Macro and Credit - Volition

"The true test of a leader is whether his followers will adhere to his cause from their own volition, enduring the most arduous hardships without being forced to do so, and remaining steadfast in the moments of greatest peril." - Xenophon

Looking at the dizzy heights being reached in equities with uninterrupted flows into US Investment Grade with yet another warning coming from the wise wizard from the BIS, namely Claudio Borio in the latest quarterly report, when it came to selecting our title analogy, we reminded ourselves of the term "Volition" from psychology given our fondness for behavioral economics. Volition or will is the cognitive process by which an individual decides on and commits to a particular course of action such as the normalization process undertaken by the Fed. It is defined as purposive striving and is one of the primary human psychological functions. Volition means the power to make your own choices or decisions. As an example of the classical concept of volition, comes from Eliezer Yudkowsky while discussing friendly AI development and "Coherent Extrapolated Volition" in 2004. The author came up with a simple thought experiment: imagine you’re facing two boxes, A and B. One of these boxes, and only one, has a diamond in it – box B. You are now asked to make a guess, whether to choose box A or B, and you chose to open box A. It was your decision to take box A, but your volition was to choose box B, since you wanted the diamond in the first place. Now imagine someone else – Fred – is faced with the same task and you want to help him in his decision by giving the box he chose, box A. Since you know where the diamond is, simply handling him the box isn’t helping. As such, you mentally extrapolate a volition for Fred, based on a version of him that knows where the diamond is, and imagine he actually wants box B. In developing friendly AI, one acting for our best interests, we would have to take care that it would have implemented, from the beginning. The question one might rightly ask is relating to the volition of the Fed, is it really for our best interests? One might wonder.

In this week's conversation, we would like to look at the volition of the Fed in its normalization process and the potential upcoming impacts in 2018 should the Fed, once again be behind the increasing flattish curve.

Synopsis:

• Macro and Credit - When the going gets tough
• Final chart -  The Fed can't escape Newtonian gravity

• Macro and Credit - When the going gets tough

Back in April 2017 in our conversation "Narrative paradigm" we argued that when it comes to credit market the only easy day was yesterday. Given the significant role of beta thanks to cheap credit and the "carry play" supported by low rates volatility, it becomes increasingly difficult for us to be supportive of at least the European beta play with the level touched by European High Yield. We also indicated recently that we were expecting a significant pick-up in M&A activity in 2018. This means that some investment grade issuers could experience some sucker punches in the form of blowing out credit spreads in 2018 hence the need of reaching out for your LBO screener à la 2007. A raft of M&A transactions in 2018 would clearly reinforce the view of the lateness in the credit cycle. In terms of change of narrative and in continuation of the "synchronicity" we mentioned in our previous post, the Fed's volition should not be taken lightly.

Also, regardless of the economic narrative put forward by many, including November payrolls rising by a seasonally adjusted 228K and beating expectations of 200K, leaving the unemployment rate in the US to 4.1%, rising wage pressure remains relatively absent. On top of that, surging consumer confidence and modest income growth should trigger much stronger loan demand in our "credit book". One could argue that the credit impulse in the US is tepid at best, no offense to the volition of the Fed. This is indicated by Wells Fargo in their Interest Weekly note from November 29th entitled "Mixed Credit Trends Among Businesses and Consumers":

"In the ninth year of the current economic expansion, credit standards point to a varied, but stable, outlook. Recent data suggest business lending demand has fallen, while consumer demand has seen modest gains.

Banks Optimistic (Yet Cautious) Approach to Lending

Banks continue to relax lending standards on business, commercial and industrial (C&I) loans and mortgages, as banks’ willingness to make loans has gained some stability. A slowdown in banks’ willingness to lend is customary with late cycle expansion. As seen in the below graph, banks’ willingness to extend credit follows a cycle-like trend.

At the start of an economic expansion, banks appear very willing to extend credit. But as the cycle matures, they become less willing to extend credit, and, in turn, tighten their standards in a cautionary nature.

Banks have reported increased competition from other bank and nonbank lenders, which in part, has led to the easing of standards. Continued loosening of lending standards of C&I and mortgage loans points to sustained confidence in the current state of the expansion. However, banks continue to tighten standards on credit card and auto loans, which may signal some caution in the consumer sector as the economic cycle ages.

Slowly Growing Consumer Demand for Loans

With an unemployment rate of just 4.1 percent, and in an environment of modest income growth and surging consumer confidence, theory would suggest robust loan demand. Loan demand, however, remains muted, pointing to a change in consumer sentiment towards debt. Credit card demand has remained unchanged, while we have seen a recent uptick in auto loan demand (below graph).

The rise in demand for auto loans is likely attributable to rebound effects in auto-sales due to damage from the recent hurricanes in Texas and Florida. Consumer demand for mortgage loans has slowed, which is expected to reverse as existing home sales edge higher off a recent slowdown.
Without an increase in income growth, loan demand should continue to increase modestly. Our forecast calls for an uptick in disposable personal income in Q2 2018, due to the effects of the proposed tax reform, followed by a slowdown in disposable personal income growth through the last year of our forecast (2019). Such slowing in income growth suggests consumers may increasingly turn to borrowing to fund their consumption habits in the future.
Demand for business loans remains weak, yet increased strength in business investment suggests that firms have turned to other sources of funding to fuel capital spending (below graph).

The loosening of lending standards, coupled with our positive outlook for business investment, should drive C&I loan demand higher in the near future. However, as the cycle continues to mature, we project equipment spending to slow, likely resulting in a reduction in business demand looking further ahead. The current credit climate insinuates stability within lending practices as growth continues in the ninth year of the current economic expansion."  - source Wells Fargo

While the Fed's volition is to continue with its hiking cycle, financial conditions remain loose and the lack of pressure on wages means that consumers are increasing their leverage through consumer loans in an environment where there is increased competition for business from other players. There are two ways we think the first part of 2018 could play out, "Goldilocks" or "Stagflation" with a sudden rise in inflation expectations that would provide support for a bond bear market narrative with rising interest rates volatility. This is of course without taking into account rising geopolitical risk aka the dreaded "exogenous" factors. We sidestepped various political "exogenous" risks in the first part of 2017 with various elections taking place in Europe in particular. It remains to be seen what will be the trigger of the return of volatility which has so badly wounded many large global macro funds in recent years thanks to its absence. As far as interest volatility is concerned it is at the lowest level in more than 20 years as displayed in the below Wells Fargo chart from their 2018 US Corporate Credit Outlook published on the first of December:

- source Wells Fargo

It won't last rest assured as it is getting late in the game we think and we are already seeing a "synchronized" change in the central banking narrative. Yet some "beta" players continue to be oblivious to the change in the central banking rhetoric. It doesn't mean that the "Goldilocks" environment won't last a little bit more in 2018 for credit, but, we think you should start thinking about playing "defense". This is why back in July we recommended to tactically going for duration again particularly in credit. This has been paying off nicely in 2017 (MDGA - Make Duration Great Again) as indicated by Bank of America Merrill Lynch Credit Market Strategist note from the 8th of December entitled "Year of Duration":

"Year of Duration

That 30-year corporate bonds, which we define in the following as 15+ years, have performed well in 2017 (+11.48% YtD) is no surprise. After all we expected “equity-like” 8-9% total returns in our 2017 outlook piece (see: 2017 US high grade outlook: Let’s do the twist 21 November 2016) on the back of a 27bps decline in 30-year corporate yields (actual: -48bps YtD, Figure 1).

However the surprise has been that credit spreads and Treasury yields were almost equally responsible for this decline in yields (25bps tightening in spreads and 30ps decline in 30-year Treasury yields as of yesterday, Figure 2).

This positive correlation between credit spreads and Treasury yields for such large moves is noteworthy and counterintuitive, but not unseen in the post-crisis years.

How did duration become king?

There are many reasons corporate yield curves are flattening so much including first and foremost that the Fed plans to hike rates actively in an environment of weak inflation data (Figure 3, Figure 4).

This was highlighted by today’s mixed jobs report for November where, although headline nonfarm payrolls were strong at +228k (vs. +195k consensus, Figure 5), average hourly earnings grew only 2.5% YoY (vs. 2.7% expected, Figure 5).

