Macro and Credit - Rescission

"Perfection of planned layout is achieved only by institutions on the point of collapse." -  C. Northcote Parkinson, British Historian

Looking with interest at the decisions taken by the Fed at its FOMC meeting to start unwinding its bloated balance sheet, when it came to selecting our title analogy, we reacquainted ourselves with the term "Rescission" from contract law, (not to be confused with "Recession" yet). In contract law, "Rescission" has been defined as the unmaking of a contract between parties. "Rescission" is the unwinding of a transaction. This is done to bring the parties, as far as possible, back to the position in which they were before they entered into a contract (the status quo ante). One could opine that "Rescission" is typically viewed as "an extreme remedy" which is rarely granted, but in the case of the Fed, it was a unanimous decision to hold the federal funds rate between 1.00% and 1.25% and begin the process of shrinking its balance sheet by October hence our chosen analogy for this week's conversation.

Before we go into more details of this week's conversation, we would like to make a support appeal on behalf of our surfing friends in Saint Martin. They lost everything when hurricane Irma levelled their island. While we do have a tip jar on the blog page, for those of you who enjoy our free weekly musings, we would be extremely grateful if you could be helping out in providing financial support for the reconstruction of Saint Martin's surf club facilities given they really need a new boat. These facilities have been effectively wiped out. Jean-Sebastien Lavocat, a great windsurfer and surfer, is running the place. In 23 years of existences the surfing club of Saint Martin has generated numerous young surfing champions including current top French number three Maud Le Car. He really needs your support to continue to do so. You can make donations at the following address: Solidarity with Windy Reef. Please give them a hand. As well, the natural reserve area where the surf club is located, needs financial support. You can also donate on the following page: "Réserve Naturelle St-Martin Vs IRMA". After Irma please participate in the restoration of the last natural sites of the island of Saint Martin! Thanks again.

In this week's conversation, we would like to look at the Fed's low inflation mystery, in relation to the fall of productivity in the US, yet another nail in their Norwegian Blue parrot aka the Phillips Curve. Another wise wizard from the BIS, namely Claudio Borio has delivered another blow to the outdated model used by the central banking "cult members".

Synopsis:

• Macro - Low inflation mystery? The Fed is gone fishing.
• Credit - Beware of rapid credit expansion
• Final chart - "Broken" asset investment in Developed Markets

• Macro - Low inflation mystery? The Fed is gone fishing.

Given the colloquial meaning of "Gone Fishing" relates to a checkout from reality, as well as being unaware of what's going on, Janet Yellen's latest comment on the low inflation mystery is another indication of their lack of understanding of why their Phillips Curve model is clearly past its due date we think. 

While in various recent musings we have been pounding this Norwegian Blue Parrot, which is still resting for the Phillips Curve "cult members", we couldn't resist to bring back this subject following the support coming from Claudio Borio, Head of the BIS Monetary and Economic Department in his most recent discussion on the low inflation issues entitled "Through the looking glass" published on the 22nd of September 2017.  

"Central banks must feel like they have stepped through a mirror, and who can blame them? They used to struggle to bring inflation down or keep it under control; now they toil to push it up. They used to fear wage increases; now they urge them on. They used to dread fiscal expansion; now they sometimes invoke it. Fighting inflation defined a generation of postwar central bankers; encouraging it could define the current one.

What is going on in this topsy-turvy world? Could it be that inflation is like a compass with a broken needle? That would be a dreadful prospect – central bankers’ worst nightmare. And what would be the broader implications for central banking?

In my presentation today, I would like to address these troubling questions. I will do so recognising that “in order to make progress, one must leave the door to the unknown ajar”, as Richard Feynman once said. We should not take for granted even our strongest-held beliefs. That, of course, means that I will be intentionally provocative.

I will make three key points – putting forward two hypotheses and drawing one implication.

First, we may be underestimating the influence that real factors have on inflation, even over long horizons. Put differently, Friedman’s famous saying that “inflation is always and everywhere a monetary phenomenon” requires nuancing (Friedman (1970)). Looking back, I will focus mainly on the role of globalisation; but, looking forward, technology could have an even larger impact.

