Macro and Credit - Alprazolam

"Anxiety does not empty tomorrow of its sorrows, but only empties today of its strength." - Charles Spurgeon British clergyman

Watching with interest the historical defeat of Prime Minister Theresa May relating to Brexit, in conjunction with the Chinese central bank injecting a net 560 billion yuan ($83 billion) into the Chinese banking system, the highest ever recorded for a single day given the weakening tone of the economy, when it came to selecting our title analogy we decided to go for a medical reference to "Alprazolam". "Alprazolam", also the trade name for Xanax among others, is the most commonly used benzodiazepine in short term management of anxiety disorders, specifically panic disorder or generalized anxiety disorder. It seems to us that the Chinese authorities have decided to act decisively on the very weak tone taken on their economy and the slowdown in global trade and its impact. Due to concern about "misuse", some strategists like us would not recommend "Aprazolam" as an initial treatment for panic disorder such as the MSCI China index down 23% over the past year. With the University of Michigan’s consumer confidence index falling to a more than two-year low of 90.7 in January, down from 98.3 in December, and well below expectations of 97.5, we wonder if our quote above is correct in asserting that anxiety does indeed empties today of its strength, namely consumer confidence. After all, clinical studies have shown that the effectiveness of Alprazolam is limited to 4 months for anxiety disorders but we ramble again...

In this week's conversation, we would like to look at the rising cost of attrition on the global economy, with the continuation of the stalemate in Brexit, US vs China trade/tech war, yellow jackets in France and of course the government shutdown in the United States. While Alprazolam has brought some solace to the December angst for investors, it remains to be seen how long the effect will last on the recovering "patients".

Synopsis:

• Macro and Credit - Does A for attrition equate R for recession?
• Final charts -  Mind the liquidity shock...

• Macro and Credit - Does A for attrition equate R for recession?

As we indicated in our previous conversations, "Bad News" has been the new "Good News" at least for asset prices in general and high beta in particular, the rally seen so far this year appears to us as more of a respite than a secular change to the overall picture. 

We indicated more downside risk at least from a European perspective and we continue to have a very negative view on France given the continuation of the unrest and the "yellow jackets" movement not giving any respite to president Macron. 

In our conversation "The European crisis: The Greatest Show on Earth", we indicated:

"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

In the AFTE latest survey, there is now a clear trend in the deterioration in their operating cash situation showing up:

- source AFTE

The situation for French corporate treasures when it comes to cash flows from operations is deteriorating to a level close to 2012-2013 follow the Euro crisis. This we think, warrants close monitoring, given we think that the ongoing "attrition warfare" between the French government and the "yellow jackets" is taking its toll on the French economy as a whole, which as we reminded you last week is very much "services" orientated relative to other countries of the European Union (80% for France vs 76% of GDP on average).

On this "attrition" subject we read with interest Bank of America Merrill Lynch's take from their Cause and Effect note from the 18th of January entitled "Investing in the age of the attrition game":

"Attrition bites in Europe

The “yellow vest” protest in France, which has resulted in the “worst riots since 1968” is now its 9th week. Not only it has shown no sign of ending, the number of demonstrators rebounded sharply over the past two weeks (Chart 6).

What began as a protest against fuel hikes has morphed into a broader movement of discontent with the government. President Macron has so far has refused to restore the wealth tax, one of the key demands of the protesters. This could turn into another war of attrition, especially with the fast approach of the EU parliamentary elections (May 23-26). French consumer confidence has tumbled sharply and is approaching levels reached during the Eurozone crisis (Chart 7).

The slowdown within the Eurozone is spreading. Both Italy and Germany are already in a recession (“the “R” club is recruiting”, January 11). For Italy, despite the passage of the 2019 budget bill, our European economics team has observed that the busy electoral calendar and decrees (not least those implementing pension reform and an income support scheme) could challenge the current ruling majority in the first half of the year. In Spain, a new far right party is emerging and the government lacks parliamentary support to pass a 2019 budget. The latest manufacturing PMI surveys show that new orders for Germany, France, Italy and Spain, the four largest economies in the Eurozone, were all below 50 (contractionary) in December, the first time in four years (Chart 8).

In our view, the greatest risk facing Europe is that the slowing economy fuels further populist discontent, creating a vicious circle." - source Bank of America Merrill Lynch

The numerous "attrition wars" being fought on a global scale are indeed clear headwinds regardless of the latest injection of "Alprazolam". As we indicated in our previous conversation "Respite",

"As we stated in various conversations including our last, we tend to behave like any good behavioral psychologist in the sense that we would rather focus on the flows than on the stock. On that note we continue to monitor very closely fund flows when it comes to the validation of the recent "Respite" seen in the market and it is not a case of confirmation bias from our side. 

We think that a continued surge in oil prices will be supportive to US High Yield. As well, any additional weakness in the US dollar will support an outperformance of selected Emerging Markets. Sure we might be short term "Keynesian" but overall, at this stage of the cycle we do remain cautiously medium-term "Austrian". 

A flattening curve in our book is not positive for banks and cyclicals such as housing and autos have already turned.  Also as briefly pointed out, a sustained shutdown is likely to be another drag on US growth which will therefore push the Fed's hand further into "dovish" territory". In that context, and if inflows return into credit markets, then high beta credit as well as Investment Grade could continue to thrive in the near term given Fed Chair Powell indicated in the latest FOMC minutes a willingness to be patient with future rate hikes. 4Q US GDP might disappoint we think." - source Macronomics, January 2019

We also discussed in our conversation the importance of the return of "macro" and the need to "monitor" fund flows for any signs of stabilization in "credit markets" as well as the need to track oil prices relative to US High Yield given its exposure.

Flow wise, Bank of America Merrill Lynch in their Follow The Flow note from the 18th of January entitled "Just a bounce?" question the most recent positive tone in financial markets given the weakening mood coming out from the macro data:

"Light positioning and known-unknowns

This year started on a positive note. Despite further weakness on the macroeconomic data front across the globe (more here), risk assets have staged a strong bounce higher. This is not because everything is in the price and we already know that macro is slowing and that the synchronised recovery has turned to a synchronized slowdown. It is the fact that positioning has been very light at the end of last year and thus cash balances have been put to work in January. With slower primary and tighter spreads last week it feels that the outflow trend is slowing down. However we are skeptical for how long markets can keep ignoring the continuing deterioration in macro. We feel this rally will not last, and thus we would use this bounce higher to reduce risk.

Over the past week…

High grade funds suffered another outflow, making this the 23rd week of outflows over the past 24 weeks. However, this week’s outflow is the smallest observed over that period. High yield funds recorded another outflow, the 16th in a row, but also the smallest in a while. Looking into the domicile breakdown, Globally-focused funds recorded the lion's share of outflows while US-focused funds outflow was more moderate. Actually Europe-focused funds have recorded small inflow, the first in 15wks.

Government bond funds recorded a small outflow this week. Meanwhile, Money Market funds recorded an outflow as risk assets moved higher. All in all, Fixed Income funds recorded an inflow, the second in a row.

European equity funds recorded another outflow this week, the 19th consecutive one. During the past 45 weeks, equity funds experienced 44 weeks of outflows.

Global EM debt funds continued to record inflows, the second weekly one. This confirms the improving trend observed recently as a dovish Fed has weakened the dollar. Commodity funds recorded another (albeit marginal) inflow, the 6th in a row.

On the duration front, short-term IG funds led the negative trend by far. Mid-term funds saw a small outflow while long-term funds experienced a decent inflow, continuing the recent trend of strength on the back-end of the curve." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch that, the significant rally in high beta should entice you to become more "defensive" and favor "quality" (rating) over "quantity" (yield). In the ongoing attrition game, it is more a question of capital preservation than capital appreciation we think.

