Macro and Credit - The Grapes of Wrath

"When anger rises, think of the consequences." -  Confucius

Looking at the impervious performance of credit markets and in particular US High Yield since this year lows while noticing no doubt a rise in global discontent and populism, it seems to us appropriate this time around for our title analogy to steer towards John Steinbeck's 1939 masterpiece "The Grapes of Wrath". In recent musings we have been pretty vocal about our pre-revolutionary mindset, not because we are of the revolutionary breed but, as we noted in our conversation "Empire Days", there is in Europe growth in disillusion / social tensions which can be ascertained for instance in France with the daily demonstrations of the French police and growing discontent hence our title. The Grapes of Wrath was set during the Great Depression and focuses on a poor family of tenant farmers which when they reach their Californian destination finds out that the state is oversupplied with labor, wages are low and workers are exploited to the point of starvation while big corporate farmers are in collusion and smaller farmers suffer from collapsing prices. When preparing to write the novel, Steinbeck wrote: "I want to put a tag of shame on the greedy bastards who are responsible for this [the Great Depression and its effects]."

The intensity of the US presidential election is indeed resonating with Steinbeck's work as it is representative in similar fashion to the growing global discontent with "elites" and the rising disconnect given the rise in inequality thanks to soaring asset prices courtesy of central banks "wealth effect" policies. It might still be goldilocks period for asset prices and in particular credit with additional melt-up but, no doubt in our minds that political clouds are lining up, while the tide is slowly but surely turning for the credit cycle.

In this week's conversation, we would like to look at the relationship between inflation, wages and labor growth, which would entice us to "buy" the recovery mantra of some sell-side pundits. Furthermore, we believe that for the "stagflation" story to play out it is conditional on a continued rebound of oil prices and an overall surge in commodity prices.

Synopsis:

• Macro and Credit - Is inflation truly rearing its ugly head? A look at the United States, Japan and Europe
• Final chart: The ongoing deterioration of credit fundamentals in the US remains the key market risk

• Macro and Credit - Is inflation truly rearing its ugly head?

With the intensification of the use of the dreaded "stagflation" word and in continuation to our most recent musing, we continue to believe that rising 10 year US breakevens have been mostly driven by the change in oil prices as illustrated by the below Bank of America Merrill Lynch chart from their CMBS Weekly note from the 28th of October entitled "Still neutral for now":

- source Bank of America Merrill Lynch

In terms of validating the "recovery mantra", we believe that meaningful wage inflation is a necessary condition. When it comes to inflation expectations, demographics and additional components in different parts of the world such as Japan, the United States and Europe have to be assessed differently.

For instance, in the United States, the recent decline in apartment rents in some big cities points towards near term "inflation headwinds" for the stagflationary camp we think.as reported in the Wall Street Journal on the 4th of October:

"Rents in San Francisco declined 3%, while they fell about 1% in New York and edged lower in Houston and San Jose, Calif., the first drops in those markets since 2010, according to apartment tracker MPF Research. Across the U.S., rent growth was 4.1% on average." - source WSJ

As a reminder, rising rents have been an important factor in keeping US inflation expectations alive given the importance of the shelter component in US CPI calculations which represents one third of headline CPI and 42% of core CPI. When it comes to assessing some of the drivers of inflation, labor demographics are a key driver of real long-term fed funds as posited by Société Générale in their American Themes note of the 19th of October entitled "Equilibrium fed funds: how low and for how long? Demographics the answer!":

"Historic observation: Labor demographics key driver of real long-term fed funds rate

An equilibrium fed funds rate—or interest rate—can depend on many factors that vary over time. The biggest driver under consideration is the inflation rate. Inflation is a straight-forward driver, and more scrutiny is placed on movement in the real interest rate. Economic growth and demographics are key. The perception of equilibrium is an issue too. In the current environment, we believe 2.0% inflation is achieved in balance. In the post-war period, the US economy has operated mostly out of inflation equilibrium with an average inflation rate of 3.64% (CPI) since the 1950s. So far in the 2010s, inflation is averaging 1.53%, just about the closest the US economy has been to a sense of equilibrium, and we are generally worried about deflation risks. The 2.0% inflation-equilibrium may be a challenge for a fed funds equilibrium rate, but we use it.

Drivers and rules of thumb for the Fed Funds rate

Old rules of thumb for determining the fed funds rate have lost prominence over the past decade as the rules appear to have changed. The fed funds rate is substantially lower than these rules of thumb might have suggested. Yet an examination of why they may have worked in the past but fail today is insightful. There are two key rules of thumb:

1. Fed funds rate should equal nominal GDP. Traditionally, nominal GDP has exceeded fed funds, yet the components of GDP are all the same and influence long-term GDP, namely inflation and real growth. Real growth is determined by demographics, productivity and investment. These latter variables are all the key variables contributing to a dynamic real fed funds determination.
2. Fed Funds equal 2% plus inflation. This rule coincides with the Taylor rule (In appendix) which originally had 2.0% as a real component. If output gaps and inflation gaps zero out over time, then the fed funds rate rule would be 2% plus inflation. Since the original formulation, however, the 2.0% is now in question. The rule was dependent on the time period examined and later updates used a lower real rate as the time horizon expanded or shifted. We can select a different fixed rate. Yet it is the dynamism of the real rate that is now in question. A different time period could yield a different fixed rate and we could fit the data but gain no insight into an evolving real rate. Today, we assume the real rate component is lower than the past but don’t know how low. Also important, if the real rate turns higher again, will we observe or be aware of the upturn?

