Friday, 17 May 2019

Macro and Credit - The Lady, or the Tiger?

"In waking a tiger, use a long stick." -  Mao Zedong

Watching with interest the collapse of the China trade deal with the US triggering the return of much muted volatility, as the fear of the "sell in May" motto settles in, given the rising tensions between the two powers, when it came to selecting our title analogy, we decided to go for a literary analogy,  "The Lady, or the Tiger?". It is a much-anthologized short story written by Frank R. Stockton for publication in the magazine The Century in 1882. 

The short story takes place in a land ruled by a semi-barbaric king. Some of the king's ideas are progressive, but others cause people to suffer. One of the king's innovations is the use of a public trial by ordeal as an agent of poetic justice, with guilt or innocence decided by the result of chance. A person accused of a crime is brought into a public arena and must choose one of two doors. Behind one door is a lady whom the king has deemed an appropriate match for the accused; behind the other is a fierce, hungry tiger. Both doors are heavily soundproofed to prevent the accused from hearing what is behind each one. If he chooses the door with the lady behind it, he is innocent and must immediately marry her, but if he chooses the door with the tiger behind it, he is deemed guilty and is immediately devoured by it.

The king learns that his daughter has a lover, a handsome and brave youth who is of lower status than the princess, and has him imprisoned to await trial. By the time that day comes, the princess has used her influence to learn the positions of the lady and the tiger behind the two doors. She has also discovered that the lady is someone whom she hates, thinking her to be a rival for the affections of the accused. When he looks to the princess for help, she discreetly indicates the door on his right, which he opens.

The outcome of this choice is not revealed. Instead, the narrator departs from the story to summarize the princess's state of mind and her thoughts about directing the accused to one fate or the other, as she will lose him to either death or marriage. She contemplates the pros and cons of each option, though notably considering the lady more. "And so I leave it with all of you: Which came out of the opened door – the lady, or the tiger?"

Obviously for those who remember our June 2018 conversation "Prometheus Unbound", we argued the following:
"It seems more and more probable that the United States and China cannot escape the Thucydides Trap being the theory proposed by Graham Allison former director of the Harvard Kennedy School’s Belfer Center for Science and International Affairs and a former U.S. assistant secretary of defense for policy and plans in 2015 who postulates that war between a rising power and an established power is inevitable:
"It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable." Thucydides from "The History of the Peloponnesian War"  
- source Macronomics June 2016
Also, in our September 2018 conversation "White Tiger" we indicated that maverick hedge fund manager Ray Dalio came to a similar prognosis in his musing entitled "A Path to War" on the 19th of September. With our chosen title, we reminded ourselves that "The Lady, or the Tiger?" has entered the English language as an allegorical expression, a shorthand indication or signifier, for a problem that is unsolvable and we are not even talking again about BREXIT here...

In this week's conversation, we would like to look at Financials Conditions, given we recently took a look at the latest quarterly Fed Senior Loan Officer Opinion Survey.

Synopsis:
  • Macro and Credit - Financial Conditions? It's a "Slow grind"
  • Final charts - The credit market cycle is very well correlated to the macro cycle.
  • Macro and Credit - Financial Conditions? It's a "Slow grind"
Back in February, in our conversation "Cryoseism" we indicated the following in relation to the SLOOs:
"We think we will probably have to wait until April/May for the next SLOOS to confirm (or not) the clear tightening of financial conditions. If confirmed, that would not bode well for the 2020 U.S. economic outlook so think about reducing high beta cyclicals. Also, the deterioration of financial conditions are indicative of a future rise in the default rate and will therefore weight on significantly on high beta and evidently US High Yield." - source Macronomics, February 2019
The latest publication of the SLOOs point towards a slowly but surely turning credit cycle. Yet, with the most recent easing stance of the stance, there are indeed clear signs of slow deterioration. With around 8.1% of credit-card balances held by people aged 18 to 29 being delinquent by 90 days or more in the first quarter of the year, the highest share since the first quarter of 2011, we believe it is essential to monitor going forward any weakness coming from the Fed's SLOOs.

On the subject of SLOOs we read with interest Bank of America Merrill Lynch's take from their Credit Strategist Note from the 12th of May entitled "BBBonvexity in IG":
"April Senior Loan Officer Survey: Back to easing 
Not surprisingly, given the sharp decline in uncertainties this year, as the Fed abandoned the rate hiking cycle/QT and the US economy not going into recession any time soon, banks are now back to easing lending standards for large and medium sized firms (neutral for small firms). The Fed’s fresh April senior loan officer survey released today also showed continued weak demand across the board for C&I, CRE, residential mortgage, auto and credit card loans. In addition, the April survey added special questions on foreign exposure with a moderate fraction of banks expecting deteriorating loan quality from current levels over the remainder of 2019. C&I and CRE loans
A net 4.2% of banks reported easing lending standards for large/medium C&I loans in April, a reversal from a net 2.8% reporting tightening standards in January, while lending standards for small C&I loans were unchanged in the April survey after a net 4.3% of banks reported tighter lending standards in January (Figure 20).

