Macro and Credit - Dyslipidemia

"You can stroke people with words." -  F. Scott Fitzgerald

While learning that Global debt had reached a record $237 trillion in 2017 which is more than 327% of global GDP and that since 2007 global debt has increased by $68 trillion, when it came to selecting our title analogy for this week's musing, we reminded ourselves of the medical term "Dyslipidemia". "Dyslipidemia" is an abnormal amount of lipids (e.g. triglycerides, cholesterol and/or fat phospholipids) in the blood (such as global debt). In developed countries, most dyslipidemias are hyperlipidemias; that is, an elevation of lipids in the blood such as debt levels in comparison to many Emerging Market countries. This "abnormality" level is often due to diet and lifestyle. "Dyslipidemia" can lead to cardiovascular disease, which can be symptomatic but we ramble again...

In this week's conversation, we would like to look at cracks showing up in the "growth" narrative put forward by many pundits. 

Synopsis:

• Macro and Credit - Mirror Mirror...is global growth beautiful?
• Final charts -  Confidence can turn on a dime

• Macro and Credit - Mirror Mirror...is global growth beautiful?

As we concluded our previous conversation about some stretched positioning such as long oil, short US Treasury Notes, to name a few, the recent weakness in macro data seems to point somewhat to a different story painted by the rosy tainted narrative of strong global growth which has been prevailing in recent months. As we also pointed out in our last musing, on top of weakening macro data, fund outflows have been increasing, particularly from credit funds. We also argued that the "goldilocks" narrative which had prevailed in credit markets in general and Investment Grade in particular has been changing since the beginning of the year. This is particularly due to the "technical bid" from central banks which has been prevailing for so long, on top of significant issuance levels. Yet, it seems to us that with the central banking put slowly but surely fading, rising dispersion as pointed out as well in numerous conversations is a sign of the lateness in the credit cycle given investors are becoming much more discerning at the issuer level. This also why we advised for a reduction in beta exposure as well as the need to raise cash levels, moving towards a more defensive position. 

When it comes to global data and our "Mirror Mirror", they have started to turn negative. On this subject we read with interest Bank of America Merrill Lynch's take from their Global Liquid Markets Weekly note from the 9th of April entitled "Synchronized cracks":

"Global data surprises turn negative

Synchronized global growth was the buzzword of 2017 and generally expected to continue into 2018. However, global data surprises have turned negative for the first time since mid-2017, potentially due to forecasts being optimistic in the first place. While trade tensions have been widely cited as the reason for the drop in global equities, the realized weakness in global data may be a more straightforward explanation. Chart 1 depicts the stable relationship between MSCI World returns and global data surprises over the past five years.

Markets are assuming Euro zone data deterioration will be transitory

The immediate focus in terms of weaker data is the Euro zone, where data surprises are now the most negative since the peripheral crisis. There are two unknowns here – how much of this weakness is related to weather disruptions and how much reflects a convergence of soft survey data with the reality of weaker hard data. However, this also means the typical rationale for mean reversion in data surprises (economists revising projections) is unlikely to apply here if the weakness is being attributed to temporary factors. Upcoming data, particularly the April PMIs, will be crucial and the fact that EUR has been resilient to the data deterioration suggests the pain trade for markets will be if the weakness persists.

While seasonal distortions mean China slowdown is a blind spot

The relative blind spot in our view is China. With investors mostly looking past the distortions of the Jan-Feb Chinese data, the March numbers should help provide more clarity. Our economists expect a broad deterioration in the official numbers that begin releasing this week (China Economic Watch: Preview of March and 1Q macro data: Softer activity growth momentum 05 April 2018), while some of the higher frequency indicators warrant caution as well.

• Shipments of iron ore to China’s key ports has been weakening in both annual and sequential terms (Chart 3).

The latest March data show the biggest YoY decline since 2015 in both value and volumes. This may partly reflect the very high level of inventories at Chinese ports but at least partly symptomatic of a weaker demand trend.

• Steel production data, particularly for key factories, is less sensitive to inventory swings and supply adjustments, therefore providing some indication of the state of domestic investment, particularly property and infrastructure. Data including the first 20 days of March shows production is still positive YoY but rolling over recently (Chart 4).

• Chinese asset prices are reflecting a growing sense of unease, with a simultaneous drop in commodity prices, domestic rates and equities in recent months (China – sensing the unease 21 March 2018). While this may partly reflect risk premium associated with US-China trade tensions, the fact that even non-tradeable sectors such as real estate have been hit point to domestic demand concerns as well.

