Macro and Credit - Hypertonic surroundings

"The advancement and diffusion of knowledge is the only guardian of true liberty." - James Madison

Watching with interest the numerous convolutions in Emerging Markets, with Gold taking the proverbial sucker punches thanks to the bloody rampage of "Mack the Knife" (King Dollar + positive real US interest rates), when it came to selecting our title analogy, we decided to return to a biology one, namely "Hypertonic surroundings" given our global macro reverse osmosis theory we discussed in our conversation "Osmotic pressure" back in August 2013 seems to be playing out for the weakest EM "cells" out there:

"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

 This is the theory we put forward in terms of biology analogy 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." - Macronomics, August 2013.

We also added in our July 2015 conversation the following: 

"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike." - Source Macronomics July 2015.

A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been the pain in EM most recently with the usual suspects such as Turkey and Argentina being first in the line of the murderous rampage of "King Dollar". 

Nota bene: Hypertonic

"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

What we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs rest of the world). Animal cells lack rigid cell walls. When they are exposed to hypertonic environments, water rushes out of the cell, and the cell shrinks. The resulting cells are dehydrated and lose most or all physiological functions while in the shriveled state. If cells are returned to isotonic or hypotonic environments, water reenters the cell and normal functioning may be restored. Cells without cell walls (capital controls) can burst when in a hypertonic condition. Too few solutes (US dollars) and the environment will become the hypertonic solution. There goes our reverse osmosis global macro analogy for you.

In this week's conversation, we would like to look at the main reasons for the start of the "unwind" of the carry trade and the pain inflicted to EM macro tourists, namely that Mack the Knife is a consequence of financial conditions tightening for many leveraged global players. 

Synopsis:

• Macro and Credit - The Fed is tightening its financial conditions tourniquet 
• Final charts - So you want to be bearish? Oil-price spikes have preceded most recessions

• Macro and Credit - The Fed is tightening its financial conditions tourniquet 

While every pundits around the financial sphere are pointing the rise of the US dollar as the main reason for the ongoing bloodbath in the EM space, we think that the rise in the greenback is a manifestation, not the main cause of Mack the Knife's rampage. The reality as pointed out by David P. Goldman in Asia Times on the 16th of August is that financial conditions are getting tighter as per his article entitled "It’s all about financial conditions":

"The collapse of the copper price by 20% from its June peak evidently is not an economic phenomenon driven by demand. Rather, it is an expression of risk aversion.

The world has gotten riskier during the past few months, for two primary reasons:

1. There is a low-level trade war between the US and China underway that could turn into a high-level trade war; and
2. The Italian elections put a bunch of unpredictable firebrands in charge of an economy with US$2.3 trillion in foreign debt and a dodgy banking system.

Heightened risk translates into a greater desire to hold cash balances (and that means a higher dollar, because most people pay bills in dollars and therefore hold cash balances in dollars). To get higher cash balances, market participants sell things like raw materials.

Turkey is utterly irrelevant to this shift towards risk aversion. The Turks may make the mistake of thinking that they matter but no-one else should encourage them. Turkey’s whole stock market is worth about US$30 billion at current prices, roughly the market capitalization of Monster Beverage Co. The big issues are European disintegration and Italian dyspepsia, and the US-China trade war." - source David P. Goldman - Asia Times

Because of fears of dollar scarcity, thanks to QT and the Fed turning off gradually the monetary spigot, the commodities rout has been about raising dollar cash/playing defense as indicated by David P. Goldman. As well there are the usual "known unknowns" everyone and their dog have been talking about, namely the risk of trade war escalation and of course the potential brewing internal rift between the European Commission and Italy. It's going to be interesting to say the least to see how Le Chiffre at the helm of the ECB aka Mario Draghi is going to deal with the Italians and their budget which will no doubt necessitate some helping hand in buying their bond issuance. This is what we wrote in our October 2015 Le Chiffre conversation:

"While in the movie Le Chiffre pretty much made a game out of it with nothing on his cards in the first game, in similar fashion Mario Draghi made a game out of it with his "OMT" and "Whatever it takes" July 2012 moment. In the movie it made Bond surmise that Le Chiffre was in desperation to get the money and resorted to bluffing (It was exactly our thought at the time). Le Chiffre and Mario Draghi share the same trait, both are poker prodigies hence our title analogy." - Macronomics, October 2015

 But, hey whatever it takes...as we wrote as well in the same conversation:

"While Le Chiffre has been a prodigious  Poker player when it comes to "bluffing" his way out of the "bond vigilantes" in Europe setting their sights on weaker European government bonds, when it comes to both "credit growth" and "inflation expectations", we think Le Chiffre has indeed been "overplaying" it." - Macronomics, October 2015

So while the US dollar is indeed on everyone's mind when it comes to EM woes and the Turkish side show, still the big European elephant in the room remains Italy. The current Fed normalization process is making Le Chiffre's balancing work even more complicated we think if he intends to remain a "forced" marginal buyer of Italian BTPs with of course Merkel's German consent.

But, moving back to our recurring themes in recent conversations, we discussed rising dispersion and large standard deviation moves. This late cycle phenomenon is attributable we think to liquidity being withdrawn thanks to QT and global financial conditions being tightened. As we saw earlier one the short-vol pigs house of straw blown away, obviously the next levered candidate were the macro-tourist pigs house of sticks such as Turkey and Argentina. 

In our March 2017 conversation entitled "The Endless Summer" we concluded our missive at the time asking ourselves how many hikes it would take before the Fed finally breaks something. As well we commented the following in our February missive "Buckling":

"The difficulty for the Fed in the current environment is the velocity of both the rates rise and inflation, because if indeed the Fed hike rates too quickly then it will trigger some other avalanches down the capital structure (short-vol complex being the equity tranche or first loss piece of the capital structure we think). If inflation and growth rise well above trend, then obviously the Fed will be under tremendous pressure to accelerate its normalization process. It is a very difficult balancing act." - Macronomics, February 2018

The Fed is still relentless on its hiking path, particularly in the light of US CPI coming at 2.9% year-over-year, unchanged from June; the fastest pace in more than six years. As we repeated in numerous conversations, for a bear market to materialize you would need a significant pick-up in inflation for your "buckling" to occur and to lead to a significant repricing of risky asset prices such as equities and US High Yield. In recent conversation "Bracket creep", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. To repeat ourselves "Protectionism", in our view, is inherently inflationary in nature. At some point there might be a confrontation between the Trump administration and the Fed we think.

A clear sign of financials conditions tightening we think has been the unwind of the EM carry trade to the benefit of our friend "Mack the Knife" aka the US dollar. This is clearly indicated by Bank of America Merrill Lynch in their Liquid Insight note from the 16th of August entitled USD in the FX carry driver's seat:

• "USD has been a top yielder in G10; a fundamentally-strong USD with asset status supports FX carry and further dollar gains
• USD on the asset side and SEK on the funding side has upended correlations; FX carry beta risk is low and investors own vol
• After the momentum surge in February-April, FX carry looks poised for another leg higher; will AUD & NZD stand in the way?

The shifting dynamics of FX carry

The US dollar resides firmly on the asset side of the FX carry spectrum, currently occupying the top yield rank (Chart of the day).

Its presence atop the yield ranking is historically atypical and a reflection of a robust US economic cycle and a steadily hiking Fed, attributes that have supported USD higher since 1Q18. USD asset status alongside SEK liability status (displacing JPY) has also sharply shifted historical FX carry correlations, resulting in long carry positions now having very low traditional “beta” (risk-on/risk-off) exposure as well as long exposure to implied volatility. FX carry investors now actually get paid to own tail risk in a robust economic cycle, which has traditionally supported carry returns. These are important shifts that enhance the attractiveness of both FX carry as an investment approach in an uncertain world as well as support the USD as principal currency beneficiary. After a strong surge in momentum through mid-April, event analysis suggests FX carry is poised to make another run higher in the weeks ahead. Of key importance will be whether recent sharp depreciation in AUD and NZD – the two other asset currencies aside from USD – moderates.

