Macro and Credit - The Korsakoff syndrome

"A nation that forgets its past can function no better than an individual with amnesia." -  David McCullough, American historian

Watching with interest the continuation of "Mack the Knife" (King Dollar + positive real US interest rates) Emerging Markets bloody rampage with Gold continuing to suffer thanks to Gibson Paradox (negative correlation between gold prices and real interest rates), and also reminding ourselves it has been ten years since the onset of the Great Financial Crisis (GFC), when it came to selecting our title analogy, we decided to go for the Korsakoff syndrome. The "Alcoholic" Korsakoff syndrome is an amenestic disorder caused by thiamine deficiency (Vitamin B) associated with prolonged ingestion of alcohol (or QE...some might argue). This neurologic disorder is caused by lack of thiamine in the brain and is as well exacerbated by the neurotoxic effects of alcohol (or QE...).  The syndrome and psychosis are named after Sergei Korsakoff, a Russian neuropsychiatrist who discovered the syndrome during the late 19th century. There are seven major symptoms of alcoholic Korsakoff syndrome (amnestic-confabulatory syndrome): 

1. anterograde amnesia, memory loss for events after the onset of the syndrome
2. retrograde amnesia, memory loss extends back for some time before the onset of the syndrome
3. amnesia of fixation, also known as fixation amnesia (loss of immediate memory, a person being unable to remember events of the past few minutes)
4. confabulation, that is, invented memories which are then taken by the patient as true due to gaps in memory, with such gaps sometimes associated with blackouts
5. minimal content in conversation
6. lack of insight
7. apathy – the patients lose interest in things quickly, and generally appear indifferent to change.

Back in 2011, in our conversation "Anterograde and Retrograde Amnesia", we commented on the dollar liquidity crisis which was brewing at the time and severely impacted EM as well as the European banking sector as whole which was saved by the ECB's LTROs late that year. The difference of course this time around is thanks to the ECB support, European financials credit spreads have not exploded à la 2011. Yet, with the Fed busy withdrawing liquidity thanks to QT in conjunction with a rising US dollar, as a reminder, a liquidity crisis always lead to a financial crisis. That simple, unfortunately.

We touched on the various form crisis could take in our long February 2016 conversation "The disappearance of MS München". While we won't go again about the various forms a crisis can take, from a currency crisis to a credit crisis, everyone not suffering from the Korsakoff syndrome is rightly asking when this already long cycle will end and what to look for.

In this week's conversation, we would like to look at the potential signs marking the end of the cycle.

Synopsis:

• Macro and Credit - What to look for the Boom moving to Bust?
• Final chart - Boom to Bust? Follow high-yield corporate bond mutual funds flows...

• Macro and Credit - What to look for the Boom moving to Bust?

There is no doubt that liquidity issues always lead to financial crisis. This was the case in 2011 and the ECB prevented the meltdown in the European banking system with its LTROs which was followed by Swap agreements with the Fed. The normalization process followed by the Fed in conjunction with its QT is of course validating our much vaunted global macro reverse osmosis theory discussed on numerous occasions on this very blog hence the continues pressure applied on Emerging Markets thanks to the surge in the US dollar, providing a strong headwind on gold for the time being. 

Given the 10 year anniversary of the GFC, many pundits are questioning how long until the music stops given the flattening of the yield curve as a sign we are reaching the end of the credit cycle. Timing is of course everything, eventually perma bears will be right but the question is when. On this subject we read with interest CITI's latest Global Multi-Asset View entitled "For Whom the Clock Ticks: How Long Till End-Cycle" published on the 4th of September:

"Even a broken clock...

“A man with a watch knows what time it is. A man with two watches isn’t so sure.”
- Segal’s law

Probably the most common question any strategist gets asked is where we are in the investment cycle. Even those who don’t like our debt-equity clock seem to have a triangle or a wave or some equivalent alternative: the notion of the economic cycle, and how markets respond to it, is simply the foundation of how most people think about investing.

But recent months have revealed a problem – even for strategists purportedly using the same framework. While Rob and the equity strategists would put the hands on the clock earlier in “Phase 3” – say 7 o’clock (Figure 1) – Matt and the credit strategists argue markets are closer to Phase 4, or 9 o’clock (Figure 2) – if indeed they recommend using the clock these days at all.

Our debate mirrors parallel discussions on the shape of the US yield curve. Many economists are dismissive of its current flatness, arguing that it has been distorted by QE, and that rising inflation should soon lead to higher yields and steeper curves. But others, including the San Francisco Fed, our rates strategists and our credit strategists, argue that its steady flattening poses a genuine and immediate problem for risk assets.

Settling these questions is of critical importance. This is especially true for equity investors, who face the dangerous challenge of riding a late-cycle bull market but avoiding the end-cycle carnage when it breaks. Credit investors lose out in both stages, but somehow they seem resigned to that.

While we always receive a steady stream of such questions, recent weeks have seen the trickle turn into a torrent – perhaps fuelled both by the yield curve and this year’s fading returns in most assets outside the S&P. These enquiries are coming not only from traditional asset managers but also from corporates, private equity,  infrastructure and other “alternatives” investors – counterparties whom we do not speak to regularly, and who may well change their positions only once or twice a cycle.

This note is designed at least to air our differences, if not necessarily to resolve them. First, we lay out how the cycle has worked traditionally, and explain why markets seem to follow a global cycle even in the face of regional and sectoral differences in growth and in earnings. Second, we examine the many ways in which this cycle has bucked the traditional pattern. Finally, we look for guidance in history as to what really triggers the transition to Phase 4, and hence what happens next. Unfortunately it is hard to provide definitive answers: we argue that much depends on whether you think the cycle is driven by fundamentals or by market movements, and on whether this cycle’s distortions have merely slowed down the clock’s alarm function, or broken it entirely.

How the cycle works

Our thoughts on how the cycle is supposed to work haven’t really changed over the decades. Companies go through regular phases of leveraging and deleveraging, and you can normally tell where you are in the cycle both from what they’re doing with their balance sheets and from the response in credit and equity markets. Here’s how we put it back in 2005:

Starting at 12 o’clock, in the depths of recessions companies go through intense periods of restructuring in order to reduce their debt burdens. Assets are spun off, dividends skipped and equity raised in order to generate cash and reduce the risk of bankruptcy by paying down debt. Once this activity gets underway, credit spreads rally sharply — the risk of default is perceived to be past its peak — even though equity markets remain in the doldrums because issuance is dilutive and earnings continue to fall.