Market implications

If Euro zone and China growth moderate, the assumption of synchronized global growth could be challenged. While US Treasuries are becoming desensitized to equity swings (see Rates section), economic data still matter and would temper the upside for US rates. The US dollar would benefit against high-beta commodity and EM FX, but also against the EUR where the divergence with data is extreme. Finally, we are bearish thermal coal relative to forwards (see Commodities section)." - source Bank of America Merrill Lynch

As we have hinted on many occasions, when everyone is thinking the same (in terms of the consensus positioning being very stretched), one might indeed wonder if everyone is thinking. As the central banking "technical bid" is fading, fundamentals matter more than ever. Given rising geopolitical tensions in conjunction with the trade war rhetoric seen lately, one might wonder whether this is sufficient enough to put a further dent into confidence, which has shown in the past its capacity to turn on a dime. For us the short positioning on the 10 year part of the US curve appears to us stretched. Sure the trade war narrative doesn't seem to provide some support to increase the duration exposure, though we think possible further deterioration of fundamentals could eventually cost the bond bears crowd. 

On the subject of the rates story we read with interest Bank of America Merrill Lynch "Rates" segment of their "Synchronized cracks" note:

"• Levered funds' record short positioning remains, and still a risk for bond bears.
• Unlike 2017, asset managers did most of the buying in the rally; unlike 2015-16, USTs pale vs. cash in a risk-off.
• Looking ahead, economic data hold the key for the direction of rates more than equity markets.

This time is different

In our view, the impact of trade tensions ultimately translates into higher rates. As we detail here, the market is only reacting to the growth impact of tariffs but not the inflation impact with both real rates and breakevens lower since February.
In terms of flows, the two biggest differences in this rally compared to recent history are: 1) most of the UST buying came from asset managers, not short covering from levered funds; 2) the rise of cash as a Treasury alternative in risk-off moves. The former suggests economic data hold the key for the direction of rates, more so than risk-off flows; the latter is a confirmation of our view that cash as the new ‘safe haven’ asset threatens the stock/bond correlation.

Levered funds positioning risk remains

Despite the 10% equity market correction and the 20bp rally in 10y rate from February highs, levered funds community stood firm with their net short positions in the futures market. According to CFTC data, the week following the March FOMC meeting did see some profit taking, especially in the 2-year contract. However, overall positioning among levered funds barely budged from the record shorts reached a few weeks ago (Chart 5).

While we have seen evidence of UST short positioning unwind among European investors, the risk of a rally led by positioning unwind remains.

Asset managers did most of the buying since Feb, unlike 2017

Compared to a year ago, this time is different. Much of the buying over the last two months came from asset managers – Treasury futures market saw about $70bn (in 10y equivalent terms) increase in net long positions from this community, whereas levered funds saw $13bn increase in net shorts over the same period. A year ago, the month after March 2017 FOMC meeting saw over 40bp rally in 10y Treasuries and levered funds bought the most, with almost $40bn reduction in net shorts (Chart 6).

The asset manager demand recently was likely propelled by the volatility in risk assets, whereas the levered funds buying in 2017 was driven by a slowdown in tax reform progress and disappointing economic data after Q1.

Cash is now a competing asset

The other interesting development in this risk-off move was the rise of cash as an asset class, threatening rate/equity correlation. Unlike what we were used to seeing, government bond fund inflows in recent weeks were almost negligible compared to historical episodes, especially funds investing in medium and long maturity securities (Chart 7).

At the same time, evidence from money market fund flows reflects greater interest in cash. Seasonally, Q1 tended to see outflows from these funds largely due to anticipation of tax-related withdrawals. However, February and March saw almost $30bn inflows, compared to the average of $40bn outflows from 2012 to 2017 (Chart 8).

Holding cash in the MMF now seems to be a much better alternative for many investors than holding Treasuries with much bigger duration risk.

Watch what the data say, not just what the stocks do

The fact that levered funds are willing to shrug off the risk-off moves in the equity market and trade discussions suggest to us that the driver behind the market volatility is more important than the volatility itself. While we have seen sporadic weaker economic data prints in the US from the consumer side, it’s not enough to convince investors the growth momentum has run its course. The risk-off move could certainly put pressure for rates to move higher, the ultimate test though comes down to the data." - source Bank of America Merrill Lynch

Mirror, Mirror...indeed, watch the data more and more, because it matters. We do agree with Bank of America Merrill Lynch that it is becoming more important than volatility itself. Sure, investors are not convinced yet the growth momentum has run its course, but, as per confidence, the stretched positioning seen on the long end of the US yield curve has the potential to change rapidly should the growth narrative appears to what it seems to us, namely, slowing. No offense to the bond bears out there but even in this much vaunted global synchronized recovery narrative, yield can and will move lower as shown in the below chart from Bank of America Merrill Lynch The Flow Show note from the 12th of April entitled "Gold-ishocks":

"Buried Treasuries: record pace of YTD US Treasury inflows ($18.6 YTD, $3.4 this week); global synchronized recovery, record profits, low unemployment, massive fiscal stimulus, Fed selling, $70 oil…yet 10-year USTs still unable to break >3% and equities (homebuilders down, utilities up – Chart 3) confirm yields can move lower.