Moving back to the "attrition game" and Bank of America Merrill Lynch's note from their Cause and Effect from the 18th of January entitled "Investing in the age of the attrition game", regardless of the positive liquidity injection from the PBOC and dovish tilt of the Fed, earnings as well are slowing down and there is more risk to US consumer confidence with the shutdown:

"Shutdown raises trade war risk

What does a destabilizing gridlock in Washington mean for the US-China trade war? Given the peril of fighting two battles at the same time, it seems reasonable to assume that the incentive for Trump to close a deal with China sooner than later has gone up. The fact that he has been talking up the prospect of a deal with China in recent weeks (“I think we’re going to be able to do a deal with China,” January 14) is consistent with this hypothesis. The market has taken these upbeat remarks at face value and has been driving up EM assets, the main casualties of the US-China trade war last year.

However, it takes two to tango. Trump’s loss of full control of Congress may be viewed by Beijing as justifying a less conciliatory stance. With the shutdown in Washington and growing expectations that the Mueller report will be out soon, Beijing may decide that it is not in a hurry to close a deal. Trump set a precedent by agreeing to a 3-month extension for the next round of US tariff. Beijing might think that the Americans could be forced into giving another extension if there is no deal by March 1.

The recent US slowdown could be giving China another reason to wait. Despite the reductions in reserve requirements to decade lows (Chart 3), Chinese credit growth has so far shown no signs of picking up (Chart 4).

Beijing might have eased monetary policy even more aggressively last year if it weren’t for the fact that rate hikes by the Fed was pushing down the renminbi (Chart 5).

A much weaker renminbi might have further complicated the US-China negotiation. The fact that the Washington shutdown is increasing the chance of a Fed pause, giving China a wider window to ease policy, could also reduce the urgency for Beijing to close a deal with Trump." - source Bank of America Merrill Lynch

Unless there is a rapid resolution between the United States and China on the trade/tech war narrative which has led to a significant rally in Emerging Markets so far this year on the back of a weaker US dollar, then indeed there is a high probability that the effect of the "Alprazolam" will fade and the bounce experienced so far could end rapidly and abruptly.

Bank of America Merrill Lynch added the following in their report:

"Market implications

Developments over the past two months suggest to us that political risks are rising.
This puts us at odds with current market consensus.

The contrast between our views and those of consensus is giving us confidence in our investment thesis for 2019:

The USD is vulnerable. We view the escalation of the gridlock risk in Washington as posing the greatest risk to the decoupling trade and to the USD. We are soon approaching a key support level that, if broken, will usher in further USD weakness (USD topped and target reached, but is this it? January 16). We like selling the USD especially against the JPY and the CHF. The EUR has been unable to capitalize on the USD’s retracement this year, reflecting concerns about the growth outlook for the Eurozone. If Eurozone political tension continues unabated, we may have to revisit our bullish EUR/USD forecasts.

EM rally won’t last forever. EM is rallying on Trump’s upbeat comments on the prospect of a trade deal with China. We think the risk of a no deal by March 1 is higher than expected. We also think that the inability of the EUR to gain against the USD will limit the room for further gains in commodity prices and EM. We think EM investors should not wait too long before taking some money off the table. We continue to believe that in 2019 investors need to think strategically but act tactically.

US rates vol looks cheap. Rates vol has fallen sharply year-to-date as risky assets stabilized (Chart 9).

We see the sell-off as possibly overdone given the binary nature of the political risks we highlighted in this report and the increasingly binary decision the Fed is facing. The worsening supply-demand dynamics as we head into possibly debt ceiling crisis #2 will likely provide strong support to rates vol." - source Bank of America Merrill Lynch

Any spike in rates volatility would obviously be negative for asset prices given carry players, risk-parity investors and other pundits love one thing, and that's low rates volatility. Any return of volatility on the aforementioned would definitely trigger another bout in "risk-off" rest assured.

How convinced are we with the strong rally seen so far from the December "oversold" situation? Not very much, we would argue. Sure, we have seen a welcome respite with the central banking cavalry arriving late, once again to an already damaged macro situation. Given the amount of known "unknowns" and the weaker tone in the overall macro picture, yes bad news are good news again for asset prices, but, we do think that buying some protection to the downside with potential bouts of volatility is a wise move.

Remember 2018 has marked the return of "cash" in your allocation toolbox and it should be used more extensively in 2019 given the risk for even more volatility events than in 2018. Bank of America Merrill Lynch in their High Yield Strategy note from the 18th of January entitled "When Cash Becomes King" makes some compelling arguments about the current tactical rally we are seeing:

"Low-risk yields appear compelling in this macro setup

The rally in leveraged credit has taken a pause in recent sessions, with our DM USD HY index oscillating around 450bps, more or less where it stood a week ago. The same could be said of rates as well, where the 10yr remained range-bound over the past week, spending most of its time around 2.70-2.75%. Even equities exhibited low volatility, by recent standards, with S&P500 moving 10-20pts in most sessions, a sea-change from 80-100pt sessions around year-end.

So, can this be considered an all-clear signal? Perhaps. It undoubtedly adds one reason to think so, although it is hard to make it sound convincing in and of itself. We prefer to rely on more tangible events, something that would not be forgotten tomorrow if volatility were to return.

Among such new developments, we counted the following:

• China: has responded strongly to apparent signs of weakness in its economy by cutting bank reserve requirements, policy rates, and business taxes. The extent of cuts in reserve requirements now exceeds those witnessed in 2008 and 2015. Business taxes were cut to the tune of $30bn/year; for some perspective US corporate tax cuts of 2017 amounted to $600bn/10yrs, or $60bn/yr for an economy that is 1.5x larger. In other words, very meaningful policy actions out of China.
• Earnings: banks opened the reporting season with a bang despite notable shortfalls in FICC results; their other businesses appeared to be doing well. Tax-reform bump is likely to begin coming out of numbers only next quarter, and will potentially reach its peak in Q2-Q3 of 2019. So US earnings could stay artificially elevated for a couple more quarters, in our view.
• Sectors: financials led, while utilities and staples trailed in the whole S&P500 round-trip between Dec 14-Jan 15. The argument goes that financials underperform and defensives outperform into a downturn. And yet the fact that utilities underperformed through a potential PCG bankruptcy does not help the case of this not being a cyclical turn.

On the other side of the ledger, the following reasons support continued caution:

• China: would probably not be throwing this much stimulus if its economy was performing in an acceptable way. The leadership there must know something we don’t know, in our view.
• Earnings: our model for US EPS has experienced further deceleration in recent weeks, and points to +6% growth over the next year. While this is not a level consistent with a cyclical downturn, we note that earnings went from 20%+ actual yoy growth rate in Q3, to earlier estimates around +10-12% to +6% today (Figure 1). So the trajectory and the remaining cushion are a concern.

• Wide IG: with spreads elevated in the IG space, HY looks tight. BBs offer only 100bps premium over BBBs (Figure 2). While not unheard of, we think this is too tight in today’s market environment given the shift in risk sentiment that has occurred over the past several months. Historical relationship between BBBs and BBs implies the latter should be 60bps wider given where the former is, ex PCG.

• Illiquidity gap: while liquid bonds have rallied and retraced a good chunk of Dec losses, illiquid paper remains marked at discounted levels (Figure 3 and Figure 4). This behavior is inconsistent with a sustainable turn in market sentiment, i.e. investors must become comfortable bidding for illiquid stuff to demonstrate their conviction. Buying HYG does not cut it.