Eventually, cost cutting and aggressive restructuring, accompanied by economic recovery, yields a rebound in profits (after 3 o’clock). In this next phase, both earnings growth and debt/EBITDA are improving, causing credit and equity to rally together. However, as the cycle matures, this progressively gives way to a period of lower quality earnings growth, in which share gains are often achieved at the expense of corporate leverage, for example through acquisitions or share buybacks (after 6 o’clock). This keeps equities rallying, but deteriorating balance sheets start to drive credit spreads higher.

Finally, the resultant balance sheet deterioration comes to a head, creating a crisis in which profits cannot be sustained, and both equities and credit sell off (after 9 o’clock). It’s time to take all risk trades off. This is usually associated with a recession which induces the retrenchment which eventually allows the cycle to start all over again.

By and large, we think this framework has held up pretty well, and it is not too difficult to discern its workings in the US over multiple decades. Equities and credit are sometimes positively correlated (Phase 2 and 4) but they can also be negatively correlated (Phase 1 and 3). This is visible in terms of the alternation between credit and equity market returns (Figure 3), and in terms of the cyclical leveraging and deleveraging of nonfinancial corporates’ balance sheets (Figure 4).

To be sure, not every cycle is driven by corporates, and the credit and equity market movements are not quite as regular as, well, clockwork. In the 1970s, movements in oil prices were larger drivers of the economy than corporate leverage per se, and emerging from the 1982-3 recession in particular, we cannot see a “Phase 1” in which credit rallied before equities.

But even when recessions were not actually caused by the non-financial corporate sector – as in 2008 – the broad patterns have still seemed to hold. The recession was preceded by a long period of leveraging up, in corporates as well as in households, and credit market returns turned south months (if not years) before equity market returns did. Understanding the workings of the cycle is a useful way to think about how you should invest.

Time waits for no man (but seemingly for a few corporates)

Note that we have never claimed that it has to be the same “time” for different regions, or even for different sectors. Indeed, while similar principles hold at the individual company level, with credit and equity prices responding to changes in  balance sheets, different companies can employ very different strategies. For example, while US-based Apple is reducing its cash pile with the primary intention of rewarding shareholders, China’s Anbang – after a previous spree of debt-fuelled acquisitions – is now making bond-friendly disposals and trying to shore up its balance sheet.

Aggregating leverage statistics across companies and sectors is as much an art as a science; we often joke that you can demonstrate that aggregate leverage is doing almost anything if only you try hard enough. To what extent when calculating net debt/EBITDA should the tech sector cash pile be allowed to offset the debt burdens shouldered elsewhere? Should you calculate median (net debt/EBITDA), median (net debt)/median(EBITDA), or use means? How as an investor in public equities should you treat the hundreds of billions in debt from private-equity-owned names?

Nevertheless, even given substantial variation at the company and sector level, it is possible to calculate overall averages (Figure 5).

It is almost remarkable how similar are the patterns those averages follow across regions and different data sources (Figure 6).

From the noise of individual companies’ balance sheet decisions, there emerges a global cycle.

We can see different levels of global correlation when we look at other important variables. While GDP growth is imperfectly correlated, with the US generally considered to be ahead of other countries, EPS growth by region is more closely related, especially recently. And, despite being more volatile, actual stock price returns (Figure 9) or credit spread changes (Figure 10) are all but indistinguishable across regions. Markets are highly correlated, even if fundamentals aren’t.

Beyond this, it seems to us that there is a strong element of reflexivity to the process. Company balance sheet decisions, and investor calls on what to buy and sell in credit and equities, are not taken in a vacuum: they influence one another. When Vodafone bought Mannesmann in 1999 in what was then the largest ever M&A deal, its stock continued to rally. This increased the likelihood that AOL would end up buying Time Warner. When Enron filed for bankruptcy in 2001, the environment of increased investor nervousness added to the risk that WorldCom would subsequently do so in 2002. Market movements – and investors’ and corporates’ responses to them – are themselves significant drivers of the cycle.

But how have markets been moving this time round, and what does that tell us about the all-important transition to Phase 4?

Who stopped the clock?

In fundamental terms, this cycle things seem to have proceeded pretty much as usual. A period in which profits were growing faster than debt, from 2009 to 2012, has been followed by one in which debt has been growing faster than profits. As a result, overall corporate leverage has risen well beyond that reached in 2008, to the highest level ever recorded outside of an actual recession (Figure 4, Figure 5, Figure 6). Presumably one reason this has been possible is that record-low levels of interest rates have made interest payments look manageable, even with record-high levels of debt (Figure 11).

When broken down by sector, the pattern is more varied, but probably no more so than normal.

The sectors seemingly most intent on leveraging up are those which it might be reasonably argued ought to be most able to bear it: Utilities, Healthcare, Consumer Staples and Telecoms. That said, in many cases they are now running with substantially more leverage than ever previously (Figure 12).

A second group of sectors – traditional cyclicals – have likewise spent most of the past few years leveraging up. But they are not running with significantly more debt than in previous cycles (Figure 13).

Energy and Materials seem almost to have come out the other side, and are now engaged in deleveraging following a leverage peak in 2015 (eg Glencore making disposals and Anglo American buying back bonds). These are also the sectors which have led to the recent deleveraging visible in the overall statistics for US HY and Emerging Markets (Figure 6).

Finally, Industrials and IT have bucked the broader trend entirely, and have largely been reducing indebtedness since the early 1990s (Figure 14).

A second group of sectors – traditional cyclicals – have likewise spent most of the past few years leveraging up. But they are not running with significantly more debt than in previous cycles (Figure 13). Energy and Materials seem almost to have come out the other side, and are now engaged in deleveraging following a leverage peak in 2015 (eg Glencore making disposals and Anglo American buying back bonds). These are also the sectors which have led to the recent deleveraging visible in the overall statistics for US HY and Emerging Markets (Figure 6). Finally, Industrials and IT have bucked the broader trend entirely, and have largely been reducing indebtedness since the early 1990s (Figure 14).

Putting these numbers together, Matt thinks aggregate leverage is higher than might be expected outside of a recession, and hence more reminiscent of late Phase 3 than early Phase 3. But low interest rates and the predominance of increased leverage amongst the more defensive sectors help explain why this has not yet been seen as a problem for markets as a whole. Moreover, there are even signs that aggregate leverage is beginning to decline given recent strong profit growth and helpful US tax cuts.