- source Bank of America Merrill Lynch

If you want to play the "bond bears" at some point down the credit cycle road then obviously, you should look at credit markets. As we posited in our previous musing, given the size of the ETF complex in that space and dwindling inventories since the Great Financial Complex, you don't need to be a genius to figure out, that the ETF Fixed Income complex dwarfs the "exit" door. 

As a reminder:

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

This is what we wrote in our November 2017 conversation "The Roots of Coincidence":

"When it comes to the paranormal phenomena of the low volatility regime instigated by our central bankers, no offense to their narrative" but modern physics still works and normalisation of interest rates should lead to some repricing and a less repressed volatility in conjunction to a fall in the "free put" strike price set up by our central planners in 2018. You probably do not want to hold on too long on "illiquid parts" of your portfolio going forward, given, as many knows, liquidity is indeed a coward.

As we move towards 2018, the big question on everyone's mind should be the sustainability of the low volatility regime which has been feeding the carry trade and the fuel for the beta game" - source Macronomics, November 2017

If liquidity is a coward, then obviously reducing the illiquid beta part of your portfolio would be a sensible thing to do. While we have seen some flows return to High Bonds according to Bank of America Merrill Lynch to the tune of $0.4 billion which has been the first inflow for the last 13 weeks and with some rebound as well in Investment Grade with $3.8 billion inflows (66 fund inflows of past 68 weeks), the narrative we think is slowly changing for "goldilocks" in the credit space. This is probably tied up to lower volatility in interest rate volatility and it remain to be seen if the important Japanese investing crowd will return in the coming weeks to US credit markets shores. So yes we could see short term some sort of "relief rally" but we don't expect this to last medium term.

As we pointed out earlier on in our conversation, the central banking technical bid is fading and fundamentals are starting to matter more again. On that note we read with interest Société Générale's note from the 11th of April entitled "The Sword of Damocles - 2Q18 Outlook - Why spreads should widen and how to protect your portfolio":

1. The real worry is whether growth will slow in 2019, and defaults rise in 2020.
2. We see a return to late 2015 levels on this fear.
3. Avoid high beta credits and cyclicals. Be defensive.

1. The market is expensive
2. And valuations are the mother of returns
3. Asset allocators may switch credit for cash and equities (though it is slow to do)

The worst combination would be higher inflation and weaker growth. Yet it is not impossible.

Conclusion on technicals:

1. Supply has been low but should accelerate.
2. ECB demand will decline (as we all know).
3. Which means Europe will follow the US, and it is too expensive." - source Socété Générale

In our credit book as well, increase dispersion, should eventually drive spreads wider particularly in the light of our recent comments surrounding the rise in leverage and the fall in credit quality overall. For the moment, dispersion are coming from single names rather than sectors such as we have seen in the past with the energy sector credit woes in 2016 and recent credit woes in the retail sector. We expect dispersion to rise and impact more sectors going forward. Of course the usual suspects in the US are where the "leverage" is namely tech and healthcare but, that's not a secret. 

If inflation is indeed accelerating and growth is slowing, then again, the dreaded "stagflation" word comes to mind as we posited also in past musings. Back in October in our conversation "Who's Afraid of the Big Bad Wolf?", we indicated that for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation. Sure the explosion of the pigs' short-vol house of straw was triggered by sudden fear of rising wage inflation, but, we continue to believe that a sudden burst of inflation, would no doubt take down their "credit" houses of straw and twigs:

"If as indicated by Christopher Cole, volatility is the brother of credit, then obviously assessing the longevity of the credit cycle is paramount. We do agree with Christopher that, for the time being, we do not see the credit stress required for a sustained expansion of volatility. It's only when the Big Bad Wolf will rear its ugly face that we will change our "Practical yield pigs" stance. But if indeed the credit cycle matters from an Ouroboros perspective, then obviously one has to wonder how the death of the credit snake comes about" - Macronomics

We pointed out as well in this prior conversation that credit cycles die because too much debt has been raised in the final point of this long conversation. Yet another veiled reference to "Dyslipidemia" one could point out. 

 Some might point out, it could be too early to see the fear of trade wars sapping "confidence" in the growth outlook, but we do think as per our last point, that when it comes to "growth" and "stability" in complex structures such as financial markets, confidence matters.

• Final charts -  Confidence can turn on a dime

While geopolitical tensions are quite palpable, the increasing trade war narrative has proven in the first quarter to be "bullish" gold as we anticipated. We believe that for a continuation of the global growth narrative to prevail, confidence matters and matters a lot. We continue to see cracks in the macro narrative on both the hard side as well as a weaker tone now in soft data such as consumer confidence. Our final charts come from Bank of America Merrill Lynch Global Economic Weekly note from the 13th of April entitled "Fear factor" and display the reaction of various equity markets since the announcement of steel and aluminum tariffs as well as the Global PMI Manufacturing New Export Orders and Volume of world merchandise trade:

"Fear factor

One of the striking developments in the last two years is how investors, consumers and business leaders have learned to shrug off confidence shocks. The result is not only a steady pick-up in confidence indicators, but a pick-up in growth as well. In recent weeks, however, the markets seem to have found something they can’t dismiss: the prospect of trade wars. Here we argue that the way this “war” is developing, the US is the most exposed, followed by China and then relatively open economies around the world. This is because the US is looking to change its relationship with all of its major trading partners, with a particular focus on China. In other words, while most countries are “fighting” on only one front, the US is fighting on many fronts.

