Macro and Credit - The Zeigarnik effect

"Both poker and investing are games of incomplete information. You have a certain set of facts and you are looking for situations where you have an edge, whether the edge is psychological or statistical." -  David Einhorn

Looking with interest at the continuation of the rally in both equities and credit, including the high beta space while looking at the continuation in worsening macro data coming out of Europe, when it came to selecting our title analogy, thanks our fondness for behavioral psychology, we decided to go for the "Zeigarnik" effect given most investors are focusing these days on the uncompleted task of the Fed's balance sheet reduction. In psychology, the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks. In Gestalt psychology, the Zeigarnik effect has been used to demonstrate the general presence of Gestalt phenomena: not just appearing as perceptual effects, but also present in cognition. If a task is interrupted, the reduction of tension is impeded. Through continuous tension, the content is made more easily accessible, and can be easily remembered. The Zeigarnik effect suggests that students who suspend their study, during which they do unrelated activities (such as studying unrelated subjects or playing games), will remember material better than students who complete study sessions without a break (McKinney 1935; Zeigarnik, 1927). The results of the study of the "Zeigarnik effect" suggest that a desire to complete a task can cause it to be retained in a person’s memory until it has been completed, and that the finality of its completion enables the process of forgetting it to take place. In similar fashion the desire of the Fed to complete its balance sheet reduction could generate we think, a "Zeigarnik effect" in investors mind. After all it seems to us that the Fed's balance sheet contraction is more influential on assets prices than rates hike, hence the importance of the "Zeigarnik effect" but we ramble again...

In this week's conversation, we would like to look at the state of credit markets and US in particular given the significant rise in leverage in recent years versus Europe, as well as the state of the US consumer. 

Synopsis:

• Macro and Credit - R is for "recession" and D is for "deleveraging". 
• Final charts - Central banks to markets: let's be friends again...

• Macro and Credit - R is for "recession" and D is for "deleveraging". 

The central banking cavalry came late to the rescue with both the Fed and the PBOC coming to support risk assets in general and high beta in particular. Given the even weaker tone coming out of Europe we think it won't take long until we see more support coming from the ECB particularly given the grim growth outlook for the likes of Italy and its continuing ailing financial sector. Given that the European Banking Union remain "unfinished business", it is we think another case of "Zeigarnik effect" as the "doom loop" aka the nexus between the sovereign and the banks is yet to be meaningfully addressed. 

In our previous conversation we pointed out to the more pronounced slowdown affecting Europe including France as well. With French Services PMI at 47.5 in January, at the lowest level in the last 4 years versus 49 in December it doesn't bode well for French GDP going forward:

- graph source Bloomberg

This is what we had to say about France in our last conversation about France:

"The situation for French corporate treasures when it comes to cash flows from operations is deteriorating to a level close to 2012-2013 follow the Euro crisis. This we think, warrants close monitoring, given we think that the ongoing "attrition warfare" between the French government and the "yellow jackets" is taking its toll on the French economy as a whole, which as we reminded you last week is very much "services" orientated relative to other countries of the European Union (80% for France vs 76% of GDP on average)." - source Macronomics January 2019

Sure there is global weaker tone when it comes to macro data, but it is no doubt more pronounced in some places and in Europe in particular hence our concerns and the use of the dreaded "R" word, "R" for recession when it comes to Europe, with Germany coming close to it recently.

But, the latest dovish tone from the Fed is very supportive for high beta, bearish US dollar, bullish Emerging Markets equities, bullish gold and gold stocks as well.

With global "easing" on its way back, following investors fears of a policy mistakes and with a Fed more S&P 500 dependent thanks to the wealth effect, credit could see a return of "goldilocks" thanks to low rates volatility. 

The "R" word has been rising as of late thanks to the global deceleration in global trade on top of a flattening yield curve, but when it comes to credit markets in general and US credit markets in particular, it seems that the "D" word, "D" for deleveraging is staging a comeback as indicated by Bank of America Merrill Lynch in their Situation Room note from the 29th of January entitled "The (soft) floor on credit fundamentals":

"The (soft) floor on credit fundamentals

Our view is that large capital structures in the corporate bond market will go to great length to defend their IG ratings as it could become prohibitively expensive to operate in high yield. That (soft) floor on fundamentals remains one of the reasons we are overweight BBB-rated names. We make a couple of timely observations. First, although the situation remains evolving, we note that General Electric – the 6th largest BBB-rated issuer - is now again trading like the BBB-rated name it currently is, which is a remarkable turnaround after trading in line with BB-rated names during its weakest period last October/November (Figure 1).

Second, when Verizon – the second largest BBB - reported earnings this morning they managed to disappoint and the stock declined more than 3%. However with the company’s emphasis on deleveraging credit investors where not disappointed as spreads tightened about 2bps. AT&T – the largest BBB – was downgraded to BBB-flat in June last year. We would argue that for very large issuers BBB-flat is effectively the floor on ratings, as with further downgrades Fallen Angel risk would be too high for many investors. Since June 30, 2018 – when AT&T became BBB-flat rated in the indices – credit spreads in the Telecom sector, which is dominated by Verizon and AT&T, have tightened 12bps even as the overall IG market widened 10bps (Figure 2).

While we appreciate the longer term challenges to the Telecom industry from technological change, for the next several years we are comforted by relatively stable cash flows and the financial flexibility to support BBB ratings afforded by high dividend yields in the 4.5%-6.6% range. Hence our overweight stance on the Telecom sector." - source Bank of America Merrill Lynch

If there is indeed a slowly but surely rise in the cost of capital, yet at more tepid pace thanks to the latest dovish tone from the Fed, then indeed, this could be more supportive for credit, if companies choose the deleveraging route in the US to defend their credit ratings. In this kind of scenario, it would be more "bond" friendly than "equity" friendly from a dividend perspective we think.

In addition to a potential "D" for deleveraging story playing out for the US, Europe as well could also see a more defensive balance sheet stance coming from CFOs given the weakening growth outlook more pronounced on European shores. On that very subject we read some interesting additional points made by Bank of America Merrill Lynch in their note mentioned above:

"Credit Strategy/Equity Strategy: Who are the refi “losers”?

From the era of hubris… to the reality check

Between 2012 and 2017, European corporates basked in ever-declining debt costs, thanks to unprecedented support from the ECB. The result was a steady boost to Earnings Per Share estimates. Buoyant credit markets thus led equity markets higher. But now the tables have turned, and the equity market should be prepared for a reversal of this symbiotic relationship. European credit spreads have doubled over the last year and companies are finding that they must now pay large concessions on bond deals to attract the requisite demand. Moreover, bond refinancing is a pressing need for a number of companies that failed to term-out their debt maturities during the good times. We think that credit markets now signal that EPS downgrades lie ahead.

A walk into the future - who are the refinancing "losers"?

Table 1 screens for European issuers that could see the greatest EPS downgrades from refinancing their 1-5yr debt. Based on today's credit landscape, we calculate EPS hits of up to 4%. Which names tend to be captured by our screen? Those with plenty of frontend debt still, and those where credit markets have already priced-in steep credit curves.

While Table 1 highlights a variety of names, reflecting these mix of themes, (peripheral) utilities, autos, industrials and telecoms feature prominently. And while there may be mitigants to EPS hits for utilities (regulatory regimes) and autos (financial debt), if debt costs continue to rise in Europe, these sectors would be impacted in other ways.

The canary in the credit mine for stocks

At the height of ECB QE, interest costs for European companies had dropped to 20yr lows. However, interest expenses returning to pre-QE levels will likely become a reality, and will be a further headwind to an already slowing profit cycle. EPS Revision Ratios have been trending down since 2017, when credit spreads turned, and our top-down profit cycle model is predicting 0% EPS growth this year. While operational leverage is undoubtedly the key profitability driver, a 100bps rise in interest costs could lead to a ~2% hit to European EPS. Our strategic view on equity styles and sectors is to focus on quality companies with higher profitability and lower leverage - names that we think will be less vulnerable to rising interest cost and widening credit spreads.

Defend the debt…not the dividend

Companies manage to shareholders, not bondholders. That is the unspoken rule. But we believe that this narrative may no longer hold in today's world of tougher debt rollovers. Equity investors should be prepared for companies to "defend" their debt more than their dividend going forward. Equity investors should therefore be mindful of companies with a high quantum of front-end bonds, and with high dividend payout ratios.