The real short-term rate can depend on a large set of factors. In fact, the number of variables that can influence the real rate, and the inability to observe these variables, renders many ambitious under-takings to model the real rate useless. The potential growth rate, or GDP, is likely a top choice as a variable determining the real interest rate. However, the real potential GDP can only be estimated. Further, changes in potential GDP growth are difficult to detect and often require a period of time before a consensus can build on what the potential GDP growth is and how it has changed.

Historically, the nominal GDP averaged a rate significantly higher than the fed funds rate. Nominal GDP is composed of two easy parts, inflation plus real GDP. Like the fed funds rate, it suggests that the real fed funds would over time be equal to real growth. Over the six decade period of examination, nominal GDP exceeded the fed funds rate by 1.55%, and the standard deviation of that spread was 4.45%. Historically, we conclude that nominal GDP has not offered an appropriate guide.

Using a simple benchmark as nominal GDP for the fed funds rate is clearly an oversimplified approach. Yet much of the modeling approaches to consider the long-term fed funds rate are decomposing GDP and weighting the components.

Inflation is the first component, and in the long term, we expect inflation and inflation expectations to converge. The inflation component is assumed one-for-one in the long-term GDP. The real components to GDP are demographics, productivity and technological change. We can model and weight these components, but the approach is fraught with limited transparency. Productivity and technological change are observed with certainty only in hindsight, and sometimes many years after revisions. Additionally, it takes several years to distinguish between a temporary or a more permanent change in these variables.

Labor force and demographics – a more observable component of real growth.

Examining the different components of real GDP over the long term such as labor demographics and productivity as well as the aggregate real GDP growth rate, the movement in the labor force commanded strong interest. What is most compelling about the labor force growth is that it has some predictability, at least far more so than productivity or real GDP growth. Labor force growth is determined by population growth and retirement. Many of these features we can predict long in advance. On a monthly basis, we find the labor force participation rate (percent of working age population that has employment or is looking for job), but large moves can be predicted by the aging of the population. Another interesting characteristic is that the labor force data is not subject to major quarterly revisions like productivity and GDP.

In the tables above, we created another fed funds benchmark, which is the simple addition of inflation and the labor force growth rate. The aim is to generate a function based upon more readily observable components of potential growth. The goal is also to keep it simple. The two components, labor force and inflation, together offer an easy, dynamic calculation for long-term GDP. Over six decades, such an easy measure posted the narrowest spread to the fed funds rate. Moreover, the standard deviation on the spread was only modestly higher than using a fixed real rate benchmark. Labor force movements appear to be capturing a key, dynamic portion of the real rate movement, and importantly, the labor force variation is more observable, less prone to revision, and easier to project going forward relative to other fundamental explanatory variables.

Labor force growth has slowed appreciably in the 21st century and particularly after the crisis. The slowdown is a chief factor explaining a slowdown in GDP. Since 2009, the labor force has grown at just a 0.5% pace. That was down from 0.8% in the 2000s and 1.3% in the 1990s. Adding to that an equilibrium inflation rate of 2.0% would generate an equilibrium fed funds rate of 2.5% in the 2010s, versus 2.8% in the 2000s and 3.3% in the 1990s. Inflation was higher or lower than 2.0% during the decades and our historical calculation uses the actual CPI inflation measure.

 

Reasons to use such a simple labor force and CPI construct for considering long-term equilibrium:

1. Historical accuracy: If we consider a long-term analysis assuming that short-term rates find their needed equilibrium, the simple rate has been accurate. Moreover, the points of departure in the 1970s and 1980s are of interest. Fed funds were arguably held too low in the 1970s, giving rise to high inflation. Conversely, in the 1980s the fed funds was higher than it should have been due to abnormally high inflation expectations. Back testing this simple measure offers intriguing results. Over a six decade history, a simple benchmark of adding the labor force and the CPI inflation rate than GDP that implicitly moves with productivity and technological innovation.
2. Observable: A black-box model on the real rate can be constructed. Transparency and ease of observations are strong positives. Many important concepts behind a real rate—from demographics, real growth, productivity, potential growth—are not directly observable. Furthermore, the variables can be revised substantially over time. Variables used to fit a model could be materially altered at a later date. Labor force counts and the CPI are less subject to revisions.
3. Robustness of time varying real rate: Demographics pay a large role in potential GDP growth and additionally on the supply/demand for savings/investment. Having a simple demographic measure such as that has historically had a degree of accuracy, which offers a neat tool for gaining insight. The aging US population and the slowdown in immigration are captured indirectly in the labor force statistic.

There are weaknesses as well that are a narrowly focused driver of the real fed funds and the labor force overall. First, consider the chart on US labor force growth on the preceding page. Volatility argues against using this variable as any short-term guide for the fed funds rate. Second, the swings are numerous enough that deciphering a temporary versus a more permanent change is not straight forward. Yet variation could be minimized with more judgment, given that the aging labor force and the growing participation of women in the workforce were robust elements for change. Labor force gains accelerated into the late 1970s and have been decelerating since.

Conclusion

Estimates of the long-term fed funds rate remain well above current levels and therefore do not offer any short-term guidance for the fed funds rate. Demographics may be suggesting that we have reached a low point. At present, we expect labor force growth of 0.5-1.0%. With an inflation goal of 2.0%, the fed funds rate needs to converge to a 2.5-3.0% range. That range encompasses the Fed’s view and that of many other forecasters as well. It would also allow for further revisions downward. Yet, there is a growing risk that the next step in labor force growth will be faster. We see workers putting off retirement until later and /or the effects of the baby boomers entering retirement fading.