• High dispersion: only 1/4 of all HY bonds trade within +/-100bps of overall index level; under normal circumstances, 40-50% of them trade this way. High degree of dispersion could be a function of illiquidity gap described above. Regardless of its origin, dispersion tends to increase (percent trading at index levels drops) at times of market downturns. The current levels of dispersion are consistent with 500- 525bps HY spreads and 1,300-1,400bps CCC spreads.
• Default estimates: With most factors now fully refreshed with Dec levels, the model continues to point towards 5.5% issuer-weighted and 4.25% par-weighted default rates. Such credit losses, if materialized, imply meaningful pickup over realized levels (2.8%) and point towards wider HY spreads (500bp as a risk-neutral level).

While these data points are not yet known, and could change our thinking as they come in, we remain mindful of a scenario where this episode eventually proves itself to be a cyclical turn. As such, we find current HY valuations to be somewhat out of balance, in terms of likely ranges going forward, i.e. we think probability is higher to see spreads in high-500s rather than low-300s; these two are otherwise equal distance away from here. Given this view, we are reducing our model portfolio beta to a modest underweight at this point, which we intend to move towards a more substantial underweight if  spreads continue to grind tighter from current levels.

Think about what you believe are reasonable return expectations from here, and compare them to low-risk alternatives: Libor is at 2.75%, short-duration IG is at 3.70% yield, and short duration BBs are at 5.20%.

In the environment where the next few months carry a reasonable chance of marking the turning point in this credit cycle, we find such yields increasingly attractive. Even if the cycle overcomes all obstacles and rolls on, you can blend-average the above into 3.5-4% portfolio, with a strong likelihood of actually realizing this return, in our view.

So we are probably entering a period of time when cash is becoming king again. HY may end up showing bouts of strong performance during this time, just as it did in early January, and we remain open-minded to tactically shifting our views when opportunities present themselves. We just struggle to see how it could happen from 450bps overall index levels or from 100bps BBs-BBBs differential." - source Bank of America Merrill Lynch

Being underweight high beta is we think indeed a good recommendation at this stage. Stay nimble and get tactical. Buying HYG might not cut it for Bank of America Merrill Lynch from a "liquidity" perspective, but, from our side and as a useful "macro" defensive tool for credit exposure "hedging", we believe synthetic exposure through credit indices such as Itraxx Main Europe 5 year and CDX IG for the lucky few of you benefiting from an ISDA agreement provide sufficient liquidity to sidestep any Investment Grade liquidity concerns. The US equivalent to the European CDS investment Grade index, namely the CDX, does not include banks as a reminder. The Itraxx Main Europe 5 year index is therefore a good "macro" hedge instrument for investment grade exposure to more turmoil with "European" banks, though we do not expect Mario Draghi to rock the ECB boat before his departure and it is highly likely the ECB will provide additional LTRO funding to the ailing banks in the European banking system, some more "Alprazolam", one would opine.

On that note, if indeed we are back into a "macro" world when it comes to "trading" then, using the rights "macro" instruments such as synthetic credit indices and options on credit indices might provide mitigation to heightened volatility over the course of 2019 and sufficient liquidity if indeed there is a "liquidity shock" when the "Alprazolam" effect will truly fade.

• Final charts -  Mind the liquidity shock...

While as we pointed out like many pundits that "liquidity" is a concern given how credit markets have swollen in recent years thanks to buybacks supported by very large issuance levels, then looking at the CDS market as a proxy for risk ahead is again warranted as pointed out by Bank of America Merrill Lynch in their Credit Derivatives note from the 16th of January entitled "The basis for a correction" with the below chart pointing out to the underperformance of bonds relative to the CDS market:

"Macro data continue to disappoint; we remain cautious

The globally synchronised bullish macro backdrop markets enjoyed in 2017 and the early part of 2018 is now firmly behind us. A year later, European data weakness continues while US strength is losing steam, fairly sharply. Chinese data are not improving either as PMIs are now at recessionary levels.

Despite the somewhat better start to the year for risk assets, we think that volatility will remain a key theme for another year. Large swings and lack of clarity underpin our bearish stance on spreads and beta in the following months; we continue to advise a defensive positioning. The deterioration in macro indicators will keep market sentiment fragile, in our view.

It feels like 2015-16

2018 is likely to be remembered as the worst year since the 2008 crisis. Performance was poor and funds suffered outflows. The performance over the past 12 months resembles that of 2015-16. However, this year started on a much more upbeat note than. 2016. Nonetheless, we are concerned that several factors are reminiscent of the drivers that pushed spreads wider in January and the early part of February 2016. A macro slowdown, lack of inflation in Europe and tightening conditions that risk assets were dealing with back then are still adversely affecting markets.

Gap risks and basis

We also think that CDS is too tight to cash bond spreads and negative basis is supportive for more downside risk in the synthetics space. The “gap” wider risk for the CDS market makes us less comfortable at current levels and, as we see fewer catalysts to reverse this market weakness we would use the recent move tighter as reason to reset shorts, especially by selling receivers to own payers. We also screen for negative basis opportunities.

The globally synchronised bullish macro backdrop markets enjoyed in 2017 and the early part of 2018 is now firmly behind us. A year later, European data weakness continues while US strength is losing steam, fairly sharply. Chinese data are not improving either as PMIs are now at recessionary levels.

Despite the somewhat better start to this year, we think that volatility will remain a key theme in 2019 too. Large swings and lack of clarity underpin our stance to remain bearish spreads and beta in the coming months; we continue to advocate defensive positioning. We expect the deterioration of macro indicators to keep markets sentiment fragile, and until we see the cycle trough, we remain skeptical on how well higher risk/beta pockets will perform." - source Bank of America Merrill Lynch.

So enjoy "Alprazolam" effects while they last as we concluded in similar fashion our previous conversation. Remember that those taking more than 4 mg per day of Alprazolam have an increased potential for dependence. This medication may cause withdrawal symptoms upon abrupt withdrawal or rapid tapering, which in some cases have been known to cause seizures, as well as marked delirium.  The physical dependence and withdrawal syndrome of Alprazolam also add to its addictive nature. Alprazolam is one of the most commonly prescribed and misused benzodiazepines in the United States, benzodiazepines are recreationally the most frequently used pharmaceuticals due to their widespread availability. Alprazolam, along with other benzodiazepines, is often used with other recreational drugs such as QEs but we ramble again...

"A crust eaten in peace is better than a banquet partaken in anxiety." - Aesop

Stay tuned !

Macro and Credit - The Trail of the Hawk

"Excess generally causes reaction, and produces a change in the opposite direction, whether it be in the seasons, or in individuals, or in governments." - Plato

Watching with interest the change in the narrative from our "Generous Gamblers" aka central bankers, leading to some rise in sovereign yields, when it came to selecting our title analogy, we reacquainted ourselves with Nobel Prize-winning novel 1915 "The Trail of the Hawk" by Sinclair Lewis. He was the first American writer to win the prestigious award. It is the fictional story of the life of Carl "Hawk" Ericson, from rural Minnesota. He begins his amazing career as a stunt pilot in the early years of aviation. As his friends and colleagues meet tragic ends, he realizes there must be a better way to use his life. His path is highly non-linear; he tries an assortment of opportunities (ZIRP, QE, NIRP). Fearing the mortal dangers of flying, maybe like Icarus who flew too close to the sun, at some point the hero Carl "Hawk" Ericson decides to retire to avoid the fate of his friends and colleagues. In similar fashion, it seems to us that our "liquidity" providers of recent years have decided to "retire" as of late, hence the recent small turmoil seen in the Government bond markets. 