There are many other reasons for flattening yield curves including Treasury’s refunding announcement, where they committed to meet any increased issuance needs using shorter maturities (see: On funding and refunding), the ongoing shift in Europe out of cash and way out the curves (see: QE is dead, long live NIRP), macro risks, etc.

Re-iterate 10s/30s spread curve flatteners

Unusually - and a testament to extreme investor need for both yield and duration – we have seen the 10s/30s corporate spread curve (non-fin, commodities) flatten 8-9bps this year, despite the fact that the 10s/30s Treasury curve has flattened 22bps. More broadly this environment of both flattening Treasury and spread curves has been in place since spreads began tightening in early 2016 (Figure 7). However, the past six months has seen little flattening of the spread curve – but the lack of steepening is actually very impressive as the Treasury curve has flattened 27bps over the same period of time. Needless to say if the Treasury curve continues to bull flatten our recommended non-banks spread curve flattener will not work. We are probably even now reaching levels where further bull flattening actually leads to steeper spread curves. Our house view (see: Global Rates Year Ahead) remains that the Treasury curve is too flat and eventually will re-steepen, which should be very favorable for our spread curve flattener trade. The trade also works with higher interest rates as long as the curve does not flatten.

- source Bank of America Merrill Lynch

As we concluded back in early June in our conversation "Voltage spike", the MDGA trade (Make Duration Great Again) has made a very good come back as indicated by the ETF ZROZ we follow, which delivered a 10.53% return so far this year. For 2018, we continue to favor style over substance, quality that is, over yield chasing from a tactical perspective. As well in another conversation of ours in June this year entitled "Goldilocks principle" we indicated:

"The relentless flattening of the US yield curve shows that in the current inning of the credit cycle, and with a Fed determined in continuing with its hiking path, from a risk-reward perspective, we believe long duration Investment Grade still offers support to the asset class and not only from a fund flows perspective with retail joining late the credit party. On another note the "Trumpflation" narrative has now truly faded to the extent that the deflation trade du jour, long US Treasuries (the long end that is) is back with a vengeance, while inflation expectations has been dwindling on the back of weaker oil prices (after all they still remain "expectations" from our central bankers perspective). " - source Macronomics, June 2017

Our call has been vindicated as well as our contrarian stance against the "bullish" dollar crowd. We continue to believe we will see further weakness ahead for the US dollar in 2018. If we do see additional pressure on the leverage play thanks to the carry trade due to central banking's volition, then one should expect a rise in the Japanese yen we think. As well we continue to see value in the long end of the US curve. Also while gold prices have been weaker recently, the recent pullback as for goldminers looks to us enticing, particularly in the light of a growing risk in "exogenous" factors. If credit options are cheap, gold/gold miners options are "cheaper" as well from a convexity reward perspective in 2018. When it comes to the bull run in credit spreads it has not yet ended and probably will last longer than many might expect, until we hit 11 that is on the "credit amplifier" in true Spinal Tap fashion. We do not see any value left (apart from playing the "dispersion" game with active credit management) in European High Yield at these levels. What is left is "carry" and clearly not enticing enough for us from a risk reward perspective in 2018. We would rather continue playing the US Investment Grade long duration play when it comes to credit allocation. What about US equities being priced to perfection and US High Yield? Given the strong correlations of both asset classes (close to 1 regardless of what some pundits would like to tell us), it is all a matter of "earnings" and they have been so far holding fairly well.

The big risk out there is, as we pointed out the return of the "Big Bad Wolf" aka inflation. This would force the hand of central banks and lead to a more rapid pace in rate hikes leading to some significant repricing on the way. Inflation is our concern numero uno and this would we think be the trigger for higher volatility. This is as well the view of Deutsche Bank from their Asset Allocation note from the 4th of December entitled "What to make of volatility at 50-years lows":

"In our view the leading candidate for a shock that would lead to a sustained increase in vol is a sharp increase in inflation

As noted above, exogenous shocks have historically played a significant role in increasing and sustaining vol at higher levels. Shocks in general of course tend to be inherently unpredictable. Our economists forecast is for a gradual rise in inflation. But in the current context a sharp increase in inflation sticks out as a leading candidate for a shock that raises volatility in a sustained manner in 2018 given the extent to which it is priced in and the likely reaction of monetary policy:

• Slow inflation priced in. The slowdown in US inflation beginning in March this year had large impacts across asset classes and looks to be priced in (The Growth-Inflation Split, Sep 2017).
• Few expect a sharp pickup in inflation. The market and FOMC narrative around low inflation with widespread buying into structural declines and a breakdown of traditional relationships looks to have gotten carried away (Six Myths About Inflation, Oct 2017). This suggests few are expecting a sharp pickup in inflation.
• Four fundamental reasons to expect inflation to move up. First, the lagged impacts of inflation to the growth slowdown during the dollar and oil shocks points to a pick up. Second, the labor market continues to tighten and in our reading there is no reason to believe the traditional Phillips curve has broken down, just swamped by other factors. Third, the direct drag from the past appreciation of the dollar should begin to pass through. Fourth, idiosyncratic factors together have had a strong negative run but tend to mean revert over time. Acting in concert, the four factors clearly have the potential to create a sharp move higher in inflation.
• A sharp pickup in inflation is likely to be interpreted as a sign of the economy overheating and the Fed embarking on hiking until it ends the cycle. Fed hiking to keep inflation in check has been a—if not the —leading driver of recessions historically. Market expectations of Fed hikes are currently of course far below the Fed’s guidance and a sharp pickup in inflation is likely to entail a significant re-pricing. We don’t see Fed rate hikes from current low levels as ending the cycle any time soon (Is Unprecedented Monetary Policy Easing Creating Secular Stagnation? Jul 2016). But we do see faster rate hikes against the backdrop of a sharp pickup in inflation as having the potential of raising and sustaining vol at higher levels as concerns about the end of the cycle grow." - source Deutsche Bank

Make no mistake, inflation is the "Boogeyman" for financial markets. From the long interesting report from Deutsche Banks, three graph stand out when it comes to heightened risk for large "sigma" events in 2018 given how coiled the volatility spring is:

- source Deutsche Bank

No matter how high your "interval of confidence" is, your VaR model is looking/asking for trouble, particularly your "liquidity" hypothesis. It is time to build some cheap "convexity" defenses as we posited above, not to mention the need for your LBO screener with rising M&A risk and the sucker punches they can deliver to your Investment Grade portfolio à la 2007. Just some thoughts for 2018.

When it comes to the relentless flattening of the US Yield curve as a harbinger for rising recession risk in a classical macro way, we read with interest Deutsche Bank's take from their Global Market Strategy note from the 1st of December entitled "The Fed, the Curve and Risk Assets in the Great Rate Normalization about the recession risk transmission:

"Recession risk transmission

The sharp curve flattening has given renewed life to worries that recession risks are on the rise. Given the flattening, our recession probability metrics – one using the outright slope of the 1s10s yield curve, and one that adjusts the 1s10s curve for the level of 1s – both suggest that November’s flattening was worth a ~6pp increase of the probability that a recession will begin in the next 12 months.

Holding all other inputs equal (the u-rate vs nairu, aggregate hours worked growth, core CPI ex-shelter, and the change in oil prices) puts the probability of a recession beginning in the next 12 months at 16.4% on the unadjusted model, and 26.4% when we adjust the curve for the level of front-end rates. This is still low.

The parallels between the current environment and the Greenspan conundrum are inevitable given the apparent insensitivity of long-end rates to the Fed’s hiking cycle – particularly in the context of a balance sheet unwind that many expected to put sustained steepening pressure on the curve. There is no “conundrum” in our mind – the Fed is simply hiking into a very low neutral rate, with no evidence that inflation is set to materialize to allow them to move faster. This cycle is following a somewhat similar path, however, to the mid 2000’s cycle from the perspective of recession probability.

Now 2 years into the current cycle, the recession probability is at a similar spot to mid-2006 (which was just months away from being within the 12 month window to the start of the great recession).

The risks presented by a flattening yield curve have a clear transmission mechanism to broader conditions as the Fed’s balance sheet shrinks. Before the Fed began to pare its balance sheet we discussed why a steep curve is important to a successful QE unwind – if the curve flattens too much, banks will have no incentive to hold securities over cash earning IOER, meaning non-banks will likely be the marginal buyers of securities no longer owned by the Fed, and deposits will leave the system. This in turn carries meaningful risks to loan growth, which had caught a fair amount of attention given the slowing earlier in the year. Our financial conditions index suggests that C&I growth should be accelerating, though that has not really materialized yet.