FX carry revisited

Traditional FX carry strategies involve going long currencies offering the highest yields, funded in currencies offering the lowest yields. The number of currencies on respective asset and funding sides can vary but often is symmetrically three (particularly in G10). For the sake of simplicity, our analysis uses Bloomberg’s G10 FX carry index, which uses a simple top three/bottom three construction and, in our view, is representative of the approach used by many FX carry-themed investors.

The general historical pattern of FX carry positions should be unsurprising to those familiar with the strategy. On average, since 2000, the highest ranking carry currencies have been NZD, AUD and NOK, in that order. The lowest ranking carry currencies have been CHF, DKK and JPY. Historically, USD, EUR, GBP and CAD have been positioned somewhere in the middle.

The carry spectrum today: What’s wrong with this picture?

Chart 1 shows the current FX carry spectrum based on implied three-month yield. A simple top three/bottom three FX carry strategy would currently be long USD (2.32% yield ), NZD (2.31%) and AUD (2.19%), funded in CHF (-0.80%), DKK (-0.59%) and SEK (-0.49%).

The position of USD on the asset side of G10 FX carry clearly represents a major departure from the past (Chart 2).

Moreover, its position at number one represents a full five rank positions above the historical average (about number 6). This is by far the greatest discrepancy with respect to current FX yield rank vs historical average across G10.

Additional anomalies worth highlighting are SEK, currently squarely on the funding side and two positions below its historical average; and JPY, now approaching middle-of-the pack status and two positions above its historical average (no longer a funder). Nonstandard monetary policy measures and forward guidance put in place by the ECB are responsible for low European yields, in particular that of SEK. Indeed, the Riksbank responded with aggressive measures of its own aimed at preventing unwanted exchange-rate appreciation, the practical result being relegation of SEK to the FX funding bin. Negative funding yields have clearly enhanced the spread of high yielders.

Factors affecting carry performance

FX carry has traditionally been a risk-on and implicitly short volatility strategy, essentially a reflection of relative yield providing compensation for relative perceived risk (Chart 3).

High yield also provides an incentive to fund external deficit currencies, often on the asset side of an FX carry strategy historically. Conversely, low (currently  negatively) yielding funding currencies usually exhibit safe-haven status, often due to external surpluses and correspondingly high international investment positions (IIPs). FX carry investors earn a positive return in one of two ways: (1) exchange rates remain stable or decline by less than the yield spread between the asset and funding currencies; or (2) asset currencies increase in value relative to funding currencies, hence producing capital appreciation additive to the positive carry differential. The latter scenario is the ideal one for carry seekers. FX carry investors lose money (ie, experience negative total return) when depreciation in asset currencies vs funding currencies exceeds the positive carry earned. Losses have been severe at times, as was the case during the Global Financial Crisis (GFC), when financial markets convulsed and global growth dove into recession.

Investors are likely aware that FX (forward) markets are priced such that the expected rate of depreciation in high yielding currencies relative to low yielding ones equals the positive carry earned (interest rate parity), meaning long carry investors implicitly think the FX market is incorrectly priced (generally too ‘pessimistic’). This is a key reason why FX carry traditionally suffers when risk tolerance takes a dive. With global risk appetite heavily influenced by global growth (Chart 4), FX carry performs well in periods of cyclical strength.

This makes tepid performance of the strategy all the more perplexing, particularly considering strength of the US cycle, particularly this year.

Carry momentum to re-assert

FX carry experienced a surge in momentum back in mid-April. After a protracted four month consolidation period, history suggests another leg higher in the weeks ahead. Back on 13 April, the 50-day information ratio of FX carry returns rose above 4.0, a two standard deviation event indicative of a significantly high level of carry momentum (Chart 5).

Readings of this magnitude have only happened 19 times since 2000. Of those 19 instances, 17 were higher after 100 trading days for an average total return of about 3% (vs currently only about 1% after day 87) (Chart 6).

Within this sample, 26 November 2012, stands out as having strikingly similar price action to today. This instance is 70% correlated over the last 60 trading days and 80% correlated over the last 20 trading days and suggests an impending 4% surge higher in the FX carry index to peak levels over the next few weeks. 

Carry caveat: will the antipodeans cease plummeting?

We believe USD will contribute to another leg higher in FX carry for fundamental reasons (strong cyclical position, monetary policy divergence). Our confidence in AUD and NZD – the other two currencies currently on the asset side of the strategy – is lower. Recent sharp slides in the antipodeans have been amplified by elevated global trade war, China and EM-related uncertainty. At a minimum, the pace of depreciation needs to moderate. So far, our LCBF flow data, which show four-week flows recently crossing into negative territory, for now do not support potential cessation of selling pressure. That said, speculative positioning as measured by CFTC and other data sources is very short AUD and NZD, potentially helping to contain a continued downside slide.

Note that in the recent February-April FX carry upswing, AUD and NZD trended moderately lower. But because of sharp USD strength and SEK weakness the strategy produced strong positive returns anyway. Resumption of AUD and NZD strength against SEK would clearly bode well for the FX carry strategy looking forward.

On a relative basis, our views are constructive AUD vs NZD (Greater AU and NZ divergence 15 Aug 2018). Of the three currencies currently included on the asset side of FX carry, NZD is clearly the weak fundamental link" - source Bank of America Merrill Lynch

There you go, if the USD is on a rampage, not only do we have rising dispersion among asset classes such as credit and equities but, now there is indeed a "hypertonic surrounding" situation when it comes to the swelling US dollar carry. This of course is the manifestation rest assured of QT hence the reason for the commodities bloodbath with many players busy raising their USD cash levels for protective measure.

While in our previous conversation we indicated we remained short term "Keynesian" and starting to become "Austrian" from a medium perspective, there is no doubt in our mind that there are clouds lining up on the horizon that warrants close attention. For instance from a "flow" perspective the latest Follow The Flow note from Bank of America Merrill Lynch from the 17th of August is aptly entitled "Nowhere to hide":

"Outflows from IG, HY, govies, EM and equities

It seems that investors have nowhere to hide. Almost all the asset classes we follow recorded outflows last week. We saw outflows from IG, HY, Govies and EM debt. Same in equities and even in money market funds. Higher risk assets volatility, EM FX sell offs, trade wars and Italian political risks have instigated a risk off trend in flows across risk assets. Will risk aversion abate any time soon? Should the aforementioned risks not disappear, we struggle to see a structural shift in flows back to Europe especially amid dollar strength and global interest rate differentials.

Over the past week…

High grade funds flows dipped further into negative territory. Further euro weakness (vs. the dollar) has pushed more outflows out of euro funds over the past week. High yield funds were hit again by outflows, erasing the inflows we have seen over the previous two weeks. Looking into the domicile breakdown, Global and European-focused funds have recorded outflows while US-focused funds recorded inflows.

Government bond funds recorded a strong outflow over the past week; almost reversing the inflow we saw a week ago. All in all, Fixed Income funds recorded a sizable outflow; the largest in eight weeks and the first after three consecutive weeks of inflows.

European equity funds recorded outflows for the 23rd consecutive week. $55bn has left the asset class over that period.

Global EM debt funds recorded another outflow last week, amid a rapidly weakening
trend in EM FX land. Commodity funds recorded a small inflow.

On the duration front, there were outflows across all parts of the curve. It feels that outflows were more sizable on the back-end of the curve." - source Bank of America Merrill Lynch

No wonder, the winner take all mentality is taking its toll flow wise and the US powering ahead in true "Dissymmetry of lift" fashion. But good news might indeed be history as we move towards the fall. While we recently wondered about MDGA (Making Duration Great Again) from an exposure point of view, we think that it is the time to reduce some risk and starting playing defense we think. On that specific point we read with interest Bank of America Merrill Lynch's take in their Securitization Weekly Overview from the 17th of August entitled "Risk off stew: QT, rate hikes, refi's dead, declining breakevens, expensive housing":

"Risk off stew: QT, rate hikes, refi’s dead, declining breakevens, expensive housing

Risk off signals are escalating. In our view, the only positive note this week was the trade war news that China will send a delegation to the US to try to resolve differences. We’re doubtful that a meaningful “fix” to a situation that has been brewing at least since China’s entry into the WTO in 2001 will be reached, but we’ll see. The Shanghai Composite closed the week at 2669, the lowest level in over two years, so market skepticism about trade war resolution appears intact. Meanwhile, the list of negatives for markets, away from trade, is getting longer, creating a risk off stew in our opinion.