In this week's conversation, we would like to look at other signs that the credit cycle is indeed in its last inning with the return of Jumbo leveraged deals and other cautious signs.

Synopsis:

• Macro and Credit - Credit mumbo jumbo
• Final chart - Compensation costs and interest costs are not as in sync as they were in previous cycles.

• Macro and Credit - Credit mumbo jumbo

Whereas "mumbo jumbo" is a language or ritual causing or intended to cause confusion or bewilderment, the latest U-turn taken by the ECB following Le Chiffre's comment (aka Mario Draghi) ties up nicely with the definition which is confusing or meaningless language. The phrase is often used to express humorous criticism of middle-management and civil-service doublespeak (or central bankers):

"The current context where global uncertainties remain elevated, there are strong grounds for prudence in the adjustment of monetary policy parameters, even when accompanying the recovery. Any adjustments to our stance have to be made gradually, and only when the improving dynamics that justify them appear sufficiently secure," - Mario Draghi

What could be a better definition of "Credit mumbo jumbo" after vice president of the ECB Vitor Costancio suggested market participants had read too much into Draghi’s comments, and that they should not be considered a hawkish shift in language we wonder? But, as we have seen, as of late, it's not only the Fed that is on "The Trail of the Hawk", it seems the Bank of England and others are on a similar pattern.

While we have indicated in our past musings our growing 2007 feeling, with tighter spreads, higher leverage, clearly the returns of significant large deals in the LBO (Leverage Buy-Out) space is a clear reminder of the lateness in the credit cycle. LBOs are definitely a sign and we agree with DataGrapple's recent blog post on this subject on the 29th of July entitled "Jumbo Leveraged Deals Are Back":

"Roughly a year ago, SPLS’s (Staples Inc) attempt to buy ODP (Office Depot Inc) for $6.3Bln was thwarted by antitrust regulators. A tough year ensued after its CEO stepped down, during which the company scrambled for a plan B, closing stores and seeking to recast itself as a source of business services. It looks as if these transformation efforts seduced Sycamore though. They announced yesterday night that they are ready to bid $6.9Bln to buy SPLS in what could be the largest LBO announced this year. Even though a deal had been rumoured for some time – it was reported in May that a takeover offer from Cerberus had been rejected because it was too low -, investors initially sent SPLS’s 5-year risk premium soaring 50bps wider at 350bps, as such deals inevitably mean more debt. But soon it transpired that Sycamore, in a similar move to what it did when it bought Jones Group in 2014 and split it in 4 different independent operating companies, could divide SPLS into three different entities: US retail, Canadian retail and corporate-supply business. It inevitably raised the question of where the debt will sit and which entity (or entities) CDS currently referencing SPLS will cover. The answer is not necessarily the most leveraged. The CDS gave up all its widening and more, to close 25bps tighter on the day at 272bps." - source DataGrapple

At the same time we hear that Apollo Global Management has raised $23.5 billion for the largest buyout fund ever.  Blackstone's fund raise of nearly $22 billion in 2007 was near the top of the previous bull market as a reminder. For us this is another sign of the lateness in this credit cycle and no this time it's not different rest assured.

This is what we wrote about the return of LBOs in 2013 in our post "For whom the Dell tolls":

"In the run-up to the financial crisis of 2008, 2006 and 2007 where the years where "cheap credit" fueled the housing bubble, but it was the years as well of the mega-buyouts. In 2006, private equity firms bought 654 US companies for 375 billion USD, 18 times the level of 2003 and raising 215.4 billion USD in investor commitments to 322 funds. 2007 saw yet another record with 302 billion USD of investor commitments to 415 funds. 
The paroxysm of the mega-buyout deals of the period was Energy Future, formerly known as TXU Corp which was taken private by KKR and Co. for a cool 43 billion USD in 2007. The deal did not evolve favorably for bond holders given Energy Future is now seeking an extension of maturity for the portion of Texas Competitive's revolving loan that matures in 2013 (2.1 billion million USD of revolving credit facility used in total).  Energy Future Holdings was loaded with 37.4 billion USD worth of obligations whereas Texas Competitive was saddled with 32.2 billion USD in debt, 700 million USD of which was due in 2013, and with 2.7 billion USD in interest payment due in 2014 according to Bloomberg. 
KKR and Co., TPG Capital and Goldman Sachs Capital partners paid themselves 528.3 million USD in fees while TXU Corp moved towards bankruptcy and restructuring 
Buyout firms went on a record-breaking shopping spree in 2006-07, saddling themselves with 1.5 trillion USD in assets that they intended to sell at a profit. For 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, according to the Private Equity Council." - source Macronomics, 2013

As a reminder, during the run-up to the credit crisis of 2008, the impact of LBOs where not only a nightmare for investment grade credit portfolio managers given a LBO is by definition a negative credit event (more leverage with more debt on the balance sheet meaning an obvious fall in the rating spectrum), it was as well a nightmare for market makers in the credit space, natural sellers of CDS protection to their clients, given the "sucker punch" capacity and P&L pain infliction caused by widening CDS spread on LBO news.

There lies the crux of the current tactical issue, leverage has been creeping up in US investment Grade and High Yield is facing headwinds thanks to rising oil woes, which is triggering some fund outflows as of late, including the feeble ETF retail space. Now as a credit portfolio manager, you probably want to dust out your LBO screeners. Not only are central bankers with their mumbo jumbo lingo triggering heightened volatility in government yields, but there are indeed potential sucker punches awaiting credit investors with the return of the 2007 LBO trend. In relation to the US Investment Grade Outlook we read with interest Wells Fargo's take on the subject in their latest outlook note entitled "Hoping for Carry":

"U.S. Investment Grade (IG) corporate credit spreads are currently close to the tights of the year (112 bps) but remain within our expected target of +/-10 bps this year. A healthy rally at the beginning of the year has given way to a steady ‘lo-vol’ grind as credit spreads remained in an 8 bps range over the quarter. The benefit of last year's aggressive loosening of global monetary conditions has started to fade, while hope for a meaningful fiscal stimulus in the U.S. has been tempered as well. That said, credit fundamentals appear to have stabilized as corporate profitability has improved. Looking forward, we expect the current environment of ‘lo-vol’ carry to continue with few macro catalysts on the near-term horizon. However , the trajectory of spreads could become more choppy as the summer ends and monetary and fiscal policies return to center stage. Over the course of the year, we expect the YTD range to hold for credit spreads with IG +/- 10 bps and HY +/- 50 bps, but in the near term, the grind should continue . To position portfolios, we recommend credit investors stay fully invested to capture as much carry and residual spread compression as possible, but also strongly recommend moving up in quality where possible to minimize a big macro beta bet and instead focus on more micro trades to drive outperformance. To do so, we recommend remaining Market Weight in IG and prefer to focus on sector and curve strategy.

Fundamentals: IG companies continue to run historically high levels of leverage with Non-Financial debt/EBITDA of 3.0x. Q1 earnings came in well ahead of expectations, marking the best earnings season since 2011, and strong earnings growth is expected to continue over the balance of the year. However, while earnings are rising, debt is also rising at a rapid clip, particularly for the lower beta portions of the market. As a result, overall Non-Financial leverage remains unchanged as leverage ex-Energy is expected to converge toward Energy over the balance of the year.