The lagged relationship between C&I loans and the Senior Loan Officer survey points to a pick-up in loan growth, but only into the ~5% y/y range, not the double digit range of years past. This has failed to materialize, however, and is a going risk amid the Fed’s balance sheet wind down.

It is still sufficiently early into the Fed’s balance sheet unwind that banks’ reaction function is hard to gauge – securities holdings have risen since the end of September, while cash holdings have been more or less stable and deposits have shown some recent volatility but might still be on an upward trend. So the limited evidence does not yet suggest that this is posing an imminent risk to the economy, but the flatter the curve gets, the more likely banks are to eschew securities for cash, increasing the risk that deposits leave the system, and banks have to pull back on lending."  - source Deutsche Bank

There you have it, no matter how strong the "volition" of the Fed is, the exercise is difficult to execute. While there is no imminent threat to the positive narrative from a fundamentals perspective, the relentless flattening of the Us yield curve is difficult to ignore on top of rising geopolitical exogenous factors. We could easily entertain a blow out of oil prices on the back of exogenous factor in an already tensed Middle East, which would no doubt spill into the inflation expectations surprises on the upside and lead to some repricing and heightened volatility. As we pointed out in our bullet point, when the going gets tough...volition or not.

In our last conversation, we pointed out that "volatility" conundrum was not a paranormal phenomenon, and no matter our strong the Fed's volition and "Forward Guidance" (or imprudence), what the US yield curve is telling us is that no matter how strong the Fed's volition is, they cannot escape Newtonian gravity:

"When it comes to the paranormal phenomena of the low volatility regime instigated by our central bankers, no offense to their narrative" but modern physics still works and normalisation of interest rates should lead to some repricing and a less repressed volatility in conjunction to a fall in the "free put" strike price set up by our central planners in 2018. You probably do not want to hold on too long on "illiquid parts" of your portfolio going forward, given, as many knows, liquidity is indeed a coward." - source Macronomics, November 2017 

Our final chart below points towards the gravitational pull the Fed is facing.

• Final chart -  The Fed can't escape Newtonian gravity

No matter how strong the spells of the "wizards" at the Fed have been in recent years as pointed out by the wise wizard of the BIS aka Claudio Borio, the Fed's volition is one thing, Newtonian gravity is another. Our final chart comes from Bank of America Merrill Lynch's Weekly Securitization Overview from the 8th of December entitled "The gravity of the yield curve" and displays the 2Y10Y versus the US unemployment rate:

"Given the magnitude of recent yield curve flattening, we revisit our framework where we look at the 2y-10y spreads relative to the unemployment rate back to 1989 (Chart 1).

The flattener has moved more slowly than we anticipated back in 2014, dropping by about 50 bps per year over the last 4 years. Given where unemployment already is, and expectations that it will move lower in the year ahead, we see a strong gravitational pull lower on the curve. Moreover, given that the Fed likely has 4-5 rate hikes in store over the next year (including December 2017), while inflation readings remain low, dropping an additional 50 bps on the curve over the next year seems very achievable, particularly after the 30 bps drop in the 2y-10y spread in the past six weeks.

We note that flattening is not the house call: BofAML rates strategists believe the curve will steepen due to easier fiscal policy, higher deficits, and a higher inflation expectation and the Fed will require higher 5y-10y yields as a precondition to flattening or inverting the curve. We recognize that the flattening process has already taken longer than we expected a few years back, due to multiple “dovish” Fed hikes or pauses, and we acknowledge the potential for what we think would be steepening detours along the way.

Newton's law of gravitation resembles Coulomb's law of electrical forces, which is used to calculate the magnitude of the electrical force arising between two charged bodies. Both are inverse-square laws, where force is inversely proportional to the square of the distance between the bodies. In similar fashion, the relationship between the US 2Y10Y and the US unemployment rate could be seen as inverse-square laws when it comes to the ongoing flattening stance of the US yield curve but we ramble again...

"A man of genius makes no mistakes; his errors are volitional and are the portals of discovery." -  James Joyce

Stay tuned!

Macro and Credit - The Ghost of Christmas Past

"These are the shadows of things that have been. That they are what they are, do not blame me!" - The Ghost of Christmas Past, A Christmas Carol by English novelist Charles Dickens, 19th December 1843

While discovering with great pleasure that we had won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our recent "Cinderella's golden carriage", we reminded ourselves for this week's title analogy of the sayings of the Ghost of Christmas Past that came to haunt Ebenezer Scrooge in Dicken's 1843 masterpiece "A Christmas Carol". This angelic spirit showed Scrooge scenes from his past that occurred on or around Christmas, in order to demonstrate to him the necessity of "changing his ways", as well as to show the reader how Scrooge came to be a bitter, cold-hearted miser. Looking at where some High Yield Energy spreads are close to ending the year with the continuous downward pressure on oil prices and most of the commodity sector, is indeed, an illustration of the Ghost's philosophy. Credit spreads are what they are and do not blame us for having commented over the last few years over the deterioration of the credit cycle. If the Ebenezer Scrooges of the credit world have been hurt in the latest sell-off in the High Yield space, they had it coming. Low spreads of yesterday are indeed the shadows of things that have been to paraphrase Charles Dickens.

While typing this very note, we watched with great interest Central Bank of Azerbaijan (CBAz) decision to devalue the AZN by another 35% to AZN1.55/$ and deciding to shift to a fully floating exchange rate starting from December 21. We pointed out in our recent conversation "Cinderella's golden carriage" that in similar fashion to AAA ratings, currency pegs are as well a dying breed:

"In similar fashion AAA ratings are a "dying breed" and "golden carriages" often return to "pumpkin" state, currency pegs are not eternal as we reminder ourselves in our long September 2015 conversation "Availability heuristic - Part 2":

"There is indeed a clear trend in "de-pegging" currencies in the Emerging Market world, but in Developed Markets (DM) as well, the CHF event of this year has shown that pegging a currency in the current monetary system is bound to fail at some point. The sovereign crisis in Europe has also shown the inadequacy of the Euro for various European countries with different economic and fiscal policies as well as different composition (hence our negative stance on the whole European project...).

When it comes to our recent "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop" - Macronomics

 - source of the table - Société Générale 

Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. These are indeed the "shadows of things that have been", hence our recent HKD peg break case that earned us some praise from Saxo Bank.

Before we move on towards our usual ramblings, it is that time of the year where we would like to take the time to wish you dear reader and your family a wonderful Christmas and a happy and prosperous New Year. On that special occasion, we would like to extend our thanks for the support we received on our blogging journey and to our growing number of our readers (thanks for your praise in 2015). We would also like to thanks our good friends from Rcube Global Macro Asset Management for their numerous qualitative and quantitative contributions throughout 2015. We also would like to extend our thanks to our good cross-asset friend "Sormiou" for providing us with his great insights on the subject of volatility and his regular comments, and interesting exchanges we had during the course of 2015. We are looking forward to hearing more of him in 2016 given the clear potential for more volatility to come in that respect. We also hope we will hear more from you dear reader in 2016. Don't hesitate to reach out and comment!

As we move towards the last few days of yet another eventful year full of "sucker punches" such as the CHF move thanks to yet another peg blowing out courtesy of the SNB and the Yuan "surprise" of the summer thanks to the PBOC, we would like this week in our closing conversation for 2015 to continue looking forward towards 2016, as we think, the rising instability will generate interesting proposals for the "contrarian" punters. Also we do think that our "outrageous" prediction prominently featured in Saxo Bank's recent publication is by no mean "outrageous", more on this later in the conversation. Similar  "convex" trades abound, as central banks' magic spells are losing their strength, and these "macro" trades will go hand in hand with "volatility" in 2016. To reiterate ourselves, there lies the crux of central banks interventions, there is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis.

Synopsis:

• 2016, will be all about "risk-reversal" trades
• The EM 2016 outlook - its weaker than you think
• Final chart - Short Hong-Kong? Go long Japan "tourism"

• 2016, will be all about "risk-reversal" trades

It seems to us that many investors today are "living in the shadows of things that have been", namely that they live under the "pretence" that the "central bank put" is still in play. This "pretence", we think is particularly entrenched within the "equities" crowd who suffers from "overoptimism", whereas us, in the "credit" crowd, we suffer from "overpessimism". Overall, investors, suffer from deep bipolar disorder but, that is another subject.