Who are the refi "winners" still?

The silver lining for equity investors is that while debt costs are rising everywhere, some companies have been relatively slow to refinance their bonds over the last few years, and are thus paying higher-than-market coupons on their existing debt. When refinancing time comes, we believe these companies (Table 2) will likely see a small EPS boost.

- source Bank of America Merrill Lynch.

Whereas 2018 was not a good vintage for European stocks, then indeed there might be more additional pain for some equities holders should CFOs in Europe as well embrace a more defensive balance sheet stance, though, leverage in Europe has been creeping up at a much slower pace with the exception of France, being the outlier when it comes to corporate credit leverage overall.

We pointed out in our previous conversations that corporate treasurers in France were becoming more cautious given the deterioration they were seeing in their operating cash flows and slowdown in activity. We could therefore see more dividend cuts coming from French local players, if indeed CFOs adopt a more credit friendly approach when it comes to their balance sheet. The French "leverage" is highlighted in the below Barclays chart from their European Equity and Credit Strategy report from the 30th of January entitled "How worried should we be about Credit?":

- source Barclays

In relation to the European situation we read with interest Bank of America Merrill Lynch's Credit/Equity Strategy note from the 29th of January entitled "Who are the refi losers":

"Canary in the credit mine for stocks

The end of all-time lows on interest charges, as QE ends Since the inception of ECB QE in 2015, corporate borrowing costs have been falling up until 2017, when we saw the Euro cost of debt drop to all-time lows (Chart 5).

With ECB QE coming to an end, we have seen widening corporate credit spreads amid a widespread economic downturn and trade tensions. In periods of declining macro conditions, although safe-haven government bond yields tend to fall amid expectations of looser monetary policy, corporate credit spreads tend to widen due to the perception of rising default risks.

Interest expenses returning to pre-QE levels becomes especially important when EPS Revision Ratios in Europe have been trending down since May ’17 (chart 6) and our topdown earnings model predicts 0% EPS growth in Europe over the next 12 months (chart 7).

Unsurprisingly, investors are increasingly demanding that companies preserve cash to pay down debt rather than spend it on dividends or capex (chart 8).

We prefer more defensive High Quality names with lower relative quantities of frontend debt (or flatter credit curves). These are names that are less likely to see a hit to EPS from future debt refinancing, we think. Also similar to the list, we are strategically overweight the Food & Beverages equity sector in Europe.

European stocks dropped 18% last year, peak-to-trough, but have recovered the majority of December’s losses this year. Recent Fed action has clearly brought short-term relief, but so far has failed to generate large inflows back into Euro corporate credit. The key question is whether we can see a repeat of 2016, when the Fed took a long pause – and helped credit markets. However, in Europe, we think the ECB are unlikely to be able to offer new big stimulus, given the political constraints of QE.

We would note that equities have 88% correlation with credit spreads. But credit markets can also serve as useful leading indicators for equity investors. Large declines in EUR HY credit spreads have reliably signaled major troughs in equities in the past. With global growth in question, central banks are the only game in town (chart 9).

The credit market-equity market nexus

Note as well, that our analysis shows that a rise in European high-yield spreads of 100bp leads to an approximate 2% hit to market EPS in Europe (from the current levels). Given that our top-down model for European earnings suggests 0% EPS growth in 2019, we think that this is quite a meaningful number." - source Bank of America Merrill Lynch

If indeed the Fed's dovish pattern has been more positive for US equity holders including the high beta space, we do agree with Bank of America Merrill Lynch that, in Europe, the story might play out differently, with equities benefiting less from the ECB than credit markets overall. With slowing growth we continue to dislike European banks equities. From a credit perspective, it is more on a case by case basis we think but we would rather own selected credit from European banks than their stocks as far as we are concerned regardless of the high beta/cheap valuation put forward by some pundits or "confidence men" out there. 

So does it mean a return for "goldilocks" for credit? Sure they are many external factors such as Brexit and other geopolitical factors that come into play but, given the Fed has been in the driving seat in the most recent "risk-on" mood, there is a potential for a continuation of the rebound but probably not as significant as the one we saw during the second part of 2016 thanks to the rally in oil prices. We have touched this subject before on numerous occasions but when it come to a sustained rally for US High Yield, oil prices do matter a lot given the exposure to the Energy sector. 

With a notable slowdown in global growth on the back of rising angst surrounding the outcome of the trade war between the United States and China, with central banks coming to the rescue there is indeed a potential for credit to continue to perform on the back of the stabilization of fund flows in the asset class. In relation to US corporate credit's potential for pushing the United States into recession, as we stated before, earnings will be essential in 2019. On this subject we read with interest UBS's take from their Global Macro Strategy note from the 28th of January entitled "Credit Perspectives - US Corporate Credit - What we worry about and what we don't":

"While US growth is coming lower, rest of the world growth is still falling even quicker. Much as we think that at the aggregate level there are mitigating factors that imply US corporate debt won't itself lead to a US recession, there seems to be little doubt higher leverage means the US economy is more vulnerable to a profits slowdown, even one that has its origin abroad. The lack of willingness and ability from China to give a major stimulus this time has compromised growth both in Asia and Europe. Given that Asia has been a big driver of the demand for both tech and energy, key sectors for the US LL and HY markets, a slowdown here could have a big impact on US spreads. Energy issuers are still amongst the most vulnerable, even if the breakeven price for shale has fallen to USD 40-50 per barrel on WTI (Figure 24).

At those levels HY energy spreads could rise to 800-1000bps, we estimate. For the IG space, the big risk is European financials, to which US financials display a very tight correlation (Figure 25), and which have widened but less than would have been expected in the face of a sharp growth slowdown in Europe.

However, the decline in credit market liquidity means a sign of relative calm should not be read as a signal of health. Things could change dramatically with a few downgrades, or an uptick in NPLs." - source UBS

Given the significant rally in European credit since the inception of QE in Europe and with the ECB purchasing directly corporate credit, should a new TLTRO materialize in the coming months to continue to support the European financial sector, we do not think the upside will be as significant as seen before. We do have to agree with UBS namely that the "Zeigarnik effect" of our "generous gamblers" will probably be less potent than previously in engineering a significant rebound in credit markets à la 2016.

Moving back to the subject of earnings and risk-on/Goldilocks, we think there is limited upside in 2019 and we did warn in 2018, that when it came to earnings estimates, analysts were being overly optimistic in their outlook. December has clearly set the tone for vicious EPS revisions and cuts in many instances. If indeed CFOs become much more defensive of their balance sheet, then we could see more dividend cuts in 2019, which would be more credit positive, no wonder we suggested to seek higher quality in US Investment Grade versus high beta credit, performance wise, it has been more supportive to play quality (ratings) over quantity (high beta/yield) as highlighted in the below charts from Bank of America Merrill Lynch from their Credit Market Strategist note from the 25th of January entitled "High grades to IG":

"High grades to IG

While equities and high yield ended this week roughly flat (Figure 1) the strong rally in investment grade continued with credit spreads tightening at a roughly 5bps weekly pace (Figure 2).

This makes sense as the key economic data release this week – Jobless Claims – at the best level since the 1960s (Figure 3) confirms recession risk remains remote. Moreover, the Fed remains clearly on hold for an extended period of time (Figure 4) on the negative GDP impacts of tighter financial conditions and uncertainties surrounding trade war and the government shutdown.

For IG, the material decline in rate hiking risks in reaction to just some tenths cuts to economic growth is a good tradeoff. Being relatively more sensitive to economic growth for high yield and equities the tradeoff is a bit different.

The most likely scenario for how this year plays out, in our view, is continued improvement in the macro – US government reopens, Brexit resolves, US–China relations de-escalate and the US economy continues to grow above trend. As financial conditions ease this environment eventually puts the Fed in a position to resume its rate hiking cycle – probably sometime in the middle part of the year – which is going to be a more formidable challenge for IG. For now, we expect tighter credit spreads – although obviously the first big step has already been taken – but over time IG outperformance fades and turns to underperformance. We remain overweight IG corporate bonds." - source Bank of America Merrill Lynch

So yes, clearly, there is room for slightly more tightening with the Fed's dovish tilt and lack of interest rates volatility with falling inflation expectations. In terms of upside, it is a question of not having "great expectations" and being very selective hence the return of global macro and active management at this stage of the cycle with continued rising dispersion. 