Has the drop in interest rates reached its bottom? 

That is a question regarding most bond maturities. Beyond the inflation question, a bottoming of labor force growth suggests that real rates have reached a bottom. This is an interesting outcome that we stress. The  models now used to explain the persistence of low rates may not yet be ready to determine whether an upturn is underway. Two contributions to slowing labor force growth since 2000  have been the retirement of the baby-boom generation and the slowdown of immigration. The oldest baby boomers are now 70, and the mid-point of the baby boom generation (those born in 1955) reach 62 in 2017.

Meanwhile, we know we have not considered productivity and technological change in this analysis. The question of productivity growth is immensely important, but even more difficult to answer relative to labor force growth as a driver of the economy. In terms of our six-decade view, productivity appears useful in explaining current low interest rates, but not much prior to the current period." - source Société Générale

While Société Générale has an interesting take in relation to demographics, the question of productivity growth is paramount we think, particular when one looks at the quality of the jobs created since the onset of the Great Financial Crisis (GFC)., mostly of low quality. On top of that we do not agree with Société Générale that real rates have reached a bottom. The effect of ZIRP has in effect pushed many baby boomers to postpone taking their retirement due to lack of returns and until we see a clear change in the Fed's monetary policy, we disagree with Société Générale and do not think workers putting off retirement until later and /or the effects of the baby boomers entering retirement  will be fading anytime soon.

When it comes to Japan and Europe (which is undergoing a clear "Japanification" process), both countries face different inflation expectations than the US mostly due to demographics headwinds as we have pointed out in numerous conversations. Interestingly enough, when it comes to demographics, Japan leading the timing of Europe, it does boast a key advantage compare to Europe which is indeed its much tighter labour market leading to some creeping wage inflation as highlighted by Société Générale Albert Edwards in his latest note from the 26th of October:

"After consolidating around ¥100 for about one year, the yen saw a second step decline in H2 2014 towards ¥125. This additional competitiveness caused Japanese corporate profits to boom. The downside was that household incomes were squeezed as higher import prices pushed up headline CPI inflation - this sounds much like the UK today! Although all this was exactly the intention of government policy, the trick is, like kick-starting a motorcycle, to get this one-off stimulus to profits to fire up the engine into a virtuous wage/price spiral and sustainable growth. And from long experience of kick-starting a BSA 1954 M21 600cc single cylinder, it often takes repeated attempts and bruised ankles to get it fired up - link.
Having driven the yen down towards the key 30-year support level of ¥126 at the start of 2015, the BoJ blew its big chance to drive it down through ¥126. If the yen had broken ¥126, I felt it would have quickly run down to ¥145. But having failed to break below this key support level, this year saw it rapidly head in the opposite direction to peak at ¥100 by June, hence squeezing profits (see chart above) and stalling growth. This led foreigners to take flight by selling a record ¥6tn of Japanese shares in the first nine months of the year. I felt the BoJ had blown their chance of reviving the economy via QE and that Abenomics was doomed.

But I might yet be premature in writing Japan off. One key advantage Japan has in trying to produce inflation is, perversely, its appalling demographics. Why? Because even quite moderate GDP growth has resulted in a very tight Japanese labour market (see chart above), and this has resulted in wage inflation crawling higher. In real terms, wage inflation is now rising above 1% (see charts below – indeed Japan’s real wages are rising faster than the US).

Much to my surprise, despite this year’s H1 yen strength hitting growth badly, the Japanese PMI has actually revived in H2 (see left-hand chart below). But this H2 Japanese PMI recovery may be coming at the cost of the US recovery as PMIs now seem to move inversely (see chart below) – especially with the dollar now surging on expectations of a Fed rate hike).

Leo Lewis of the FT wrote a very interesting Short View, essentially concurring with Andrew’s front page chart, that Japanese companies are heaving with surplus cash. He notes a record high 55 per cent of Japanese non-financial companies now hold more cash than debt, in contrast to less than 20% of the S&P 500. And with valuations where they are (see chart below), which equity market do you think QE has set up to collapse in the next recession?

- source Société Générale

Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June this year in our conversation "Road to Nowhere":

"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.

While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016

We concluded at the time:

"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016

Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street".

For Europe, the story is as well different, though from a credit perspective, the on-going Japanification means that Europe, in similar traits to Japan has been deleveraging overall (except Italy and Spain) whereas in the United States and as illustrated by Albert Edwards' note the US has been releveraging thanks to cheap credit and buybacks favoring in the process multiple expansion on a grand scale:

"In a low-growth world, debt is dangerous; in a deflationary world, debt is toxic. Japanese companies, through years of experience, probably understand this and have deleveraged as a result; US corporates, perhaps foolishly, have done the exact opposite.” No “perhaps” about it Andrew. This is nuts!

- source Société Générale

Exactly, in a low yield environment, defaults tend to spike as low yields tend to coincide with higher spreads and default rates. Often low yields are associated with slow growth which eventually should evolve towards wider credit spreads when the credit cycle eventually turns but, we are not there yet. If growth eventually picks up while yields stay low then spreads could indeed normalize but it is not our core scenario.

Why inflation matters therefore? Because in low inflation environment, like the one we are going through often tend to be associated with spiking defaults historically (deflation bust of the energy sector earlier this year).

But, moving back to Europe and its inflation conundrum, when it comes to wage growth, it could put additional pressure on its inflation expectations due to decelerating wage growth as highlighted by Ban of America Merrill Lynch in their Euro Area Economic Watch note from the 28th of October entitled "Wage growth: potential for worse":

"Wage growth: potential for worse

This is a half-hearted labour market recovery

Employment growth in the Euro area is continuing its relatively steady recovery. The number of employees (excluding self-employed) rose 1.7% and 1.6% in 1Q and 2Q16, respectively, predominantly driven by the services sectors. The number of employees is back at 2008 levels now (Chart 1).