At the same time, the net share of banks reporting tighter standards on CRE loans declined to 10.8% in April from 12.3% in January. Please note that the CRE value reported here is the average for the three separate questions on loans for construction and land development, loans secured by nonfarm nonresidential structures, and loans secured by multifamily residential structures. 
Loan demand continued to weaken as the net shares of banks reporting weaker large/medium, small C&I and CRE loan demand increased to 16.9%, 10.3% and 16.9% in April, respectively, from 8.3%, 10.1% and 11.0% in January (Figure 21).
Mortgages 
Net 3.2% and 4.6% of banks returned to easing lending standards for GSE-eligible and QM-jumbo mortgage loans in the April survey, respectively, following net unchanged standards for GSE-eligible mortgages and 1.6% of banks reporting tighter standards for QM-Jumbo loans in the January (Figure 22).

At the same time, the net share reporting weaker demand for GSE-eligible and QM-Jumbo mortgages declined to 17.5% and 12.3% in April, respectively, from net 41.0% and 31.7% in January (Figure 23). 
Consumer loans 
Net 15.2% and 1.8% of banks reported tightening lending standards for credit card and auto loans according to the fresh April survey. This compares to net 6.4% and 1.9% of banks tightening lending standards on credit card loans and auto loans in the prior January survey (Figure 24).

Meanwhile, the net shares of banks reporting weaker demand for auto and credit card loans declined to 6.8% and 1.8% in April, respectively, from 17.4% and 18.2% in January (Figure 25). 
- source Bank of America Merrill Lynch

Overall, there is tepid loan growth on the back of rising delinquencies, not only from the younger generation but, as well for older generations. Delinquency rates are trending up again, and not just for younger consumers. The report found that seriously delinquent credit card balances have also risen for consumers aged 50–69. For borrowers aged 50–59 and 60–69, the 90-day delinquency rate increased by nearly 100 basis points each. It is indeed a "slow grinding" process when it comes to financial conditions. 

Tracking financial conditions is paramount when it comes to assessing "credit availability. The very strong rally seen in credit in general and high yield in particular, even in Europe where macro data has been very disappointing in the first part of the year. Clearly the rally in European High Yield has been based not on fundamentals but mostly due to strong "technicals" such as issuance levels overall. 

We would like to reiterate what we discussed earlier in 2018 in our conversation "Buckling" in when it comes to our views for credit markets at the time:
"As long as growth and inflation doesn't run not too hot, the goldilocks environment could continue to hold for some months provided, as we mentioned above there is no exogenous factor from a geopolitical point of view coming into play which would trigger an acceleration in oil prices. " - source Macronomics, February 2018.

Unfortunately, as of late, we have seen plenty of deterioration from a geopolitical point of view such as the unresolved trade war between the United States and China, or rising tensions with Iran hence the heightened volatility seen so far, in some way validating somewhat the "sell in may" narrative.

While the rally in high beta has been significant, in our most recent musings we have been advocating favoring a rotation into quality (Investment Grade) over quantity (High Yield). Since the beginning of the year the feeble retail crowd has been rotating at least in the high beta space from leveraged loans to US High Yield.

From the same Bank of America Merrill Lynch's Credit Strategist Note from the 12th of May entitled "BBBonvexity in IG" the "defensive" rotation has been confirmed:
"Outflows from risk 
US mutual fund and ETF investors sold stocks and high yield and bought high grade and munis following the recent pickup in volatility. Hence over the past week ending on March 8th investors redeemed $13.71bn from stocks – the biggest outflow since the week of March 20th. A week earlier stocks instead saw a small $0.36bn inflow. On the other hand buying of bonds increased to $3.85bn from $2.12bn (Figure 26), as stronger inflows to high grade, government bonds and munis more than offset outflows from high yield and leveraged loans.

 
Inflows to high grade accelerated to $3.10bn from $2.47bn. The increase was entirely driven by inflows to short-term high grade rising to $0.92bn from $0.30bn. Flows ex. short-term remained unchanged at $2.17bn. Inflows to high grade funds declined to $1.98bn from $2.97bn, while ETF flows turned positive with a $1.12bn inflow this past week after a $0.50bn outflow in the prior week (Figure 27).

Flows also improved for munis (to +$1.31bn from +$0.92bn) and government bonds (to +$0.04bn from -$1.54bn). On the other hand high yield reported a $0.28bn outflow after a flat reading a week earlier, while outflows from loans accelerated to $0.21bn from $0.17bn. For global EM bonds inflows declined to $1.03bn from $2.36bn. Finally money markets had a $16.32bn inflow this past week and a $13.83bn inflow in the prior week." - source Bank of America Merrill Lynch
The most recent heightened volatility, at least in credit markets, is more due to exogenous factors than solely fundamentals such as financial conditions, given that what we are seeing so far is much more akin to a "slow grind" than a complete change in the narrative and the turn in the credit cycle. 