Second, we may be underestimating the influence that monetary policy has on real (inflation-adjusted) interest rates over long horizons. This, in fact, is the mirror image of the previous statement: at the limit, if inflation were entirely unresponsive to monetary policy, changes in nominal rates, over which central banks have a strong influence, would translate one-to-one into changes in real rates. And it raises questions about the idea that central banks passively follow some natural real interest rate determined exclusively by real factors, embodied in the familiar statement that interest rates are historically low because the natural rate has fallen a lot. Here, I will provide some new empirical evidence to support my hypothesis.

Finally, if these hypotheses are correct, we may need to adjust monetary policy frameworks accordingly. As I shall explain, that would mean putting less weight on inflation and more weight on the longer-term real effects of monetary policy through its impact on financial stability (financial cycles). Incidentally, the stronger focus on financial stability would bring central banking closer to its origins (Goodhart (1988), Borio (2014a))." - source Claudio Borio, BIS

Of course, we would argue that, if indeed, one is to make progress, one should be ready to reassess the validity of its framework such as the sacrosanct Phillips Curve. We were pleasantly surprised to read in the excellent speech from one of the BIS maverick economists, that globalization was put forward as one of the reasons for the lack of responsiveness of the Phillips Curve framework, which for some is simply resting like a "Norwegian Blue parrot":

"The one I find particularly attractive is that the globalisation of product, capital and labour markets has played a significant role. Is it reasonable to believe that the inflation process should have remained immune to the entry into the global economy of the former Soviet bloc and China and to the opening-up of other emerging market economies? This added something like 1.6 billion people to the effective labour force, drastically shrinking the share of advanced economies, and cut that share by about half by 2015. Similarly, could it have remained immune to the technological advances that allowed the de-location of the production of goods and services across the world? Surely we should expect the behaviour of both labour and firms to have become much more sensitive to global conditions. We know that workers are not just competing with fellow workers in the same country but also with those abroad. We know that, for a given nominal exchange rate, the prices of two tradable goods that are close substitutes should track each other pretty closely. And we know that exchange rates have not been fully flexible, as the authorities have been far from indifferent to exchange rate movements. In other words, we should expect globalisation to have made markets much more contestable, eroding the “pricing” power of both labour and firms. If so, it is quite possible that all this has made the wage-price spirals of the past much less likely.
More specifically, one can think of two types of effect of globalisation on inflation. The first is symmetrical: assuming something akin to a global Phillips curve, one would expect domestic slack to be an insufficient measure of inflationary or disinflationary pressures; global slack would matter too. The second is asymmetrical: one would expect the entry of lower-cost producers and of cheaper labour into the global economy to have put persistent downward pressure on inflation, especially in advanced economies and at least until costs converge." - source Claudio Borio, BIS

As we pointed out earlier in September in our conversation "Ouroboros", these are the reasons why the Phillips Curve is broken we think:

"For us, there are three main reasons why the Phillips curve is a Norwegian Blue parrot, simply resting in a Monty Pythonesque way:

1. Demographics: as population ages, there are more pressure on aggregate demand and total consumption. 
2. Globalization: real wages have come under pressure thanks to offshoring of labor in different parts of the world, leading to good solid wages jobs in the industrial sector being replaced by low qualification low paying jobs in the service and hospitality sectors.
3. Technology: As per Henderson's work and recent progress in technology, pressure on prices as been appearing thanks to the Experience curve. The fight between Amazon and the retail sector comes to mind we think about it. Technology has been holding down costs overall and facilitated rapid price competition in some sector (internet on retail).

This is why we think the Phillips curve is obsolete, for structural reasons." - source Macronomics, September 2017

Obviously our hypotheses have been given some much appreciated boost from none other than the wise and respected Claudio Borio from the BIS. We will not delve into more details of Claudio Borio's speech, but, in our opinion, it is a must read, particularly for the Phillips Curve "cult members". As Richard Feynman once said, and as pointed out by BIS Head of Monetary and Economic Department, in order to make progress, one must leave the door to the unknown ajar. Unfortunately, for many it seems, the door is closed. For them, the Phillips Curve is simply "resting".