Technicals: Demand for IG continues to be robust in H1 2017 with record inflows to IG mutual funds and ETFs, pushing up total assets in IG mutual funds to $2.0 trillion. IG bond issuance has similarly clocked a record pace in H1, but the slowdown in Q2 from Q1 has allowed spreads to continue to grind tighter. Foreign demand has been choppier this year as the cost to hedge USD fixed income positions remains high and the USD has started to weaken. Looking forward, we expect slightly less technical support in 2017 versus 2016 as monetary policy moves tighter and foreign flows decelerate.

Valuations: The current spread level of 112 bps is through our year-end spread target of 120 bps. With expectations of modest widening, but still positive excess returns, we believe chasing beta is a low-quality trade and recommend investors move up in quality to take advantage of currently compressed valuations. We favor curve flatteners at the long end as we expect rates to end the year above today’s levels, while we favor curve steepeners at the front end to take advantage of historically flat curves." -source Wells Fargo

We keep repeating this but in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger. In our January 2014 conversation "Actus Tragicus" we indicated that the end of low interest rate volatility would end the "goldilocks" period for Investment Grade credit. We therefore think that rather than being focusing your volatility attention towards the VIX index, you should switch your attention towards the MOVE index we discussed in our previous conversation:

"Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is  the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...)." - Macronomics, January 2014.

As noted above for leveraged and carry players, namely the "Beta" crowd, interest rate volatility matters, particularly the "Risk-parity crowd". From a positioning perspective in an environment impacted by dwindling liquidity and rising "convexity" risk from both a duration and credit quality perspective, we believe in a defensive position in H2 on US investment Grade, meaning lower duration exposure in credit as well as higher credit quality given the disappearance of interest rate buffers in the credit space, thanks to central banks "meddling" and "overmedication". Investors have had no choice but to take on more credit risk hence and what we have called in the past a credit "mousetrap". Recently we indicated that tactically going for duration again particularly in credit has been paying off nicely (MDGA - Make Duration Great Again). This positioning has been vindicated as shown in the below chart from Wells Fargo US Investment Grade Outlook note showing that IG 10 years + has been outperforming:

- source Wells Fargo

Why the advice to continue playing defense in H2 and reduce duration? Not only inflows and new issues have been very significant but, as per the below Wells Fargo chart, duration risk is at all-time high:

- source Wells Fargo

So far, with the latest gyrations in sovereign spreads thanks to "The Trail of the Hawks" has been contained in the Investment Grade space, yet, with a potential return of Interest Rates volatility, one would be wise in the current context to dial down a bit his duration exposure we think. 

Whereas credit risk is increasing, giving the lower for longer mantra thanks to the macro fundamentals backdrop playing out and financial repression, not only as we have highlighted credit investors have been extending credit risk, they also have extended their duration risk significantly as per the above Wells Fargo chart, increasing in effect the duration mismatch between US cash investment grade and its synthetic credit hedge tool the CDX IG series. Durations have continued to extend thanks to lower coupons so to fully hedge out a market-based cash portfolio with 7.5 years of duration, you would require an extra 60% of protection to result in a CR01 neutral portfolio. This means that as hedging tool, one would need to compensate for the extended duration rise in the cash market and needs to buy more "protection" to hedge a cash investment grade credit portfolio if one wants to be "duration neutral" that is. So if indeed "The Trail of the Hawk" is the new mantra for our central bankers, not only you need to reassess your beta exposure credit wise, but, given the renewed pressure on High Yield outflows thanks to pressure on oil prices, you might as well need to rethink about "Gamma". On this subject we agree with DataGrapple post from the 28th of June entitled "Gamma or Theta?": 

"In the morning, investors appeared to be reappraising the outlook for global borrowing costs and monetary policy in the wake of the comments from the usually dovish Mr Draghi. Global central bankers are coalescing around the message that the cost of money is headed higher. These concerns about tighter monetary conditions were compounded by remarks by Mrs Yellen yesterday that asset valuations look high by some measures, another global cyber-attack, an IMF cut to their US growth forecast. As a precautionary measure, iTraxx Main (ITXEB) was sent 1.5bps at 56.5bps, iTraxx Crossover was sent 6bps wider at 244bps, and all risky assets felt a bit shaky. That proved too much for the ECB to handle and they felt they had to say markets had misjudged Mr Draghi speech on stimulus. It certainly produced the desired effect, and risky assets went in reverse across the board. So, for the first time in a while, volatility has reared its head again, with investors able to capture a 4bps total variation on ITXEB today. The potential for tape-bombs to rock the market is now clear to everyone. That leaves options players conflicted between owning cheap gamma and having positive theta for the US holiday week-end coming up." - source DataGrapple

So if you think that on top of LBOs bombs falling in Investment Grade, you might fell prey of the hawks' latest mumbo jumbo, you might want to think about owning indeed cheap gamma. You might enjoy the low volatility regime providing you so far a "Goldilocks" scenario for credit, but should you want to play it safe through "Gamma" rather than being negative carry through a straight purchase of CDS indices, then you might want to look at credit options given they are still relatively cheap to own as displayed in the below table from Barclays CDS Index Options note from the 27th of June:

- source Barclays

As per the above, even in credit, spot volatility has been trending down, mist likely thanks to the relentless hunt for yields and Structured Credit players continuing to sell protection and hitting the bid of market-makers in the process as discussed recently.

As we have indicated in recent musings, there are many late credit cycle similarities to the 2007 period with credit spreads tightening, low volatility and renewed structured credit activity, with investors extending both credit risk and duration risk. There is as well on "The Trail of the Hawk", tighter monetary policy and a flatter yield curve typical of late economic expansion. Yet as per our final chart below, there is something different this time around, which is that compensation costs and interest costs are not in sync. 

• Final chart - Compensation costs and interest costs are not as in sync as they were in previous cycles.

As we concluded above, there is something puzzling in the current late credit cycle, namely that compensation costs and interest costs have been diverging, which remains an oddity. Our final chart comes from Société Générale American Themes note from the 29th of June entitled "US recession odds remain extremely low but concerns are growing". The chart displays the net margin expenses for US companies which in this current late cycle are not behaving like in previous cycles:

"One item different than previous cycles – Net interest margins remain low

We highlight the evolution of profit margins in a business cycle. Importantly, margins are getting squeezed due to labor compensation. We would be remiss not to point out the benign nature of net interest margins.

Net interest margins typically climb during the late phase of a business cycle. At present, we are not seeing that pattern. Low interest rates are restricting interest expenses despite heavy debt issuance.

Limited tightening from the Federal Reserve is keeping a lid on interest costs for US companies. If we are in the later stages of a business cycle, interest rate expenses are behaving in a different fashion than previous late-cycle periods. Conversely, the lack of interest expense pressures reduces the odds that the US economy is in a late cycle.

Tighter Fed monetary policy is a feature of many late economic expansions. In June, the Fed hiked rates for the fourth time in the current business cycle. The amount of tightening is low, the 10y Treasury yield is lower than it was when the Fed first hiked rates (December 2015), and credit spreads are mostly tighter. Do profit margins or interest costs matter more for the investment decision? The charts above offer some glimpse into a method of answering this question. Businesses seek profits and bear costs, such as interest expenses, to the point that margins justify the investment. The current period is unique in that compensation costs and interest costs are not as in sync as they were in previous cycles.

Debt stresses may be materializing despite restrained interest costs. Notably, we are seeing rising delinquencies in auto loans and rising charge-off rates for consumer credit. Further, the Fed’s Loan Officer Surveys show slowing credit demand and some instances of more restrictive credit. These debt features may be signs of stress not evident in issuance volumes or credit spreads." - source Société Générale

To paraphrase Bastiat, there is always what you see and what you don't see. Today the Treasury curve is the flattest it has been since March 2008. No doubt to us that the Treasury yield has had an historic accuracy. Additional rate hikes will increase the flattening on "The Trail of the Hawk". Also as we pointed out recently consumer credit recent weaknesses are a cause for concern and we are increasingly monitoring this space. If profit margins continue to shrink like they did through 1Q2017 to 12.5%, the lowest level since 2011, you could get your double whammy. The Trail of the Hawk might be tortuous but is nonetheless treacherous.