From a "flow" perspective, we continue to monitor the appetite in particular of Japanese investors, which remain very supportive in particular of US credit markets. As we commented in numerous conversations, they have decided to add on more credit risk on a unhedged basis. We therefore think that FX volatility should be monitor closely and in particular any move in the US dollar against the Japanese yen for instance.

On the subject of Japanese flows we read with interest Nomura's Matsuzawa Morning Report from the 16th of May entitled "Banks hold off on foreign bond investment, while lifers continue to shift to credit":
"While the stock market remains unstable, the credit market was solid globally. In this respect, there were no signs that the market is looking to price in an economic downturn, and in fact it seems to be looking for the right time and catalyst to return to a risk-on flow. We expect Japanese investors to continue shifting out of government bonds to credit both in Japan and overseas. The April International Transactions in Securities data showed that lifers bought foreign bonds in line with levels in typical years, but we see this as a surprise given the drop in foreign yields and flattening along the curve. We believe this is reflected in the gradual, ongoing widening in USD/JPY and EUR/JPY basis since the start of the fiscal year (Figure 1).

By taking credit risk, they are trying to cover currency hedging costs, in our view. 

The International Transactions in Securities data for the week of 6 May, released this morning, showed that Japanese investors were net buyers of foreign bonds at only JPY20.8bn (Figure 2).

Given that they were net sellers in the previous two weeks, they remain cautious. In the week of 6 May, foreign yields fell sharply in response to President Trump’s tweets, but Japanese investors do not yet seem to be trading on the issue of the US-China trade conflict. However, we believe that banks’ short-term trading, not the aforementioned lifers, are primarily responsible for this trend. Banks were net sellers throughout April, and seem to be seeking to lock in profits in the near term. Foreign investors’ net buying of yen bonds remains high, at JPY553.5bn. In addition to the drop in foreign yields (currently, 10yr Bund yields are materially below 10yr JGB yields), widening currency basis also seems to support this trend." - source Nomura
"Bondzilla" the NIRP monster is still very much supportive of global allocation into fixed income and particularly in credit markets given the current levels of Japanese JGB yields and the German Bund 10 year yield.

This is what we recommended in our April conversation "Easy Come, Easy Go":
"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." - source Macronomics, April 2019
As we stated in our most recent conversation, Investment Grade is as well a far less volatile proposal and as indicated by Nomura, the stock market remains unstable whereas the credit market continues to be solid globally. Sure the trend in the SLOOs is not very positive with rising delinquencies and interest rates levels on credit cards for the US consumer, but, we do not think the credit cycle has finally turned as per our final chart below.

  • Final charts - The credit market cycle is very well correlated to the macro cycle.
After all our blog has been dealing with "Macro" and "Credit" since 2009, and there is a reason for this which can be resumed in the title of our final chapter in this conversation. The credit market cycle follows very closely the macro cycle. Our final chart comes from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 15th of May entitled "Keep calm and carry (on)" and displays the relationship between the credit cycle and the macro cycle:
"The cycle of risk assets 
The credit market cycle is very well correlated to the macro cycle. As the chart below illustrates, a weakening economic backdrop is typically associated with wider spreads and a weakening market trend. To the contrary, when the economic cycle recovers spreads tend to tighten and market trends to improve.
The cycle of “ratings” beta 
The macro cycle is not only a great tool to assess credit spread trends, but also a tool to track the cycle of “ratings” beta (chart 6). We define “ratings” beta as the slope between the monthly total return observed in high-yield vs. that in high-grade credit market (rolling twelve months). We then present in the chart below the trend of that beta (slope of returns) via a z-score analysis (12m z-score). When the macroeconomic backdrop improves and bounces from the lows, investors can realise higher (than average) betas in the high-yield market.
The cycle of “subordination” beta 
Last but not least, the macroeconomic data cycle is also valuable to assess the trends seen in subs vs. senior bonds space. Using the typical pair of IG corporate hybrids vs. senior non-financial senior bonds, to capture subordination premium trends, one can observe similar patterns between the macro cycle and the “subordination” beta cycle. When the macro cycle rebounds from the lows, subs can realise higher betas (than average). Subsequently, betas tend to normalise as the cycle becomes more mature.
- source Bank of America Merrill Lynch 

Financial conditions overall remain fairly accommodative, the issues we are seeing rising again as of late are from an exogenous nature such as "The Lady, or the Tiger?". Can China and the United States resolved their trade issues? Which door investors should choose? We wonder, but, in a volatile environment such as this one, quality credit markets offers more stability we think at this very moment given the Chinese "tiger" is yet to be tamed.

"An infallible method of conciliating a tiger is to allow oneself to be devoured." -  Konrad Adenauer

Stay tuned !  

No comments:

Post a comment

 
View My Stats