Furthermore, as we have shown in our last conversation "Charles' law", rising positive correlations due to the intervention of our "generous gamblers" aka "omnipotent" central bankers have led to significant rising "instability" à la Minsky, and they also have induced a reach for yield, pushing many "players" outside of their "comfort zone" leading to "yield compression" on a "grand scale" as displayed in the below chart from Bank of America Merrill Lynch's Global Equity Derivatives Outlook for 2016 published on the 9th of December:

"Reaching for yield in Europe given QEWith almost €3trn of negative yielding govt debt (~45% of the total outstanding), the hunt for yield in Europe is as strong as ever. With such low (negative) returns on safe haven assets, central banks have pushed income-seeking investors further out on the risk curve, resulting in a policy-induced contraction in yields across asset classes (Chart 26). 

With Mario Draghi unleashing QE in 2015 and leaving room to further expand it in 2016, the hunt for yield will likely gather steam, in our view. Indeed, the higher yields on offer in both EU equities and HY credit relative to safe haven assets are among the key investment reasons cited by our equity & credit strategists in their 2016 outlooks.

Yield is only half the story: need to weigh vs. asset riskYield vs risk framework: With a lack of assets offering reasonable yields, investors often focus excessively on (just) the yield on offer with less attention to the associated investment risk." - source Bank of America Merrill Lynch

Indeed, "yield hogs" are still on the "yield trail" and have been enticed by our generous gamblers to play on the "beta" game a little further up the risk scale.

What is once again "striking" to us, as me move towards 2016 is the "consensus" in many positions, which we think that from a "positioning" perspective and contrarian approach could be enticing. Could it be that when everyone is thinking the same, that no one is really thinking? We wonder.

In terms of "risk-reversal" punts, we read with interest Bank of America Merrill Lynch's Futures and HF positioning report from the 20th of December entitled "Leveraged Funds bought record S&P 500 –tugging a war with Asset Manager":

"Futures positioning across asset classes (CFTC data) 

Equities (disaggregated data)
S&P 500 (consolidated) – Leveraged Funds (LF) decrease short by $34.6bn over four week to -$16.6bn – a record buy since the consolidated TFF data started in June 2010. Asset Manager/Institutional (AI) decrease long by $6.1bn last week to $40.5bn. AI net position is near 3-year low (3.2%tile); LF near 3-year high (98%tile).
NASDAQ 100 (consolidated before June 2013) - Asset Manager/Institutional increase long by $0.2bn to $10.1bn. Leveraged Funds increase long by $1.5bn to $4.0bn.
Russell 2000 - Asset Manager/Institutional increase short by $0.7bn to -$6.4bn. Leveraged Funds decrease short by $0.6bn to -$0.9bn. One-year z-score is above two for LF (i.e. contrarian bearish). Total Open Interest is near a 3-year high (95.5%tile). 

Interest Rates (disaggregated data)
CBT US Treasury - Asset Manager/Institutional decrease long by $1.3bn to $19.3bn. Leveraged Funds decrease short by $3.0bn to -$1.4bn. Other reportables (sovereign) net
position is near a 3-year low (1.9%tile), with one year z-score below two.
10-yr T-notes - Asset Manager/Institutional decrease long by $2.6bn to $28.1bn. Leveraged Funds increase short by $0.7bn to -$28.8bn.
2-yr T-notes - Asset Manager/Institutional bought $4.1bn and flipped to a long for the first time since Nov. 3rd, with one-year z-score above two (abnormally bullish sentiments among AI). Leveraged Funds decrease long by $0.9bn to $11.2bn, with one year z-score below two (i.e. abnormally bearish sentiments among LF). 

FX (disaggregated data)
EURO - Asset Manager/Institutional increase short by -$1.4bn to -$2.2bn. Leveraged Funds decrease short by $1.7bn to -$17.3bn.
JPY - Asset Manager/Institutional (AI) decrease short by $0.9bn to -$3.7bn. Net position stays near 3-year low for AI (5.7%tile) and sentiment is on a buy signal (one-year z-score rallying from the Nov. 3rd low). Leveraged Funds decrease short by $2.7bn to -$5.7bn.
AUD – Asset Manager/Institutional decrease short by $0.2bn to -$1.9bn. Leveraged Funds bought $1.2bn and flipped to a net long for the first time since Oct. 2014; z-score is above two (contrarian bearish). Meanwhile, net positon for Other Reportables -(sovereign) remains near 3-year low (6.4%tile)." - source Bank of America Merrill Lynch

Whereas Asset Managers and Leveraged Funds agree on the Russell 2000 short position, which is of no surprise given its correlation with High Yield, what seems to us very interesting is the significant positioning of the Leverage community in being short 10 year T-Notes to the tune of -$28.8bn as per the chart below from Bank of America Merrill Lynch's report:

 - source Bank of America Merrill Lynch

Given the recent US Q3 GDP print at 2% (well below 3.9% growth in Q2) and given the current high level of inventories we highlighted recently in our conversation "Cinderella's golden carriage", it seems to us that US GDP is weaker than expected and is going to be "weaker for longer". On a side note, we have increased our US long duration exposure for this very reason. As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:

"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you."

From a "risk-reversal" perspective, we think, the current sizable "short positioning" from the "Leveraged crowd", offers a good contrarian punt, given the "weaker" outlook as of late of the US economy. 

In similar fashion, the "consensus" trade of being "short" the Euro versus the USD, appears to us overly "crowded". In that sense, Steen Jakobsen's CIO of Saxo Bank's call of EURUSD flying towards 1.23 in the latest Outrageous Predictions for 2016  is not that "outrageous" we think, particularly if you factor in that for the 12 months to October, the cumulated current account surplus represented 2.9% of eurozone gross domestic product, compared with 2.4% for the 12 months to October 2014. The latest October figure for the current account surplus came at €19.8bn, which is €9bn more than at the same period in October 2014 (€10.8bn).

Here is below the significant positioning of the Leverage community in being short EUR/USD to the tune of -$17.3bn as per the chart below from Bank of America Merrill Lynch's report:

 - source Bank of America Merrill Lynch

It certainly looks crowded to us, and are the shadows of things that have been, given that as of late,  Le Chiffre aka Mario Draghi, hasn't been on his best "bluffing/betting" behavior.

When it comes to Emerging Markets woes which have been well commented by all the usual suspects, when it comes to our prognosis for 2016, we think that there is indeed more pain to come rather than to expect a "relief rally" from an "outrageous prediction" perspective. Our "reverse osmosis" macro theory we touched on again recently is still playing out. This brings us to our second point.

• The EM 2016 outlook - its weaker than you think

While the "commodity rout" is well documented, we think that in 2016, we will the materialization of defaults and restructuring in the EM world given the exposure of the banking sector in these countries to the sector. In relation to this exposure, we would like to point out to a Bank of America Merrill Lynch report published on the 16th of October and entitled "China spillovers and the leverage channel":

"The commodity channelCommodity exporters – Malaysia, Thailand and Indonesia (see Chart 2) – have been disproportionately impacted, largely as commodity prices slump on weaker demand, as China rebalances away from investment-driven growth. 

Casualties include coal, base metals (iron and copper) and palm oil. Coal prices, for instance, have fallen some 62% since January 2011. Falling commodity exports hurt the current account balance, fiscal revenue and also the wages of lower income, rural households.
Lower export revenues and the declining terms of trade have weighed on the growth of commodity exporters. Indonesia’s GDP growth is at its weakest since the Global Financial Crisis, at +4.7%. Infrastructure spending is failing to offset slumping commodity exports so far, given the slow progress. Malaysia's GDP growth will likely slow markedly in the second half of the year, as slowing exports spill over to weaker consumer and investment spending.
The IMF highlighted in its latest October WEO report that the weaker outlook for commodity prices implies that the annual growth in output for net commodity exporters will decline further, by almost 1% point, in 2015–17 compared with 2012–14. The reduction in growth for energy exporters is projected to be larger, at about 2.25ppt over the same period.