"To be interested in the changing seasons is a happier state of mind than to be hopelessly in love with spring." - George Santayana

Stay tuned!

Macro and Credit - The Cult of the Supreme Being

"The supreme quality for leadership is unquestionably integrity. Without it, no real success is possible, no matter whether it is on a section gang, a football field, in an army, or in an office." -  Dwight D. Eisenhower, American president

Looking at the continuation in the rally in risky assets and watching with interest our friend Michael Lebowitz getting blocked on Twitter by Narayana Kocherlakota, the former president of the Federal Reserve Bank of Minneapolis, we made the following sarcastic comment that if you are not a "cargo cult" follower you get blocked. While being a "cargo cult member" entails various ritualistic acts such as "wealth effect" via QE not manifesting itself in the appearance of material real economic recovery, we could have used this very reference for our title analogy but, given our previous reference to the French Revolution in our last conversation, it made us want to dig further into history when it comes to selecting an appropriate title. 

The Cult of the Supreme Being (French: Culte de l'Être suprême) was a form of deism established in France by Maximilien Robespierre during the French Revolution. It was intended to become the state religion of the new French Republic and a replacement for Catholicism and its rival, the Cult of Reason. It can be easily argued that the Cult of Reason, namely reasonable/rational central banking has indeed been replaced by the Cult of the Supreme Being, namely the "cult of the central banker". The Cult of Reason distilled a mixture of largely atheistic views into an anthropocentric philosophy. No gods at all were worshiped in the Cult—the guiding principle was devotion to the abstract conception of Reason which seems to have been totally ditched by our central bankers "deities" as of late. For Maximilien Robespierre, "The Cult of the Supreme Being" was said to have contributed to the Thermidorian Reaction and the ultimate downfall of Robespierre and his execution.

Furthermore, in our July conversation "Confusion" we made another reference to French economist Florin Aftalion 1987 seminal book entitled "The French Revolution - An Economic Interpretation" given the extension of Negative Interest Rate Policy now in German banks affecting retail deposits above the €100,000 threshold, the words of revolutionary figure Louis Antoine de Saint-Just, one of Robespierre's closest ally during the French revolution who ended up guillotined the very same day on the 28th of July 1794 are very interesting in relation to "monetary creation" and "assignats" we have discussed in our recent musings:

"There is no money-saving going on nowadays. We have no gold, and yet a state must have gold; otherwise it is basic commodities that are piled up or kept back, and the currency loses more and more value. This, and nothing else, lies behind the grain shortage. A labourer, having no wish whatsoever to put paper money in his nest-egg, is very reluctant to sell his grain. In any other trade, one must sell in order to live off one's profits. A labourer, however, does not have to buy anything, for his needs have nothing to do with trade. This class of persons was accustomed to hoarding every year, in kind, a part of the produce of the earth, and nowadays it prefers to keep its grain rather than to accumulate paper" - Louis Antoine de Saint-Just.

No offense to the Supreme Being Cult members out there, but, in our book, NIRP is insanity as there cannot be productivity and economic growth without accumulation of capital, because simply put, NIRP is killing capital (savings).

In this week's conversation we will look at the continuation of the rally thanks to inflows which validates our short-term "Keynesian" stance. We do remain though medium to long-term "Austrian" when it comes to assessing the credit cycle and the slowly but surely tightening noose of financial conditions as displayed evidently in the below chart from Bank of America Merrill Lynch CMBS weekly note from the 12th of August entitled "Bad news is once again good news; remain overweight":

"Through the rest of 2016, we expect several headwinds to CRE price growth will remain. For instance, underwriting standards look set to continue to tighten. Over 44% of respondents to the most recent Senior Loan Officers Survey, which was released last month, indicated they were tightening underwriting standards (Chart 24), although the OCC’s most recent semi-annual risk report says differently. Regardless, with the topic squarely on the regulators’ radar screens, we think it is only a matter of time before underwriting standards begin to tighten, particularly for smaller local and regional banks. " - source Bank of America Merrill Lynch.

Of course the evolution of US Senior Loan Officers Survey is worth tracking as it will clearly impact going forward the default rate and the US High Yield asset class. For now, everyone is "dancing", but, we think, it's worth "dancing" closer towards the exit we think, hence our recommendation in favoring "Style" over "Substance", namely US Investment Grade over US High Yield or playing simply the "beta" game.

Synopsis:

• Macro and Credit - The melt-up is "Breaking bad" thanks to "cult members" inflows
• Macro and Credit  - While credit spreads are grinding tighter, quality is eroding faster
• Final chart: US Investment Grade credit - Growing duration mismatch between cash and synthetic

• Macro and Credit - The melt-up is "Breaking bad" thanks to "cult members" inflows

When looks at the continuing rally into risky assets and particularly "credit", one would indeed conclude that the cult of the Supreme Being is alive and well particularly in the light of some long dated corporate bonds trading in the region of $200 cash price. As indicated by the Financial Times in their article "Latest bond rally eye sore: one for the price of two", "Bondzilla" the NIRP monster is getting bigger every day thanks to the Supreme Being cult members:

"The Bank of England’s recent stimulus splurge, including a move to buy corporate paper, has driven the market prices for several sterling corporate bonds up to more than two times their initial face value, even for those unlikely to qualify for the central bank’s shopping list, writes Joel Lewin.
The price of US industrial conglomerate General Electric’s 2039 sterling bond, for example, has rocketed to a record high of 215.5 pence on the pound. That’s up from 165p at the start of the year and 100p when it was issued in 2009.
The yield has plunged from more than 10 per cent in 2009 to a low of 1.805 per cent.
Coupons aside, paying £215.50 today to be repaid £100 in 2039 amounts to a capital loss of 5 per cent every year for the next 23 years. Tasty.
“It’s another sign of how far central banks have pushed things,” says Luke Hickmore, a senior investment manager at Aberdeen Asset Management.
National Grid Gas’ 2044 bond has surged from 154p at the start of the year to 205p.
While those are the only two sterling corporate bonds* past the 200p mark at the moment, according to Bloomberg data, a number of others are on the brink." - source Financial Times

In conjunction to cult members being induced price wise by their Supreme Being, putting aside any reason or rational thinking, flow wise, the latest move by the Bank of England has also added fuel to the fire leading to some "overdrive" in spread tightening but inflows as well! This can be clearly seen in the United Kingdom credit markets as shown by Bank of America Merrill Lynch in their Follow the Flow note from the 12th of August entitled "Thank you Carney – Largest inflow ever":

"The state of play: IG > EM > HY >Equities
In a world dominated by central banks’ QE programs, BoE has been the latest to join – or re-join – the party. Last week’s inflows into sterling IG funds were the largest ever.
Since the ECB announced the CSPP, $30bn has flown into IG funds. And from February’s risk assets lows, equity funds have lost $82bn. During the same period, EM debt funds have been boosted by $28bn of inflows. 

High grade funds recorded their 22nd week of inflows. Despite getting into August, inflows to the asset class remained strong. High yield funds retraced back from negative territory with a marginal inflow. As shown in chart 13, inflows emanated mainly from global and European funds, while US-focused high yield funds recorded outflows.