But Rob’s primary reason for thinking this is Phase 3 is not based on fundamentals but more on market movements – in particular, the current outperformance of equities relative to credit is classic Phase 3. Other Phase 3 characteristics, such as narrowing market leadership, are also evident (Global Equity Quarterly: Narrowing Bull Market)." - source CITI

The reason the credit clock has been much slower than usual is of course due to the Korsakoff syndrome, namely that central banks intervention have been very supportive of credit spreads in many instances, providing as well some support to many "zombie" companies which should have been eliminated but managed to survive thanks to the low interest rates environment. Record low levels of interest rates have made interest payments manageable even with higher leverage creeping up thanks to the distortion created by our central banking deities.

While EM have been on the receiving end of the latest summer heat thanks to the strong dollar, the S&P 500 and US stocks have been racing ahead while the rest of the world has been languishing. Credit wise both US High Yield and US Investment Grade have had a less torrid time than EM High Yield or EM equities. Indicators of aggressive issuance such as the percentage of the CCC credit bucket accessing the primary market has remained fairly stable still and revenues even for US High Yield remain overall solid as per the below Bank of America Merrill Lynch chart:

- source Bank of America Merrill Lynch

The most recent quarterly Fed Senior Loan Officer Opinion Survey (SLOOs) points that financial conditions still remain favorable. Overall credit remains fairly stable for now at least in the US as pointed out by CITI's comprehensive report:

"A central banker in the works

Most importantly, the steady leveraging-up by companies since 2012 has simply not been accompanied by spread widening on anything like the same scale as in previous cycles. Indeed, even with non-financial corporate leverage higher than the levels seen in 2008 and (on some universes) 2001-2, credit spreads are not far off traditional cyclical tights, especially in US HY (Figure 15).

The pattern in € HY and $ and € investment-grade is similar, if slightly less extreme. Even long-term charts – over which period it becomes difficult to difficult to obtain consistent universes for both spreads and leverage – suggest that something is awry (Figure 16).

If it were just credit spreads which were behaving in this fashion, the signal could perhaps be ignored, or dismissed as an excessive focus on headline debt levels rather than interest coverage and debt sustainability. Indeed, the rating agencies invoke just such an argument when asked why such high debt levels have not led to an increase in downgrades.

But the same time period – since 2012 – which has seen leverage rising and spreads tightening also reflects a breakdown in other market relationships. Equity volatility traditionally correlates with metrics designed to capture policy uncertainty (the number of references to uncertainty in the news, for example). But since 2012 uncertainty has been high, and yet volatility across markets has been setting new record lows (Figure 17). 

Changes in consensus earnings expectations used to correlate with equity market moves in every region, yet since 2012 that relationship has broken down too, even if it is now beginning to re-establish itself (Figure 18, Figure 19).

Matt has argued loudly for several years that all these breakdowns are due to QE, and “too much money chasing too few assets”. He thinks that as central banks pull back, both credit and equities are vulnerable, and cites in his support continuing strong correlations between global central bank purchases and market movements. As was visible in February this year, the central banks have effectively “broken” the normal clock functioning, and credit can no longer be relied upon to lead equities in the way it has done historically.

Rob sees it slightly differently. QE intentionally decoupled credit spreads (kept falling) from corporate leverage (kept rising). Even as balance sheets moved through 6 o’clock, so central bankers kept risk asset pricing back at 5 o’clock. The reason that equity volatility fell is that it is highly correlated to credit spreads (Figure 20), and QE kept spreads falling.

But now that has changed. As central banks step back, so the credit and equity markets will catch up with fundamentals. This year’s rise in spreads and volatility finally marks the move into Phase 3 that, without QE, would have started in 2012. Rob thinks that QE has held the clock back, not broken it." - source CITI

One could indeed agree somewhat with Rob from CITI that, indeed the Korsakoff syndrome associated with prolonged ingestion of QE has clearly distorted the "credit clock" and slow down the normal aging process thanks to financial repression and low interest rates. Now with QT in full swing, the tide is slowly but surely turning, with the over-leveraged players being the first one taken to the cleaners such as the house of straw of short-vol yield pigs and now the house of sticks of macro EM tourists carry pigs.

What about record high corporate margins? Surely trade war and surging PPI will eventually put a dent in corporate margins one might argue as corporations pass on price increases onto their customers. CITI discusses as well this issue in their note:

"Time is an illusion. Lunchtime doubly so.

Unfortunately a closer examination of both market and fundamental data in this cycle does relatively little to shed light on this debate, or at a minimum can be construed as arguing in both directions.

One potential end-cycle sign is compression of corporate margins, at least as proxied by companies’ unit labour costs (usually the major driver of their cost base) relative to output prices (tracked by the broad GDP deflator). In the US in 1979, 1989,1999 and 2007, labour costs rose more rapidly than output prices as the cycle matured, labour gained in pricing power and corporate profit margins were  squeezed (Figure 21).

Something similar happened for the Euro area in 1999, 2007- 8 and in 2012 (Figure 22).

Each time, this was a useful warning that companies were resorting to leverage in order to support earnings growth, and of the consequent vulnerability of the equity market.

Rob agrees that you may get a rolling over in “per unit” margins in the macro data, even as overall profit margins of listed corporates keep rising. But a combination of strong volumes and high margins are enough to keep profits rising and the bull market rattling along (Figure 23).

Overall profit margins don’t collapse until the recession begins, volumes fall and companies are left with excess fixed cost bases. As such profit margins are a coincident indicator with the stock market, which is why Matt doesn’t like them. They don’t give any prior warning; they always look great right up to the last minute.

The trouble is, this time round, while there is some evidence of margin compression in the Euro area, US unit labour costs have been oscillating without any clear trend. However you look at it, the sort of earnings growth and especially revenue growth we have seen in 2017-18 simply defies traditional models for what is “supposed” to happen at this stage of the cycle." - source CITI

There is indeed a "Dissymmetry of lift" between the US and Europe, leading to the current growth differential outcome with Europe slowing at the moment while the US showing signs of expansion with the latest ISM. Some would argue it could be a peaking sign in this credit cycle. Also as we have argued various times, a sudden acceleration and surge in oil prices would obviously ignite more inflationary expectations (or scare) and lead to a more hawkish Fed. This would of course be much more negative for asset prices overall and lead to the famous bust after the boom.

Another interesting discussion within CITI's note has been around mutual fund flows. Those who read us on a regular basis know that we look at mutual fund flows as an indicator of investors mood and confidence. This we think is quite interesting:

Yet another potentially useful late-cycle indicator is mutual fund flows. You might reasonably have expected Phase 3 to be associated with strong flows into equities. A strong rotation from bonds into equities is very visible in 1997-2000, and is notable by its absence this time round, perhaps suggesting Phase 3 has much further to run (Figure 24).