Our final charts below clearly highlight the importance of central banks and in particular the Fed in driving asset prices, with its balance sheet policy reduction being the most important factor at play when it comes to the "Zeigarnik effect".

• Final charts - Central banks to markets: let's be friends again...

With the most recent dovish tilt coming out of the US Federal Reserve, no surprise "risk-on" lives on. It is all about after all a question of "growth sensitive assets" as indicated in our final charts from Bank of America Merrill Lynch The Inquirer note from the 30th of January entitled "Wanted: Monetary easing, not Verbal flexibility":

All indicators point to weak global growth, and suggest EASING monetary policy

1) Only 5 out of 38 economies are seeing rising OECD leading economic indicators (LEI). The net proportion of countries with rising LEI is in the bottom decile of its history since 1988. 2) The world's monetary base shrunk 1.7% YoY in November, only the sixth time since 1980. All prior five occurrences of a shrinking monetary base were associated with recessions in Asia/emerging markets, and ALL were eventually associated with global monetary easing. The Fed's plan to "watch paint dry" and shrink its balance sheet by USD50bn/month this year, is likely to shrink the global real monetary base by 5% YoY by end-2019. Global central banks are implying a massive rise in the money multiplier to counteract this, and/or a rise in monetary velocity to keep nominal GDP growth humming. We think these assumptions are heroic. 3) The global 1m earnings revisions at 0.5 (i.e. for every upward revision there are two downward revisions) is in its bottom decile. 4) Asset prices that have an opinion on global growth (Dr Copper, Dr Sotheby's, Dr. Halliburton etc.) are in their lowest decile. Again, prior instances of such analyst pessimism and weak asset prices were followed by monetary easing. Policymakers seem to be flexible, and the markets like this flexibility if data weakens. Next stop easing?" - source Bank of America Merrill Lynch

Given the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks, it seems that markets are more than happy to remember an incomplete balance sheet reduction from the Fed at this stage but, we ramble again...

"An educated person is one who has learned that information almost always turns out to be at best incomplete and very often false, misleading, fictitious, mendacious - just dead wrong." - Russell Baker, American journalist.

Stay tuned!

Macro and Credit - Respite

"I decided that there was only one place to make money in the mutual fund business, as there is only one place for a temperate man to be in a saloon: behind the bar and not in front of it." - Paul Samuelson

Looking with interest at the strong rebound in high beta in credit markets in conjunction with oil prices, with bad news (European macro) becoming good news for asset prices thanks to central banking intervention and dovish tilt, when it came to selecting our title analogy, we decided to steer towards a legal one "Respite". A "Respite" is a delay in the imposition of sentence but in no way modifies a sentence or addresses questions of due process, guilt or innocence. The pardon power of the United States Constitution has been broadly interpreted to include a variety of specific powers. Among those powers are: pardons, conditional pardons, commutations of sentence, conditional commutations of sentence, remissions of fines and forfeitures, respites and amnesties. Historically, presidents have granted most respites for periods of 30 to 90 days and have renewed (extended) such delays when it seemed necessary. We therefore wonder how long the current "respite" and "rebound" in asset prices will last but we ramble again...

In this week's conversation, we would like to look at the most recent bounce in asset prices in the light of the weakening tone from the macro data coming recently from Europe and indicative of the dreaded "R" word, "R" for recession. So, is good news bad news again?

Synopsis:

• Macro and Credit - Bad News is the new Good News...
• Final charts -  Macro matters again...

• Macro and Credit - Bad News is the new Good News...

With Germany on track for "technical" recession, with Italy and France slowing down markedly and with Industrial Production falling depicting a bleak picture overall for Europe (German Industrial Production fell by 4.7% in December, the biggest decline since December 2009), the rally seen so far this year appears to us as more of a respite than a secular change to the overall picture:

- Graph source Bloomberg

Industrial production has been falling in Europe off the proverbial cliff and regardless of the continuation of the "yellow jackets" movement in France, we continue to believe that France's budget deficit for 2019 could be "North" of 4.5%. The services industry in France has been cratering and people tend to forget that services represent 80% in GDP for France versus an average of 76% in the European Union. So, yes, we do believe there is more downside from there for the European macro picture. We are not the only ones sounding the alarm. We read with interest Bank of America Merrill Lynch Europe Economic Weekly note from the 11th of January entitled "The "R" club is recruiting":

"December PMIs: closer to 50, but risks still to the downside

The final print of Euro area composite PMI came in at 51.1, down from 52.7 in November, and the weakest level in four years. A slowdown was reported in both sectors, with manufacturing PMI down to 51.4 from 51.7 in November and service PMI at 51.7 from 53.4 previously. The decline was driven mainly by core countries: French business sentiment was hit by the ‘gilets jaunes’ protests in December (PMIs for both monitored sectors fell below the 50-threshold), and in Germany manufacturing weakness is spilling over to the services sector. On the flipside, Italian PMIs recorded a small improvement in December, with composite PMI back at 50 (no-change threshold), after two months in contractionary territory. With composite PMI averaging below-50 (49.5) in Q4, growth momentum for Italy remains weak. However this improvement (in particular in the new orders balance) suggests some stabilisation in Q1.

Meanwhile hard data for 4Q is not helping either. Industrial production prints were particularly negative. We insist, the weakness goes beyond one offs. Trade data did not help either, neither in Germany nor in France. External demand lacks traction, consequence of the lagged impact of the NEER strengthening and Chinese weakness.

We still think that the Euro area data trough is only for 1Q19, foreign demand permitting. It is then when our China colleagues expect the region to start improving and, given the usual lags, when the negative impact of the NEER should start fading. But remember that Europe typically lags the rest of the world by a few months, and continued weakness in China and the ugly US manufacturing ISM print in December would suggest that foreign demand input to the Euro area is still a drag (Chart 1).

It is crucial for us to see whether the drop in US PMI was a one-off and when the impact of policy support will materialize in China. Meanwhile, we have to rely on low oil prices as a tailwind helping purchasing power and corporate profit margins in the Euro area (Chart 2).

- source Bank of America Merrill Lynch

Obviously given Germany is an export driven powerhouse, no wonder the trade war narrative which has prevailed over most of the course of 2018 has had the desired effect of not only pushing the German DAX index into bear market territory but also has had the effect of plunging Germany into technical recession.

Given the bloodbath experienced during the "Slaughter" Claus bear market of December, it is not surprising to see some sort of strong rebound in "high beta" land and for credit markets to rally particularly on the back of rising oil prices given the exposure of the US High Yield sector we have discussed in recent conversations. 

When it comes to the "Respite" and intensity of the rally in US credit, Bank of America Merrill Lynch in their High Yield Strategy note from the 11th of January entitled "HY Energy: Any Value Left Here?" made some interesting comments:

"Intensity of risk rally reaches historical records

An incredibly strong rally in credit has taken HY spreads down to 450bps from 540bps levels reached in early January. HYG has rallied 5.4% from its low prints around Christmas, the strongest such 10-day rally since Oct 2011 (post-US downgrade rebound) and March 2009 (post-GFC recovery). CCCs have outperformed BBs by 230bps in this move, and Energy was the strongest sector contributor.

As we outlined in our Jan 2 piece, a tactical bounce was likely from the oversold late- December levels as the market has done so in every episode of previous 200bp/3mo widenings. We also noted there that the average rally was 170bps within subsequent three-month horizons in such earlier episodes, and so a 90bp move so far provides a material down-payment towards that. While the market can continue to trend tighter in coming weeks, we think a pullback is possible and even likely here, just given the intensity of the move so far. In the 12 year history of HYG, it has only managed to post stronger 10-day gain in two instances: in 2011 when the market rallied from 900bps levels, and in 2009, when the market was coming out of the global financial crisis (GFC) with 1,800bps spreads. Spreads are not in 900s this time around and this is not 2009.

We continue to think that 500bps is an appropriate risk-neutral level of HY spreads here and the likely trading range around that is going to be +/-100bps. As such we view the current 450bps as somewhat tight and prefer to reduce our risk exposures towards more neutral levels from an earlier overweight. We will be looking to extend this to an outright underweight if the market continues to grind tighter from here towards 400bps levels.