QT has been accelerating: the Fed’s balance sheet is now down by $219 billion in 2018 and the 4-week rolling change of $64 billion is by far the largest decline in a 4-week period since the unwind started. 10 years after the crisis led to dramatic expansion of the Fed’s balance sheet, the unwind is picking up steam; we look for another $175-$200 billion by YE 2018. On top of that, another rate hike in September seems fairly certain, consistent with our Economist’s views. Jackson Hole or the upcoming Fed minutes seem unlikely to offer any meaningful change from the Fed’s somewhat autopilot policy tightening plans. But these events will be worth watching, as a dovish shift could alter the risk off conditions.

Another negative is recent declines in the 10-year breakeven inflation rate, which has dropped down to 2.08%. While the breakeven rate has stabilized above 2.0% in 2018, the Fed’s continued policy tightening may well challenge that stability. BofAML technical strategist Paul Ciana is now highlighting that the 10y breakeven rate is at risk of a bearish breakdown to 1.91%-1.98% in the months ahead. Based on our breakeven inflation valuation framework for securitized products, this would be consistent with our view that spread widening risk now dominates for the sector. In mortgages and housing, things are not great either. The MBA Refinancing index dropped to an 18-year low this week. Long gone are the days that increased refinancing activity provided a savings stimulus to the household sector. Instead, declining refinancing activity is consistent with policy tightening from the Fed. Meanwhile, the latest UMich consumer sentiment reading reported “home buying conditions were viewed less favorably in early August than any time since August 2006.” This is consistent with the recent sharp drop in the MBA purchase index and is even more negative than the affordability index, which is back to 2008 levels, would suggest; given the changes in mortgage credit availability since the pre-crisis era, affordability is probably more constrained than the nominal time series suggests.

As we noted in “Soft housing data piling up: prepare for risk-off,” the mortgage/housing market could use a 10Y rally back to the 2.25%-2.50% range over the near term. If the trade war and Fed remain on their recent, market-unfriendly paths, the chances seem increasingly good that a sharp risk off rally in bonds is coming, as is more pronounced spread widening in securitized products. We’ll watch for change in the coming weeks, but, in our view, now is the time to become more defensive. We doubt either the Fed or China will meaningfully change course without more pronounced market turmoil as motivation. Most likely, spread widening in securitized products has only just begun."  - source Bank of America Merrill Lynch

From a contrarian perspective, two things stand out, not only the consensus short US Treasury Notes is stretched but if indeed we are starting to see a fall in breakevens, there could be a potential for a rebound in gold which has been relentlessly impacted by the surge of "Mack The Knife" though one could argue that given the momentum in USD FX carry, it might be still difficult to time your entry. 

In their notes Bank of America Merrill Lynch highlights the different factors pleading for a more cautious stance in the weeks ahead of us:

"This week, we survey a number of factors that argue in favor of a more pronounced risk off phase for markets in the period ahead. We began warning of this phase back on July 27 in “Soft housing data piling up: prepare for risk-off.” This week provided a hint of what we think is in store for markets in the next 2-3 months. In our view, spread widening risk in securitized products now dominates. We think defensive positioning is warranted.

Two factors could change this: a sudden change in tone from China on the trade war and the Fed on tightening policy. We think more downside in markets is likely need to create such changes, but we will watch in the weeks ahead, particularly in the upcoming Fed minutes and Jackson Hole, for signs of a shift.

Factor 1: the trade war

The simple trade war gauge we have been watching is the Shanghai Composite index. While it is heading lower, we see risk that weakness in China spills over and increases global recession risk, which will be reflected in wider credit spreads. Chart 1 shows the index closing this week at the lowest level since 2016, down 25% since the January high.

Chart 2 shows the index inverted against the IG corporate index spread. Our point with this chart is that at least some of the trade-related weakness in China is spilling over to the US.

As we write, there is a report of a possible high-level US-China trade summit in the months ahead. While this is positive news, it is a long way from resolving a host of issues that date back at least to 2001, when China entered the WTO. More downside pain in markets may be necessary to lead to true resolution.

Factor 2: the Fed balance sheet and rate hikes

It’s almost 10 years since the financial crisis led the Fed on a path of significant balance sheet expansion. 2018 has seen the start to the unwind (Chart 3): down $219 billion YTD in 2018, with the last 4 weeks seeing a drop of $63 billion.

The unwind is accelerating, as the balance sheet should see another $175-$200 billion decline by YE 2018. On top of this, the Fed maintains ambitious rate hike plans relative to the market (Chart 4).

The upcoming minutes release and Jackson Hole meeting provide opportunities for the Fed to offer new views on policy. Our rates and economics colleagues Mark Cabana and Joe Song suggest the Fed will provide “updated guidance on the longer-run operating framework, which will have implications for a potential end date to the balance sheet unwind.” See “The week in fedspeak,” 17 August 2018. Whether this will be enough to signal a meaningful shift in tightening plans remains to be seen. For now, as with trade, we’re skeptical.

Factor 3: breakeven inflation rates are declining once again

The combination of trade war and tightening policy has reversed the rise in the 10yr breakeven inflation rate (Chart 5).

We’ve seen this movie before in the past few years (2015 and 2016-2017): inflation expectations move higher and then roll over. This year has seen more stability above the important 2% threshold, which is why we have retreated from frequent discussion of our breakeven inflation valuation framework for securitized products.

Now, as the breakeven rate has dropped to its 200d moving average, BofAML technical strategist Paul Ciana is highlighting that the 10y breakeven rate is at risk of a bearish breakdown to 1.91%-1.98% in the months ahead. Our valuation framework suggests this is consistent with spread widening risk for securitized products.

Essentially, it appears as if the market has reached a critical, potential break point on factors 1 and 2 above, the trade war and Fed tightening. If there is no capitulation by either the Chinese or the Fed, the chances are good that breakevens will indeed head meaningfully lower, undoing the work that has been done to stabilize inflation expectations above 2%.

Factor 4: mortgages and housing – refi’s are dead and housing is expensive

This week saw the MBA refinancing index drop to the lowest level since 2000 (Chart 6), nearly 18 years ago.

Gone are the days when an increasing refinancing incentive created a savings stimulus for household. Instead, the Fed’s policy tightening is showing one additional sign of stimulus withdrawal, in the form of declining refinancings. Higher rates have mattered.

Similarly, the MBA purchase index has rolled over sharply in recent weeks (Chart 7), as high home prices and high mortgage rates have hurt affordability.

Confirming this, the latest University of Michigan consumer sentiment reading reported “home buying conditions were viewed less favorably in early August than any time since August 2006.”

The sentiment is interesting, as affordability is currently at 2008 levels, which were actually better than 2006 levels. Chart 8 shows affordability along with the MBA’s mortgage credit availability index.

2006 was the lowest level of affordability in the history of the index. But it was also the year of maximum credit availability that acted as an “offset” to low affordability.

While we see potential for some loosening of mortgage credit, we see little chance of a return to pre-crisis levels of availability. The best solution to low affordability is lower rates. As we noted in “Soft housing data piling up: prepare for risk-off,” the mortgage/housing market could use a 10Y rally back to the 2.25%-2.50% range over the near term. Given the risk off stew that is brewing,  a risk off move in markets may give the mortgage and housing market what it needs." - source Bank of America Merrill Lynch

Sure housing would indeed get a respite from lower yield no doubt. It's all about Wall Street versus Main Street. Given the amount of known unknowns in these "hypertonic surroundings" we would rather take a more cautious tone and raise cash levels in dollar terms within our allocation tool box, given cash in the US thanks to the rise of the front-end is appealing again.