But both 1985-87 and 2005-2007 were associated with exuberance in fund flows in general – an exuberance which now seems to be running out of steam. Another way to think of fund flows is in terms of total inflows to all risky assets (bonds, equities and hybrid funds combined) relative to inflows to money market funds and deposits. This seems to follow a regular cycle with respect to deposit rates (Figure 25).

In Phases 1 & 2, emerging from recession, when deposit rates are low, and valuations are cheap, investors do most of their saving in risk assets. As the cycle matures and as deposit rates rise, they steadily move some of their savings in deposits. Eventually in Phase 4, they sell all risk assets, prices fall, deposit rates are cut and the, eventually, the cycle starts again. This year’s tremors in markets may be a sign that just such a phase is being reached already.

Yet here too, the signals are ambiguous. Fund flows both influence market returns and are influenced by them (Figure 26).

While we find it quite easy to imagine a scenario in which fund outflows drive markets lower and trigger a growth slowdown, it is by no means a foregone conclusion. We seemed to be embarking on just such a negative path in February 2016, but then an unusual (from the perspective of these charts) rally in markets – admittedly following more central bank intervention – halted the outflows and triggered two years of further inflows. While central bank easing now feels much less likely, positive market returns in equities, driven by earnings growth and share buybacks, may well suffice to spark inflows of their own
accord.

If Matt is right, further central bank withdrawal should mean the inflows fizzle out and turn to outflows, conclusively creating a bear market not just for credit but also for equities. If Rob is right, central bank withdrawal and renewed corporate releveraging should cause credit spreads to widen, but equities may yet have further to rally. They become the only game in town. But equally, it would not be that surprising – especially given the example of the Energy and Materials sectors, and the broad-based deleveraging thanks to earnings growth – for us to skip Phases 4 and 1 entirely, and go straight back to the “organic” deleveraging associated with Phase 2, in which both credit and equities rally. This is, in effect, what markets did during 2017. But was that fundamentals, or the effect of extraordinary central bank policies? Once again, this cycle defies easy categorization." - source CITI

We think, when it comes to Matt King's argument about inflows fizzling out and turning to outflows, creating a bear market is an interesting proposal. In our final chart below we would like to provide additional support to Matt King's view

• Final chart - Boom to Bust? Follow high-yield corporate bond mutual funds flows...

To add more ammunition to this hypothesis we would like to point out towards a Wharton paper written by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein published in September and entitled "Mutual Fund Flows and Fluctuations in Credit and Business Cycles" (h/t Tracy Alloway for pointing this very interesting research paper on Twitter).

This paper points to using flows into junk bond mutual funds as a gauge of an overheated credit market to tell where we are in the credit cycle. Could that be finally a reliable "Boom to Bust" indicator?

"Several measures of credit-market booms are known to precede downturns in real economic activity. We offer an early indicator for all known measures of credit booms. Our measure is based on intra-family flow shifts towards high-yield bond mutual funds. It predicts indicators such as growth in financial intermediary balance sheets, increase in shares of high-yield bond issuers, and downturns of various measures of credit spreads. It also directly predicts the business cycle by positively predicting GDP growth and negatively predicting unemployment. Our results provide support for the investor demand–based narrative of credit cycles and can be useful for policymakers.

A large body of literature in macroeconomics and finance studies the link between credit markets and macroeconomic cycles. A pattern that emerges from the data is that credit booms precede downturns in macroeconomic activity. This pattern attracts considerable attention from academics and policymakers: if credit markets are at the root of macroeconomic fluctuations, then it is important to better understand what drives credit cycles and identify leading indicators to try and design policies that will moderate them.

In this paper we show that investor portfolio choice toward high-yield corporate bond mutual funds is a strong predictor of all previously identified indicators of credit booms. An increase in our measure in year t predicts credit booms marked by the other indicators in the literature in years t+1 and t+2. These other indicators include the proportion of low-quality bond issuers (Greenwood and Hanson, 2013; López-Salido, Stein, and Zakrajšek, 2017), the degree of reaching for yield in the bond market (Becker and Ivashina, 2015), balance sheet growth in financial intermediaries (Schularick and Taylor, 2012; Krishnamurthy and Muir, 2015), and various measures of credit spreads (Gertler and Lown, 1999), in particular the excess bond premium (EBP) recently proposed by Gilchrist and Zakrajšek (2012).

In addition, our measure, as a leading indicator of credit booms, positively predicts GDP growth and negatively predicts unemployment rates in years t+1 and t+2 (before they turn in the reverse direction in year t+3)."  - source Wharton paper, by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein 

Prolonged ingestion of QE surely is a way leading to many credit investors getting the Korsakoff syndrome such as the Macro EM tourists that piled into the 100 years bond issued by Argentina, causing them memory loss of their fiduciary duty but we ramble again...

"We live in a world where amnesia is the most wished-for state. When did history become a bad word?" - John Guare, American playwright.

Stay tuned !

Macro and Credit - The Zimmermann Telegram

"No matter what political reasons are given for war, the underlying reason is always economic." - A. J. P. Taylor, British historian

Looking at the evolution of the trade war rhetoric in conjunction with cold war 2.0 heating up following the events in London as of late, as well as the weakness in risky asset prices and issues surrounding FANG stocks darling Facebook, when it came to selecting our title analogy we reacquainted ourselves with the "Zimmerman Telegram". The Zimmermann Telegram was a secret diplomatic communication issued from the German Foreign Office in January 1917 that proposed a military alliance between Germany and Mexico in the prior event of the United States entering World War I against Germany. Mexico would recover Texas, Arizona, and New Mexico. The proposal was intercepted and decoded by British intelligence. Revelation of the contents enraged American public opinion, especially after the German Foreign Secretary Arthur Zimmermann publicly admitted the telegram was genuine on March 3rd 1917, and helped generate support for the United States declaration of war on Germany in April 1917. The decryption was described as the most significant intelligence triumph for Britain during World War I, and one of the earliest occasions on which a piece of signals intelligence influenced world events. One could indeed make a parallel and wonder if the latest disclosure on privacy issues relating to Facebook will not mark a turning point for the strong winners (FANG stocks) of the rally seen in recent years in equities.

In this week's conversation, we would like to look at the US dollar funding pressure which has been highlighted by many pundits particularly given that the Libor-OIS spread, has more than doubled since the end of January to 55 basis points, a level unseen since 2009 reflecting an increasing scarcity of dollar funding it seems with large implications as per the below Bloomberg charts as well as US corporate leverage:

- source Bloomberg

Synopsis:

• Macro and Credit - Libor and leverage, my dear Watson...
• Final charts - Dispersion matters 

• Macro and Credit - Libor and leverage, my dear Watson...