Let’s take a look at signs of confidence effects thus far, and what to watch if the “war” escalates.

First responder: global equity markets

It is much too early for fears of trade wars to impact hard data. In the meantime, equity markets are the best canary in this coal mine. Chart 1 shows the change in equity prices since the day before the steel and aluminum tariffs were announced for the US and the countries the Trump Administration is targeting.

Not surprisingly, the US (S&P 500) and China (Shanghai Composite Index) markets have dropped the most over this period.

Thus far the equity market seems to be pricing in a high probability of a benign outcome, with small drops in response to major threats and then rebounds on more assuring comments. The market response to the US-Korea trade deal is also telling. Korea made concessions on autos, steel and currency manipulation, but there was virtually no response for stock prices of the impacted companies. For example, Korea agreed to raise its quota on US car imports from 25,000 to 50,000. However, the “big three” US companies only shipped 19,911 cars to Korea last year. Not surprising the stock price of US and Korean car companies shrugged off the news.

Second responder: confidence surveys

A similar story applies for confidence indicators. As Michelle Meyer and team show, there are early hints that trade war fears are impacting confidence indicators in the US, particularly for manufacturing firms. Canadians are also growing concerned. The latest Business Outlook Survey from the Bank of Canada found that “while firms’ expectations for US economic growth have strengthened further, some cited rising protectionism and reduced competitiveness as factors limiting the impact on their sales.” The survey also shows a shift toward negative views of US policy overall. Asked how US policies had impacted “your business”: a year ago 11% said favorably and 10% unfavorably while in the latest survey 8.8% said favorably and 20.1% unfavorably. Confidence in Mexico dipped sharply in response to the initial threats to NAFTA, but has rebounded recently on hopes of minor changes to the treaty.

Outside of the NAFTA region, only Germany seems worried. Here are some representative thoughts from our regional economists:

• Germany: According to the latest IFO survey, “the threat of protectionism is dampening the mood in the German economy.”
• UK: The local press has generally reported this as something that is happening elsewhere rather than to the UK.
• Japan: Our equity analysts say firms don’t seem overly concerned about trade wars.
• Australia: At this stage, the press has focused on the opportunities these frictions presents for Australian exporters, particularly in agriculture. Perhaps the most important hint of global risk comes from Purchasing Managers reports. The global index of manufacturing export orders dipped in February and March (Chart 2). 

Two months does not make a trend, and the level of the index is still healthy, but this bears watching.

The biggest loser(s)

It is not surprising that even a small probability of an outright trade war is resonating in the markets. After all, the main battle involves the two most important economies in the world. It also comes at a time when stronger trade is underpinning global growth. The World Trade Organization reports that the growth in global merchandise trade volumes accelerated from 1.8% in 2016 to 4.7% last year. Hence, after a period of weakness, trade is again significantly outgrowing GDP. Looking ahead, they expect 4.4% growth this year, but also present a downside scenario in which trade volumes drop (Chart 3).

- source Bank of America Merrill Lynch

For us, stretched positioning in conjunction with geopolitical risks are major looming threats. That simple. This could lead to a "hot summer" indeed. Sell in May and go away? As say the old adage, in the current case of "Dyslipidemia", high cholesterol and high blood pressure do not mix well, in similar fashion, high debt level (leverage) and volatility do not either...

"Confidence is contagious. So is lack of confidence." - Vince Lombardi

Stay tuned !

Macro and Credit - Buckling

"There exists everywhere a medium in things, determined by equilibrium." -  Dmitri Mendeleev, Russian scientist

Watching with interest the slowly grind higher in US interest rates with some weakening signs coming from US economic data such as the US trade deficit in goods getting spanked with orders for larger domestic appliances and other durable goods falling by a cool 3.7% from the month before, led by a hard drop in vehicle demand, when it came to choosing our title analogy for this week's conversation we reminded ourselves of "buckling" being a mathematical instability that leads to a failure mode. When a structure is subjected to compressive stress, buckling may occur. Buckling is characterized by a sudden sideways deflection of a structural member. This may occur even though the stresses that develop in the structure are well below those needed to cause failure of the material of which the structure is composed. As an applied load is increased (US interest rate hikes) on a member, such as a column, it will ultimately become large enough to cause the member to become unstable and it is said to have buckled. Further loading will cause significant and somewhat unpredictable deformations, possibly leading to complete loss of the member's load-carrying capacity. If the deformations that occur after buckling do not cause the complete collapse of that member, the member will continue to support the load that caused it to buckle. If the buckled member is part of a larger assemblage of components such as a building, any load applied to the buckled part of the structure beyond that which caused the member to buckle will be redistributed within the structure. In a mathematical sense, buckling is a bifurcation in the solution to the equations of static equilibrium. At a certain point, under an increasing load, any further load is able to be sustained in one of two states of equilibrium: a purely compressed state (with no lateral deviation) or a laterally-deformed state. Obviously we thing that financial markets have reached a bifurcation point and we have yet to see how the buckle of rising interest rates will be redistributed within the complex structures without leading to some renewed avalanche in some parts of the markets.