Finally, as per our final charts below, what could really trigger a more recessionary and bear market outlook to the current scenario would be rapid rise in oil prices with an escalation with Iran we think. As we pointed out earlier one, for a bear market to materialize you would need a significant pick-up in inflation and oil could be the match that triggers the lot. 

• Final charts - So you want to be bearish? Oil-price spikes have preceded most recessions

What matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years.  It is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation with Iran. Our final charts come from Bank of America Merrill Lynch Global Economic Weekly note from the 17th of August entitled "the law of large numbers". The first chart displays the surge of the US dollar since tariffs were imposed in March and the second chart displays the risk posed by oil shocks in post-war recessions:

"Since the steel and aluminum tariffs were imposed on March 1, the dollar has strengthened against many currencies (Chart 1).

Iran: oil slick?

Oil sanctions against Iran pose an almost equal risk to global growth. Recall that oil shocks have played a role in most post-war recessions (Chart 2). Given the steady shrinkage in Venezuelan supply, the large gyrations in Libyan supply, and the fact that OPEC and US fracking supply is already high, a cut-off in Iranian oil could have a major impact on prices. Iran currently exports about 2.3mn barrels of crude oil per day (b/d). Francisco Blanch and team estimate that a reduction of 1mn b/d in Iranian supply would increase Brent prices by about $17/barrel. This means that if the Trump administration pursues its stated goal of cutting Iranian oil exports to zero, Brent could rise above $100/barrel. This would be a major headwind to global growth, especially since dollar strength is pushing the non-dollar price of oil up even faster.

The Iran story is not just about global oil supply. It has created yet another split between the US and many of its allies. The sanctions could also worsen US relations with major importers of Iranian oil, including China and India, which together have purchased nearly 60% of Iranian crude oil exports this year. Although the sanctions have been imposed unilaterally by the US, they would apply to any shipping or insurance company that deals with Iranian oil. This gives the US the power to effect substantial cuts in Iranian exports globally, should it choose to do so.

A final striking aspect of the sanctions is their timing. Full sanctions on Iranian oil go into effect on November 5, just one day before the US midterm elections. In our view, this is a sign that the Trump Administration views getting tough with Iran as a winning political issue. The timing argues against a common view that the Trump Administration will moderate its policies—and reduce the risks to the markets and the economy—in the run-up to the election." - source Bank of America Merrill Lynch

We do live indeed in interesting "hypertonic surroundings" times, with of course many known unknowns to keep us entertained for the weeks ahead. What's always more worrying is the unknown unknowns but that's another story and we ramble again...

"Knowledge is not simply another commodity. On the contrary. Knowledge is never used up. It increases by diffusion and grows by dispersion." - Daniel J. Boorstin, American historian

 Stay tuned!

Macro and Credit - The Decoy effect

"In a time of universal deceit - telling the truth is a revolutionary act." - source unknown

Looking at our home team (France that is) getting away with the Football World Cup for a second time in 20 years (1998-2018) hence our lack of recent posting, 8 being a lucky number it seems, we were drawn again to the parallel with 1998 with the ongoing Emerging Markets (EM) woes, whereas this time around, Asian countries are in much better shape, including Russia, while the usual suspects (Turkey, Argentina and Brazil and even South Africa) are still feeling the summer heat from the Fed's liquidity drain thanks to QT. With the escalating rhetoric of trade war between China and the US and the strong arm negotiating tactics from the Trump administration, when it came to select our title analogy, we decided to go for a marketing one, namely the "Decoy effect". In marketing, the decoy effect (or attraction effect or asymmetric dominance effect) is the phenomenon whereby consumers will tend to have a specific change in preference between two options when also presented with a third option that is asymmetrically dominated. An option is asymmetrically dominated when it is inferior in all respects to one option; but, in comparison to the other option, it is inferior in some respects and superior in others. In other words, in terms of specific attributes determining preferences, it is completely dominated by (i.e., inferior to) one option and only partially dominated by the other. When the asymmetrically dominated option is present, a higher percentage of consumers will prefer the dominating option than when the asymmetrically dominated option is absent. The asymmetrically dominated option is therefore a decoy serving to increase preference for the dominating option. The decoy effect is also an example of the violation of the independence of irrelevant alternatives axiom of decision theory. Of course, it is a great tool to use when one relates to trade negotiation we think but we ramble again...

In this week's conversation, we would like to look at the rise in inflation, and trade war escalation and the impact in can have on global growth as well. Also, overweight US relative to Emerging Markets (EM) and the rest of the world, continues to be the trade du jour, with FANG still racing ahead in the rally game. 

Synopsis:

• Macro and Credit - Deglobalization goes hand in hand with inflation
• Final chart - Credit versus Equities - "until death do us apart"

• Macro and Credit - Deglobalization goes hand in hand with inflation

While we thought the ratcheting up of the trade war narrative would be bullish for gold, latest price action with the continuation of the surge in the US dollar has put a dent on this scenario playing out so far. Real interest rate, US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple. 

Given it seems that US inflation expectations are moving upwards it seems, we like US TIPS 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. At least with US TIPS you can side with the "inflationistas" camp while having downside protection should the "deflationista camp" of Dr Lacy Hunt wins the argument eventually. Also, in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. 

If inflation creeps up, then companies will suffer margin compression and will be forced to raise prices which will lead to wage increases to compensate that higher price level. We have pointed in the past that trade wars could lead to a stagflationary scenario playing out, meaning lower growth and higher inflation. Are tariffs really the culprit leading to higher inflation? On that subject we read with interest UBS Global Strategy note from the 18th of July entitled "What will drive TIPS in the 2nd half?":

"What about tariffs? Do they matter? It matters much more for growth than inflation

As discussed by our economics team and shown in Figure 4, Laundry equipment prices have jumped by 12% above their January level following the implementation of 20% tariffs in early February.

That said, its impact on headline inflation is very small because of its less than 0.08% weight in CPI. Nonetheless, this clearly shows tariff do have an effect on near-term inflation. Since these early tariffs, US has implemented additional 25% tariffs on $50bn of products from China and the President has proposed 10% tariffs on an additional $200bn of imports from China with other investigations going on in parallel. Thus the scope of tariff tensions is much larger now. We estimate that the current set of announced tariffs would push up consumer prices by roughly 15bp, but with notable uncertainty on both the upside and downside. We discussed ramification of various upside tariff scenarios on growth/inflation and financial markets in Trade Wars- What is the impact on growth, inflation and financial markets? A Top Down View. Albeit, we view this document more as the upside risk scenario than our current baseline; based largely on a lower effective autos tariff and smaller Chinese retaliation is somewhat less.

Specifically, in the aforementioned note, we discuss the following scenarios and their impact on GDP inflation. The 1st scenario is ("Escalation") 25% car tariff (US/global retaliation plus an additional 10% tariff on $200bn US-China trade with proportional retaliation. In the 2nd scenario ("Trade War"), we assume 30% tariffs on virtually all US/China trade + earlier car tariff disruption. In Figure 5, we see that under the trade "Escalation" scenario, we would see near-term inflation rise by 31bp and real GDP fall by 100bp.

In Scenario 2 – "Trade War", we see inflation rising by 71bp and real GDP falling by 245bp. A key takeaway is that the hit to real growth is much larger than rise in inflation on trade tariffs. For details on these estimates, please see the Q-Series. Next, we consider what is the TIPS market priced for and how they could react to escalating trade tensions.

Is the TIPS market pricing in trade dynamics correctly?

The TIPS market is right in reacting trade war by not widening breakevens but by lowering long-end real yields. 5y and 10y real yield have declined by 3bp and 9bp since early June while 5y and 10y BEIs barely moved (Figure 6).

On the inflation impact, we think the market already seems to be priced for our escalation scenario. In Figure 7, we see that 2y ex-energy inflation (which is close estimate to implied core inflation) has risen quite sharply this year. It's near 252bp if you assume  240bp as consistent with target CPI inflation.