The pace of wage inflation is influenced by productivity growth. In this environment of weak productivity growth, firms may be more hesitant to raise wages. Productivity growth has averaged 0.5 - 1.0% yoy over most of this recovery, which is a historically slow pace of growth. Without productivity growth, it becomes harder for companies to justify raising wages since the output per worker has failed to increase, that simple. We already discussed the issue of US productivity in June 2016 in our conversation "Optimism bias":

"In our book, "secular stagnation" is not only due to the burden of high global debt levels but, as well by the evident slowdown in productivity labor growth, which is clearly impacted by the "rise of the robots". This does not bode well for the stability of the "social fabric" and with rising populism in many parts of the world." - source Macronomics, June 2016

As we pointed out to Kevin Muir author of the Macro Tourist in our conversation "The Dead Parrot sketch", a business owner is a "deflationista" at heart because he fights day and night to compress his costs and find smart ways to do more and earn more with less in order to maximize his profits. Also it is worth mentioning French economist Jean Fourastié's work relating to real wages, real prices and in particular around productivity. In our last conversation we indicated that when it comes to the Phillips curve, the deflationary bias of capitalism and the Experience Curve should not be neglected in addition to the globalization factor:

"As we move towards the end of an economic expansion in the US, productivity has been falling, and jobs have been mostly created for lower skills workers, hence the lower wages conundrum weighting on inflation expectations." - source Macronomics, September 2017

When it comes to productivity issues, it seems to us that the Fed is unaware of what's going on, namely, that they've "gone fishing". On the issue of low productivity, we read with interest Bank of America Merrill Lynch's Economic Weekly note from the 22nd of September entitled "Productivity growth is a procrastinator":

• "The US economy is currently in a low productivity regime, averaging just 0.6% growth since 2011.
• The near-term outlook appears dim due to headwinds from unfavorable demographic factors and weak capital investment.
• Broad adoption of new IT goods and services could generate better productivity growth. But a regime shift is likely a long-term story.

Productivity growth down in the dumps

Labor productivity growth has been abysmal. Since 2011, it has averaged less than 1% and the trend is pointing down, as it came in flat in 2016. As we wrote last week, low productivity growth is likely one of the factors holding down wage gains and one of the catalysts that led some FOMC participants to revise down their longer-run dot in the latest SEP projections. In this note, we break down productivity growth into its three major components—labor quality, capital deepening and multifactor productivity—and ponder the near-term outlook.

Not all hours are created equal

Labor quality measures the effect of shifts in the age, education, and gender composition of the workforce. One can imagine that total output will vary given a workforce with a certain set of education, skills, and experience. Contribution of labor quality to productivity growth has varied over time as the composition of the workforce has shifted (Chart 1).

Labor quality took a dip in the late 60s to the 70s as a surge of young inexperienced workers (Baby-Boomers) entered the job market, lowering the experience level of the overall workforce. But as those workers gained experience and entered their prime-working age (when they are likely to be the most productive), the labor quality of the workforce increased, leading to greater productivity gains. Additionally, we saw the skill level of the workforce rise as a greater share of workers obtained higher degrees, helping to usher in an era of high productivity growth.

Today, the forces affecting labor quality are mixed (Chart 2).

On one hand, the share of the prime-age workers is declining as Baby-Boomers begin to retire and the Bureau of Labor Statistics projects that the trend will remain flat over the next decade. On the other hand, a greater share of workers are obtaining college degrees or higher and the trend looks broadly positive. In the long run, a more-educated labor force should pay dividends for productivity growth. However, in the near term the “Silver-Tsunami” effect will likely be a bigger countervailing force, keeping the contribution of labor quality to productivity growth below levels experienced in the 90s and 2000s.

You got to spend money to make money

Capital deepening or capital intensity is the amount of capital investment in relation to labor input. More machinery or equipment should make a worker more efficient, which should translate to more output per hour. Prior to the Great Recession, capital deepening contributed on average 0.9pp to labor productivity growth. Moreover, we experienced a big surge in capital investment at the turn of the century as businesses invested more in information and communication technology during the IT revolution. Since then, the pace of capital investment has slowed. The Great Recession played a role in holding down business investment, but during the current recovery, the pace of net stock of capital investment growth has remained well below prior trends (Chart 3).

Recently, businesses have placed investments on hold, as they wait to see if Congress passes corporate tax reform. Moreover, in the industrial sector, capacity utilization remains well below pre-recession levels and overall capital formation is only modestly outpacing depreciation, lessening the need to invest heavily in new equipment and machinery. All told, given our expectations for nonresidential fixed investment to grow at a tepid pace over the next several years, we see little prospects of a strong pickup in capital deepening.