In this week's conversation, we would like to look at the vulnerability of equities and credit markets to a more hawkish tone of the Fed which would lead to more aggressive rate hikes should the "Big Bad Wolf" aka inflation continue to rear its ugly head.  

Synopsis:

• Macro and Credit - Hike it till you break it
• Final chart - Afraid of buckling? Watch credit availability

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. Given the arrival of a new Fed "sheriff" in town one might wonder if the pace will be as gradual as it seems should the Fed feels it is falling behind the curves when it comes the "Big Bad Wolf" aka inflation and current loose financial conditions. As we pointed out in our recent conversations the recent uptick in inflation coincided with a sharp sell-off in equities. Sure, one would point out to us that correlation doesn't mean causation, but, it certainly felt like the very crowded short-volatility complex was looking for a match that triggered the explosion and for some their ultimate demise.  The U.S. Average Hourly Earnings triggered the "buckling" as it brought back the fear in the markets of the return of the Big Bad Wolf aka "inflation".  For some it seems like us, it seems the "Big Bad Wolf" has already blown apart the "short vol" pig's house which was made of straw. If indeed the short-vol house was made of straw we wonder if the pig's equities markets house is made of sticks or and if the pig's credit markets house is made of bricks. 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.

When it comes to the bounce back for equities following the short-vol avalanche, which could have been possibly triggered by the recent uptick of inflation, we read with interest Deutsche Bank's Asset Allocation note from the 23rd of February entitled "Inflation and Equities" with the long summary below:

"The recent uptick in inflation coincided with a sharp correction in equities

Whether this was cause and effect is debatable for a variety of reasons and around half the correction reversed quickly (Stretched Consensus Positioning, Jan 31 2018; An Update On The Unwind, Feb 12 2018). Nonetheless, late in the business cycle with a tight labor market, strong growth, a lower dollar, higher oil prices and a fading of one off factors, all point to inflation moving up. What does higher inflation mean for equities? We discuss five key questions.

Is inflation bad for margins and earnings? Historically, higher inflation has been associated with higher margins and strong earnings growth

■ Conceptually, higher inflation is ambiguous. From a pricing vs cost perspective, whether higher inflation leads to higher or lower margins depends on the relative strengths of price vs wage and other input cost inflation. It depends on the relative importance of variable vs fixed costs. And on the extent to which corporates can increase productivity in response to cost pressures. It is notable that while markets seem to have been surprised by the recent uptick in wage inflation, corporates have been noting it for at least a year. Finally, inflation does not occur in a vacuum. The drivers of higher inflation matter and when it reflects strong growth, it implies not only higher sales but operating leverage from fixed costs can raise margins and amplify the impact on earnings.

■ Historically, the empirical evidence is unambiguous. Higher inflation was clearly associated with higher margins and strong earnings growth.

Does higher inflation mean lower equity multiples? By how much? A 1 pp rise in inflation compresses equity multiples by 1 point or a decline in prices of around 5% from recent pre-correction levels

■ The correlation between bond yields and equities depends on the driver: inflation (-) or real rates (+). Contrary to popular notions that higher bond yields mean lower equities, the historical relationship between bond yields and equities has been ambiguous (Long Cycles In The Bond-Equity Correlation, May 2014). Instead, the impact of higher yields on equities depends on whether they reflect higher inflation (-) which has always been negative for equities; or whether higher yields reflect higher real rates (+) which have always been positive for equities until real rates reached very high levels (greater than 4%--seen only once during the Volcker disinflation) (Do Higher Rates Mean Lower Equity Multiples? Sep 2014).

■ Why is higher inflation negative for equity valuations? When inflation moves up, the hurdle rate for all nominal investments moves up and in turn bond yields and earnings yields (inverse of the equity multiple) move up.

■ A 1pp rise in inflation compresses multiples by 1 point. A majority (70%) of the historical variation in the S&P 500 multiple is explained by its drivers: earnings/normalized levels (-); payouts (+); rates broken up into inflation (-) and real rates (+); and macro vol (-). Our estimates imply that a 1pp rise in inflation lowers the equity multiple by 1 point or a 5% decline in prices from the recent peak. Our house view and the consensus sees a somewhat smaller rise in inflation over the next 2 years. These ranges of increases in inflation imply a modest pullback in equities that would put it within the bands of normal 3-5% pullbacks that have historically occurred every 2-3 months.