Government bond funds recorded their second week of inflows. Money Market funds flows also remained positive for a second week.
Outflows from European equity funds continued for a 27th consecutive week. The intensity of the outflows – which peaked in mid-July – has been slowing down over the past four weeks.

EM global debt funds recorded a sixth week of inflows, but the summer season is taking its toll on the flow strength. Commodity funds recorded their 16th consecutive inflow, the 31st so far this year, and the highest in four weeks.
Looking at duration, all parts of the IG curve recorded strong inflows. Short-term funds recorded their third consecutive inflow, slightly lower than the previous week, but still high in AUM % terms. Mid-term IG funds had their seventh week of inflows, while longterm ones had a sixth positive week." - source Bank of America Merrill Lynch

We might be sounding like a broken record, at least for our "Cult of Reason" members, but, the "Supreme Beings" of various central banks are not only pushing investors outside their comfort zone into credit risk they should not be taking, they are also pushing them into increasing significantly duration risk rest assured. Some are indeed racing into the "beta" transformation game into "alpha", in a dwindling liquidity world, this will not end well, but, for the time being it's "rally monkey" time for the Cult of the Supreme Being Members.

While we are indeed tactically bullish for "religious" reasons, we do think that we are witnessing the final melt-up in risky assets given that many signs are starting to add up when it comes to gauging the state of the credit markets. 

When it comes to "Bondzilla" the NIRP monster now close up to $13.4 trillion, we expect the Japanese to come back into play in September thanks to additional "unconventional" measures from the Bank of Japan, and their "zealous devots". 

In a world turned upside down by rising "financial repression", Bondzilla's growth is evidently more and more "Made in Japan". This can be clearly seen in the below Nomura chart from their Flow Monitor note of the 8th of August entitled "Lifers’ foreign bond investment reached a record high":

"Japanese foreign portfolio investment accelerated in July. Excluding banks, Japanese investors bought JPY3287bn (USD32.2bn) of foreign securities in July, a much higher pace than in June. Life insurance companies’ foreign bond investment continued to accelerate, although we judge most was on an FX-hedged basis. Toshins also increased foreign investment in July. On the other hand, pension funds decreased their foreign investment. Although retail investors’ foreign investment is likely to stay weak for now, their risk appetite for foreign investment should improve thanks to the supplementary budget. Pension funds will probably remain dip-buyers, but their additional capacity to buy foreign securities also increased. 

Foreign portfolio investment stayed strong in July 

According to the International Transactions in Securities for July, released on 8 August by the MOF, Japanese investors bought a net JPY6,365.6bn (USD62.4bn) in foreign securities (equities and intermediate and long-term bonds). Since banks were major net buyers of foreign bonds at JPY2,685.7bn (USD26.3bn), this represents a sharp gain over the previous month (JPY2,453.0bn in net buying). If we eliminate the bank accounts that carry out FX-neutral short-term trades, net buying amounted to JPY3,286.5bn (USD32.2bn) in July. This is a major increase in net buying over the previous month (JPY2,311.7bn in net buying; Figure 1).

The breakdown by asset shows that Japanese investors were net buyers of JPY522.8bn (USD5.1bn) in foreign equity, flat over the JPY525.6bn in net buying the previous month. At the same time, they were net buyers of JPY2,763.7bn (USD27.0bn) of foreign bonds, up sharply over the previous month (JPY1,786.1bn in net buying).

Lifers bought foreign bonds at the highest pace
Life insurers bought a net JPY2,037.8bn (USD20.0bn) in foreign bonds, the highest net buying since these data began to be compiled (Figure 2).

This is also the eleventh straight month of net buying. With 20yr JGB yields near 0%, foreign bond investment has picked up sharply as lifers look for even slightly higher yields. Although JGB yields have risen to the 0.3% range again, we expect foreign bond investment to continue at a pace of more than JPY1trn per month if yields remain at current levels.
That said, we expect most of their foreign bond investment to be hedged. Although USD/JPY rose to the 107 range in mid-July in response to heightened expectations of BOJ easing, lifers took a cautious view of the July BOJ policy board meeting. They likely bought hedged foreign bonds and also increased currency hedges. Accordingly, despite a large amount of foreign government bond investment, upward pressure on USD/JPY should be minimal, in our view. Nevertheless, some lifers seem to be starting to buy unhedged foreign bonds at rates near JPY100.
With the US presidential election about to get under way in earnest, we see little chance of investments in unhedged foreign bonds picking up significantly. We expect lifers to continue investing primarily in hedged foreign bonds in the near term. " - source Nomura

While the ECB and now the Bank of England are in the corporate bond buying business making the "fun" going "uphill" thanks to the "wealth effect" and in no way flowing "downhill" to the "real economy" that is, the Japanese investor crowd is ratching up its bidding as the competition for financial assets rises.

A good illustration of the success of the Cult of the Supreme Being, when it comes to "capital destruction" can be seen in Japanese's net household savings rate thanks to "financial repression" as well as major demographic headwinds as illustrated in the below chart from Deutsche Bank's Japan Economics Weekly note from the 5th of August entitled "Inconsistency of policy to promote 'savings into investment'":

"Japanese households have been said to be persistently highly risk-averse, with a strong preference for financial assets with principal guarantees. This tendency has been structural, both in the bubble era and now. Financial flows from households since the end of the 1990s show continued inflows into principal-guaranteed financial assets, including cash, deposits, government debt, insurance, pensions and corporate bonds, with the exception of 2006-08. In the most recent years, fiduciary trusts have become popular, mainly for inheritance reasons, although inflows to these assets remain small.
The Japanese government plans to expand the eligibility for the personal defined contribution pension system (personal DC) to house wives, employees in the government sector, and those in the private sector whose employers are equipped with corporate pensions. The eligibility is said to expand by 26m people. The personal DC account has tax benefits of 1) fully deductible contributions from income, 2) no tax on investment returns and 3) taxdeductible benefits after retirement. These are much more generous than NISA (Nippon Individual Savings Account), which was introduced in January 2014, with active accounts of 2.9m. NISA’s sole tax advantage is #2 above. We believe that financial inflows from households into the expanded personal DC will likely be JPY3.1tr a year, twice the size of the inflows via NISA. However, a large part of these new inflows should go into principal-guaranteed assets.
We are curious about the effect of the introduction of these investment schemes with tax benefits on the household saving rate, which has been stuck near zero over the past ten years. Considering various strong headwinds against target savers, such as lack of income growth and inability to save, strong preference for principal-guaranteed assets, persistent low interest rates, QQE for more than three years and the introduction of negative rates in January, we believe that the households could view this expanded personal DC as a tailwind to mitigate those headwinds. This could lead to a continued rise in the household saving rate that began in 2015 well into 2017 and beyond, and might pose a downside risk in the near-term economic outlook. 

The proposition of ‘savings into investment’ contains misleading elements. Investing (in flow terms) in financial assets is nothing more than giving up current-period consumption out of disposable income for saving (in flow terms), regardless of its destination (say, bank deposits or equities). The proposition of mobilizing households’ financial assets (in stock terms) worth JPY1,700tr into investments does forget that these financial assets have already been deployed to the final borrowers, regardless of its channels (i.e., directly through capital markets or indirectly via financial intermediaries). There is no guarantee that the use of these funds by the current borrowers is inefficient and that by alternate borrowers is efficient." - source Deutsche Bank

We will not go back into the false "rethoric" from "The Cult of the Supreme Being" related to the "Savings glut" as we have already touched on this very subject in February in our conversation "The disappearance of MS München". Put it simply, no offense to the "zealous devots" of the "Supreme Beings" but in our book (and also in Claudi Borio's book from the Bank for International Settlements), "financing" doesn't equate "savings", at least in our cult, "The Cult of Reason" that is. If NIRP is killing "savings", there cannot be "proper" financing" to the "real economy" as stipulated earlier on in our conversation.