No doubt the returns on everything beta including the Russell 2000 since Trump's election in the US has been stellar but, we are seeing it seems a change in the narrative since early 2018 with the continuous hiking pattern of the Fed, making markets more prone to heightened volatility and questioning the continuation of the "goldilocks environment" which had prevailed so far in credit markets. One most sensitive candidate we think for a "short" bias when the markets will eventually turn in the footsteps of the Fed's hiking course that will in the end "break something" is the Russell 2000 small cap index we think. Given that more than 40 percent of debt issued by Russell 2000 companies is floating, they are therefore susceptible to the rise in the benchmark rate namely our old friend Libor. While the CFOs of some of these firms have made good use of derivatives to effectively swap from floating-rate into fixed obligations, these companies are still more interest-rate sensitive than their larger counterparts that have embarked on a bond-issuance frenzy in recent years particularly so with a significant amount of leverage. At the end of 2017 around 34% of the Russell 2000 was made up of loss-making companies with an average LT debt to Capital of around 35% versus 29% in 2007. In our book higher leverage and rising Libor even if some smart CFOs have swapped some exposure from floating to fixed doesn't look too promising when the market will finally turn to a bearish stance (we are not quite there yet).

On the pressing subject of Libor and OIS rates, we read with interest UBS Global Macro Strategy note from the 2nd of March entitled "USD Funding Pressures: Myth and Reality:

"Here's what's happening

Some investors are worried about the rising gap between LIBOR and OIS rates (Figure 1) as being indicative of a nascent funding problem.

At the root of this widening is an increase in T-bill rates; as Fed funds and T-bill yields rise, so does the cost of unsecured LIBOR funding. The gap between T-bills and LIBOR rates, the Ted spread, has not changed much. Bill rates have been rising particularly sharply since early February, as Congress agreed on further fiscal spending (we estimate net bill issuance in '18 at $475bn vs $200bn in '17). Supply is in play here, not credit issues. The gap between LIBOR and Fed funds rate is hardly out of line with previous hiking cycles (Figure 2).

Will this widening between LIBOR and OIS persist?

If we're right about T-bills being the real driver of this move, then LIBOR-OIS should not widen much more. The spread between T-bills and OIS is now positive (Figure 3), and this has typically been a limit in the widening.

Note that when funding stresses have risen in the past because of credit reasons, the T-bill to OIS spread has gone the other way. What we're witnessing today is higher rates, not a clogging of financial plumbing. 

Distinguish between the price of funding and access to funding

It is undeniable that higher US rates will have an impact on the 'price' of funding, perhaps globally, and that this will have consequences. But 'access' to funding is a completely different story. We see few signs of this having been compromised thus far. 

Neither credit nor currency markets suggest funding is becoming a problem

As we have argued, the underbelly of the risk trade – the weakest rating buckets in the US HY – are actually outperforming on a beta-adjusted basis. Spreads are remarkably stable in the context of higher front end rates and equity volatility (Figure 4).

Issuance and demand for paper have not been a problem. In currency markets, basis swaps (Figure 5) (difference between local currency and $ funding), risk reversals (the price of a $ call vs a $ put), and volatility are showing no signs of stress.

So, is there nothing to see here? Does the cost of funding not matter at all?

It does. But instead of LIBOR–OIS widening, which is likely a red herring, we need to focus on the right channels to assess changes in market trends. First, watch the hit from yields to floating rate HY credit. We estimate floating rate loans at $2.2tn, of which $1.1tn of loans ($690bn of leveraged loans, $459bn of bank C&I loans) have been extended to issuers rated below BB-. Our recent analysis shows leveraged loan issuers fundamentally will remain resilient to the next 75-100bp increase in Fed Funds rates, but further rises could elevate funding vulnerabilities. Second, watch US growth surprises relative to those in the rest of the world. Widening front end rate differentials will become more meaningful for currency trends if mirrored in growth differentials. We would pay particular attention to China, where data has been mixed to weak. The EM currency complex, thus far calm, may begin to weaken if growth here softens in backdrop of higher US rates (Figure 6).

Third, and most importantly, we would watch term premium in the US. Markets have been worried about the impact of higher rates, but thus far US rates volatility itself hasn’t risen meaningfully, and shouldn't do so unless term premium rises sharply (Figure 7). We have argued against a big shift here.

Where does this leave us?

We are positioned defensively on US HY credit, and are looking for modest trade weighted weakness in EM currencies (Figure 8).

However, we think back-end rates are likely more range-bound here and, based on the facts today, are not inclined to take a negative view on US stocks. We would be watching the three channels above to reassess our view." - source UBS

Obviously when it comes to the LIBOR-OIS widening more, UBS hasn't got it entirely right given, it Libor has been rising for 31 days in row so far. Is it a case of "reflexivity"? We wonder. One thing for certain, we have noticed since the beginning of the year a weaker tone in fund flows, particularly in US High Yield, which, we think could be indicative of the start of the end of the "Goldilocks environment" in credit markets which had still been prevailing in 2017 in the beta part of the market, with the CCC rating bucket posting some strong returns (Russell 2000 as well...).

While recently we have touched on the "hidden" leverage in the US consumer in our conversation "Intermezzo", if Libor is indeed a growing concern for some credit market and sell-side pundits then obviously one need to take into account "leverage". As per the explosion of the yield pig's short vol straw house in February akin to the equity tranche in the capital structure of our complex markets, identifying the leveraged players is essential as the credit cycle shows clear signs of fatigue and the start of tightening thanks to the hiking path of the Fed (and QT). On that particular question about leverage we read with interest UBS Global Credit Strategy note from the 19th of March entitled "Is US corporate leverage higher than reported?" and below is the summary before we go into their detailed note:

"Key questions

The state of US corporate balance sheets and the outlook is one of the key debates for fixed income investors. The consensus is, while we are in the later stages of the US credit cycle, a recession is not on the horizon. We agree. But we believe identifying those pockets within credit markets where credit and leverage growth has been excessive is crucial to capturing a potential inflection point in the credit cycle early and to calibrating the extent of the fallout.

Where are US corporate credit market excesses? A focus on loans

Our view is there are three corporate credit market imbalances in this cycle. First, the rise in lower-rated, longer dated investment grade debt1; second, a 100% increase in the number of triple C rated issuers to over 1,400, many of which have floating-rate liabilities; and third, excessive debt growth in the technology, electronics and pharmaceutical sectors. Our focus here is on US leveraged loans (LL), where $1.1tn in lower rated, spec grade loans is more vulnerable to our house view for 7 Fed hikes and a material flatting in the US yield curve through '19.