Is the inflection in inflation a leading indicator of the end of the cycle? How long is the lead? On average 3 years, but the Fed’s reaction is key

With an average correction in equities of 21% around recessions, the timing of the next one is obviously key. If the recent uptick marks the typical mid- to latecycle inflection up in inflation, how long after did the next recession typically occur? On average 3 years, which would put it in late 2020. But the timing is likely determined critically by the Fed’s reaction. Historically, a Fed rate-hiking cycle preceded most recessions since World War II, with recessions occurring only after the Fed moved rates into contractionary territory. Arguably the Fed did this only after it was convinced the economy was overheating and it continued hiking until the economy slowed sufficiently or went into recession. At the current juncture, core inflation has remained below the Fed’s target of 2% for the last 10 years and several Fed officials have argued for symmetry in inflation outcomes around the target, i.e., to tolerate inflation above 2%. It is thus likely that the Fed will welcome the rise in inflation for now and simply stick to its current guidance, possibly moving it up modestly.

How high will inflation go? If inflation expectations remain range bound, core PCE inflation will stay within its narrow band of 1-2.3% in which it has been for the last 23 years

■ Outside the Great Inflation of 1968-1995, core PCE inflation has remained in a remarkably narrow band (Six Myths About Inflation, Oct 2017). The period since 1996 encompassed 3 business cycles that saw unemployment fluctuate between 3.8% and 10%; the dollar rise and fall by 40% more than once; oil prices rise 7-fold and almost completely reverse. Yet inflation remained in a narrow band unusual for an economic time series. Indeed, with a standard deviation of 35 bps, much of the range of variation in inflation since 1996 cannot be differentiated from the normal noise inherent in macro data.

■ The stability of inflation across large business- dollar- and oil-cycles in our view reflects the stability of inflation expectations which are the only driver of inflation over the long run. Inflation expectations have been stable since the mid-1990s, fluctuating for most of the last 23 years in a tight 50bps range and for most of it in an even narrower 30bps range. Following the dollar and oil shocks of 2014-2015, inflation expectations fell out of and are still 20bps below this range and 50bps below average. Absent large unexpected and persistent shocks, inflation expectations evolve slowly. It has in fact been difficult for policy makers to effect changes in inflation expectations as the recent experience of Japan and  the 10-year miss on the core PCE inflation target in the US illustrate (Six Myths About Inflation, Oct 2017).

What about all the stimulus? The impact of the stimulus will follow a pickup in growth with long lags (1½ years)

■ It is well known that inflation responds with long lags to growth, a tightening labor market and the dollar. Consider that the correlation between real GDP growth and core CPI inflation is a modest positive 5%. But when GDP growth is lagged by 6 quarters, the correlation jumps to a much stronger 80%. The lagged relationship implies that a sustained 1pp increase in GDP growth raises core inflation by 20bps after 1½ years. Our house forecast for GDP growth which is above consensus implies GDP growth of near 3% and core inflation peaking around 2.2% in 2020.

■ Growth outcomes significantly above our house view would need to materialize and sustain to raise inflation above and outside the band of the last 23 years. Moreover there would be plenty of lead time with growth needing to sustain at high levels for a prolonged period (1½ years) before it moved inflation up."  - source Deutsche Bank

As we repeated in numerous conversation, 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. But what is very interesting to us is that the buildup in the trade war rhetoric coming from the US could be a harbinger for higher inflation down the line given that companies would most likely increase their prices with rising import prices that would be passed on already stretched consumers thanks to solid use of the credit cart (nonrevolving credit). 

In our 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. 

To preserve corporate margins, output prices will need to rise, that simple, and it is already happening. This can have a significant impact on earnings particularly when the S&P 500 Net Income Margins LTM is at close to record levels as indicated in Deutsche Bank's note:

"Inflation and earnings

Is inflation bad for margins and earnings? Historically, higher inflation has been associated with higher margins and strong earnings growth

■ Conceptually, higher inflation is ambiguous. From a pricing vs cost perspective, whether higher inflation leads to higher or lower margins depends on the relative strengths of price vs wage and other input cost inflation. It depends on the relative importance of variable vs fixed costs. And on the extent to which corporates can increase productivity in response to cost pressures. It is notable that while markets seem to have been surprised by the recent uptick in wage inflation, corporates have been noting it for at least a year. Finally, inflation does not occur in a vacuum. The drivers of higher inflation matter and when it reflects strong growth, it implies not only higher sales but operating leverage from fixed costs can raise margins and amplify the impact on earnings.

■ Historically, the empirical evidence is unambiguous. Higher inflation was clearly associated with higher margins and strong earnings growth.