However, robust headline employment growth masks a much shallower recovery in hours worked, which continue to stand nearly 4% below their 2008 level in the economy as a whole (Chart 2). 

Meanwhile, Euro area wage measures, including compensation, wages and salaries, contractual wages, etc, continue a gentle downward trajectory. Wages and salaries per employee, for example, slowed to 1.4% yoy in 1H16 on average compared with 1.5% in 2015 and 2.1% on average since 2001.

Some blame sector composition for slower wage growth – we disagree

A predominantly services sector-driven labour market recovery is not surprising given the composition of the Euro area growth recovery: domestic demand components, public and private consumption in particular, are a lot more service-intense than capex or exports. Services, in turn, are more labour-intense.
Some hawkish ECB council members have cited the sector composition of the labour market recovery as the driver of slowing wage growth, as services wage growth typically underperforms that of industry.
We believe this line of argument is flawed and not supported by the data. On the contrary, our findings suggest that wage-setting behaviour may have changed also in the services sector post-crisis, which would be disconcerting. Even if we assume that wage structures did not change, wage growth prospects would still be rather gloomy and under pressure to decelerate further.

Sector drag on aggregate wage levels? Not if you look at hourly wages

Since 2002, the share of employment in industry excluding construction has fallen by more than 4pp to 17% in the Euro area, while that of the services sector has risen 6pp to 77%. We wanted to know if and how much drag this reshuffle of employment poses to average wage levels. To do this, we calculated a counterfactual wage level measure, assuming the composition of employment and the composition of working hours had remained at the 2002 level. Results are shown in Chart 3.

We find that wages per employee are currently some 1.5% lower than they would have been if the sector shares of employment had not changed. The trend has been very steady, however, lowering wage growth per headcount by 0.1pp every year – hardly enough to justify the wage growth deceleration we have seen post-crisis.

Wage growth per employed, however, does not reflect the rise in part-time employment. So we run the same exercise for hourly wages. We find that, if anything, wage levels today are marginally higher than they would have been (blue line in Chart 3). This would suggest that sector composition cannot really be held responsible for what we see in the recovery.

Wage growth has slowed across most sectorsIf sector composition were solely to blame, we would also expect wage growth to have remained intact across sectors, particularly in those where wage growth is typically lower but employment growth currently faster. Again, data suggests that things are not so simple.

Chart 4 shows hourly wage growth in the industry (excl. construction) and services sectors (including the public sector). In both aggregates, dynamics have slowed from pre-crisis standards (although industry wages have continued to decelerate more quickly recently).

We have equally checked standard deviations of wage growth across 10 different sectors at any point in time (grey area in Chart 4). During 2012-14, wage growth was more harmonious across sectors, but it has started to reflect typical dispersion again (as has the differential between the fastest and slowest sector wage growth). This could suggest the entire spectrum has shifted a gear lower.

Slowing wage growth in response to inflation – even in services

Generally, a lower wage level could be “normal” if it results from a) lower productivity growth and/or b) more economic slack now than before. But again we find that more may be at play here, both in the economy as a whole and in individual sectors.

We replicate an exercise we ran over the summer, when we were warning to be vigilant of second round effects of inflation on wages. As a reminder, we had found at the aggregate level that the deviation in compensation growth from its long-term average could be explained by slack (high unemployment), but also larger and more persistent than usual negative contributions of inflation. These, we argued, were tentative signs of second-round effects."  -source Bank of America Merrill Lynch

So, if wages are a backward looking indicator of inflationary pressures and labor markets continue to weaken in the US and in some parts of Europe such as France and oil prices finally recede, we have a hard time buying the stagflationary story for the time being. We also have a hard time buying the Q3 US GDP at 2.9% but that's another story.

What we are seeing we think, is more akin to the development of "biflation" rather than "stagflation" in the sense that we could see the development of the simultaneous existence of inflation and deflation in an economy. This would lead to a resurgence in inflation in commodity prices with deflation in debt-based assets. Biflation can occur when a fragile economic recovery causes central banks to "overmedicate" via their monetary policies. This may results in higher prices for certain assets such as energy and precious metals with declining prices for leveraged assets such as real estates and automobiles (see our July conversation on declining prices for classic cars "Who is Afraid of the Noise of Art?"). With biflation,  the economy is tempered by increasing unemployment and decreasing purchasing power. As a result, a greater amount of money is directed toward buying essential items and directed away from buying non-essential items. Debt-based assets (mega-houses, high-end automobiles and other typically debt based assets) become less essential and increasingly fall into lower demand. The illustration of buying essential items is clearly shown by Visual Capitalist.com Jeff Desjardins on the 28th of October:
"Prices Are Skyrocketing, But Only For Things You Actually Need

"The average price increase, as shown by the CPI (Consumer Price Index), is 55% over the last 20 years. Meanwhile, the prices of individual sub-categories have a much wider variance." - source Visual Capitalist, Jeff Desjardins.

Of course the consequences of central banks meddling with interest rates is in our mind seeding "The Grapes of Wrath" and is causing biflation to some extent. This is leading to not only rising cross asset correlations as of late between stocks and bonds, but, leading to wider variances and larger standard deviation moves. Instability is not only brewing in financial markets but is leading as well towards instability in various countries and risks of social unrest.