The market is implying that the US may have up to 10-15bp/annum of trade related inflation over the next two years. In our trade escalation scenario, we see 31bp inflation uptick over 1-year. This would imply about 15bp tick-up in 2-year core inflation and market seems to be pricing such an uptick. Thus, the market is fairly priced for the inflation uptick. For growth hit due to trade "escalation", we should have seen a bigger decline in real yields. 2y yields are basically unchanged over the past few months, which suggest the market is not assuming a growth hit at this juncture. Thus, for increasing trade concerns, we recommend receiving front-end real rates, or set up 2s5s real curve steepeners which we discuss later in the note. In general, the market is not priced for a "trade war" scenario on both real yields and breakevens." - source UBS

It seems to us that the market has been a little bit too complacent for a trade war scenario playing out. At least with TIPS with the embedded deflation floor, you have some downside protection should the global slowdown scenario play out thanks to escalating tensions. With this known unknown, we do think that the long end of the US yield curve (30 years) at current levels remains enticing from a carry and roll down perspective. We have recently started to add exposure to it on a side note.

But, in respect to the inflation risk, US inflation is creeping up, no doubt about it. This is clearly illustrated by Wells Fargo in their Economics Group note from the 11th of July entitled "Producer Prices: More Inflation to Come":

"Producer prices for final demand rose 0.3 percent in June, which was slightly stronger than expected. Core prices continue to climb higher as U.S. producers are facing rising input costs.

Broad Increases in Producer Prices in June

• Inflation continues to gradually climb higher, with the producer price index advancing 0.3 percent in June. Gains were broad based, with food being the only major category to see prices slip.
• Excluding food, energy and trade services (measured by margins), prices increased 0.3 percent. That pushed the year ago rate of our preferred measure of core PPI back to 2.7 percent, which is up from 2.1 percent last June.

Processing Input Cost Increases

• Input costs continue to rise as capacity has become more constrained and businesses are grappling with tariffs. Processed intermediate goods increased 0.7 percent in June and are up 6.8 percent over the past year. While higher energy costs have led the pickup, non-energy materials for manufacturing and construction are up 6.5 percent since last June. Service inputs are up, led by fuel and labor shortages driving transport costs higher.

- source U.S. Department of Labor and Wells Fargo Securities 

June PPI report showed an acceleration in the price appreciation with year over year PPI at 3.4% and year over year core PPI coming at 2.8%. With year over year CPI up to 2.9%, meeting estimate, Core CPI printed at 2.3% beating expectations. It might be the case of the US economy running hotter than anticipated? We wonder. Wage growth are essential to validate this prognosis we think. For some other pundits such as Knowledge Leaders Capital, "The Inflation Story is Alive and Well in Five Charts".

As we pointed out in our previous conversation "Attrition warfare":

"The rise of the US dollar in conjunction with trade war escalation and rising oil prices could indeed decelerate even more global growth and led to a stagflationary outcomes. Some signs are already there. We are very closely looking at the rise of gas prices in the US and monitoring closely the US consumer. If indeed, the US consumer starts retrenching as pointed out recently by another note from David P Goldman on Asia Times on the 30th of June then all bets are off.

To repeat ourselves, rising energy prices could be the match that lights the bear market. Continued inflationary pressure coming from energy prices will eventually lead to financial markets "repricing" accordingly. We are already seeing blood in some selected EM with rising inflation in double digits (Turkey for example). It is probably understandable why the Trump administration is reaching out to OPEC for them to slowdown the steady rise in oil prices with elections coming later this year.

While escalation in the trade war would no doubt affect Developed Markets and Europe in particular, Emerging Markets which have been more recently on the receiving end of tighter liquidity and rising US dollar would as well be seriously impacted by a stagflationary income."- source Macronomics, July 2018

This raises the question about inflation and the US consumer in general and the price at the pump in particular. What is the pain threshold one might rightly ask? On that subject we read with interest Bank of America's take in their US Economic Watch from the 11th of July entitled "High pain tolerance at the pump":

"Higher gas prices a partial offset to tax cuts benefits

Gasoline prices are up around 50 cents since the start of the year and currently hovering nationally around $3, owing to tightening global oil supply and demand balances. Our calculations suggest that the recent rise in gasoline prices increases the average cost to the consumer by $30 per month. So far, this has had limited impact on overall consumer spending as most consumers have been able to offset higher prices at the pump with the extra income from tax cuts. According to the Tax Policy Center, the median consumer is receiving roughly an extra $78 per month due to tax cuts this year.

The breakeven price: $4/gallon

At what point would higher gas prices fully offset the tax cuts? We would likely need to see oil prices jump another $60 per barrel (bbl), adding about $1 per gallon to gasoline prices. This would increase the cost of gasoline almost $60 per month, effectively wiping out the extra income from tax cuts for most consumers.

Of course there could be effects beyond these simple calculations. A common rule of thumb from Hamilton (2008) is that an oil “price shock” is when prices go above the highest level in the last three years. That seems to be happening now, although we are still below the highs of 2011-14 (Chart 1).

Francisco Blanch and team see upside risk to their crude oil price outlook should sanctions on Iranian oil exports prove binding. Higher gasoline prices could lead to “sticker price shock” at the gas pump, causing consumers to pull back spending more than one-for-one. An additional downside risk comes from the fact that the “gasoline tax” is regressive and has a bigger percentage impact on low income families (Chart 2).

From the oil rig to the gas station

Translating moves in crude oil prices to gasoline prices is fairly straight forward. According to the Energy Information Administration, crude oil represents about half the retail cost of gasoline. Indeed, looking at the relationship between the % mom in Brent oil prices and % mom in gasoline prices, we find a coefficient of roughly 0.5 suggesting that a 10% increase in the price of crude oil would be associated with a 5% increase in the price of gasoline (Chart 3).

Currently, a $60 boost would amount to a 75% increase in crude oil or 37.5% increase in gasoline prices. With gasoline currently near $3, such a shock would increase prices at the pump by over an additional $1.

From the gas station to the consumer’s wallet

Vehicles on the road in the US consumed, on average, 55 gallons of fuel per month in 2016 according to the Federal Highway Administration (Chart 4).

To put this into context, for a compact car or a medium size sedan, this works out to be a full tank of gas per week. Demand for gasoline is relatively inelastic so we can safely assume no demand response from an oil price shock in the short run. Therefore, the run up in gasoline price since the start of the year would cost the average consumer around $30 per month.

We think most consumers have been able to offset the latest increase in gasoline prices. According to the Tax Policy Center, with the exception of the bottom quintile, taxpayers are receiving at least a $30 tax cut per month due to the Tax Cuts and Jobs Act (Table 1).

However, further boost in gasoline prices could ultimately offset most of the tax cut benefits. For example, another $1 per gallon at the gas pump would cost another $60 dollars per month. All told, the extra $90 per month spending at the gasoline station would be enough to offset tax cuts for majority of consumers.

From the consumer’s wallet to consumer behavior

While demand for gasoline is relatively inelastic, marginal propensity to consume out of gasoline (dis)savings is likely greater than 1. That is, a rise in gasoline prices will force consumers to substitute away from other categories more than one-for-one and vice versa. For example, Gicheva et. al. (2007) find that gasoline expenditures rise one-for-one with gasoline prices but consumers substitute away from food services toward  groceries in order to partially offset higher gasoline expenditures. Moreover, they find that even within grocery spending, consumers substitute away from regular price products and towards promotional items. On the flip side, Alexander and Poirier (2018) calculate that the marginal propensity to consumer out of the gasoline savings in 2014- 15 was greater than 1 with most of the spending going toward discretionary spending. The upshot is that most consumers have so far absorbed higher gasoline prices in stride but further increases at the gasoline stations could start to broadly hurt consumer demand." - source Bank of America Merrill Lynch

While everyone and their dog is focusing on the flattening of the yield curve, we would rather focus on inflation creeping up and in particular oil prices as a potential lethal trigger for asset prices and a bear market to ensue. Clearly we are not there yet, but we think that the "decoy effect" of the flattening of the yield curve hides the fact that trade war rhetoric is weighting on both consumer sentiment as well as leading to higher PPI. At some point these factors will weight on growth. The continuous surge in the US dollar means that EM are still in a painful situation. In that context, cash has returned as a valid yielding tool in the allocation toolbox and so are US Tips. As we stated above the long end of the US yield curve remains enticing.