Furthermore, we keep hammering this, but, our "core" macro approach lies in distinguishing "stocks" from "flows". When it comes to dealing swiftly with "stocks" of Nonperforming loans (NPLs) such as in Italy via "flows" of liquidity, it looks to us that the "Supreme Beings" do not understand that "liquidity" doesn't equate solvency.

Moving one to our second point, while the rally is "technically" driven thanks to "financial repression" thanks to the mischiefs of the "religious cult", we continue to believe we are in the last inning of this credit cycle, making us continue to believe in quality and capital preservation rather than chasing yield for the sake of it.

• Macro and Credit  - While credit spreads are grinding tighter, quality is eroding faster

As we pointed out at the beginning of our conversation, we will continue to monitor closely US Senior Loan Officers Surveys in the coming quarters as it has always been driving the default rate in the past. Of course "flows" are driving the relentless search for yield while "credit tourists" are punting for "beta" but, nevertheless, we do believe that no matter our "zealous" the members of the "Cult of the Supreme Beings" are, the credit cycle is slowly but surely turning. On that note we read with interest Wells Fargo Securities latest Credit Connections note from the 12th of August entitled "The Linchpin":

"Credit spreads remain in a sideways pattern with a bias to grind tighter. We expect this trend to persist as we work through the dog days of summer. With Q2 earnings largely complete, coming in modestly better than expected, and most central banks on holiday, the market has little to focus on other than the regular flow of economic data and the technical underpinnings of demand and supply. On balance, the technical backdrop remains the dominant thread and remains supportive of a firm market tone as inflows to credit more than outpace bond issuance. Conversely, credit quality continues to slowly, but persistently erode as companies borrow money at a much faster pace than they earn it. To be fair, the steady drop in the cost of borrowing has helped alleviate some of the pressure. But with most of the proceeds going toward share buy backs and dividends, the funding gap within the corporate sector continues to expand and leverage is on the rise. Finally, corporate credit valuations look stretched by most traditional measures. Indeed, according to our proprietary fair value model, the current high yield (HY) yield-to-worst (YTW) of approximately 6.37% is about two standard deviations rich. However, when you consider that HY YTW is approximately 600% above the risk free rate, it is easy to understand why the "reach-for-yield" trade continues in an otherwise expensive market. As such, we continue to advocate a Neutral/Market Weight allocation to IG and HY credit to capture current yield, and emphasize sectors that offer "defensive carry." These include IG and HY Communications, IG Utilities, IG Consumer Staples and HY Consumer Discretionary.

Corporate bond prices have been on a steady march higher this year as interest rates have plunged, yield curves have flattened and credit spreads have narrowed following the ramp-up and expansion of quantitative easing (QE) outside the U.S. Although the U.S. Fed has not participated directly in these types of programs, its lack of action and continued dovish stance has effectively endorsed a dramatic loosening of credit conditions around the world (Exhibit 1). As such, the linchpin holding the bullish trade in corporate bonds together is on-going dovish central bank policy. To the extent it continues, credit investors should expect “more of the same,” namely, higher prices, lower yields, flatter curves and tighter credit spreads.
However, should central banks start to dial back, or simply slow, their stimulative policies, then bond prices and credit spreads could be in for a sharp reversal. To be clear, we expect "more of the same," albeit at a slower pace, as sluggish growth and tame inflation should keep dovish policies in place for the time being.

- source Wells Fargo Securities

There could no better illustration of all the "fun" playing "uphill" in the bond market that is, than the above chart. You can indeed put aside the "Great Rotation" marketing ploy by some pundits given, as we stated before, the only "riskless" game for now, worth playing thanks to the "Supreme Beings" is the bond market.

While "The Cult of the Supreme Being" is still thriving, credit investors should be well advised to read the wise words of one of the members of the "Cult of Reason, namely Nassim Taleb from his recently published note entitled "The Most Intolerant Wins: The Dictatorship of the Small Minority":

"The market is like a large movie theatre with a small door. 

And the best way to detect a sucker (say the usual finance journalist) is to see if his focus is on the size of the door or on that of the theater. Stampedes happen in cinemas, say when someone shouts “fire”, because those who want to be out do not want to stay in, exactly the same unconditionality we saw with Kosher observance." - Nassim Taleb

Whereas credit risk is increasing, giving the lower for longer mantra thanks to the macro fundamentals backdrop playing out and financial repression, not only as we have highlighted credit investors have been extending credit risk, they also have extended their duration risk, increasing in effect the duration mismatch between US cash investment grade and its synthetic credit hedge tool the CDX IG series 26 5 credit index as per our final point and final chart below.

• Final chart: US Investment Grade credit - Growing duration mismatch between cash and synthetic

While we have been recommending since the beginning of the year to favor quality over quantity (High Yield and size of the coupon that is...) through US Investment Grade credit and extended duration us, being in the camp of "lower for longer", credit investors have had no choice bit to take on both more credit risk as well as duration risk thanks to "The Cult of the Supreme Being". Our final chart comes as well from Wells Fargo Securities latest Credit Connections note from the 12th of August entitled "The Linchpin" and illustrate the growing duration mismatch between "cash" and "synthetic":

"While IG26 is a reasonable, liquid hedge for IG cash bonds, it does have some limitations. 

First, there is a meaningful duration differential. IG26 has a current duration of about 4.7 years, compared to the cash bond index of 7.5. Not only is there a difference in aggregate duration, there is a meaningful difference is where that duration comes from. Increasingly, the spread duration in the cash index is being driven by the long end of the curve, where durations continue to extend due to lower coupons.

Implications for Investors 

First, to fully hedge out a market-based cash portfolio with 7.5 years of duration, would require an extra 60% of protection to result in a CR01 neutral portfolio. The extra hedging costs would still leave the trade positive carry as even an additional 60% would only cost 114 bps based on today’s current index levels. For IG investors hedging CR01 is, in many ways, just as valuable as hedging the default risk, as the risk of spread widening is more clear and present for IG companies than actual defaults.
A second consideration is the contribution to duration within the IG market. With the long end being so key to IG investors, movements in the shape of the credit curve are also important. As a result, CDX, while a reasonable proxy for the overall IG market, can be less effective in periods of significant under- or outperformance from the long end of the market. For example, the overall market widened 32 bps in 2015, as front-end spreads widened 19 while long-end spreads widened a full 43 bps. By contrast, IG CDX widened only 22 bps." - Wells Fargo Securities

This means that as hedging tool, one would need to compensate for the extended duration rise in the cash market and needs to buy more "protection" to hedge a cash investment grade credit portfolio if ones wants to be "duration neutral" that is.

Finally for our parting quote, when it comes to "The Cult of the Supreme Being" we would like to end up our conversation with yet another extract from Florin Aftalion's 1987 seminal book entitled "The French Revolution - An Economic Interpretation", over the issues and discussions surrounding the "assignats" and what the abbé Maury, a deputy on the Right had to say about them at the French National Assembly during the French Revolution:

"What is one doing when ones creates a paper currency? One is stealing at sword point. Every man in France who owes nothing, and to whom everything is owed, is a man ruined by the paper currency. Have we the right to bring about the ruin of even a single one of our fellow citizens?" - Abbé Maury, extract from "The French Revolution - An Economic Interpretation" by Florin Aftalion, 1987

Stay tuned!