Whereas the United States, Japan and Europe face different situations when it comes to dealing with inflation expectations and wage pressure in conjunction with different demographics, back in October we recommended (a little bit early) to look at US TIPS  in our conversation "Sympathetic detonation" from a great diversification perspective:

"Given secular stagnation, and "Japanification" of the economy (which has long been our scenario, Europe wise), indeed US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015

In March again in our conversation "Unobtainium" we commented that we continued to like US TIPS:

"We continue to like US TIPS particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment?" - Macronomics, 19th of March 2016

So from a biflation allocation perspective, US TIPS still remain particularly attractive particularly given their embedded deflation floor. While "balanced funds" are getting "unbalanced" by recent correlated move downwards for both bond prices and stocks, what is not to like about the lower correlation offered between linkers and equities/sovereign bonds? Inflation-linked bonds still provides you with very interesting diversification benefits. For instance the Ishare TIPS bond ETF exposed to US TIPS has delivered you a total return of 6.53% so far. For the long duration braves out there Pimco's 15 years + ETF has LPTZ has rewarded them with handsome year to date total return after fees of 18.70%. Who said there wasn't sometimes some "embedded" actionable ideas in our musings? We rest our case.

In our final chart, while we have been monitoring the credit cycle as it is slowly turning in this "overmedicated" central bank meddling environment, we continue to look at the slow but evident deterioration in credit fundamentals particularly in the US which has been "releveraging" thanks to cheap credit.

• Final chart: The ongoing deterioration of credit fundamentals in the US remains the key market risk

While the relentless liquidity provided to the credit markets thanks to Japanese NIRP and the ECB and now BOE being competing with investors in the credit investment world, when it comes to default in a low yield environment, leverage matters and so does credit fundamentals. Our final chart displays US debt growth relative to EBITDA and comes from JP Morgan's Credit and Market Outlook and Strategy note from the 20th of October:

"The ongoing deterioration of credit fundamentals remains the key market risk, however. Debt issuance continues to grow much faster than EBITDA, even if the expected uptick in revenue growth this quarter materializes. Investors are aware of this, but are focused on the strong technicals outweighing these risks. This has been the right view since 1Q of this year. However, our sense is that some investors are uncomfortable with market valuation given these technicals, and if there is a catalyst for a risk off market, this concern about fundamentals would reassert itself.
Fundamental credit metric deterioration is not itself likely to be a catalyst as it occurs slowly and it is difficult to define a red line for specific metrics that causes a problem. A renewed trend of rating downgrades, as occurred in 1Q in the Energy sector, could refocus markets on these risks, but if and when this will happen is difficult to predict." - source JP Morgan

While the party has been running strong "uphill", mostly to the bond market that it, courtesy of the "wealth effect", and not downhill to the real economy, if real assets are positively correlated with inflation and deflation fears are subsiding, we believe that some commodities could stage a comeback, US TIPS will be as well one of the beneficiaries rest assured. Meanwhile, our politicians and central bankers alike have indeed sowed "The Grapes of Wrath", putting financial assets at risk of heightened political backlash from the have not of the real economy namely "Main Street" versus "Wall Street". 

"You will not be punished for your anger, you will be punished by your anger." - Buddha

Stay tuned!

Credit - The Departed

"Faithless is he that says farewell when the road darkens." -  J. R. R. Tolkien 

We have long posited that by suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns. This week's chosen title is not only a reference to departing Fed chairman Ben Bernanke, but as well a reference to Martin Scorsese movie masterpiece "The Departed". In the final scene, a rat is seen on the window ledge, symbolizing according to Scorsese "the quest for the rat", which we can ascertain today in the strong sense of distrust towards the actions of the US central bank and in relation to our chosen analogy. We could ramble further and quote Don Delillo's 2003 Cosmopolis: "A rat became the unit of currency".

Under Ben Bernanke's guidance, there has been a growing disconnect between Wall Street and Main Street as displayed by Bank of America Merrill Lynch graph displaying the evolution of Wall Street versus Main Street:

From its 2009 lows the US economy has grown by $1.3 trillion while the US stock market has grown by $12.0 trillion.

No doubt to us that the 2013 performance of the US stock market has been artificially "boosted" by "de-equitization", namely the reduction of the number of shares courtesy of buybacks thanks to increase leverage given many corporates have issued bonds to finance their buybacks program as displayed by the graph below displaying the growing divergence between the S&P 500 and trailing PE since January 2012  - graph source Bloomberg:

 The S&P 500 trades at 25x cyclically adjusted PE ratio (CAPE), exceeding the highs reached in 1901 and 1966. In 1929 CAPE reached 33x and in 2000 44x. 

Our "Departed" strategy has relied heavily on the "Cantillon Effects". The rise of the Fed's Balance sheet coincided with the rise of the S&P 500, and boosted as well by the rise of buybacks. The greatest failure of "the Departed" can be clearly seen in the fall in the US labor participation rate (inversely plotted) - source Bloomberg:

In red: the Fed's balance sheet

In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

What the "Departed" aka Ben Bernanke as achieved is as follows:

More liquidity = greater economic instability once QE ends

No surprise therefore that the $4 trillion of flows which have been going towards Emerging Markets have been impacted by the return of US rates into positive real yields territory as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment."

Of course, what we are seeing right now in Emerging Markets is the continuation of "reverse osmosis".

So in this week's conversation, we will look at the growing downside risk posed by some Emerging Markets, the implication for European stocks, and our growing uneasiness with the credit risks being taken and the deflation build-up we are seeing.