 

The leverage channelConcerns over financial system vulnerabilities have risen, given the commodity downcycle and the sharp depreciation of currencies in emerging economies, particularly commodity exporters. The latter has implications for foreign-denominated debt. Economies with high foreign currency borrowings and high exposure to commodities are particularly at risk of loan defaults and banking system losses.

We identify loan exposures to the commodity sector, defined as loans extended to the agriculture, forestry & fishing, and mining & quarrying segments. Singapore (9.2% of GDP), India (7.2%), Malaysia (3.7%) and Indonesia (3.4%) have the largest share of bank loans to the commodity sector, as a proportion of nominal GDP (see Chart 3).

As a share of total corporate debt, Thailand and Indonesia rank highest, with about 31% and 30% of corporate debt borrowed by commodity producers. China (26% of total), India (26%) and Malaysia (18%) also have relatively sizeable amounts of debt borrowed by energy and metals & mining companies (see Chart 4). This is worrying and may have profound implications on financial stability, as commodity demand and prices remain under pressure. Based on IMF data, ASEAN countries Indonesia (52% of total corporate debt), the Philippines (28%), Malaysia (18%) and Thailand (16.5%) have the largest share of foreign-currency non-financial corporate debt out of total company borrowings in Emerging Asia.

Our Asia Pacific financials team recently highlighted that Hong Kong banks would be the most directly impacted by a China hard-landing. Many Chinese firms borrow funds offshore in Hong Kong and firms in Hong Kong are also reliant on cross-border businesses (tourism, trade, shipping, etc.). Among banks in the rest of Asia, Singapore banks DBS and OCBC have the largest loan book exposure to HK/China, accounting for 36% and 26% of total loans, respectively. The exposure of UOB, Taiwanese financials, Public Bank in Malaysia, and Australian banks are generally much smaller, in the 4% to13% range. Banks in other markets have insignificant exposure, but could be indirectly impacted by any slowdown in their domestic economies. 

Defaults and restructuring of commodity-related firms may be early indicators of potential financial stress for banks. High gearing and foreign currency-denominated debt appear to be a characteristic of commodity producers and trading companies. Commodities are priced in US dollars and are, therefore, hedged, goes one argument. Exploration and mining often require heavy capital investment and, hence, large-financing requirements. Commodity trading companies are also highly geared by their very nature. The China contagion may be far from being over, as the financial stress on commodity and debt-laden firms starts testing banks." - source Bank of America Merrill Lynch.

The path of normalization of the Fed has continued to exert additional pressure on already strained EMs thanks to Global Tightening Financial Conditions triggered by the US Dollar "margin call" thanks to the tapering of the Fed and now with the latest small increase in rates.

When it comes to the Fed's hiking cycle, the Fed is not only hiking in an environment of slowing earnings in the US, it is also hiking in an environment where Asian growth is slowing as displayed by Deutsche Bank in the below chart from their report from the 17th of December entitled "Asia Macro in a non-zero world":

"Business cycles in the region are in much weaker shape, with growth slowing – not accelerating – into this Fed hike (Chart above). Export growth has been printing in negative territory across Asia, a far cry from the double-digit growth seen when the Fed last raised rates (2004). Asian central banks will not be able to keep up with even a gradual Fed this time, and front-end rate differentials will narrow. The only central bank we think could hike rates is the Philippines. Elsewhere, rates in China, Taiwan, Korea, and Thailand could be very close to, or even below, US rates by end-2016. The market appears underpriced for this divergence." - source Deutsche Bank

Furthermore, when it comes to EMs' growth, this time it's different as their growth have been much tepid as of late. On the subject of the outlook for EMs, we read with interest LCM's take from their Cross Asset Weekly Report from the 15th of December entitled "Themes for 2016":

"EM: How Will It End?This is a good transition for our second point: the EM situation. We wonder how it could end because we do not see any positive outcome for them. In the developed world, the most flexible economies that have enjoyed the highest accommodative financial conditions of history have needed several years to recover after the US centric financial crisis. How long will need an EM country under
financial repression to recover from an EM centric financial and economic crisis? We do not know precisely but we suspect much longer than the US.
The chart below gives an indication of the negative pressure on the whole EM universe. If we exclude the global crisis of 2009, never before so many EM countries have failed to generate an economic growth rate above 3-4%. 

High economic growth is becoming scarce for these countries so clearly, we can talk about a new paradigm for them. On the right, the chart shows that a consequence of that lower growth is a higher accumulation of the public debt, leading to a rise of the Debt/GDP ratio towards its 90’s level. The current crisis seems deeper than the 97/98 crisis which was initiated by a financial crisis. 

This time, it is not a financial crisis that triggers the economic crisis but an endogenous economic crisis that arises following excess investment in assets that turned unproductive (real estate and manufacturing for China and commodity-related sectors for LatAm, the Middle East and Russia). This is a big difference. This economic crisis is not the result of a fundamental financial vulnerability that would have been exploited by investors. There has been no US$ interest rates shock, no speculative attacks on countries. The weakness comes from the real economy and the depreciation of the currency is the consequence of that weakness, not the cause. 

We show with the following chart the Budget balance for 2015 of selected EM countries and their short term cost of funding (5-year sovereign bond yield). There is a clear discrimination: Brazil suffers unaffordable rates whilst Chile and Peru, its neighbours that are also affected by weaker growth, maintain access to global markets. 

On the right, we see that the Government bond yields of Brazil and Russia have reached very high levels. Contrary to Turkey, these countries are already in recession making the situation desperate. The financial system is under great pressure, NPLs are on the rise, the risk for them of running out of a US$ financing is a reality. Equity valuation is therefore intriguing as Brazilian banks trade at 0.7 times their book value and Russian banks at 1.0 times their book value. In other words, this does not look to be a capitulation phase. The situation is critical but investors have not thrown in the towel and this is why in our opinion the downside for the most fragile EM equities is intact.

The underweight position on EM assets is supposedly consensual but as we discussed in our weekly note #115 “Story Positioning”, we do not believe this lie. PMs are not underweight EM assets because they cannot short an oversold asset; it is inconceivable for them.
This negative trend is therefore intact because the investor participation rate is very low. The EM currencies are depreciating because of two events: 1) the US dollar rise with the expectations of higher real rates and 2) because of financial outflows resulting from a deterioration of the EM external position and a loss of investor confidence. 

 - source LCM, Bloomberg

The new story among EM countries is the weakness of the rich Middle East countries. Their economic disarray looks like 1998 as they return to deficit in terms of budget balance and current account position. It is clear that they can afford it after having benefited for several years from the oil rent but as is often the case, the deterioration is faster and stronger than the improvement. The currency peg of these countries may be tested. We should therefore keep an eye on this region because being anchored to the winner when you are a loser is of limited interest. 

The consequences of the reduced amount of petrodollars flooding to developed and emerging markets are unknown but in the EM case it helps to further reinforce the vicious circle they suffer. The later, slower and weaker recovery scenario that we mention is obvious and this is why on financial markets investors should not expect too much from EM assets.

The accumulation of debt adds another challenge to EM countries that could act as an accelerating factor for the economic crisis. Within the EM world we continue to distinguish three groups: 1) commodity exporting countries 2) China and 3) the rest (mainly EM Asia ex-China). This EM crisis started with the first group as the decline of commodity prices quickly revealed their intrinsic weaknesses. Now it is moving to Asia and because there remain many unanswered questions, it should be a recurring topic for 2016.
For markets, this change of focus from LatAM/Russia to China does not mean that the situation is fixed but that it is extending. This is the problem and this is why 2016 could be another bad year for EM assets. The corporate bond defaults remain limited, the help of the IMF has not been required, so we have not as yet seen the classic indicators of capitulation that increases the reward/risk ratio of being contrarian." - source LCM, Cross Asset Weekly Report, 15th of December 2015.

While these are the shadows of things that have been in 2015, we have to agree, with LCM. We do not think we have yet reach the "capitulation" point that would make the asset class an "enticing" investment proposal.

In terms of "enticing" proposal, we would like to end up on a more "positive" note in our final point of our conversation, with the "attractiveness of the Japanese tourism sector.