We would be surprised if the index tightening deep into 3-handles in coming months. Similarly, we are inclined to move closer to home with our recent tactical CCC overweight given the move so far, which we viewed purely as a short-term reaction to oversold levels and not a fundamentally-driven position. In rates, the reversal in the 10yr yield from 2.55% low print on Jan 3rd to 2.75% recently makes us more interested in adding duration risk here again. We continue to see decent longer-term fundamental value in rates at current levels as inflation fears of 2018 fade into oblivion.

All changes to positioning described above should be viewed as a tactical reaction to very strong moves in the markets since early January, not as changes to our fundamental view this could be a turn in the credit cycle. No question, the return of risk appetite helps decrease the probability of irreversible tightening in financial conditions, but we think it would be too premature to argue conclusively that this is an all-clear signal.

Tactical rallies are perfectly natural after deep selloffs, but we will need more hard evidence that the damage to economic momentum so far is reversible. What will ultimately determine the course of history here is the direction of earnings growth. Our +10–12% US EPS growth estimate for next year provides us with the strongest argument that this cycle could roll on. However, we remain cognizant that this is a model estimate and models could be wrong. We also know that earnings growth in recent years was largely driven by technology, and recent downbeat outlooks from heavyweights like Apple and Samsung do not help this case. The best course of action here, we think, is to stay open-minded on the question of a cyclical turn." - source Bank of America Merrill Lynch

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

We think that a continued surge in oil prices will be supportive to US High Yield. As well, any additional weakness in the US dollar will support an outperformance of selected Emerging Markets. Sure we might be short term "Keynesian" but overall, at this stage of the cycle we do remain cautiously medium-term "Austrian".  When it comes to fund flows we read with great interest Bank of America Merrill Lynch Follow the Flow note from the 11th of January entitled "Is the worst finally behind us?":

"Some signs of relief

This year has started on a positive note. Despite further weakness on the macroeconomic data front across the globe, risk assets managed to rebound. Light positioning and the end of year sell-off allowed investors to buy the dip. Flows have shown signs of relative stabilisation with fixed income funds seeing inflows and equity funds suffering the smallest outflows in a while. However, we feel that this rally will be short lived as macro continues to disappoint and spreads need to head wider before they tighten again.

Over the past week…

High grade funds suffered another outflow, making this one the 22nd week of outflows over the past 23 weeks. However, this week’s outflow is the second smallest observed over that period. High yield funds recorded another outflow, the 15th in a row, but also the smallest in a while. Looking into the domicile breakdown, European focused funds recorded the lion's share of outflows while US-focused funds outflow was more moderate. Global-focused funds only marginally suffered.

Government bond funds recorded a large inflow this week, the largest in 27 weeks and the 5th over the past 6 weeks. Meanwhile, Money Market funds recorded another sizable inflow. All in all, Fixed Income funds recorded an inflow, putting an end to 18 consecutive weeks of outflows.

European equity funds saw some relief, recording a very marginal outflow this week. Still, this makes it the 18th consecutive week of outflows. During the past 44 weeks, European equity funds experienced 43 weeks of outflows. Chart 1: Risk assets fund flows managed to record a rebound in the first week

Global EM debt shifted back into positive territory this week with a sizable inflow, thus ending a series of 13 consecutive weeks of outflows. This confirms the improving trend observed recently. Commodity funds recorded another inflow, the 5th in a row.

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

Following the December rout, it is all about damage assessment we think at this stage. The macro picture continues to display a deceleration in both global trade and global growth, now we think, it is all about the earnings picture and given the large standard deviation moves seen in some instances such as Apple, Delta Airlines, Macy's and many more, we are left wondering if indeed this rally can sustain itself on the back of a more dovish tilt from the Fed.

If indeed from a macro perspective at least in Europe it's the "R" word, for "Recession" in many instances, then we wonder if the "D" word, for "Deflation" when it comes to looking at the savage earnings revisions seen so far at a very rapid pace:

- graph source Bloomberg

On the question of the "Deflation" and earnings we read with interest the latest article on Asia Times from our esteemed former colleague David P. Goldman in his article from the 11th of January entitled "How widespread is creeping deflation in the US stock market?":

"Companies with challenged business models account for nearly two-thirds of the S&P 500's top 50 earners

"Investors are waiting for guidance from the US-China trade negotiations, but most of all they are waiting for indications of how the economic disruptions of the past few months will affect earnings.

The slightest hint of squishier earnings guidance provokes brutal punishment. Wednesday it was telecom providers, today retailers. Fragile business models make most US market leaders risky. That’s why I don’t think a dovish Fed is enough to sustain a market rally.

Department stores led declines today, with Target bringing up the rear in the S&P 100 (-4%) and department stores taking the bottom slots in S&P 500 performance – Macy’s (-19%), L Brands (-7%), Kohls (-7%), Nordstrom (-5.4%).

Airlines took yet another beating, with American Airlines down 6.2%. It’s all about pricing power. Consumers are still spending, with real personal consumption expenditures up 1.9% year-on-year as of November, and more workers are earning a paycheck. Consumer debt service comprises the lowest percentage of personal income since the data were collected.

Yet consumer names have been battered. Apartment real estate investment trusts face falling rents, airlines face passenger pushback on price, aging brands face competition from cheaper generics, and tech companies face resistance to overpriced products, for example, Apple.

Roughly two-thirds of the top 50 S&P 500 companies (ranked by earnings before interest, taxes, depreciation and amortization) face a serious challenge to their business models.

The complete annotated ranking is shown below. Economic growth is not the only issue worrying the stock market. Most of the market leaders are aging monopolies that risk losing their grip on customers.

The biggest exception to this rule is Amazon, which is doing most of the disrupting. But the fact that Amazon is able to disrupt everyone else depends on the willingness of Amazon shareholders to live without earnings. It now trades at around 110 times trailing earnings. Netflix trades at 95 times trailing earnings.

Deflation and value destruction are bad for equity markets. Amazon eats the retail market, and the department stores crash, along with CVS, and the REITs that own the properties from which the retailers rent.

Huawei crushes Apple in the Chinese market. Sprint, T-mobile and even more aggressive discounters erode the earnings of AT&T and Verizon. Proctor and Gamble, Johnson and Johnson, General Mills, Campbell’s and Kraft-Heinz have to sell their products on an Amazon web page that conveniently flashes an ad for a generic alternative.

Taken together, companies with challenged business models generate nearly two-thirds of the earnings among the top 50 members of the S&P 500.

(click to enlarge)

- source Asia Times - David P. Goldman

Now if higher profits were somewhat "juiced" up by stock buybacks, then indeed no wonder earnings revision have been savage so far. Back in October last year in our conversation "The Armstrong limit", we quoted as well another article from David P. Goldman and discussed the "profit illusion". 

In our macro book, the "velocity" in "earnings revisions" regardless of the "Respite" due to "bad news" being "good news" again in forcing the hand of our "generous gamblers" aka our central bankers, mean that the growth outlook for the US is also at risk. This is pointed out by Bank of America Merrill Lynch in their US Economic Weekly note from the 11th of January entitled "Earnings downgrades =  GDP downgrades" and we are not even mentioning the ongoing government shutdown at this stage:

"Earnings downgrades = GDP downgrades

• Earnings estimates continue to be slashed, which suggest that further downward revisions to GDP growth are forthcoming.
• While the direction of revisions is relevant, be careful relating actual earnings growth to economic performance.
• After controlling for oil prices and the services share of the economy, economic and earnings growth become much less correlated.

Resetting expectations

Earnings estimates for 2019 are being slashed. Just this week, Macy's and Barnes & Nobles made news by cutting their profit estimates while American Airlines warned that earnings may fall short of expectations. It seems that analyst estimates may still be too optimistic even after a slew of downward revisions over the past few months. According to Savita Subramanian and team, the consensus EPS growth is 7% for this year, which is down from the 10% forecast just three months ago

What does this tell us about the economy? It is intuitive for earnings estimates to correlate with economic growth as earnings are a function of expected revenue growth. A simple scatter plot of annual EPS growth and nominal GDP growth shows the positive correlation (Chart 1) but with very low significance.