Leverage is high. After normalizing for addbacks, it is even higher.

US leveraged loan gross issuance hit $500bn in 2017, with 60% used for M&A, LBOs or recapitalizations. Total leverage on new deals is 5x, and near 5x since 2014, while 1st lien leverage is 3.9x, the highest in two decades. But are these figures understated? EBITDA add-backs are rampant and material, averaging 20-21% for M&A related deals in 2017 and 26% for large sponsor deals YTD (largest in the tech, metals and food sectors). The jury is still out on add-back realization rates, but a conservative view would push average total/ 1st lien leverage to 6.2x and 5x, respectively, on M&A deals.

What are the early warning signals and current prognosis?

Corporate leverage is therefore a structural risk. But are we at an inflection point in the credit cycle? Leveraged loans (1.35%) have outperformed high yield bonds (-0.52%) YTD even as LL default rates have risen moderately to 2.2% (from 1.4% in Q3 '17). First, we have created a proprietary non-bank LL liquidity indicator to assess if lenders are beginning to ration loan supply. This metric led spread widening in '15 and '07, but currently the indicator is at -2%, indicative of slight easing and a stable backdrop. Second, the key demand source for LL is collateralized debt obligations (CLOs), and portfolio concentrations are highest in technology (13-15%), healthcare (11-12%) and cable/media (8-9%). Our recent flows analysis suggests rising USD hedging costs and duration concerns are driving more foreign investors into loans. And while total returns in the above sectors are lagging the LL index, they remain in positive territory.

How to position credit portfolios?

Overall bank and non-bank lending standards are not showing signs of tightening credit, our credit-based recession gauge is at a modest 13% through Q3 '18 and broad US credit valuations are moderately overvalued. With the house view calling for materially higher short rates but a modest rise in long end yields and USD depreciation, we favour EM over DM corporate credit and US leveraged loans over US high yield. Our HY spread target remains 380bp vs 341bp current. We maintain the view that corporate credit markets can absorb the next several rate hikes, but spread tightening is over and investors should be more cautious as the hiking cycle matures. And we remain structurally underweight healthcare and tech across credit portfolios for 2018." - source UBS

We do agree with the above, namely that we would favor EM over DM in corporate credit. The recent outperformance of local-currency emerging-markets credit has been impressive, with the debt returning 2.4% so far this year while U.S. IG credit has lost 2.5%. If indeed the weaker tone in the US dollar continues its course, then again having exposure to Emerging Markets Local Currency debt is still an enticing proposal, even in the light of recent outperformance of the asset class. Regardless of some Zimmermann Telegram and Cold War 2.0 narrative, Russian debt continues to be appealing we think, and much more appealing than dangerously overpriced European Government bonds which in fact, like the German bund as of late, are barely trading in similar fashion to what happened with Japanese Government Bonds market (which in effect has ceased to trade). Getting Japanese? We really think so: Private investors hold only 10% of German government bonds. It’s impressive that this market functions at all.

- source IMF and ECB

But moving back to our US leverage story, UBS looks into details about the state of the US corporate leverage:

"Is US corporate leverage higher than reported?

The health of corporate balance sheets, particularly speculative grade and private firms, was one of the key thematic debates during our client visits in London. We break down the genesis of the questions into three sub-themes: first, within the US corporate credit markets where are the excesses? Second, how concerned are you about levels of leverage, and to what extent are earnings add-backs hiding risks? And third, what early warning signals are you monitoring and what is the current outlook?

Where are corporate credit market excesses?

We have previously outlined three corporate credit market imbalances that bear close tracking, with the latter two in focus in this piece3. First, in high grade the rise in lower-rated, longer dated issuance with the ratio of BBB/BB 10yr+ debt rising from 4.8x to 13.3x. Second, in speculative grade a doubling in the number of triple C rated issuers to over 1,400 (US corporate debt: revisiting financial stability concerns). A majority of these issuers have funding in the US leveraged loan market, issuing secured loans to boost issue level ratings; B-rated loans outstanding have risen from $195bn to $467bn since 2012 (Figure 1).

And third, above average debt growth in the technology, electronics and pharmaceutical sectors; for US leveraged loans specifically this thesis is evident in the growth of the broad manufacturing and sectors which have grown from $117 to $295bn and $256 to $448bn, respectively, since 2012 (Figure 2).

By sub-industry growth, manufacturing has been primarily electronics ($124bn from $52bn). In services, business services ($98bn from $77bn) and lodging/ leisure ($87bn vs. $52bn) have led the increase.

More recently, we have discussed lower rated firms as structurally more vulnerable to rising interest rates with near-peak leverage and relatively low interest coverage (Lesson Learned: The Underbelly of US Tightening). And we argued that $1.1trn of lower rated, spec grade loans were the fulcrum – i.e., more vulnerable to our house interest rate outlook characterized by aggressive Fed rate hikes (7 through '19) but significant yield curve flattening (with 5yr Treasuries projected to remain below 3% through '19). Our analysis suggested these issuers would be resilient to 3-4 Fed rate hikes, but 4 more would lower coverage ratios near pre-crisis ('06) levels (A deeper dive into US credit markets more vulnerable to aggressive Fed hikes).

How concerning are leverage levels, and are earnings add-backs hiding risks

US leveraged loan gross issuance hit a record of approximately $500bn in 2017, with about 60% of use of proceeds for leveraged buyouts (LBOs), M&A/acquisition or recapitalizations (Figure 3).

While the theme of LBOs is less prevalent this cycle vs the prior, M&A has been a more persistent theme – primarily between private/sponsor firms. The market has been a sellers/borrowers market in recent months, in part driven by duration concerns which are fueling inflows into floating rate products (The Technical Pulse: Where will yield-hungry investors next leave their global footprint?), the perceived safety of secured debt and financial deregulation (with bank adherence to the 2013 Leveraged Lending Guidance fading). While median total leverage metrics have declined from peak levels of 5x to 4.5x post-crisis, they are still above the 4.25-4.5x pre-crisis. In addition, the negative tail remains fatter as the proportion of issuers with leverage above 6x is 29% (vs a post-crisis high of 35%, and 19% pre-crisis).