• Final chart - Short Hong-Kong? Go long Japan "tourism"

We think that the Hong-Kong woes which we have again highlighted in our conversation "Cinderella's golden carriage" have greatly benefited Japan and will continue to do so in 2016. This has been furthemore highlighted by the WSJ in their article from the 17th of December entitled "Hong Kong Retailers Lost in Currency Translation":

"Retail goods in Tokyo are on average 34% cheaper than in Hong-Kong. Hong Kong retailers lost in currency translation as Chinese shoppers turn to Japan amid cheaper prices and yen." - source The Wall Street Journal

Given Japan has been the big beneficiary as highlighted in our previous conversations when looking at air travel surge towards Japan from China mainland, it makes sense we think, to continue to play this theme in 2016. On that note we read with interest Société Générale's Best Trade Ideas for December and January and would like to point out to additional points made in their research note on the subject of Japanese tourism:

"Japanese tourism is a long-term theme and its development is a pillar of Abe’s growth strategy. The government objective of reaching 20m visitors by 2020 is within reach. 

Consumer demand, a tailwind for Asian equities. Tourism expansion in Japan results from a combination of factors, including a weaker yen and government policy encouraging foreign visitors flows (for instance through easing visa deliveries). Rising wages and robust Asian consumer demand is another key element. In the past three years, the bulk of Japan’s tourism growth is attributable to Asian visitors. 

Exposure to tourism through SG Japan Tourist Basket. The basket, launched in March 2015, has been constructed along liquidity and diversification constraints. Sectors represented in the basket include transportation, appliances (30%) and retail trade (25%). Given the liquidity constraints, the basket consists of a combination or “pure” and “less pure” players, with a significant overall flavour of outbound travel.

- source Société Générale

When it comes to Honk-Kong's retail woes thanks to its US dollar peg, Japan is indeed the prime beneficiary, particularly when one notices that luxury watches exports from Switzerland to Hong-Kong have fallen by 28% according to Bloomberg.

In relation to Hong-Kong's currency peg, we are left wondering if indeed the fall in "luxury watches" is not indicating that "time" is running out? Is our prediction for 2016 so "outrageous"? We will soon find out...

"Every adversity, every failure, every heartache carries with it the seed of an equal or greater benefit." - Napoleon Hill, American writer

Stay tuned!

Credit - The Honey Pot

"Man is the only kind of varmint sets his own trap, baits it, then steps in it." - John Steinbeck, American author

Looking at the abandonment with which investors are piling into Corporate Hybrid debt such as Bayer AG 2%⅜ coupon, maturing in 2075 with a spread of 241 bps over Bunds to its first call date in 2022, we reminded ourselves for this week's chosen title analogy of the movie 'The Honey Pot", a 1967 crime comedy-drama film written for the screen and directed by Joseph L. Mankiewicz which was inspired by 1605 English play called Volpone (Italian for "sly fox"), a merciless satire of greed and lust just like today's markets we think. Movie buffs like ourselves will note that Joseph L. Mankiewicz was the brother of Herman J. Mankiewicz, famous for winning an Oscar for co-writing Citizen Kane in 1941 but we ramble again... 

But, moving back to our chosen analogy, as there is always another layer to it, it is also a computer terminology for a trap which is set up to detect, deflect or use as a bait to entice computer hackers. In our credit case, corporate subordinated debt such as hybrid have been effectively used by "sly fox" issuers to lure unsatiated yield hungry investors to dip outside their comfort "risk" zone as aptly described by our friend and former colleague Anthony Peters, strategist at SwissInvest and regularly featured in IFR in his recent column:

"Subordinated corporate debt is all the rage in a world in need of yield and issuers are not being shy in coming forward in order to oblige. Investors, on the other hand, have been hoovering the stuff up and, not surprisingly, the premium they are being paid in order to take the extra and until recently quite innovative risk has melted away.

Subordinated corporate risk satisfies a string of needs but if fixed income and credit investors think that they are getting the best of the upside, they are sorely mistaken. Corporate sub debt is the ultimate ratings arbitrage. I had, given my background in structured credit , always assumed that the CLO (Collateralised Loan Obligations) was the pinnacle in terms of making a silk purse out of a sow's ear but I am beginning to see corporate hybrid debt as a much more straightforward example of the dark art.

Why, one needs to ask one's self, would a company issue subordinated debt? It didn’t have the capital and reserve restraints which affect banks so who is the winner and why? Look no further than the boardroom. Older readers - that's the over 45s - will recall the world's leading corporate names all being in the triple-A, double-A or occasionally in the rather sad and ignominious single-A ratings space. Management was proud of the high quality of its company's debt. Then, beginning in the mid-1990s, everything became a matter of "shareholder value". Balance sheets were geared up to the ying-yangs and cash returned to shareholders. It was an age of stock-price above all else. At times, the entire stock looked like a board-approved pump-and-dump circus.

The fashion was for "making the balance sheet more efficient". Had executive remuneration not been so closely tied to the stock price, a lot of this might not have occurred. Executives couldn't buy themselves a yacht or a ski chalet from higher debt ratings but they could from a higher stock-price. Ultimately, obviously, there were limits to how far you could reasonably leverage a balance sheet until someone dreamt up the hybrid corporate bond.

The hybrid bond fulfils two principal functions. Firstly, it lets companies borrow without adding further pressure to the senior bond ratings which is good although, of course, the balance sheet is not relieved of debt, thus offering something rather akin to invisible leverage. Secondly, it gives the borrower cheap equity without diluting the share capital and hence negatively influencing the wealth of those who's remuneration is linked to share price performance and is expressed by way of stock awards. It is, in many respects, a victimless crime. There is nothing altruistic in corporates issuing subordinated debt.

And yet, investors are tripping over themselves in pursuit of such paper. Early and enthusiastic investors in hybrids made out like bandits but the juice has gone. Furthermore, as in the case of Additional Tier One (AT1) notes, the sub-class has not yet been tested in a prolonged and properly stressed market which renders the pricing process for such paper a bit of a game of pinning the tail on the donkey. The price of a bond needs to take account of the expected recovery rate in the event of default. I'm not sure anyone has come up with a usable and credible model for this one. Does one insert zero recovery? If so, how should that risk be correctly priced? 241 bps certainly doesn't seem to cover the bases. And that, incidentally, does not even include any meaningful pricing adjustment for the higher liquidity risk of junior sub debt in a stressed market where bids for institutional size will surely once again be scarcer than pink and blue striped unicorns.

The principal risk which should be worrying us is not, when push comes to shove, the one covering default and recovery but the one of mark to market volatility. The higher convexity which the currently low coupons impose on bonds brings with it higher price volatility and hence much higher risk to investment portfolios. What effect this might have on such matters as the solvency of insurance companies has not, in my opinion been taken on board. In their race to slaughter market liquidity on the altar of transparency, the regulators are doing just what we feared they were, namely they are preparing to re-fight the last war. "- Anthony Peters, strategist at SwissInvest   

Exactly! We agree with our friends when it comes to convexity risk. Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:

"In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."

So Corporate Hybrids investors beware, because, the reward doesn't justify anymore the risk and the lack of liquidity will one day come back to haunt you when you will be seeking "price discovery" for your holdings rest assured.

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Asset Management which we introduced in our conversation "The Night of the Yield Hunter":

In this week's conversation, as we move into the second quarter of 2015, we will look at the current business cycle from a credit perspective and ponder were we stand when it comes to allocation in "nth" inning game.

Synopsis:

• Although "leverage" is rising, it is still "goldilocks" for credit in particular for US Investment Grade Credit
• In this late credit cycle game, we recommend playing "quality"
• Global QE is not only leading to the "Honey Pot" but as well extending the game into "overtime"
• What to do in Q2?
• Final note: the only "Great Rotation" has been from retail investors to institutional investors

• Although "leverage" is rising, it is still "goldilocks" for credit in particular for US Investment Grade Credit

As we pointed out in our previous conversation, there is indeed greater enthusiasm for US dollar credit. 