This means there is more to the story. We see three reasons that earnings will differ from US economic growth:

1. S&P 500 has greater sensitivity to global growth with 46% of sales coming from foreign markets. In contrast, only 12% of US growth is from exports.
2. Oil prices have a different impact on the S&P 500 than on the overall economy. There is a clear positive correlation for the market – higher oil prices boost earnings for energy companies. The impact on the US economy is slightly negative.
3. The S&P 500 has a greater concentration of manufacturing

We run a series of models to determine how much these factors influence the relationship between earnings and GDP growth. We first start with a regression of earnings growth as a function of US and global GDP growth which shows a statistically positive relationship between GDP growth and earnings. We then include oil prices which show up as a positive relationship with earnings and reduce the significance of US and global GDP growth. Swings in oil prices can overwhelm the impact of growth. Think back to 2015 when the decline in oil prices led to an earnings recession without an economic one. Adding in the change in services share of the economy ends up leaving US and global GDP growth as insignificant. This tells us that as the economy becomes more services based, the relationship between earnings and US growth weakens.

The sensitivity to global growth and oil prices allows earnings growth to be much more volatile with a standard deviation of 17% vs. nominal GDP growth of 2.5% (Chart 2).

This could also be explained by the fact that the sample for aggregated earnings change overtime, thus creating a bias that does not reflect the whole economy.

We revise together

While the relationship between GDP growth and earnings growth is complicated, as we argue above, we still can take signal from the forecasts for earnings. We find that the direction of earnings revisions can tell us something important about the direction of GDP revisions. As Chart 3 shows, the consensus forecast for earnings and GDP growth tend to be revised in tandem.

Looking at the evolution of forecast for the current year earnings and GDP growth over the past four years, the direction is consistent. The outlier was in 2015 when earnings were slashed more dramatically than GDP and the latter actually ended up being revised higher at the very end of the year.

Collecting all data

Given the high degree of uncertainty about the outlook, we should look at all sources of information. As Fed Chair Powell has made clear in recent remarks, on the one hand, the economic data continue to point to a solid expansion. But on the other hand, market measures have deteriorated with a sharp sell-off in equities and a flattening in the yield curve. We consider earnings estimates to be a mix of both economic and market signals.

We think they are pointing to a moderation in growth but not a contraction. We should heed Powell’s advice. Have patience until we see who is right – the data or the markets." - source Bank of America Merrill Lynch

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

If 2018, with liquidity being reduced thanks to central banks was volatile, 2019 marks we think the return of "macro" and given the rise in dispersion it also marks the return of active management we think as per our final charts below.

• Final charts -  Macro matters again...

With global liquidity supply on reduction mode and with 2018 marking the return of volatility, with rising dispersion and more and more large standard deviation moves, 2019 will continue to indicate a return of macro as an important factor for returns. This means that active management, should benefit from this trend. Our final charts come from Bank of America Merrill Lynch note Why They Did What They Did from the 9th of January entitled "What's past is prologue":

Macro mattered more than fundamentals in 2018

Based on the ~40 macro factors and ~50 quantitative factors we track, macro factors had higher explanatory power on stocks’ 2018 returns than fundamental factors (average R-squared of 5% for macro factors vs. 1% for fundamental factors).

And the top 10 factors with the highest explanatory power were all macro factors – in particular, credit spreads, commodities, the USD, consumer confidence, and the VIX.
As for fundamental factors, one of the most explanatory factors on returns in both 2018 and 4Q was Beta.

Stocks less sensitive to macro (idiosyncratic stocks) have outperformed

• Some stocks tend to move more with macro factors (i.e. high systematic risk) while others move less (i.e. more idiosyncratic). In our recent report we grouped BofAML-covered US stocks based on their overall macroeconomic (i.e. multivariate) impact using a principal components (PC) regression.

• The results from the screen and a backtest of its performance over time suggested that idiosyncratic stocks (those with a below-median regression Rsquared) have outperformed systematic stocks (those with an above-median regression R-squared) since the crisis (including last year), primarily due to lower annualized volatility of the former with slightly better annual returns.

• Segments of the S&P 500 most exposed to risks around trade – in particular, multinationals with high China exposure and stocks in industries with high import costs—have seen multiples compress most (by ~20%) since trade tensions began to rise last February.

- source Bank of America Merrill Lynch

While investors have been enjoying a welcome respite in the early days of 2019, with "bad news" becoming "good news" at least from a "dovish" Fed narrative, we do not buy the strong expansion narrative put forward by many sell-side pundits, though if indeed flows return to credit markets, Investment Grade credit could thrive again at least in the near term from a "Keynesian" perspective. There is no doubt that growth is decelerating and our concern is that cooler head can prevail avoiding us from moving from the "R" word of recession towards the "D" word of depression, but that's a story for another day. Enjoy the ride while it last.

"The only safe ship in a storm is leadership." -  Faye Wattleton, sociologist

Stay tuned ! 

Macro and Credit - Maneuver warfare

"War is not an independent phenomenon, but the continuation of politics by different means." - Carl von Clausewitz

Looking with interest the rise in noncooperation around the world, with increasing trade war rhetoric between the United States and China, Turkish spiraling woes, Saudi diplomatic spat with Canada, Iranian sanctions building up against a reticent yet divided Europe and the push for additional Russian sanctions making rounds, in continuation to our war analogy used in July in our conversation "Attrition warfare", we decided to go for another one, namely "Maneuver warfare". "Maneuver warfare", or manoeuvre warfare, is a military strategy that advocates attempting to defeat the enemy by incapacitating their decision-making through shock and disruption. Given the shock and awe tactics used so far by the Trump administration with North Korea and now with Iran, not to mention the tensions rising between the US and their European allies, one can clearly make sense of the use of our chosen analogy. In "Maneuver warfare", tempo and initiative are critical to the success of the operation. According to the United States Marine Corps, one key concept of maneuver warfare is that maneuver is traditionally thought of as a spatial concept, the use of maneuver to gain positional advantage. The US Marine concept of maneuver, however, is a "warfighting philosophy" that seeks to shatter the enemy's cohesion through a variety of rapid, focused, and unexpected actions which create a turbulent and rapidly deteriorating situation with which the enemy cannot cope. The U.S. Marine manual goes on to say: 

"This is not to imply that firepower is unimportant. On the contrary, firepower is central to maneuver warfare. Nor do we mean to imply that we will pass up the opportunity to physically destroy the enemy. We will concentrate fires and forces at decisive points to destroy enemy elements when the opportunity presents itself and when it fits our larger purposes."

One can argue that in recent years the United States have decided to "weaponize" the US dollar. The continuation of the surge of the US dollar thanks to QT and a hawkish Fed on the back of the US economy heating up, with the surge of inflationary pressures is indeed wreaking havoc on over-exposed and over-leveraged Emerging Markets economies such as Turkey. We do not see any respite yet for some ailing Emerging Markets which are over-exposed to US dollar funding and rollover risk.

In this week's conversation, we would like to look at the continuation of the demand in high beta and the summer rally which is continuing for US equities mostly and ask ourselves how long it can go on as we move towards fall. 

Synopsis:

• Macro and Credit - Asset prices - Still short term "Keynesian" but starting to feel "Austrian" again
• Final charts - This isn't your grandfather's market

• Macro and Credit - Asset prices - Still short term "Keynesian" but starting to feel "Austrian" again

Given the strong tone of recent earnings in the United States corporate world, we continue to advocate being overweight US versus the rest of the world. To repeat ourselves, riding the EM wave was great in 2017, and we confided bailing out in late January this year, but, 2018 is proving to validate our most recent title "Dissymmetry of lift", in the sense that the United States is powering ahead in both macro and equities, whereas so far, the rest of the world is struggling to keep up with the pace (check out MSCI World versus the S&P500, we rest our case). But, what is today's news in terms of macro data, is already yesterday. Sure earnings were strong though there are already signs, even in the US of a weaker tone in the macro data (US housing and Mortgage applications for example). The US 10 year Treasury notes yield continues to flirt with the 3% threshold. With inflationary pressures building up on global scale, if you want "real yield", even if US inflation seems to become stronger, you probably want US dollar fixed income exposure from a carry and roll-down perspective. We mentioned that 2018 marked the return of US dollar cash in the asset allocation toolbox.

When it comes to credit and asset allocation US credit and in particular the high beta space continues to benefit from the summer rally on the back of a technical bid thanks to reduced issuance. This is put forward by Bank of America Merrill Lynch in their High Yield Strategy note from the 3rd of August entitled "A Good Combination":

"HY caught in between strong earnings and weak issuance

The HY bond market performed well over the past few weeks, with spreads tightening to 340bps down from 380bps around early July. This move nearly fully offsets the earlier widening that the index has experienced in late June. A notable change that has taken place during this period of time is that IG and EM assets have rebounded, allowing HY to rally along with them. In July, our USD IG and EM IG indexes have tightened by 15bps band 17bps respectively. Modestly higher rates contributed to this backdrop, with the 10yr Treasury yield currently at 3.0%, up from 2.80-2.90 range it established earlier in the month.