We already discussed EM troubles brewing in our conversation "Misstra Know-it-all" relating to the great work from Ben Bernanke aka "The Departed":

"Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse."

And as posited by Nomura at the time of our September 2013, the risk of the situation turning nasty for lack of liquidity is significant:

"Bad liquidity markets saw asset swaps widen considerably (making swap paying less of a hedge) and start to trade like credit products. This phenomenon, if it continues, could result in a lot of proxy hedging through FX, FX vol, buying CDS and, at a more serious stage, selling what investors could unwind."

We also added at the time:

"Misstra Know-it'all has indeed played a quick hand, lifting stock prices, playing on the wealth effect game and exporting "hot money" flows in Emerging Markets"

In the same conversation we also indicated an interesting trade we particularly like and enjoy today:

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up." - David Goldman's article about Gold and Treasuries and bonds in general written in August 2011 (the former global head of fixed income research for Bank of America)

This is exactly what is happening at the moment from a tactical point of view we think and at least the gold leg of the put-call parity, has indeed been performing in this fashion year to date while Emerging Markets currencies have been on the receiving end of the sell-off - graph source Bloomberg:

Interestingly, when it comes to Japan and the crowded trade in JPY (which we have been playing since late 2012) appears to us overly crowded and the risk of a strong reversal cannot be ignored anymore, making as well the Nikkei vulnerable in the short-term (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro). The USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:

When it comes to credit and spread tightening, the above significant correlation between rising equities and tighter credit spreads is clearly explained by the wealth effect induced by the Japanese QE.

But, the recent rise in the Nikkei 3 month 100% Moneyness Implied Volatility could indicate a potential near term rise in the Itraxx Japan, representative of the credit risk perception for corporate Japan. It has stayed at record low levels for many months and could easily climb back towards the 100 bps level we think - graph source Bloomberg:

Given the recent bout of volatility, which has been caused from the "Great Rotation" from Emerging Markets aka the "Tourist Trap" (a tourist trap being an establishment, that has been created or re-purposed with the aim of "attracting tourists" and their money), when it comes to playing "defense", Consumer staples offer partial crash protection. On that subject see our April 2013 post - "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option".  From a contrarian stand-point, Consumer Staples, as displayed by Bank of America Merrill Lynch January 2014 Long & Shorts summary, appears extremely underweight:

When it comes to equities and credit sensitivity to Emerging Markets turmoil, Europe is more sensitive to China/EM weakness as indicated by the below chart from Bank of America Merrill Lynch from their note from the 25th of January entitled "Love EM or Hate EM" displaying the massive underperformance in Europe main investment grade risk perception indicator namely Itraxx Main (125 European investment grade entities):

We already touched on the sensitivity of equity index earnings versus FX sensitivity on the 21st of March 2013 in our conversation "Have Emerging Equities been the victim of currency wars?":
"For some countries, the major equity indices can be much more heavily affected by foreign earnings than by domestic earnings." - source BNP Paribas

No wonder the IBEX is on clearly on the receiving end of the latest sell-off. In similar fashion peripheral issuers such as Santander, Mapfre and BBVA in the credit space have not been spared either. The underperformance of the IBEX - graph source - stockcharts.com:

Credit wise, "The Departed" has indeed pushed "mis-allocation" to deep instability level, you would have thought the prime role of a central bank was financial stability, but then again, looking at the recent developments, one might wonder about the "unintended consequences" which increased the instability of the system were worth the efforts put on in over-reflating financial markets.

Recent examples abound to show the increasing risks taken by brazen investors moving clearly outside there comfort zone.

For instance investors are dipping their toes back into illiquid investments as reported by Lisa Abramowicz in Bloomberg on the 23rd of January 2013 in her article "Hard-To-Sell Junk Debt Lure Oaktree to JP Morgan":
"Bond investors are losing their aversion to difficult-to-trade corporate debt that handed them some of the biggest losses in the credit crisis.
The extra yield note buyers demand to own older, smaller junk bonds that trade infrequently has shrunk to an average 0.25 percentage point this month from more than 1 percentage point a year ago, according to Barclays Plc data. JPMorgan Chase & Co. money manager Jim Shanahan said he’s preferring “good credit quality and less liquidity” when picking bonds, while Howard Marks, the head of distressed debt investor Oaktree Capital Group LLC, said he’s finding bigger potential gains in private, less-traded debt.
The evaporating premium for illiquid assets is showing the depths to which money managers are reaching to boost returns after a five-year rally that pushed relative yields on junk bonds to the least since August 2007. With Federal Reserve monetary policies suppressing interest-rate benchmarks for a sixth year, credit buyers are showing more concern that they’ll miss out on a continued rally than get stuck with debt that lost 26 percent during the market seizure in 2008.
“For the past several years, people have been concerned about liquidity,” said Eric Gross, a credit strategist at Barclays in New York. “Now we’re hearing more about people seeking out illiquid bonds.”

Fragile Market

Such debt tends to be more vulnerable to price swings when market sentiment deteriorates, because there are fewer buyers to bid on it when investor withdrawals force money managers to sell. Those risks intensified after stricter banking rules accelerated a pullback by Wall Street dealers that used their own money to facilitate trading.
Primary dealers that trade directly with the Fed cut their holdings of corporate bonds by 76 percent to $56 billion after peaking at $235 billion in 2007, Fed data through March show. After the central bank changed the way it reported the holdings in April, net speculative-grade bond holdings fell as much as 24 percent to a low of $5.63 billion in May before rising to $7.7 billion on Jan. 8.
Investors are demanding an average yield of 5.94 percent to own bonds sold at least 18 months ago in batches of less than $250 million, Barclays data show. That compares with an average 5.7 percent for newer debt offerings of at least $500 million.
The gap, which averaged 0.5 percentage point last year and 0.92 percentage point in 2012, reached as much as 1.95 percentage points at the peak of the financial crisis in March 2009."  - source Bloomberg.