Multifactor productivity: the magic elixir for growth?

Multifactor productivity (MFP) measures the output per unit of capital and labor input. In essence, it measures the overall production efficiency of the economy. The driving force of MFP is hard to pinpoint. In fact, empirically MFP is usually estimated as the residual of the production function. But the right combination of labor and capital can lead to significant productivity growth similar to what we experienced during the IT boom.

Although productivity growth at the aggregate remains weak, certain sectors have benefited from adoption of new technologies (Table 1).

For example, the oil and gas industry experienced a surge in MFP growth due to new drilling methods such as “pad” drilling, which allows rig operators to drill groups of wells simultaneously. Additionally drillers have found further efficiencies by developing fracking methods, which reduce the amount sand and water needed to drill wells. The IT-producing and service industries such as “computer and electronic products” and “computer systems design and related services” industries continue to see productivity gains from faster processors and algorithms and the adoption of cloud computing technology. In the retail world, ecommerce has led to a surge in the share of retail activity at non-store retailers, while job growth has remained limited, boosting productivity growth in the sector. In fact, according to the BLS, labor productivity growth for non-store retailers has averaged 5.6% over the last five years, well above the aggregate pace.

Innovation in robotics and artificial intelligence, adoption of big data and machine learning analytics raise the prospects for productivity gains. However, broad diffusion of these technologies will likely take years if not decades, implying that the hoped for rebound is likely a long-term story. We could see some incremental increase in the meantime, but a full regime shift seems unlikely.

A word on mismeasurement

It’s possible that there are some mismeasurement issues in the data. The skeptics of low productivity growth usually argue that prices for IT products used to deflate nominal expenditures are too high given the quality improvements, implying more real output and greater productivity. The jury is still out, but the preponderance of evidence suggests that mismeasurement issues were around prior to the slowdown in productivity growth and there’s little evidence to suggest it has exacerbated. One area where we see potential measurement issues is profit shifting of US corporations abroad, distorting the way corporate income is reported, which leads to wider trade deficits than the official measure. According to Guvenen et. al., adjusting for this mismeasurement would add 0.1pp annually to productivity growth for 1994-2004 and 0.25pp for 2004-2008, mitigating some of the productivity slowdown.

Adding it all up

The prospects of returning to a high-productivity regime and seeing better potential growth in the near term seem limited. In fact, the risks are likely skewed to the downside to our already low estimate for potential growth of 1.7%. Demographic trends are unfavorable and businesses appear to be in a “wait and see” mode on capital spending. Multifactor productivity remains an unknown factor: the trend doesn’t look too promising, but broad diffusion of new IT products could lead to some modest productivity gains in the short run before seeing greater gains once potential is fully realized. Until then, we remain comfortable with our call for productivity growth to stay subdued and for growth to hover around 2% over the next several years." - source Bank of America Merrill Lynch

As we pointed out, productivity has been falling, and jobs have been mostly created for lower skills workers. On top of that, business owners have been more creative in keeping costs under control and not only due to "globalization". Overall, low inflation should not be a mystery for the Fed:

• if they had read the work of French economist Jean Fourastié, 
• if they had taken the globalization factor pointed out by Claudio Borio at the BIS 
• if they had taken into account BCG's Experience curve impact (a company’s unit production costs fall by a predictable amount - typically 20 to 30 % in real terms - for each doubling of “experience,” or accumulated production volume). 

What we called recently in one of our musings the "Amazon factor" is effectively today' application of the Experience curve in the sense that it is the ability to produce existing products more cheaply and deliver them to an ever-wider audience (or what BCG calls "shaping demand with successive innovations").

That's about it for our "Macro" bullet point. For our credit point below, we would like to point out the brewing instability coming from rapid credit expansion, as it might be the case, that, from a Financial Stability perspective, at least the Fed is getting nervous on that front.