BBs continue to show notable resilience against this backdrop of higher rates coupled with their disadvantage to CCCs in spreads (an average BB OAS is 230bps vs 690bps in CCCs). Despite these headwinds, BBs performed exactly in line with CCCs in terms of spread changes and total returns over the past two weeks, and they are only marginally behind CCCs over the past month.

Year-to-date, the HY market is 17bps tighter in spread terms against a meaningful 55bps rise in 10yr yields. It has generated a total return of 1.2% and excess return of 2.2%, in both cases driven primarily by CCCs outperforming earlier in the year. Loans have posted a 3.0% YTD total return.

In technicals, this past week saw a moderate volume of coupons and calls/tenders in HY, around $2.5bn on each side. This was met with little issuance to speak of, at less than $1bn. Next week brings light calls ($1.2bn) and no coupons. The week after, ending Aug 17, promises a heavy $5.3bn call volume, complemented with $3.7bn in coupons. For the full month of August, we are forecasting $15bn in HY gross issuance against $13.6bn in calls/tenders and $1.6bn in maturities. We are also expecting $7.3bn in coupons, although as we have argued here, these should not be viewed as longer-term sources of investable cash.

Ok, so what do we think here? Two factors define the current HY corporate credit market backdrop more than others, in our opinion: strong earnings growth and weak issuance. Starting with earnings, our equity strategists are tracking 2Q bottom-up S&P500 EPS at $40.52 amid better-than-expected results across all 11 sectors (led by Tech and Health Care). This represents roughly a 15% increase from estimates going into the year, the outcome largely driven by the corporate tax reform. Overall, 58% of companies have beaten analysts' expectations on the top- and bottom-line-the secondhighest proportion of beats in their data history.

Our own model of corporate earnings, initially introduced here, is currently pointing to an 18% growth in EPS over the next 12 months (Figure 1).

As a reminder, the model includes non-farm payrolls, consumer confidence, growth in corp debt and capex among key factors with leading relationships over earnings.

Credit cycles generally do not turn in the environment of double-digit earnings growth, and with earnings expectations outlined above we remain generally constructive on the longevity of this cycle.

Having said that, we must acknowledge that there is a number of ways a cycle could be cut short, and we are witnessing some of those ways being tried in recent weeks and months, including trade threats and otherwise generally irresponsible actions. We continue to think that little tangible long-term policy measures come of out of all this noise, and recommend heavily discounting most of it. Nevertheless, we remain cognizant of potentially being wrong at the end as second- and third-order effects begin to accumulate.

The other defining factor of the current environment is a slow pace of HY issuance. This has been the case throughout most of 2018, and it appears to have only gained further momentum in July: a month that is otherwise among the seasonally slowest has posted $8.4bn in primary volume, half of our seasonally adjusted estimate. We are also expecting a normally seasonally slow August, at $15bn (Figure 3).

YTD HY issuance is running at $117bn, or 24% below last year’s $155bn total over the same timeframe. Slow issuance is not happening in isolation, as we documented how both retail and institutional flows in HY have turned negative in recent months (Figure 7).

In addition, albeit less relevant, coupon flows are also going through a seasonally weak part of the year with both August and September among the slowest months (Figure 4).

The next key question in our discussion is whether weak demand for HY is causing financial conditions to tighten. Once/if such tightening occurs it generally leads to meaningful repricing of credit risk as investors begin to question the ability of weaker issuers to access market liquidity to satisfy their funding needs for investment and debt management activities.

To answer this question, we refer to Figure 5 (performance of recent new issues) and Figure 6 (performance of aged issuers with no market access in recent years).

We think that when underperformance is limited mostly to recent new issues, it is more reflective of their higher secondary market liquidity aspect, and not necessarily a wholesale repricing of credit risk. In this scenario, investors sell liquid assets in order to temporarily adjust portfolio risk without necessarily taking a long-term view on a credit/sector/market.

On other the hand, underperformance in aged issuers better reflects tightening financial conditions. In this scenario, investors get out of risk even if it means selling an illiquid instrument into otherwise weak market, often at prohibitively wide bid-asks. These actions require longer-term commitment to a trade and so could lead to meaningful tightening in financial conditions, particularly for the group of aged issuers who have been out of the market for a while.

Based on what we see in Figure 5 and Figure 6 the evidence leans heavily towards the first scenario, where recent weakness is limited to newly issued and liquid instruments, and thus more likely to be temporary in its nature. It provides support to our argument that this credit cycle is not yet showing signs of cracks in its basement.

So then the next question is: if this is not yet a turn in the credit cycle, why is demand weak, both on institutional and retail sides (Figure 7)? We think the answer originates in tight valuations, both in absolute sense, and also against other major yield alternatives. At 340bps, HY spread is 18th percentile of its historical range over the past 25 years, and it has never delivered positive excess returns over a three-year horizon starting with sub 300-bps spread levels. We are not quite there yet in terms of extreme tights, but we are getting there.

And in a relative value sense, some major alternatives are now becoming available to investors, including a 4% yield on our USD IG index, 4.5% on EM IG, and a 3% yield on Italian 10yr, and 7.5% on Turkish 10yr USD bonds. As Figure 8 demonstrates, HY used to deliver more that 15% of Global Agg’s expected income two years ago, and now that share has dropped to less than 8%, returning to its normal historical range for the first time in four years.

For as long as valuations in HY remain tight in absolute and relative sense, we expect weak flows to persist, leading to soft demand for new issues.

And so we are to be dealing with to contemporaneous developments going forward: strong earnings and weak issuance, a good combination indeed. Between these two forces, the HY market should continue to experience deleveraging going forward. As Figure 9 shows, US corporate credit has been in the process of slow deleveraging for the past two years, and we expect it to persist and perhaps even accelerate going forward.

As we opined previously, high leverage in corporate credit is not an indication of the next cycle being around the corner but rather a consequence of the commodity bust of 2014-2015 showing all the hallmarks of being a credit cycle, albeit limited in scope/duration.

Figure 10 also goes on to show that US corporate issuers have slowed down their share repurchase activity in recent quarters.

Note that dividend payments plummeting to negative values are a function of foreign earnings repatriation, and thus temporary in its nature (we have previously witnessed this behavior in 2005-2006 during the previous foreign tax holiday). Regardless, these repatriated funds could be used to continue the deleveraging process if corporate managements chose to do so, a development we expect to take place.

As we mentioned previously, we find HY valuations to be on a tight side both in absolute value sense (340bps actual level vs 380bps target), and relative value sense. On the latter side, Figure 11 and Figure 12 provide some context behind this view, based on our previously introduced models described here.

Both charts are showing z-score signals of deviations in HY vs IG and CCCs vs BBs respectively. We thus find HY to be trading too tight against IG by 1 standard deviation event, or roughly 50-75bps. We also find CCCs to be modestly tight to BBs, by about 0.5x stdev event.

Note that HY vs IG relative value deviation is also consistent with our strategic targets on both asset classes, where Hans Mikkelsen maintains a 100bp target in IG (-16bps from here), and HY needs to go +40bps from current levels to reach at our target.

We view these valuation gaps as modest headwinds at this point, i.e. not extreme enough to substantiate a full-scale underweight in anticipation of outright negative returns. We think higher quality outperforms in beta-adjusted terms (2.0x for IG vs HY and 1.7x for BBs vs CCCs), but not yet in direct 1-to-1 terms. We will need to see a stronger valuation gaps to be willing to take an outright underweight in CCCs vs BBs and expect unadjusted 1-to-1 underperformance in lower quality.

Another way to think about the extent of this positioning would be to say that we a willing to take 1/3rd of the total possible extent of an underweight in lower quality vs higher quality here. We would be looking for even tighter valuation gaps to be willing to go further down that line, to 2/3rds of the full extent of an underweight. Signals that would get us to a full-scale underweight need to be as strong as those generated by our model in 2000, 2007, and 2014, all turning points in previous credit cycles (Figure 12).