Just a thought for our confident credit investors:
"Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth - - they trust, instead, on their supposed ability to exit."
Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” - "Corzine Forgot Lessons of Long-Term Capital"

Another example as well to the extreme the "Departed" has pushed investors is the return of the old credit binge instruments such as "PIKs" bonds (Payment in Kind) as discussed by Sarika Gangar in Bloomberg on the 24th of January in her article "No-interest Junk Bonds Make Comeback With Twist":
"The riskiest types of corporate bonds are getting a makeover, providing more protection for investors while showing the limits of a rally in junk-rated debt that pushed yields to a record low.
Issuers from Neiman Marcus Group Ltd., which sold $600 million of notes in October that allow it to make interest payments in more debt instead of cash, to Jacksonville, Florida-based Bi-Lo Holdings LLC led $14.8 billion of payment-in-kind offerings in the U.S. last year, the most since 2008, according to data compiled by Bloomberg and Fitch Ratings. The 36 issues were a record.
While the bonds became popular during the last credit boom before the downturn, the new generation of securities are smaller in size, come from companies with less leverage and some compel borrowers to pay interest in cash unless they violate certain financial targets. These protections show that investors are treading carefully even as they search for additional yield amid unprecedented central bank stimulus measures that pushed interest rates to all-time lows.
“The issuance of PIK tends to move the same way as the credit cycle and credit has been loosening,” Sharon Bonelli, a managing director at Fitch in New York, said in a telephone interview. Still, “the market is not as aggressive as it was.” Sales of PIK-bonds were the third most on record last year, behind the $16.2 billion in 2007 and $14.9 billion in 2008." - source Bloomberg.

Kuddos to the "Departed", the Fed's ZIRP since 2008 has forced investors into riskier securities to get extra payouts. But, there is a catch we have repeatedly pointed out:
Definition of Credit Market insanity - "Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

When it comes to credit risk and luck, recently some investors in hybrid securities learned the hard way when ArcelorMittal called early some subordinated bonds at 101 when they had been trading recently around 108.96 cents, a good sucker punch for some unwary investors as indicated by Alastair March in Bloomberg on the 21st of January in his article entitled "Arcelor Mittal's Hybrid Bonds Slump on Early Redemption Call":
"ArcelorMittal’s $650 million of hybrid bonds slumped 6.8 percent after the steelmaker said it would redeem the notes early because of changes to the way the securities are treated by Moody’s Investors Service.
ArcelorMittal will buy back the subordinated securities on Feb. 20 and pay investors 101 percent of their principal, the Luxembourg-based company said in a statement. The notes, which combine elements of debt and equity, were trading at 101.55 cents on the dollar at 11:05 a.m. in London after closing on Friday at 108.96 cents. Moody’s said on July 31 that it would consider hybrids of speculative-grade companies to be entirely debt, rather than half equity as is now the case for all issuers. ArcelorMittal’s move to call the securities early “shocked the market” and highlights the vulnerability of hybrid bonds to ratings changes, ING Groep NV analysts led by Mark Harmer wrote in a note to investors." - source Bloomberg

When the facts change, which they did in July last year, as a credit investor, change your facts or face the consequences.

We are nearing a top in the gentle credit cycle and no doubt there will be a second distressed wave in the not so distant future, rest assured.

This is what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, wrote back in 2011 - Corporate Subprime - The default crisis that never happened:
"Armageddon never arrived. The Federal Reserve slashed interest rates, helping to spark a huge rebound in the price of risky debt. According to S&P, during the past five years cov-lite debt returned a total of 33 percent, versus 31 percent for standard loans with covenants. Companies that were running into trouble were able to raise more money in the markets. Corporate default rates stayed very low. And it all happened so quickly that the protection afforded by the covenants, or the lack thereof, never seriously got tested." - Bethany McLean - The default crisis that never happened.

She also added in her 2011article:
"The fact that the Fed rode to the rescue doesn't necessarily mean that cov-lite loans were a good risk to begin with."

Another interesting development in the desperate search for yields at any risk by credit investors, has been in the the speculative loan space as indicated by Sridhar Natarajan in Bloomberg on the 22nd of January in his article "Loan Surge Above Par Putting Investors at Risk":
"More speculative-grade U.S. loans are trading above par than at any time since May, exposing investors who are funneling record amounts of cash into the debt to greater risks as rising prices encourage borrowers to refinance at lower interest rates. 
Spanish-language broadcaster Univision Communications Inc. and KKR & Co.-controlled First Data Corp. are among at least 30 companies seeking to reduce rates on $31 billion of bank debt as more than 80 percent of leveraged-loan prices exceed 100 cents on the dollar, according to JPMorgan Chase & Co. That’s up from 40 percent at the beginning of October, according to a report from the New York-based lender last week. “Loans are trading well above their call prices because the investor community is reaching out for existing loans, "Jonathan Kitei, head of U.S. loan distribution at Barclays Plc in New York, said in a telephone interview. “You will see more loans getting repriced.”
Investors last year deposited about $63 billion into loan funds that invest in debt with rates that rise with benchmarks and have limited restrictions on early repayment. Banks from Barclays Plc to JPMorgan and Citigroup Inc. expect loans to underperform compared with 2013 as the Federal Reserve begins to taper its bond purchases, paving the way for an increase in rates that have been kept near zero for the last five years.