- source Deutsche Bank

With the S&P 500 Net Income Margins LTM close to record levels and with the recent rise in prices operated by companies recently, it remains to be seen how long can margin levels remain this elevated. Sure, the fiscal boost provided by the US government should provide additional support yet the big question for us is relative to the US consumer and its sensitivity to rising prices as we discussed in the final point of our conversation "Harmonic tremor". Have we seen peak "Consumer confidence" and peak PMIs recently? One thing for certain is that Citigroup’s US Economic Surprise Index (CESIUSD Index) as an indicator of economic momentum has started to "buckle" recently. There is a clear relationship between the CITI's Economic Surprise Index and the Fed's monetary policy. When the Fed is in tightening mode, good news such as rising inflation expectations is generally seen as bad news. In spread terms, only high yield is sensitive to macro surprises. Moreover, the response of high yield spreads to macro surprises is "monotonic" in ratings: the lower the rating, the stronger the response. In our conversation "A shot across the bows", we indicated the following when it comes the Citi Economic Surprise Index (CESI). It could potentially indicate that economic fundamentals are trading ahead of themselves and could portend some credit spreads widening in the near future given there is a reasonably strong relationship between the inverse of Citigroup Economic Surprise Index and both the IG CDX and HY CDX. So all in all, you want to watch what the CESI does in the coming weeks and months. 

But moving back to the impact of the "Big Bad Wolf" aka inflation on equity multiples, we read with interest as well the other part of Deutsche Bank's report on the impact inflation can have:

"Inflation and equity multiples

Does higher inflation mean lower equity multiples? By how much? A 1 pp rise in inflation compresses equity multiples by 1 point or a decline in prices of around 5% from recent pre-correction levels

■ The correlation between bond yields and equities depends on the driver: inflation (-) or real rates (+). Contrary to popular notions that higher bond yields mean lower equities, the historical relationship between bond yields and equities has been ambiguous (Long Cycles In The Bond-Equity Correlation, May 2014). Instead, the impact of higher yields on equities depends on whether they reflect higher inflation (-) which has always been negative for equities; or whether higher yields reflect higher real rates (+) which have always been positive for equities until real rates reached very high levels (greater than 4%--seen only once during the Volcker disinflation) (Do Higher Rates Mean Lower Equity Multiples? Sep 2014).

■ Why is higher inflation negative for equity valuations? When inflation moves up, the hurdle rate for all nominal investments moves up and in turn bond yields and earnings yields (inverse of the equity multiple) move up.

■ A 1pp rise in inflation compresses multiples by 1 point. A majority (70%) of the historical variation in the S&P 500 multiple is explained by its drivers: earnings/normalized levels (-); payouts (+); rates broken up into inflation (-) and real rates (+); and macro vol (-). Our estimates imply that a 1pp rise in inflation lowers the equity multiple by 1 point or a 5% decline in prices from the recent peak. Our house view and the consensus sees a somewhat smaller rise in inflation over the next 2 years. These ranges of increases in inflation imply a modest pullback in equities that would put it within the bands of normal 3-5% pullbacks that have historically occurred every 2-3 months.

- source Deutsche Bank

Obviously from a "buckling" perspective the big question is whether higher yields reflect higher real rates (+) which have always been positive for equities until real rates reached very high levels, or, are they reflecting a higher inflation risk, in which case the repricing could be more severe as the Fed would probably step up on its hiking gear. For the positive momentum to hold and goldilocks environment to continue, you would need inflation and growth not running too hot, so that the Fed can gradually hike rather than stepping up its hiking pace. This is as well clearly highlighted by Charlie Bilello from Pension Partners in his blog post from the 15th of February entitled "Inflation, deflation and stock returns".

Again, it is a matter of "velocity" in the movement. An exogenous factor such as a geopolitical event that would trigger a sudden and rapid rise in oil prices would of course upset the situation and be much more negative for equities as we saw with the huge rise in oil prices prior to the Great Financial Crisis (GFC) of 2008.

One might therefore rightly ask if indeed inflation could be a leading indicator for recession. This is also a point which has been discussed in Deutsche Bank's very interesting note:

"Inflation as a leading indicator of recession

Is the inflection in inflation a leading indicator of the end of the cycle? How long is the lead? On average 3 years, but the Fed’s reaction is key

With an average correction in equities of 21% around recessions, the timing of the next one is obviously key. If the recent uptick marks the typical mid- to latecycle inflection up in inflation, how long after did the next recession typically occur? On average 3 years, which would put it in late 2020. But the timing is likely determined critically by the Fed’s reaction. Historically, a Fed rate-hiking cycle preceded most recessions since World War II, with recessions occurring only after the Fed moved rates into contractionary territory. Arguably the Fed did this only after it was convinced the economy was overheating and it continued hiking until the economy slowed sufficiently or went into recession. At the current juncture, core inflation has remained below the Fed’s target of 2% for the last 10 years and several Fed officials have argued for symmetry in inflation outcomes around the target, i.e., to tolerate inflation above 2%. It is thus likely that the Fed will welcome the rise in inflation for now and simply stick to its current guidance, possibly moving it up modestly.

