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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