensus 0% - Chart 5).

Q2 scenarios: evolution of BofAML global EPS model forecasts will determine whether Stagnation, Recession, Recovery the dominant Q2 outcome.
Stagnation: global EPS forecast stagnates @ -5-10% as US growth dips below 2%, global PMIs vacillate around 50, US rates fall toward anchored/negative Japanese & Eurozone rates, secular “Japanification” trade of past 10 years hardens; the big bid, volatility offered; the big trades...long 30-year UST, biotech, short resources, volatility.
Recession: global EPS forecast drops to -15% as surge in US unemployment claims indicates US consumer joining manufacturing recession in China, Japan & Eurozone where PMIs drop to 45; the big tells...oil <$50/b, JNK <$33, INJCJC4 >300k; the big trades...short tech & corporate bonds, long T-bills, US dollar & VIX.
Recovery: global EPS forecast turns positive as “green shoots” in Asian exports (Chart 1) & Chinese growth blossom, while lower US rates boost US housing data; credit spreads prove once again they are better lead indicator for risk assets than government bond yields (Chart 6); the tells...SOX >1450, XHB >$42, KOSPI >2350, yield curve steepens; the trades...long global banks, short bunds & US dollar.

Next up: big 5 datapoints in coming week to set course for Q2 (see table 1); tactically we are in Q2 “Recovery” camp; H2 we expect big top in markets before debt deflation/policy impotence leads risk assets lower."  - source Bank of America Merrill Lynch
"Easy Come, Easy Go", we believe that US equities face headwinds coming from a more defensive stance from CFOs ready to defend their balance sheet and start reducing buybacks, CAPEX and even dividends in some instances. This would be more beneficial in that context to credit investors. Earnings are already facing EPS "headwinds". The continuation of the rise in oil prices though is still supportive for US High Yield. Yet, given the "high beta" nature of High Yield, we would prefer to play it safe rather than going all in à la Martin Donovan. 

"There is no gambling like politics."- Benjamin Disraeli, British statesman
Stay tuned ! 
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