To reiterate, these figures represent the median leverage for public leveraged loan issuers outstanding (i.e., leverage on the stock of public issuer loans). But 65% of the lev loans are actually from private firms. While we do not have median leverage data on the stock of private issuer loans outstanding, credit metrics are available on all new deals – public and private (i.e., the flow). This data shows average total leverage for all deals at 5x, with private leverage running at 5.2x (c1x higher than on new public deals). Total leverage on new private deals has been running above 5x on average since early 2014; in the last cycle, average leverage above 5x was seen from Mar '07 to Mar '08 (Figure 4).

Across the capital  structure, however, leverage through the 1st lien for all new deals is at 3.9x, and has been running higher than prior peaks since 2013 – one key reason why lev loan investors have heightened recovery rate concerns in this cycle (Figure 5).

But what if leverage (and coverage) figures are wrong? The issue of earnings adjustments (or engineering) has consistently reared its ugly head in our client discussions for several years, and it is certainly not confined to US leveraged loans – but the rhetoric from leveraged finance/distressed credit investors has grown stronger. Market participants suggest nearly every acquisition-related deal now has its share of EBITDA add-backs, and a number of long term investors have suggested this cycle is unlike any others they have witnessed. Figure 6 depicts our best estimate of the average EBITDA add-back (expressed as a turn of total leverage) for M&A deals over time.

We would posit that the phenomenon of EBITDA add-backs is partly an unintended consequence of macroprudential regulation. The 2013 Leveraged Lending Guidelines (not enforced until late 20147) capped pro forma leverage at 6x (and required 50% debt amortization within 5-7 years8), incentivizing issuers to manage pro forma EBITDA such that leverage would remain below the 6x threshold. Rising add-backs are likely also a byproduct of low interest rates and QE, which have pushed up asset valuations and M&A deal multiples and contributed to reach-for-yield behaviour and material easing in lending standards.

Aggregate data on the magnitude of EBITDA add-backs is not easily sourced. For this we have leveraged the work of Covenant Review, and more specifically data from their CR Trendlines Topical Reports. Their work suggests that EBITDA addbacks for M&A - related deals across sponsor/ non-sponsor deals in 2017 were approximately 20-21% of Pro Forma Adjusted EBITDA. In 2017, the tendency seemed to be greater add-backs appeared first among large sponsor deals, and then spread across mid-sized and non-sponsored loans. And in 2018 this seems to be taking shape again, as EBITDA add-backs for M&A-related deals for large sponsors are averaging 26% of Pro Forma Adjusted EBITDA – suggesting another "high water mark" for EBITDA add-backs is attempting to take shape now (as addbacks for mid-sized sponsored/ non-sponsored loans remain at 20 – 21%).

Finally, in terms of sector outliers, the magnitude of EBITDA add-backs is more aggressive in electronics, software, metals/mining and food/food services (ranging from 24 – 29%). Are the add-backs being realized? The verdict is still out. First, it is difficult to monitor the aggregate credit fundamentals for the stock of private loans post-deal. Second, the credit agreement and covenants typically allow borrowers 24 months or more to realize a majority of the add-backs, in part a function of the significant easing in lending standards post-crisis (consistent with the shift from covenant to covenant-lite loans, 75% in '17 vs. 29% in '07; Figure 7).

For illustrative purposes, if one assumes a liberal view that all add-backs are realized then leverage levels are unchanged; however, if one takes a conservative view and excludes add-backs, total and 1st lien new deal leverage would increase to 5.0x and 6.2x, respectively, on average from 3.9x and 4.9x, respectively (Figure 8).

What early warning signals are you monitoring and what is the prognosis?

At this point, we don't see an inflection in the credit cycle. First, leveraged loans (1.35%) have outperformed high yield bonds (-0.52%) year-to-date amid higher rate and equity volatility, and LL spreads remain firm at 368bp (4yr discounted spread) even as LL default rates tick up moderately to 2.2% from a low of 1.4% in August (Figure 9).

Second, we have also created a proprietary non-bank LL liquidity indicator, following the methodology of our non-bank liquidity indicator (Credit Cycle Turning? Non-bank Liquidity Hits Multi-Year Lows), which calibrates changes in net loan issuance for low quality credits to determine if lenders are starting to ration their existing liquidity to higher quality borrowers. Historically, this proxy proved to be a warning signal in Q3 2007 and Q4 2014 when net tightening in lending standards reached +5 to 10% while spreads were still relatively tight (Figure 10).

Currently the indicator is at -2%, indicative of net easing and a constructive backdrop in the LL primary market.

Third, in terms of market structure and sector risks, the key demand source in terms of flow and stock of LL is collateralized debt obligations (CLOs, Figure 11).

And CLO portfolio exposures can be quite diverse, suggesting investors should pay attention to concentration risks. In this respect, we are focused on the outlook for technology (13-15% average exposure in CLOs), mainly software given robust debt growth, M&A activity and EBITDA add-backs and, secondarily, the healthcare (11-12%) and cable/media (8-9%) industries10. YTD total returns in these sectors are lagging the overall index modestly (electronics 0.90%, healthcare 1.12%, cable television 0.86%), but remain positive overall. 

Lastly and more broadly, bank and non-bank lending standards are not showing signs of tightening credit, our proprietary credit-based recession gauge is a modest 13% through Q3 '18, and broader US credit valuations look 0.8 standard deviations rich (vs. 2 standard deviations back in Q2 '07; Where are we in the credit cycle?)." - source UBS

One thing for certain is that the M&A wave we foresaw for 2018 has been staggering and as a late cycle red flag it is as clear as you can get with global deal making this year crossing the $1tn mark on Tuesday, the fastest it has ever reached that level, as a wave of consolidation spreads across the US and activity in the UK, China, Germany and Japan accelerates. You don't need no Zimmermann Telegram to tell you this but it certainly feels like late 2007 all over again and even early 2008 one could posit given we are seeing the return of Mega M&A deals as indicated by Wells Fargo in their Credit Spotlight note from the 15th of March entitled "Mega Deals Strike Back":

"Animal spirits continue to swirl in corporate boardrooms as evidenced by the recently announced Cigna/Express Scripts and Comcast/Sky proposed acquisitions. Industry consolidation is clearly en vogue across a range of sectors, and with debt markets willing to finance mega debt cap-structures, it seems unlikely to stop anytime soon. As a result, despite a healthy economic backdrop, credit investors need to tread cautiously as they navigate an upsurge of idiosyncratic risk, and for index oriented investors, what you don’t own could be just as important as what you do when it comes to performance.

We expect a record amount of M&A in 2018. This should result in another year of record bond issuance in the IG market.