US Investment Grade Credit in terms of returns have been so far more appealing as clearly displayed by Morgan Stanley's Leveraged Finance Chartbook from the 30th of March:

- source Morgan Stanley

But, as indicated by CITI in their March 2015 note entitled "Is the credit cycle headed to extra innings?", leverage in the Investment Grade credit space has been rising, confirming we are indeed in the higher left quadrant of the "Global Credit Channel Clock":

- source CITI

We have long argued that in the "japanification" process, particularly in Europe, credit could outperform equities: 

"This somewhat validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":"-Corporates around the world have been deleveraging for longer than most people realise, starting around the time of the tech bubble in 2000.-Deleveraging is generally bad for equities, but good for credit assets. -In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute). -As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities." - source Nomura

This outperformance has played out until 2015 which saw the launch of the ECB's QE and a switch in the "regional macro" perspective as we pointed out last week:

"What we find of interest from a pure "regional macro" perspective is that whereas in the last couple of years European credit has clearly outperformed equities, it seems to us that the ECB's actions have reversed the trend by pushing yields towards negative territory and very significant inflows and performances in the European equities space. At this juncture given the different paths followed by the ECB and the Fed, it seems reasonable to switch from favoring European Credit towards US Credit and, in the equities space, to favor European Equities rather than US equities as a whole." - Macronomics, "The camel's nose", March 2015

The current "deflationary" environment is indeed a golden age for credit, and given the "macro regional switch" one should indeed favor a stronger allocation to US Investment Grade in the US while European High Yield remains more enticing than European Investment Grade credit due to the disappearance of the interest rate buffer we discussed last week as well as convexity issues (lower and lower coupons and increased duration). 

In Europe, Investment Grade has had its second best performance in 2014 since 2009 (above 7% versus 5% for European High Yield) and with the largest issuance number since 2007. When one looks at the Asset Class Total Returns in 2015 in the Fixed Income space as displayed in Morgan Stanley's Leveraged Finance Chartbook from the 30th of March, one can see that our positive stance on US Investment Grade Credit which we discussed again in August 2014 in our conversation  "Thermocline - What lies beneath" has been validated by returns:

"For those that need to seek comfort in a safe haven, we believe Investment Grade credit while tight from an historical point of view, still benefits from positive exposure thanks to the Japanification process. In that sense, we expect the Fed to keep a dovish tone in this muddling through economic situation in the US meaning that the releveraging process taking place in the US is still positive for credit." - Macronomics, 19th of August 2014.

- source Morgan Stanley

 In our conversation "Sympathy for the Devil" back in September 2014 we argued:

"The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters." - Macronomics, September 2014

Yes indeed, when it comes to the High Yield space, default perception risk matters and is ultimately linked to leverage. What could significantly impact High Yield spreads would be a sudden rise in defaults rise, particularly coming from the "Energy" sector which has been in the limelight courtesy of the sudden fall in oil prices. 

In Morgan Stanley's Leveraged Finance Chartbook from the 30th of March one can take notice of the "pessimistic" Moody's Forecast versus their much lower baseline scenario:

- source Morgan Stanley

But, as pointed out by our Rcube Global Asset Management friends, from their March 2013 guest post "Long-Term Corporate Credit Returns", credit investors have a very weak predictive power on future default rates:

"Current spreads have virtually no correlation with actual future default losses. They are therefore driven by something else (risk aversion, greed/fear cycle). Corporate credit investors actually seem to care a lot about one thing: current (i.e. trailing 12-month) default rates.

We interpret this as evidence that credit investors are collectively subject to an extrapolation bias.
When default rates are high, credit investors behave as if default rates were going to stay high for the next 5-10 years. They liquidate their portfolios in panic (or because they are forced to do so). This snowball effect leads to spread levels that have no economic rationale. At the height of the latest credit crunch, corporate high-yield spreads were pricing a 33% annualized implied default probability over the following five years (20% / ( 1 – 0.40 )), which is around four times the maximum five year annualized default probability during the Great Depression!

Inversely, when default rates are low, credit investors believe that stability is the norm, and start piling up on leverage, inventing new instruments to do so (CLOs, CDOs, CPDOs etc.). This recklessness leads to malinvestment, and sows the seeds of the next credit crisis." - source Rcube Global Asset Management

And as per our tile "The Honey Pot", credit markets are indeed a "merciless satire of greed and lust" as concluded by our friend in their 2013 guest post. Credit investors do suffer from "bipolar disorder" and alternate from greed to fear, except that contrary to 2007/2008, during the next "fear" episode, liquidity will not be around:

"Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates." - source Rcube Global Asset Management

While for some it appears to be late in "the Honey Pot" game, one thing for sure is that additional QE from the ECB has been adding extra innings into the "credit" business cycle.

• In this late credit cycle game, we recommend playing "quality"

In this late credit cycle game, we recommend playing "quality" as clearly displayed by Morgan Stanley's Leveraged Finance Chartbook from the 30th of March, it matters:

- source Morgan Stanley

Looking at the above table, both AAA exposure and CCC, doesn't justify, from a risk exposure the risk/reward due to interest rate volatility for the latter and the expected rise in defaults risk for the former. So where is the value?

On the subject of "credit quality" and given investors interest for the BBB "credit belly", we read with interest Morgan Stanley's take in their 27th of March note entitled "The BBB Tail":

"Near-Term Softness; Longer-Term Value
Credit markets continue to have a late cycle feel. Supply comes at a record pace in spite of the 40bp widening since the tights. IG has underperformed equities over the medium term. Despite the widening, our models say that spreads are slightly rich, as weaker Q1 GDP and the recent rate rally weigh on valuations. Over the longer-term, we look through some of the GDP weakness and expect higher rates, both of which will support IG credit.

Revisiting the BBB Trap
While spreads are roughly flat YTD, Non-Financial BBBs are underperforming, wider by 6bp, whereas A-rated issuers are tighter by 5bp. Though the Energy sector is certainly a reason for BBB underperformance, there are other late cycle reasons including quality deterioration, M&A and buybacks.

The BBB Trap: This is significant, as 50% of the IG market ex Financials is comprised of BBBs (35% are A-rated). Furthermore the spread differential (about 80 bps, driven in part by Energy) makes the credit quality view an important one to get right from a carry perspective. 

Are BBBs Cheap Now?
We don’t think so. Ex-Energy and Financials, BBBs provide only 61bp of spread premium over A-rated issuers. While that premium was below 50bp during the peak of the last cycle, the average premium over the past 10 years is about 84bp.

The Trap Becomes a Tail
BBBs are a significant source of dispersion relative to A-rated issuers. The formation of this tail is happening rather quickly, and in our view, represents the fallen angel class of issuers in this cycle." - source Morgan Stanley

In their note Morgan Stanley also highlight the dispersion risk involved in the "BBB" credit bucket and how to avoid it:

"How Does One Avoid the Dispersion Risk? Outside of avoiding BBB risk, credit analysis is the obvious answer, but that assumes realizing a good batting average. Within structured credit, senior tranches are the natural choice, as they are fairly immune to credit dispersion as long as overall spreads are healthy. From the short side, we would recommend protection positions in legacy CDX IG indices which tend to experience credit-quality deterioration at this point in the cycle."

- source Morgan Stanley

Even leveraged credit can be less risky than unleveraged equities as credit is far less volatile than equities, some leverage is sensible.

• Global QE is not only leading to the "Honey Pot" but as well extending the game into "overtime"

QE has indeed been stimulating on a grand scale flows not only into specific asset allocation but, as well to regional allocation (European equities) as we pointed out in our last conversation. A good proxy of the "over-stimulation" of the "Honey Pot" can be seen we think through the prism of year to date flows as a percentage of AUM as indicated in Bank of America Merrill Lynch's Situation Room note from the 2nd of April entitled "Selling stocks but holding on to bonds":

"Outflows from stocks funds increased to $9.15bn last week from a $4.40bn outflow in the prior week. High yield bond funds had a small $0.58bn inflow, while short-term high grade (- $0.45bn) and loans (-$0.20bn) continued to report outflows. Outside of short-term funds high grade flows were little changed from the prior week at $3.16bn. However, weekly data for high grade outside of short-term funds tend to be inflated by PIMCO-related flows, and PIMCO again reported outflows for the month of March." - source Bank of America Merrill Lynch

When it comes to the supposedly "Great Rotation" story of 2014 from bonds to equities, with YTD inflows of $31.7 bn into High grade versus $20.2 bn into equities, the only great rotation story of 2015 has been in Europe with significant inflows into equities courtesy of the ECB's QE.