Limited ‘Protection’

“Whenever loans are trading above par, you introduce an additional risk element as there is limited call protection,” David Breazzano, president of DDJ Capital Management LLC, which manages more than $7 billion in high yield assets, said in a telephone interview. “Value in loans has dissipated a bit in the last couple of months.” Companies reduced borrowing costs on $281 billion of speculative-grade loans last year, or almost 4 times more than 2012, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data." - source Bloomberg.

The divergence of growth between the US economy and the European economy has been indeed reflected in credit prices such as the US leveraged loan cash price index versus its European peer. - source Bloomberg:

While both the PMIs and Leveraged loan prices cratered in 2008, you can see the impressive rebound in 2009, leading in the rapid surge in cash prices for leveraged loans and the increasing divergence in cash prices as indicated by the growing spread between US leveraged loan prices and European leveraged loan prices now at only 3 points apart.

The divergence of loan growth has indeed explained the divergence of economic expansion between Europe and the US. The divergence between US and European PMI indexes - source Bloomberg:

The growth differential between both economies is due to credit conditions. You can clearly notice the uncanning similarity with leveraged loans prices in both regions.

Moving on to the growing deflationary risk we have been warning about for some time, Europe seems indeed to be sleepwalking into a deflationary trap as pointed at recently by Christopher Woods from CLSA in his recent Greed & Fear note:
"At some point the equity market must surely focus on the reality that this market action reflects an increasingly deflationary environment in the Eurozone which is fundamentally equity negative. In this respect it is worth noting that 20% of the items in the Eurozone’s CPI inflation basket are now in deflation, with an average 2.2%YoY decline in December, contributing a negative 45bps to the Eurozone CPI inflation." - CLSA, Christopher Woods

Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes going down again and indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

In similar fashion to QE2, QE3 triggered a significant rise in Inflation Expectations, since the beginning of the year, 5 year forward breakeven rates have been falling, indicative of the strength of the deflationary forces at play - source Bloomberg

Every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully.

Another sign of the many failures of the "Departed": Inflation is nowhere to be seen but in rising asset prices, which are more and more grossly disconnected from reality. QE was supposed to create inflation. It hasn't been the kind of inflation the "Departed" was hoping for.

On a final note, of course one of the main culprits in 2013 which we have discussed at length has been Japan which has been exporting deflation on a large scale and the US has not been immune. It is still the "D" world (Deflation - Deleveraging). On that point we agree with Albert Edwards from Société Générale on the deflation risk, as displayed in a recent Chart of the Day graph from Bloomberg:

"The CHART OF THE DAY shows annual rates of inflation excluding food and energy, based on indicators that Edwards cited in a similar chart two days ago. It tracks the monthly changes in a consumer-spending deflator compiled by the U.S. Commerce Department and a price index from Eurostat.
The U.S. deflator rose 1.1 percent for the 12 months ended in November. The increase was smaller than the 1.7 percent gain for the core consumer price index that month, which was matched in December. Last month’s reading for the euro-region gauge was 0.7 percent, the lowest on record.
“Investors have yet to react to the deflationary threat,” wrote Edwards, a London-based strategist who says stocks are in a multiyear bear market that he calls the Ice Age. “They simply do not believe a recession that would trigger outright deflation is on the horizon.”
International Monetary Fund Managing Director Christine Lagarde highlighted the risk of falling prices two days ago during a speech in Washington. She urged policy makers in the U.S. and other advanced economies to avert deflation, which would hamper a “feeble” economic recovery.
“If U.S. growth in 2014 proves as disappointing as in previous years, then there should be a large market reaction as inflation expectations get pegged back closer to euro-zone levels,” Edwards wrote.
Economists expect gross domestic product to rise this year by 2.8 percent, exceeding last year’s 1.9 percent, according to the average estimate in a Bloomberg survey. They also expect a bigger increase in the deflator for core consumer spending, to 1.6 percent from 1.3 percent." - source Bloomberg.

To conclude on Ben Bernanke's legacy, we quite enjoyed Doug Noland recent take on the subject in his column entitled "The Departing Bernanke on Macro-Prudential":
Q&A from the National Association of Business Economics conference, Philadelphia, January 3, 2014: William Nordhaus, Yale University economics professor and chairman of the Federal Reserve Bank of Boston: “I asked my students if they had a question for [Bernanke]. And there were a number of them, one which I won’t ask is ‘what about bitcoin?’ – which I know he knows about. But I thought a really interesting one was this: ‘If you knew in 2006 what you know now, what step or steps would you have taken then to prevent or ameliorate the financial crisis and subsequent severe downturn?’” 

Bernanke: “Well that’s a really unfair question. I mean, the reality is that everybody – every policymaker has to make – this is the nature of policy – it has to be made in very, very foggy conditions with very imperfect information – a lot of uncertainty. So, in order to do anything, I think I would not only have to know everything in advance, everyone else would have to know I knew everything in advance. In other words, if I went out and started saying – all of the sudden I’m arbitrarily raising capital requirements by five percentage points, the banks would say ‘What!’ and it would be very difficult to get Congress and the other regulators and so on and so on to agree. I mean I think the crisis was very complex, involved many many issues. One of the concerns, I want to respond indirectly to a point…, the usefulness of macro-prudential-type measures. I think one of the practical questions is, even if you think you’ve got macro-prudential measures that work, can you put them in place quickly enough and responsibly enough, preemptively enough.

"To know and not to act is not to know." - Cosmopolis - Don Delillo

So long "Departed".

Stay tuned!