Maybe the second part of the year will favor the return of the duration trade versus the high beta. This is what Bank of America Merrill Lynch mentions in their Credit Derivatives Strategist note entitled "A bull and a bear" on the 19th of July:

"European growth headwinds, trade wars and Italian risks are taking over last year’s goldilocks. With manufacturing PMIs in Italy, Spain and France at 53 and inflation risks to the downside, this is still an environment of a patient ECB on rates. Investors are concerned about an inflation shock; we think we are far from there. The potential for an
“Operation Twist” and slower macro can flatten the curves both in cash and synthetics. We think that the CDS market is offering an attractive entry point for longs on the backend of the curve. We screen for the best singles to sell protection.

To offset our bullish view on duration we hedge the market direction with bearish risk reversals in Crossover. If trade wars escalate, growth could be hit more, and higher beta pockets would be more exposed. The recent flattening of the implied vol skew and spread tightening finds bearish risk reversals (own puts/payers vs. selling calls/receivers) attractive to own.

Softer macro = lesser risk of a hawkish ECB

Macro indicators have slowed down in Europe this year versus the high run-rate of last year. In particular, manufacturing PMIs across Europe have headed lower and inflation is only slowly recovering.

But what a slower macro backdrop means for yields and yield curves more specifically? We are using the OECD Major 7 Leading Indicators and we try to define the relationship between the economic cycle and the cycle of yield curve. In chart 3 we present a z-score analysis (in order to normalise patterns for the underlying vol and levels) and we find that there is meaningful correlation between the macro cycle and the cycle of the yield curve.

When the macro indicators improve (deteriorate) yields tend to steepen (flatten). This reflects the higher growth potential and thus the stronger outlook for inflation going forward and that ultimately is priced in via higher back-end yields and steeper curves. Should the ECB remain dovish, yield curves are more likely to continue to be under pressure, we think." - source Bank of America Merrill Lynch

Whereas the first part of the year has been great for high beta in credit and US equities, with Investment Grade lagging. There could be a possibility if the trade rhetoric escalates to see lower growth, meaning a return of the duration trade in the second part we think. One thing for sure 2018 has seen a clear divergence between equities and credit as we shall see in our final chart.

• Final chart - Credit versus Equities - "until death do us apart"

In 2018 US high beta has had a better success than US Investment Grade credit which has been punished. EM equities have suffered as well relative to US equities in stark comparison to what unfolded in 2017. Our final chart comes from Bank of America Merrill Lynch Situation Room note from the 18th of July entitled "Going separate ways":

"Credit and equities are two sides of the same coin. However, while equities by now have rallied to within 2% of the highest close of the year (S&P 500), high grade credit spreads are 33bps, or 37%, off the 90bps tights from earlier in the year (Figure 1).

Given the timing of the beginning of this decoupling in May, clearly one of the drivers was the Italian risks that developed during the month. Given the outsized importance of the financial sector in credit, and the reliance on funding markets and bank balance sheets in fixed income, such sovereign risks should intuitively drive a wedge between debt and equity market performance. However, we think the most important driver of credit market underperformance is the shift in US monetary policy from quantitative easing – QE – toward quantitative tightening - QT (see: On the road from QE to QT, redux 15 June 2018). Mechanically that means less demand and associated widening pressures on credit spreads during times with supply pressures, as we have seen a number of times this year. From that perspective we consider the wider credit spreads an early indicator of more struggles to come as the level of global monetary policy accommodation declines in coming years." - source Bank of America Merrill Lynch

So the big "decoy effect" might be at play, are equities too high relative to credit or credit too wide relative to equities? We wonder.

"It is discouraging how many people are shocked by honesty and how few by deceit." -  Noel Coward, English author

Stay tuned ! 

Macro and Credit - The recurrence theorem

"Some things never change - there will be another crisis, and its impact will be felt by the financial markets." - Jamie Dimon

Looking at the elevated volatility in Emerging Markets in conjunction with continued outflows and pressure on the asset class, on the back of rising US yields and a strengthening US dollar marking the return of "Mack the Knife", with losses not limited to the currencies but with Emerging Markets Yields continuing surging throughout, when it came to selecting our title analogy we reacquainted ourselves with French mathematician Henri Poincaré's 1890 recurrence theorem building on the previous work of fellow mathematician Simeon Poisson. In mechanics, Poincaré recurrence theorem states that an initial state or configuration of a mechanical system, subjected to conserved forces, will reoccur again in the course of the time evolution of the system. The commonly used example to explain the theorem is that if one inserts a partition in a box, pumps out all the air molecules on one side, then opens the partition, the recurrence theorem states that if one waits long enough that all of the molecules will eventually recongregate in their original half of the box. The theorem is often found mixed up with the second law of thermodynamics to the effect that some will loosely argue that there exists a very small probability that an isolated system will reconfigure to a more ordered state (thus effecting an entropy decrease).The theorem is commonly discussed in the context of dynamical systems and statistical mechanics. When it comes to pressure and outflows, as we mused in our last conversation, one would argue that continued capital outflows pressure is contained until it isn't. 

In this week's conversation, we would like to look at the return of "Mack the Knife" in conjunction with rising oil prices and what it entails. 

Synopsis:

• Macro and Credit - US yields - It's getting real!
• Final chart - US core CPI tends to rise in the two years leading up to a recession

• Macro and Credit - US yields - It's getting real!

While US 10yr Real Yields are a key macro driver, the US dollar so far in 2018 has dramatically diverge from yields. "Mack the Knife" aka the King Dollar also known as the Greenback in conjunction with US real interest rates swinging in positive territory has recently put some pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation:

"When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - Macronomics

With the start of an unwind in global carry trade,  "Mack the Knife" aka King Dollar is making a murderous ballad on the EM tourists and carry players alike. Back in July 2015 in our conversation "Mack the Knife" we indicated the following as well:

"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike." - source Macronomics, July 2015

The question for continued pressure on Emerging Markets when it comes to "Mack the Knife" is are we beginning to see a reconnect between the US dollar and yields? The jury is still out there. Rising Breakevens tend to be negative for the US dollar. Also what matters for US equities given they have remained relatively spared so far would be a meaningful widening in credit spreads. This would be accompanied of course by higher volatility.

Right now, as we pointed out last week, dispersion is the name of the game in both credit and Emerging Markets with the usual suspects and weaker players getting the proverbial trouncing as of late such as Turkey and Argentina. We also indicated recently that the continuous rise of volatility in Emerging Markets would lead to additional outflows given the Hedge Funds were the first to reduce their beta exposure. Some investors might follow suit and follow a similar pattern of "derisking" it seems. On the subject of continuous volatility on EM assets we read with interest Barclays take from their Emerging Markets Weekly note from the 17th of May entitled "Shaken and stirred":

"Volatility in EM assets remains elevated. As 10y UST yields have moved further above 3% and the USD has resumed its strengthening trend, total returns in EM assets have taken a further hit – which in turn continues to weigh on flows: YTD returns in EM credit and EM local markets now stand at -3.7% and -2.4%, respectively (Bloomberg Barclays USD EM Agg and EM local-ccy government bond indices), while EM dedicated bond and equity funds had their worst week of outflows last week since the volatility spike in February (see EM flows: Outflows materialize, 11 May 2018). Economic data has hardly helped to improve sentiment, with weaker European and Chinese activity data feeding concerns about weakening global growth momentum.

The market’s focus remains firmly on those countries with external vulnerabilities and financing needs, especially Turkey and Argentina. Even though current account balances can only provide a partial reflection of external positions and vulnerabilities, there has been an interestingly clear correlation between current account dynamics (changes, rather than levels) and asset performance both in EM credit (Figure 1) and local markets (Figure 2).

Although we have argued in the past that aggregate vulnerabilities have improved in EMs since the 2013 ‘taper tantrum’, they have deteriorated over the past year (see the EM Quarterly Outlook: The going gets tougher, 27 March 2018). Furthermore, the confluence of Fed balance sheet reduction, increased UST issuance, effect of US tax law changes on the repatriation of offshore USDs alongside a wider US CA deficit has implied a potentially more challenging capital flow environment for EM.