Higher rates remain a key risk to this positioning, as they have been since February without much to show for their progress since then. We continue to believe that global rates should go on towards further normalization, while US rates are already approaching their peak levels for this cycle. As such we view US 10yr at 3.0% as good value, with an eye towards 3.25% as better value. We do not expect this benchmark to exceed 3.5% on a sustainable and meaningful basis.

We also note that measures of implied vol are again very low across the board – equities, rates, FX, and credit. This backdrop helps spreads grind tighter while it persists, and yet we think the low vol environment should be used to gradually reduce portfolio risk, not increase it. The time to use this dry powder of available portfolio risk allocation will come when we hit the next volatility episode, whatever the cause of it might be." - Bank of America Merrill Lynch

Given US Investment Grade so far has been lagging US High Yield, from a relative value perspective, if indeed we are looking at a "macro" deceleration thanks to the rise in "Maneuver warfare" then we could see the duration game coming back into play which would no doubt benefit more US Investment Grade versus the successful high beta game which has been performing well in 2018. We do agree with Bank of America Merrill Lynch in the sense that current low vol complacency should entice somewhat some risk reduction in less liquid high beta exposure as we move into the third quarter which is traditionally more jitterier it seems.

So what's the risk for US credit markets one might rightly ask?

As we pointed out in previous conversations, the US credit markets benefit from a strong outside support thanks to the large appetite of foreign investors in particular Godzilla the NIRP monster which is "Made in Japan". Both the ECB and the Bank of Japan are still failing there inflation mandate meaning that there is plenty of accommodation from their part. From our perspective, the biggest risk for US credit markets would indeed be a buyer strike emerging from Japan. On that point we read with interest UBS's take in their Global Credit Strategy note from the 6th of August entitled "What if JGB yields keep rising?":

"Last week’s BOJ decision to raise the 10year JGB ceiling to 20bps has attracted investor attention, particularly considering that JGB volatility has increased since their initial announcement. We believe the focus on Japan is warranted, given the sizeable outward portfolio flow generated by very low JGB yields. Japanese insurers have increased their allocation to corporate bonds steadily, from 8.7% in March 2010 to 13.6% in March 2018 (Figure 1).

Japanese pensions have been forced abroad to foreign fixed-income in size, as GPIF’s asset allocation demonstrates (Figure 2).

In a previous note, we estimated that Japan represented 25% of the total net flow, and 50% of the total non-US flow, into index-eligible IG credit over the past few years, easily surpassing Taiwan and Europe in importance.

Will the BOJ’s policy shift negatively impact credit?

As long as the BOJ credibly commits to defending the 20bps maximum on 10yr JGB yields, we believe credit flows will be relatively unaffected. The largest Japanese pension fund (GPIF) seeks a return target of 1.7% + the rate of increase in domestic wages (which has been roughly flat over the last several years). JPN insurers need 20-30yr JGB yields of around 1% to meet guaranteed interest rates on new insurance policies. At current JGB yields, there is still a strong incentive to invest abroad. In addition, both 7-10yr US IG and EU IG credit provide an attractive 50-100bp yield advantage over 30yr JGBs, even after paying funding costs to hedge back into yen (Figure 3).

Rising dollar hedging costs may shift demand from the US to Europe, but the flows to global credit in general should continue (Figure 4).

Lastly, nearly 40% of JPN life insurer portfolios are unhedged for currency risk; clearly this increases the appeal of holding US fixed income with Treasury yields near 3% and US IG corporate yields near 4%. Our conversations with local investors indicate unhedged dollar buying could increase this year, particularly with the marketing of dollar-based insurance policies to local clients. We would expect unhedged USD fixed income purchases to pick up most aggressively, after a strengthening in the yen to 100-105 vs the dollar, from 112 today, based on public reports.

What could materially derail the JPN flow into global credit? If 20-30yr JGB yields hit 1%+, we would become meaningfully more concerned (Figure 5).

This is not our base case in 2018, but it could occur with either 1) a formal change in the BOJ’s 10yr yield target (highly likely by July 2019) or 2) a bear steepening of the JGB yield curve, that the BOJ allows to aid a banking system squeezed by low rates at home and higher dollar funding costs, exacerbated by Fed hikes. Our conversations with local insurers and several public statements1 indicate that 1% long-end JGB yields would preclude the need to continue buying foreign fixed income. Importantly, even if US and EU yields increased to maintain their current yield advantage over JGBs, JPY lifers would still prefer to invest at home. 20-30yr JGBs reduce asset liability duration mismatches, better than global credit, given the long average duration of life insurer liabilities (19yrs). Investing in JGBs also clearly reduces portfolio volatility with respect to credit and FX risk; note that even insurer FX-hedged purchases of foreign bonds do not generally hedge the interest income that accrues, introducing another source of risk into future returns.

The good news? We find it difficult to fathom Japanese life insurers selling existing holdings of global credit; these bonds are needed to meet legacy insurance policy yield bogeys that are much higher than the current 1% rate. It would take a material increase in downgrade/credit risk to force outright selling.

But the lack of new flow would put pressure on US IG, and reduce a potential buyer for EU IG at a time when the ECB is ending CSPP. Any material period of issuance would likely lead to spread widening, as we experienced for much of 2018 until recently. And there is no obvious buyer to pick up the baton from Japan. Rising dollar funding costs have caused Taiwanese insurers to allocate less to 30yr US IG credit (Figure 6); this will be exacerbated by additional Fed hikes in 2018 & 2019.

In Europe, dollar funding costs of 2.8% are a problem and Solvency II prevents insurers from running unhedged positions to obtain extra yield. Lastly, while many investors have focused on US pension demand given an increase in funding ratios, we believe this overlooks the forest for the trees. Non-US investors purchased $1.4tn in US credit since 2013; US pensions purchased $350bn (Figure 7).

It seems unlikely that increased pension demand could make up for a reduction in foreign buying on its own; all US investors (including insurers and domestic funds) would need to increase their purchases, and likely in concert with a reduction in IG issuance and continued strong fundamentals, to keep IG spreads stable if the Japan bid fades.

1%+ back-end JGB yields would not only impact US IG credit. JPN pensions have also drastically reduced domestic holdings of JGB yields in order to buy foreign fixed-income (Figure 8).

But there is room to add if JGB yields rise, though the bar for pension reallocations is likely higher than for insurers. The more aggressive stance of JPN pensions this cycle would mean that high-yield would be at risk of a reduced inflow. In particular, EU HY has been the major beneficiary of separately managed account flows from JPY pensions (Figure 9).

While flows into other credit markets have been more limited, we would note that short duration US HY, a consensus favorite today, could also face negative side-effects.

Will US HY’s perfect technical storm last?

US HY spreads have effectively lapped the field in 2018. US HY spreads are -10bps tighter, far besting performance in US IG (+16bps) and EU HY (+61bps) and contrary to our expectations in Q2. In addition, lower-quality HY spreads have tightened considerably, with CCC spreads -63bps YTD. The easy answer to the above dynamic is that US growth is strong, which has led to improved earnings and healthier credit fundamentals. However, this does not appear to be the case. We are still awaiting full Q2’18 earnings releases, but B+CCC rated HY EBITDA growth through Q1'18 was a paltry 2% Y/Y, closer to an earnings recession than  to the peaks of this cycle (Figure 10).

We believe lower-quality US HY remains most vulnerable, given weaker fundamentals and outsized performance this year relative to BB’s. We estimate 36% of CCC, 30% of B, and 25% of BB issuer debt is floating-rate in nature (Figure 11).

Clearly, as the Fed keeps hiking, HY earnings growth has to pick up from current levels to prevent a worsening of interest coverage ratios, which while not precarious, are fairly weak for lower-quality names. We believe an additional 3-5 Fed hikes, given current coverage ratios and earnings trends, would be enough to increase default risks from today's low levels.

The real reason for US HY’s stellar performance is a significant technical imbalance, one of the strongest we have seen. As Figure 12 indicates, US HY supply has shrunk, which with the help of coupon payments, has offset notable fund outflows.

As previously discussed, many spec-grade rated firms are still borrowing debt, but they are migrating to the leveraged loan market where lending conditions are easier and demand is healthier for floating-rate instruments. We believe this technical backdrop will incrementally wane. We see little evidence that tax reform is impacting HY issuance; lower-quality firm supply is relatively higher even though the capping of interest tax deductibility post tax-reform is more painful for these firms. Higher LIBOR will also narrow the relative cost advantage of floating vs. fixed rate funding, which played out last cycle as HY issuance increased near the end of the Fed tightening cycle. We continue to expect gradual normalization in HY issuance to -12 to -15% for FY18.