M&A Update – Continue to Expect a Record Year

Mega Cap M&A continues to be a key driver of U.S. credit markets, both as a driver of leverage and a driver of bond issuance. We continue to expect M&A in 2018 to move to a new all-time high and lead to increased bond issuance in the IG market. There has been more than $387 billion of M&A announced so far in 2018, on pace to be the largest first quarter of M&A announcements on record. In fact, M&A is currently on pace to reach $1.8 trillion, breaking the previous record of $1.7 trillion from 2015.

We expect M&A to be the main driver of increased bond issuance in 2018 as we expect M&A-related funding to rise from $175 billion to $250 billion, accounting for substantially all of our increase in net supply for the year. We expect the Consumer Non-Cyclical sector to be the primary driver as M&A heats up in each of the Health Care, Pharmaceutical, Food & Beverage and Consumer Products subsectors. The rising M&A and issuance need are the key drivers of our Underweight recommendation on the sector.

The mega deals have really been the driver of increased M&A over the past few years. In each of 2016 and 2018 over 20% of the total M&A volume has come from deals over $40 billion. In addition, with the exception of 2017 over 40% of the M&A volume has come from deals in excess of $10 billion.

The increase in the propensity of these larger deals also has increased the funding need in the IG bond market and has led to a significant increase in the size of the average capital structure within the market. These large cap structures are now nearly on par with the mega banks in terms of index weightings." - source Wells Fargo.

The return of large M&A mega deals is clearly as stated a late cycle behavior we think akin to what we saw in 2007. If indeed the credit amplifier is still going to 11 in true spinal tap fashion, then again a flattening US yield curve and the rise in the front end, will make Investment Grade credit less and less alluring we think from a pure allocation perspective in the current environment. No doubt overall the liquidity picture is changing and you should take notice and start to be more defensive in regards to "cyclicals" at least, even if the FOMC shows greater "optimism" on the economic cycle.


In November in both our conversations "Stress concentration" and "The Roots of Coincidence" we argued that we were starting to see cracks in the credit narrative thanks to rising dispersion at the issuer level as well as growing negative basis credit index wise. We added that rising dispersion meant better alpha generation from pure active credit players, particularly in the light of rising M&A activity in 2018 and the need to reach for your LBO screener to avoid potential sucker punches in the form of sudden credit spreads blowing out in your face. As we pointed out in our previous conversations, dispersion is indicative of the lateness in the credit cycle and the beta game, and it means, as we posited that active managers should outperform in 2018. In our final point below, we would like to look again at dispersion given rising dispersion in our book amounts to credit deterioration.

• Final charts - Dispersion matters 

Normally, higher dispersion should drive eventually spreads wider. Since 2013, balance sheet leverage has been widening, therefore on top of Libor woes building up, investors should be wise in tracking leverage ratios in 2018. One of our final charts comes from Barclays note from the 16th of March 2018 entitled "Lessons in Leverage" and displays the history of the US High Yield Index spread versus the dispersion of net leverage at the single name level (ex-financials):

"Figure 5 overlays the history of the US High Yield Index spread versus the dispersion of net leverage at the single name level (ex-financials), with dispersion measured as the difference in turns of net leverage between the 80th and 20th percentiles of high yield credits at any point in time. While there are many drivers of spreads, we could expect at least a reasonable relationship between the dispersion of leverage and the overall market spread - namely , high and increasing dispersion likely coincides with periods of credit deterioration derived from macro challenges, and vice versa. Note that the dispersion of leverage remains reasonably far above the 2014 lows (given the drivers and observations noted above), while the high yield market spread is less dislocated. That may suggest that any credit improvement that might occur in 2018 (particularly for lower-quality segments) has already largely been factored in and that a further tightening of credit risk premia would have to be sourced from other drivers besides fundamentals" - source Barclays

This trend of rising dispersion can also be seen in the synthetic derivatives part in the US credit market namely in the CDX HY index where dispersion is also on the rise as indicated by CITI in their Global Credit Strategy Focus note from the 15th of March entitled "What is happening with CDX IG volatility?":

"There are several reasons why CDX HY may not be a good tail risk hedge at the moment. First, the default environment is expected to remain benign going forward. In addition to the decline in HY defaults over the past year, Moody’s is expecting the HY default rate to fall even further over the next year. Second, two other metrics of HY cash portfolios also provide reasons for optimism.
The maturity distribution for the Bloomberg Barclays cash HY index indicates that less than 5% of the entire portfolio by notional will mature over the next 2 years, out of which less than 1% is expected to mature in the next year. In other words, even if rates were to rise, the total amount of HY debt coming up for refinancing is quite small. there is a fairly limited overlap between CDX HY constituents and the Bloomberg Barclays cash HY index. We find only 35% of the total notional in the cash index corresponds to the names in the CDX HY index (see Figure 4 (left)). Given that a significant component of tail risk in HY is a pick-up in defaults, using CDX HY as a hedge against cash HY portfolios would leave a large portion of the average cash HY portfolio exposed.
All of these reasons have contributed to investors currently staying away from using CDX HY payers as a tail risk hedge. Instead, what we are observing at the moment in HY hedging is investor activity targeted at individual names, which has also caused dispersion to rise in the CDX HY portfolio (see Figure 4 (right)).

In contrast to CDX HY which is more sensitive to (idiosyncratic) default risk, CDX IG is more sensitive to macro risks. One of the major tail risks on investors’ radar is rising inflation. As investors digest the effects of the newly instituted tariffs on aluminum and steel, the rising risk from potential trade war scenarios and the overall wealth effects from tax cuts, we are seeing inflation tick higher, as evidenced by the rise in 5y inflation breakevens.

Our analysis of data during a past rising rate environment (1963-1981) has shown that higher inflation can potentially drive credit spreads wider (see Figure 5 right), and here) for a more detailed discussion. Such dynamics would make CDX IG spreads an appropriate choice for inflation-driven tail risk for credit investors.

At the current time, markets are pricing in roughly 3 (25bp) rate hikes over the next year, which is also the base case projection from Citi economists (see here). However, a 4th rate hike has not been completely ruled out, and if it were to materialize, we could see another sell-off in credit spreads, especially concentrated in IG since IG credit is more sensitive to duration risk." - source CITI

Rising credit dispersion, rising inflation and a potential trade war means that no matter how you look at your Zimmermann Telegram from the credit markets, the Goldilocks narrative which has been prevailing for so long look to us increasingly at risk in 2018.

"Like most of those who study history, he (Napoleon III) learned from the mistakes of the past how to make new ones." -  A. J. P. Taylor, British historian

Stay tuned !