As the flow environment for financing in international markets has become more difficult, countries’ plans (or necessity) to tap primary markets have also been in the spotlight. While EM sovereign Eurobond supply has run at a record pace in January to April, recent issuance volumes have fallen short of expectations (including the recent Ghana and South Africa bond issues). We would interpret the latter point as a market positive, however. Given the frontloading of issuance in Q1, there are few countries with sizeable issuance needs for the remainder of 2018. Based on our updated supply expectations for individual countries shown in Figure 4, we now expect an additional USD 41bn of supply in 2018.

Given that c.USD104bn has been issued YTD already, this would result in 2018 full-year supply of USD155bn. In this context, we think there is an interesting divergence between Turkey and Argentina: Argentinean authorities have indicated that they do not want to issue any more in international markets in 2018. Remaining financing needs for this year are c.USD5bn on our estimates, which could potentially be covered by an initial disbursement of the requested IMF programme, or by local currency issuance. In contrast, Turkey’s fiscal measures (including this week’s announcement to reduce the special consumption tax on fuel products) will likely keep incentives to raise financing in international markets in place, even in a less receptive market.

Supply-redemption dynamics in EM credit are not the only silver lining for markets. While recent China data has been weak, we see signs of a shift in priorities towards growth, with deleveraging de-emphasised (see China: Softer FAI and retail sales; signs of pro-growth priority and trade tension de-escalation, 15 May 2018). This should in turn support commodities and while well-supported oil and commodity prices have not been able to prevent the sell-off in EM assets, they should at least provide some fertile ground for differentiation.

With regard to oil prices, Venezuela’s election on Sunday 20 May may be of particular importance (see The ship is taking on water, 15 May 2018). Even if President Maduro is reelected, against a backdrop of the main opposition parties boycotting the process and the government’s control over the electoral system, the vote could still be a catalyst for fractures within the regime. Meanwhile, Venezuela oil exports have been disrupted, amid legal action against PDVSA and a broader decline of oil production – one of the likely drivers of the recent increase in oil prices, in addition to US sanctions on Iran.

EM oil exporters naturally benefit from the surge in oil prices. In Iraq, however, this is overshadowed by uncertainties following last week’s legislative elections (and we recommend switching out of Iraq and into Angola and Gabon in our top trade recommendations this week). Full results are yet to be announced but the partial count indicates a clear defeat of current PM al-Abadi favouring cleric Muqtada al-Sadr who has called for the end of corruption and opposed both the US and Iran. The emergence of the Saeroun and Fateh coalition as winners would complicate political negotiations to form a coalition government and it is still unclear whether PM Abadi will be able to secure a second mandate. Ultimately, we believe coalition talks may be protracted, adding uncertainty to the outlook, also with respect to the IMF talks to finalise the third review under the three-year Stand-By Arrangement. The 2018 budget and transfers to the semi-independent region have represented contentious issues which could be exacerbated by negotiations between Kurdish political parties and Baghdad over government formation." - source Barclays

When it comes to "dispersion" we continue to view favorably Russian local bonds in that context, thanks to the support of oil prices on the ruble and central bank easing that will continue.  On the subject of "dispersion" and weaker players in the EM space, we read with interest UBS take from their EM Equity Strategy note from the 18th of May 2018 entitled "This is not a 'Crisis': It is Rising Yields + a Strong $":

"The central story here, in our view, is that the recent 'less friendly' global market environment has allowed investors to 'pick away' at some of the weaker EM stories, especially via FX (Figure 5 below), as the dollar has continued to rebound. These are the EMs that typically do well when the dollar is weak, as the 'carry trade' holds sway. In the face of recent dollar strength, the result has been significant localized EM FX weakness (Figure 6).

Further, several of these so-called 'weaker' markets have also faced idiosyncratic domestic concerns:

• Turkey (-25% in USD, year-to-date): fears over central bank independence, concerns around monetary policy, widening current account deficit;
• Brazil (+1.7%): weaker than expected economic recovery, uncertainty ahead of the October elections;
• India (-6.8%): higher oil prices and higher inflation with residual concerns over whether Prime Minister Modi's BJP will be re-elected in 2019;
• Indonesia (-16.7%): current account worries and a slow policy response by the Bank of Indonesia;
• The Philippines (-12.6%): domestic overheating.

To this list, we could add South Africa (-6.3% year-to-date, on a minor hangover from the euphoria of Ramaphosa's elevation to the presidency as the market begins to understand the substantial policy challenges ahead) and Mexico (also - 6.3%, as the July 1st 'first-past-the-post' Presidential election approaches with a shift to the left seeming almost inevitable now).

Further, the dramatic weakness of financial markets in Argentina in recent weeks has added to the sense of 'crisis' in emerging markets, even though technically (from an equity perspective) the country is still, for now anyway, in the MSCI Frontier index. MSCI Argentina is down just over 25% so far this year, almost entirely due to the plunge in the peso (from ARS/USD18.35 to 24.40), which has forced a double-digit rise in interest rates to 40%.

However, the major theme of this report is that, in our view, this is far from being an EM 'crisis'. Several EM equity markets continue to do well such as China, by far the biggest EM with a weight of over 31% in the EM benchmark (+5.1% year-to-date, aided by a resilient CNY, even as other EM currencies have fallen sharply), Taiwan (+2.2%), Russia (+4.1%, which has become a relative 'safe haven' again recently as Brent oil prices hover close to $80/bbl) and parts of the ASEAN and Andean regions, notably Colombia (+10.8%) and Peru (+7.7%).

As with the equity markets, the dramatic differences in currency performance across EM so far this year are very clear from Figure 6.

By de-composing the drivers of 2018 total returns in individual markets in Figure 7 below, we partly combine the results from the two previous charts. The blue bars below show the contributions of currency movements to total returns; these are significantly negative for many markets, especially Turkey, Brazil, Russia, India, Poland and the Philippines.

It is also notable how, for most markets, there has been a negative contribution to returns from the P/E ratio, showing the breadth of the de-rating of EM equities so far this year; Peru (given very strong earnings expansion) is a small but truly remarkable example. In the other direction, sharply lower earnings in Greece and Egypt have translated into a significant re-rating in both this year. For EM as a whole, decent earnings growth (+6%) has been fully offset by currency weakness and a lower P/E ratio to leave the 2018 total return close to zero.

'Correction Counter' Update: The Dollar Rears its Head

With the recent minor break of the early-February post-correction low for MSCI GEMs, we update our 'correction counter' from earlier in the year (Figure 8).

The interpretation of this data is more important than the actual figures themselves. In our February report, we noted that the fall in the EM Currency Proxy accounted for a smaller share (14%) of the early 2018 correction in EM equities than its average share (22%) in previous bull market corrections back to 2003. Therefore, one reason, in our view, why the early 2018 correction (-10.2%) was less severe than the average of previous 'bull market corrections' (-17.2%) was the lack of a major USD rally or, alternatively, the resilient behaviour of EM currencies.

This is no longer true, given that the recent action involves more FX weakness in EM, compared to the initial correction. The updated table shows that this FX factor now accounts for much more (28%) of the newly-defined correction (-10.8% to May 5th). Even more tellingly, after EM rallied to an interim peak in mid-March, MSCI GEMs is down 5.6% since then and, with the EM Currency Proxy down by 2.8% over this period, FX weakness has accounted for exactly half of the EM pullback over the past two months. The US dollar has 'reared its ugly head' for EM equities in recent weeks." - source UBS

There goes the murderous propensity of "Mack the Knife" on EM equities. In similar fashion to the recurrence theorem, the US dollar has indeed "reared its ugly" head and reoccurred again in the course of the time evolution of the "financial system" or, to some effect our macro reverse osmosis theory once again playing out as discussed in our recent ramblings. Add to the mix rising oil prices, and if oil stays above $80/bbl (Brent) this will clearly hurt growth in all major net oil importing countries. That's a given.