The ECB QE factor has been driving equities flows in Europe. It can be ascertained from Bank of America Merrill Lynch's Flow Show chart from the 2nd of April entitled "My Herd is My Bond". The European "Honey Pot" à la Japan:

"My Herd is My Bond: another week, another week of inflows ($8.5bn) to fixed income; indeed 2015 has seen biggest first quarter of fixed income inflows ($102bn) since 2001.

Dollar driving equity flows: inflows to Europe & Japan, outflows from US & EM; overall $9.1bn weekly redemptions from equity funds.

Everyone loved QE: as noted last week ECB QE-inspired inflows to European equities now v similar as % of AUM to Japan equity inflows during launch of BoJ QE in 2013 (Chart 1)."

Cash smashed: very large $53bn outflows from Money Market funds, largest since Oct'13 US government shutdown. - source Bank of America Merrill Lynch.

As pointed out in their note as well, Europe has seen very significant inflows courtesy of our "Generous Gambler" aka Mario Draghi:

- source Bank of America Merrill Lynch.

Global QE and increasing negative yield in Europe have led to investors being led to the "Honey Pot" to smash the Piggy bank (money market outflows) and to run into overdrive towards fixed income. So much for the "Great Rotation" story...

The global easing and QE policies have effectively led to a late continuation of the the business cycle as indicated by Bank of America Merrill Lynch's US Economic Weekly note from the 2nd of April entitled "The continuing case for risk assets":

"The benefits of clean living

A popular view is that business cycles die of old age. If this were true, then the length of recoveries would tend to cluster around a certain number of years. In reality, the length of recoveries has a very flat distribution, extending from 12 to 120 months (Chart 2).

 Moreover, if anything, economic recoveries have tended to get longer over time. In the “good old days” of the gold standard the average recovery lasted only two or three years, and the economy was in recession almost as much as it was in expansion. Since World War II the average recovery has increased to 58 months. Even more telling, the last three recoveries have been among the four longest in history. By this standard, the current recovery is middle-aged, not old.

Recoveries don’t die of old age, they end due to three kinds of excesses—major asset bubbles, overexpansion of cyclical sectors and high inflation. In addition, a related excess, the shock of higher oil prices, has been an important cause of many recessions. None of these health risks are evident today:

• Healthy diet: unlike during the housing and tech bubbles, in the current cycle easy credit has been used for balance sheet repair. While there may be minibubbles in parts of the markets, there is no sign of a bubble in major asset markets such as housing and the stock market.

• Low cholesterol: Historically, the three cyclical sectors of the economy— consumer durable spending, housing and business equipment investment— tend to collapse during recessions and then over-expand late in the recovery. Today, all three sectors have taken back only about half of their decline as a share of GDP (Chart 3).

• Non smoker: Inflation remains low and given strong global headwinds it is unlikely to pick up significantly any time soon.

• Drink in moderation: Oil prices are a long way from levels that have triggered recessions in the past and are unlikely to return to their highs any time soon (Chart 4).
  

 - source Bank of America Merrill Lynch

Of course we disagree with Bank of America Merrill Lynch's take who is not seeing froth into any major asset class. As per our earlier rant of our current credit conversation, the European corporate credit hybrid space is a clear case of "overreaching" investors!

• What to do in Q2?

When it comes to the "pain trade" we benefitted from the February weakness into US Treasuries to add to our long duration exposure (partly via ETF ZROZ). The 126K weaker than expected print for Nonfarm payrolls well below the "optimism bias" economists forecast of 247K, validated even more our cautious long standing "deflationary" stance.  We continue to see value in being long duration via US Treasuries. The macro data in the US continue to point out that the US economy is much weaker than it seems and we do not see the Fed hiking in June and hiking in 2015 even. The Fed has clearly stated it is data dependent.

Looking again at the upper left quadrant of the "Global Credit Channel Clock" from Rcube Global Asset Management friends, you should:

• remain long volatility
• remain long US Government Bonds
• remain long gold
• continue to play yield curves flattening

Our position is relatively similar to what has been advocated by Bank of America Merrill Lynch in their Thundering Word latest note entitled "Moment of Truth" when it comes to being long volatility:

"We remain a buyer of volatility (so at margin add to gold and cash). Without doubt the key Q2 call is can the US economy recovery its mojo (i.e. Q2 GDP pops above 3%) or not (GDP for 3rd consecutive quarter fails to break much above 2%). Big GDP...Fed hikes get priced-in. Small GDP ..."secular stagnation" back in play, investor "buyers strike" in overvalued corporate bonds and equities. In either scenario, volatility performs well. Vol remains the "buy the dip" trade of 2015.
Lower exposure to spread product. BAML house view is US GDP above 3.5% Q2. This likely to put upward pressure on bond yields as June/Sept in play for hike. In turn this is likely to widen spreads across corporate bonds, a trend that at any moment can be exacerbated by latent investor fears on market liquidity, speculative excesses in "yield" products, and levered ETF risk parity strategies." - source Bank of America Merrill Lynch.

Where we disagree strongly is with their "house view" of US GDP above 3.5% in Q2. It will not happen for the following reasons:

• Only 34,000 jobs were added in March, according to the Household Survey. 96,000 Americans, meanwhile, left the labor force. The Labor Force Participation Rate has fallen back to post-1978 lows. The 126 K NFP print along with downward revisions of 69,000 for January and February shows that the U.S. economy is an a dead stall. The Atlanta Fed GDPNow tracking forecast shows zero growth during the first quarter.
• New York’s ISM purchasing managers’ survey came in at 50, vs. 63.1 the previous month and a survey expectation of 62.
• Most pundits assumed that cheaper oil would spur consumer spending. Check latest retail sales...
• Earnings are vulnerable to big disappointments. Factset reported on the 1st of April (not April's fool day on that matter) that positive guidance is at the lowest level since 2006: 

“For Q1 2015, 85 companies in the S&P 500 have issued negative EPS guidance and 16 companies have issued positive EPS guidance. If 16 is the final number of companies issuing positive EPS guidance for the quarter, it will mark the lowest number since Q1 2006. The number of companies issuing negative EPS guidance for Q1 2015 is above the trailing five-year average (76), but slightly below the trailing one-year average (87) for a quarter.”

• Year on year, world trade is down more than 10% between January 2014 and January 2015. as indicated by David Goldman in Asia Times:

"That’s mostly price movements, to be sure, but the collapse of export prices in dollar terms reduces capacity to service dollar debt. Deficit = death in this kind of market."

• The Chicago MNI Business Barometer came out at 46.3 in March, barely above the 45.8 reading in April, indicating more contraction. The consensus estimate called for a recovery to 51.7. Yet another miss by the "optimism bias" crowd of pundits. 
• Dallas Fed Manufacturing Survey printed at -17.4, the worst since 2011.
• Real personal consumption fell by 0.1% in February, the second-biggest drop since the 2009 crisis. It was forecast to rise by 0.2%.
• Durable goods orders were down -1.4% in February vs. a consensus estimate of +0.2.

 So all in all we do agree with Bank of America Merrill Lynch's note title: "Moment of Truth".

We could go on with the weaker than "expected" data releases in the US, but hey, "bad news" is "good news" given markets seem increasingly dependent on super easy monetary policy to go on for longer (hence the extended duration of the credit business cycle into overtime until sudden death or penalty shoot-out maybe?).

In that context think European equities investors would be wise to take a few chips from the table given the significant rally since the beginning of the year. Take a break and lock some profits.
Same apply to the short Euro crowd, beware of strong risk reversal in Q2. While the US equities crowd, we think, will continue to face disappointment, in the form of earnings, this time around. Tread cautiously in Q2.

• Final note: the only "Great Rotation" has been from retail investors to institutional investors

On a final note we leave you with a chart from CITI's March 2015 note entitled "Is the credit cycle headed to extra innings?" displaying that no matter how the Fed central bankers would like to spin it, there has not been wealth effect, only "cantillon effects":

"But if stocks go down, it’s even worse" - source CITI

What is of interest is that while quietly institutional investors have been cashing in such as Private Equity, retail investors have been piling in, indicative of the lateness in of the credit business cycle driven  by central bankers. In last 3weeks in Europe, a Portfolio Manager friend has seen big share blocks placed after market closure. It seems Insiders/PE guys really believe in the much vaunted recovery...The "Honey Pot" is indeed a satire of greed and lust...

« Murphy Junior’s law »: My central banker is too optimistic”.  - Macronomics

Stay tuned!