In addition, Figure 12 even understates the positive technical we have witnessed. At the same time that supply has shrunk, US HY managers have invested more aggressively into the market. According to eVestment, US HY cash balances of 2.3% are near the lows of this cycle (Figure 13).

It is difficult to know exactly when this perfect technical storm will end, but US HY is increasingly susceptible to any slowing of growth or large market shock that raises risk premia. A conceptually similar measure of cash balances from the ICI (Liquid Assets2 Ratio) indicates that US HY cash balances are at dangerously low levels (Figure 14).

At levels below 4%, the probability of spread widening over the  next 6 months is 67%, with a 25th-75th percentile spread performance of -21bps to +152bps.

Institutional investors are souring on high-yield credit

In addition, our latest institutional flows update indicates that global investors are positioning for credit underperformance and a likely period of decompression between global high-yield and investment-grade spreads. Figure 15 provides Q2’18 nominal flows by global credit universe, while Figure 16 details investor flows by domicile, as a percentage of the total outstanding market size captured in eVestment3.

Put simply, the investor retreat from global high-yield rated credit continues. US HY and EU HY sustained -$20bn (-3.2% AUM) & -$2bn (-2.7% AUM) of outflows respectively, driven by both institutional separately managed accounts and retail fund. This continues a trend we have seen for the last 12-18 months.

The US leveraged-loan market did receive $5bn of inflows (1.4% AUM), but the attribution of buying is shifting. Loan demand has slipped from institutional investors; we believe the loan market is becoming increasingly reliant on CLO purchases (and to a lesser extent domestic retail buying). Indeed, CLO creation is up 32% YTD and CLOs own roughly 65-70% of US leveraged loans outstanding. While fundamental risks are building in the form of covenant-lite indentures, significantly elevated leverage, aggressive use of EBITDA add-backs, and a notable increase in loan-only capital structures, we believe duration fears continued Fed hikes and an absence of near-term credit risks should keep demand for this floating-rate asset class alive." - source UBS

Regardless of the fundamentals put forward, when it comes to US High Yield, there is indeed a strong technical support coming from slower issuance. As well, the Bank of Japan most recent move clearly shows that they are ready to throw the proverbial kitchen sink to maintain stability in JGB yields for the time being, providing yet a compelling support to global credit in general and US credit markets in particular. Yet there is no denying that some institutional players have started climbing the quality ladder and shed some of their exposure in recent months to US High Yield and high beta. There might be an additional case to be made for an outperformance of US Investment Grade relative to US High Yield in the coming months should the duration trade reassert itself with a lack of strength in maintaining the US 10 year Treasury Notes yield clearly above the 3% threshold. When it comes to credit markets we therefore remain "tactically" for the time being "Keynesian" yet it appears to us that cracks are appearing in the narrative hence the more defensive move being taken by institutional investors in regards to US High Yield, making them becoming more "Austrian" to a certain extent.

We pointed out that rising dispersion in credit, with investors becoming more discerning when it comes to issuer profile would make active management "fun" again. We also pointed out in our most recent note that we were seeing more and more large standard deviation moves (such as the one seen by the Facebook stock price recently). In our final charts, though volatility has been very muted for both credit and equities as of late, rising dispersion is displaying we think markets' fragility.

• Final charts - This isn't your grandfather's market

Rising dispersion in our book is a sign of rising instability brewing. The manifestation of it comes with large standard deviation moves and marks we think the return of the "macro" players to a certain extent after years of financial volatility repression by central banks. Our final charts come from Bank of America Merrill Lynch European Credit Strategist note from the 9th of August entitled "A world of populism" and shows that when it comes to European High Yield, 2018 marks a clear return of fragility at the forefront. No wonder some are already running for the exits and reducing their high beta exposure on illiquid names in that context:

"The summer rally is the gift that keeps on giving for credit markets. Since the start of July, corporate bond spreads have retraced just under half of their Italy-inspired sell-off. And we think the rally still has legs for now…judging by the very light investor positioning reflected in our latest credit investor survey.

Yet all around there are signs that this is anything but a run-of-the-mill summer grind. The most notable trend in markets is that of performance dispersion, and examples abound almost everywhere. Take Turkey vs. Russia debt for instance, or Apple vs. Facebook shares, or value vs. growth stocks, or even US Treasuries vs JGBs. Assets that were previously well correlated, are now witnessing a much more diverse performance of late. And in credit land it’s much of the same…note the significant outperformance of single-As relative to BBBs over the summer period (chart 1), or the number of bonds dropping conspicuously across the European high-yield market (chart 2).

The end of synchronised everything…

The temptation is put these moves down to just one-offs, and there have indeed been plenty of macro shocks in ’18. Yet, rising dispersion is the clearest reflection of how the investment backdrop has fundamentally changed, in our view. The synchronisation of global growth, central bank policies and corporate fundamentals of yesteryear has given way to a more challenging world of diverse politics, economies and liquidity support.

Much – although not all – of this sea change has been instigated by the rise of populism. In our view, this has helped reshape many of the hitherto market norms.

Take “globalization”, for instance. In 2018, this theme has been chipped away at. Chart 3 shows how cross-border capital flows have evolved over the last few years, a good proxy, in our view, for measuring how globalization is changing.

While not all measures are in retreat, what looks to be suffering more is Foreign Direct Investment, which has declined from 4% of GDP in 2015 to just 2.4% recently. And note how Foreign Direct Investment into the US has slowed down over the last few quarters despite the economy’s rebound (FDI into the US in Q1 ‘18 was 45% down YoY, see appendix chart).

But such secular changes have brought big market consequences. Chart 4 shows the conspicuous drop in world trade volumes over the last few months despite a global economy that continues to hum along fairly well.

As a result, the casualties have mounted: witness the recent plunge in German factors orders (-4% MoM), even though US GDP in Q2 (+4.1%) was the strongest since Q3 ’14.

A world of corrections in ‘18

More broadly, the divergence and dispersion theme is symptomatic of a rise in the amount of market “corrections” this year. Chart 5 shows the cumulative number of market corrections over time. We look across a large sample of government bonds, equity markets, currency pairs and credit indices, and count the number of times that 4
Standard Deviation moves are being observed (both up and down).

As can be seen, 2018 has witnessed a rise in the pace of market corrections, albeit more so in government bonds, equities and credit. Conversely, there has been less of a jump in corrections in the commodity and currency space this year.

Chart 6 shows the total number of market corrections on a yearly basis. Extrapolating this year’s number suggests that 2018 will see a lot more corrections than in 2017.

In fact, 2018’s corrections shouldn’t be far off from the pace seen in 2015/16 – a period when there was genuine stress across the global economy emanating from the slowing of China’s economy, plunging commodity prices and rising default rates. And as chart 18 in the appendix shows, perhaps not suprisingly, market corrections have been common in 2018 in regions where economic growth has been more vulnerable.

Note the high number of market corrections in emerging markets and Europe this year, for instance, relative to the US (where there has barely been a pickup).

Weak hands and the rush for the doors

A rise in dispersion across markets feels like a boon for active investing. Yet, with so many market divergences – and unpredictable ones at that – risk managing portfolios can also become incredibly challenging, weakening the market’s resolve for running large positions. In the end, too much dispersion can become self-defeating…ultimately motivating a broader derisking by the market.

It’s exactly this “rush for the exit” that the corporate bond market is starting to become fearful of, based on our credit survey. And note how quickly perceptions have changed: after investors’ citing “bubbles in credit” (i.e. too much liquidity) as their biggest concern in June ‘18, their primary worry has now flipped to “market liquidity evaporating”." -source Bank of America Merrill Lynch

Rising dispersion leads to shock and disruption, hence the need for "maneuver warfare" when it comes to trading "tactically", to paraphrase Tuco from the Good, the Bad and the Ugly:

"When you have to shoot, shoot. Don't talk."

Are we seeing a case of "Making Duration Great Again"? (MDGA). For sure it seems to us that the huge short positioning on the US 10 year Treasury Notes seems overstretched from a "military" perspective, but we ramble again...

"If everyone is thinking alike, then somebody isn't thinking." - General George S. Patton

Stay tuned !