Moving back to the subject of US yields and real rates, we think they matter a lot for the direction of the US dollar. On this subject Nomura published a very interesting Rates Weekly note on the 18th of May entitled "Did UST sell-off awaken bond vigilantes?":

"10yr Treasuries break 3% with conviction

The 3% level on 10s has been frustrating to break through of late, having failed once in late April and again last week. However, as with all things related to three, the third time is usually a charm as 10yr USTs are now clearly on the other side of 3%.

All along through this process to higher rates we have sensed a great level of investor skepticism about how high rates could go and how long they would stay at higher levels. This is one reason why we are not overly concerned that spec accounts have a historical short in place. For once, as far as we can recall, specs are being proven right; so why cover now unless the economy and/or financial conditions unravel? The bigger risk we think is that those under-hedged and exposed to convexity start paying rates now.

Overall the market seems too dismissive of how high rates could go in this cycle. We think the Fed has conviction and may continue with its quarterly hikes until “something breaks.” Even then, the Fed might have a hard time throttling back if the real economy is doing well but the financial economy suffers a blow that results in lower valuations. Meanwhile, the perfect storm of more UST debt and less foreign buyers may lie ahead.

We explore some drivers that may impact our overall US rates views. Overall we expect duration dynamics to matter more now than the curve; meanwhile spreads and vols will likely have stronger correlations to higher rates and real rates could hold the key ahead.

Even if this sell-off takes a pause, we continue to see 10s moving towards our 3.25% target and are positioned paid on 5y5y US-IRS and in similar conditional expressions.

US rates views update: Still bearish but now real rates hold the directional key

Duration: 3%, besides being a nice round number, has been a hard nut to crack as the last time we crossed this level was during 2013, a year made famous by taper tantrum. For us, a move beyond 3% was always the next logical step as the Fed is hiking rates and shrinking the B/S during a period of decent growth and more UST supply.

The 3% nominal level seems to be all the focus, but in actuality the next big step for US rates is what happens with real rates. Fig. 1 highlights a few regimes for the 10yr real rate vs the real Fed Funds rate (see note for calculation).

Real rates were in a tight range during the last cycle as well, it was only once the Fed was mid-way through its hiking campaign that market real rates began to rise. The past ten years of financial repression (driven by the Fed’s QE and then Global QE) has kept 10yr real rates in a tight range. Just like the 10yr UST was held captive by the taper-tantrum high of 3%, 10yr TIPS have been unable to break and stay above 0.90-1.00% levels. We believe the Fed is on track to deliver many multiple hikes (which could drive real rates higher in the process too).

3%, well specifically the 3.05%, has been a technical level on which markets seem to have been obsessed with. The market cleared that level for the first time on Tuesday this past week and intra-week the 10yr hit an intra-day high of 3.12% before settling into the end of the week around 3.07%. We usually refrain from being super technical, with both what these levels mean and we do not like to be handicapped by chart formations; however markets often pay attention to these wrinkles. Fig. 2 shows that 10s once again broke out of the range and this time term premia is also rising with the move too.

Net net, we believe it will take a serious breakdown in all the trade talks, geopolitical tensions and/or economic data to weaken (where instead our economists are projecting stronger growth and higher inflation ahead) for 10s to start a massive rally now. It is also interesting to see that stocks, although down on the day 10s broke 3%, took it in stride. In Fig. 3 we list the top 3 two-day yield changes in 2018 vs the S&P500 reaction. If stocks do not correct meaningfully, the full UST yield curve should rise as Fed hikes.

Curve: Earlier in the year we opportunistically traded the curve before going neutral on curve spreads in late Q1 (after the last micro-steepening). Recently the sell-off has also coincided with some bear-steepening. We think this is a healthy development that serves as a reminder that the curve is not pre-destined to fully flatten in this cycle, at least not at these yield levels. The Fed is raising rates but also shrinking its bond holdings, at a time when US fiscal stimulus is resulting in a spike in govie issuance. The curve never fully flattened in Japan during its low rate experience (Fig 4).

We argue that we need a higher overall level of rates (and many more Fed hikes) before we go fully flat too.

Spreads: 10yr swap spreads have begun to see a stronger correlation with the level of 10yr USTs in the current cycle, especially since last September (Fig. 5).

In past hiking cycles, 10yr spreads tended to have a positive slope relative to 10yr UST yields. We expect this correlation to be maintained, similar to the dynamics at the end of the ’04-06 cycle. Also with higher yields, 10yr spreads are more likely to widen due to convexity hedging activities from mortgages portfolios. Less need for corporate issuance due to overseas dollar repatriation would also reduce the tightening pressure on belly spreads." - source Nomura

The continued pressure on EMs can only abate if the US dollar finally mark a pause in its recent surge. A toned down trade war rhetoric would obviously continue to be supportive of a rising dollar and support stronger US growth in the process. The trajectory of the US dollar when it comes to the recurrence theorem for EM is essential. Morgan Stanley in their EM Mid-Year Outlook published on the 18th of May reminded us in the below four graphs what to look for when assessing the US dollar in terms of being bearish (their take) or bullish:

"Why USD Is in a Long-Term Bear Market

 - source Haver Analytics, Bloomberg, Macrobond, Morgan Stanley Research

With mid-term elections coming soon in the US, it is clear to US that the administration would not like to rock the boat and therefore would favor "boosting" the US growth narrative. This would entail further gain on both US yields and the US dollar in the near term we think. 

Also of interest when it comes to growth outlook, UBS made an important point in their EM Economic Perspectives note of the 17th of May entitled "EM by the Numbers: Where is EM's growth premium over DM?":

"EM growth spread over DM has fallen close to its lowest decile since 2001

Strong Chinese growth and low US inflation strongly supported EM asset markets over the last two years. But the growth levers have slowly been shifting in the background. Having registered a cycle high in early 2017, EM growth has moderated sequentially since, while DM growth has picked up. The levels were strong enough in both to keep the market uninterested as to how far EM growth was above DM growth. Now, however, sequential EM growth has slowed to 20th percentile of its distribution since 2001, and, more importantly, the premium of EM growth over DM has shrunk to the bottom decile of its historical distribution.

The spread between EM and DM is an important input in the call of relative stock market returns in the two regions. In y/y terms, this spread is now at 15th percentile of its distribution since 2001. In q/q terms this spread has shrunk to the sixth percentile of its historical distribution." - source UBS

Whereas EM equities clearly outperformed DM in 2017, it might be that 2018 could make the reverse with DM outperforming. Reduced carry has obviously been a headwind for EM equities as discussed above. If the US dollar strength can persist then indeed, US equities will continue to outperform EM equities on a relative basis we think.

For our final chart, as we posited in numerous conversation, we have often repeated that for a bear market to materialize, you would need an "inflation" spike as a trigger. 

• Final chart - US core CPI tends to rise in the two years leading up to a recession

Positive shock to inflation would coincide with a negative shock to growth, leading to higher bond yields and lower equities. Moreover, higher inflation will coincide with lower growth, therefore bonds will not be a good hedge for an equity portfolio. As we pointed out in our conversation "Bracket creep" that bear markets for US equities generally coincide with a significant tick up in core inflation, this the biggest near term concern of markets right now we think. Our final chart comes from CITI Emerging Markets Strategy Weekly note from the 17th of May entitled "Fragile 5 now down to Fragile 2" and shows that US core CPI tends to rise in the two years leading up to a recession:

"US rates with more upside. 

After US CPI release last week we had wondered whether or not the EUR was in a bottoming process. While it had been trading better for a few days, the move higher in US rates has led to renewed USD strength. To be clear, we have been expecting higher US rates based on our belief in late-cycle behavior. Figure 4 shows that core inflation typically rises by 50bp in the last two years of an expansion.

Over the same two-year period, 10-year US Treasury yields tend to go up in the first year before retreating as rate cuts get priced by the market. Higher yields are therefore not surprising to us." - source CITI

If indeed a rising US Core CPI is a leading US recession indicator then again, we would have another demonstration of the recurrence theorem one could argue...

"Any idiot can face a crisis - it's day to day living that wears you out." -  Anton Chekhov

Stay tuned!