- source Deutsche Bank

It is most likely that the Fed's hiking process was due to its fear of not being behind the curve when it comes to rising inflation. Yet with a yield curve flattening and loose financial conditions in conjunction with renewed fear of a trade war that would entail pricing pressure and imported inflation with a bear market in the US dollar, there is indeed a big risk in having the Fed having to move at a more rapid pace than it would like to. The balancing act of the Fed is incredibly difficult but, it boast a first mover advantage other the likes of the ECB and the Bank of Japan. Volatility might have been repressed but in all honesty, it is in Europe where the repression has been the most acute as it can be seen in government bond yields.

The big question surrounding the potential lethality of the "Big Bad Wolf" aka inflation lies in the velocity of inflation expectations. On that specific point, Deutsche Bank gives us additional food for thoughts in their lengthy note:

"Inflation and inflation expectations

How high will inflation go? If inflation expectations remain range bound, core PCE inflation will stay within its narrow band of 1-2.3% in which it has been for the last 23 years

■ Outside the Great Inflation of 1968-1995, core PCE inflation has remained in a remarkably narrow band (Six Myths About Inflation, Oct 2017). The period since 1996 encompassed 3 business cycles that saw unemployment fluctuate between 3.8% and 10%; the dollar rise and fall by 40% more than once; oil prices rise 7-fold and almost completely reverse. Yet inflation remained in a narrow band unusual for an economic time series. Indeed, with a standard deviation of 35 bps, much of the range of variation in inflation since 1996 cannot be differentiated from the normal noise inherent in macro data.

■ The stability of inflation across large business- dollar- and oil-cycles in our view reflects the stability of inflation expectations which are the only driver of inflation over the long run. Inflation expectations have been stable since the mid-1990s, fluctuating for most of the last 23 years in a tight 50bps range and for most of it in an even narrower 30bps range. Following the dollar and oil shocks of 2014-2015, inflation expectations fell out of and are still 20bps below this range and 50bps below average. Absent large unexpected and persistent shocks, inflation expectations evolve slowly. It has in fact been difficult for policy makers to effect changes in inflation expectations as the recent experience of Japan and the 10-year miss on the core PCE inflation target in the US illustrate (Six Myths About Inflation, Oct 2017).

- source Deutsche Bank

As long as growth and inflation doesn't run not too hot, the goldilocks environment could continue to hold for some months provided, as we mentioned above there is no exogenous factor from a geopolitical point of view coming into play which would trigger an acceleration in oil prices. Though, in similar fashion to volatility, the game can continue to be played provided "implicit inflation" or "inflation expectations" remain below "realized" inflation. In similar fashion to the demise of the short-vol trade, if there is a change in the 23 years narrative and suddenly "realized" inflation is above "expectations" then obviously this would be another grain of sand that could trigger some new avalanches in financial markets. We are not there yet we think.

Finally in our final chart below, given the late stage of the credit game, we think it is becoming essential to track any changes in credit availability in the months ahead given our loose financial conditions have been and the flattening of the US yield curve.

• Final chart - Afraid of buckling? Watch credit availability

We have long posited that "Credit availability" is essential and a good predictor of upcoming defaults as far as US High Yield is concerned. The most predictive variable for default rates remains credit availability and if credit availability in US dollar terms vanishes, it could portend surging defaults down the line. The quarterly Senior Loan Officer Opinion Surveys (SLOOs) published by the Fed are very important to track. The SLOOS report does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. Tightening in credit standards in conjunction with rate hikes will eventually weight on High Yield, and we are already seeing some fund outflows in the asset class (15th consecutive week). Our final chart comes from CITI Global Economics View note from the 23rd of February entitled "How Could Equity Sell-offs Affect Global Growth" and displays US Non-financial corporations Debt Outstanding as a percentage of GDP and AAA-BBB Effective Yield Spread for Industrial Corporate Bonds (1997-2017):

"What to watch?Given that a tightening in financial conditions poses a risk to the outlook, we would monitor:

• The durability of the sell-off: that’s rather obvious – a brief period of financial tightening is unlikely to have any material implications on the real economy.
• Credit availability and credit spreads: given the stage of the business cycle, prospects for higher inflation, and lower monetary accommodation in advanced economies, we think credit availability and credit spreads amid high leverage across some sectors and economies are key indicators to assess whether financial conditions are starting to feed through to economic activity (Figure 6).

• Sentiment measures: measures of household and business sentiment are at very high levels across most AEs. A decline in sentiment would probably be a precursor to some moderation in spending intentions, even though the relationship between consumer sentiment and real consumption appears to have declined in recent years." - source CITI

If further loading of the credit mouse trap will eventually cause significant and somewhat unpredictable deformations, possibly leading to complete loss of the member's load-carrying capacity, low recoveries and significant losses for credit investors, when it comes to assessing a potential "buckling" in the credit markets, apart from the "Big Bad Wolf" aka inflation being the enemy of volatility and leverage, credit availability is an essential part of the credit cycle.

"Prepare for the unknown by studying how others in the past have coped with the unforeseeable and the unpredictable." - General George S. Patton

Stay tuned !