• Credit - Beware of rapid credit expansion

As we pointed out in our previous conversation, the work of Claudio Borio from the BIS, has been very interesting when it comes to pointing out the risks for Financial Stability including rapid credit expansion. As a reminder, Claudio Borio and his colleague Philip Lowe wrote in 2002 a very interesting paper entitled “Asset prices, Financial and Monetary Stability: Exploring the Nexus”, BIS Working Papers, n. 114. In this paper the authors made some very important points that are worth reminding ourselves today:

"Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions […] Booms and busts in asset prices […] are just one of a richer set of symptoms […] Other common signs include rapid credit expansion, and, often, above-average capital accumulation" - source BIS 

A common sign of brewing instability has always been rapid credit expansion. The "controlled demolition" analogy we used in the past when discussing the threat of the Shadow Banking sector in the Chinese economy was a clear illustration that the Chinese authorities were clearly aware of the risks. So far they have managed to dampen the issues at hand. It is always critical to assess rapid credit expansion to gauge rising instability in our current credit world. On this subject we reminded ourselves of September 2016 paper by Matthew Baron and Wei Xiong, Quarterly Journal of Economics, entitled "Credit Expansion and Neglected Crash Risk":

"By analyzing 20 developed economies over 1920–2012, we find the following evidence of overoptimism and neglect of crash risk by bank equity investors during credit expansions: (i) bank credit expansion predicts increased bank equity crash risk, but despite the elevated crash risk, also predicts lower mean bank equity returns in subsequent one to three years; (ii) conditional on bank credit expansion of a country exceeding a 95th percentile threshold, the predicted excess return for the bank equity index in subsequent three years is -37.3%; and (iii) bank credit expansion is distinct from equity market sentiment captured by dividend yield and yet dividend yield and credit expansion interact with each other to make credit expansion a particularly strong predictor of lower bank equity returns when dividend yield is low." - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics

As pointed out by the BIS work, rapid credit expansion can have severe consequences on the real economy. The recent Great Financial Crisis (GFC) was an illustration of out of control credit expansion in the housing markets with global dire consequences:

"The recent financial crisis in 2007–2008 has renewed economists’ interest in the causes and consequences of credit expansions. There is now substantial evidence showing that credit expansions can have severe consequences on the real economy as reflected by subsequent banking crises, housing market crashes, and economic recessions, (e.g., Borio and Lowe 2002, Mian and Sufi 2009, Schularick and Taylor 2012, and L´opez-Salido, Stein, and Zakrajˇsek 2016). However, the causes of credit expansion remain elusive. An influential yet controversial view put forth by Minsky (1977) and Kindleberger (1978) emphasizes overoptimism as an important driver of credit expansion. According to this view, prolonged periods of economic booms tend to breed optimism, which in turn leads to credit expansions that can eventually destabilize the financial system and the economy. The recent literature has proposed various mechanisms that can lead to such optimism" - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics.

As we have discussed recently, in credit booms such as the ongoing one, credit quality is deteriorating, which is the case when it comes to US Investment Grade. The deterioration of credit quality forecasts not only lower future corporate bond returns but, will also have an impact on the recovery value. In their very interesting paper, Matthew Baron and Wei Xiong look if credit expansion predicts a significantly higher likelihood of bank equity crashes:

"We find that one to three years after bank credit expansions, despite the increased crash risk, the mean excess return of the bank equity index is significantly lower rather than higher. Specifically, a one standard deviation increase in credit expansion predicts an 11.4 percentage point decrease in subsequent three-year-ahead excess returns." - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics.

Their analysis demonstrates the clear presence of overoptimism by bank shareholders during bank credit expansions, which of course not a surprise given this phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics. You might already be wondering where we are going with this but, we think that right now, loose financial conditions are leading to rapid credit expansion which is probably a concern for the Fed relating to Financial Stability. On this subject we read with interest Société Générale Market Wrap-up note from the 19th of September entitled "What the macro number tell us about borrowing" which indicates that leverage is rising now in Europe as well:

"Market thoughts

In “Leverage is rising in Europe too,” we used two bottom-up data series of leverage, built from the companies in the iBoxx euro-denominated IG and high yield indices, to show how European companies were getting more risky. Do the macro figures back these conclusions up?

The Banque de France published its latest update on the financing of the corporate sector on 12 September. The year-on-year growth rate of loans to non-financials remains just under 5%, more or less unchanged from where it has been since mid-2015 (as Chart 1 shows).

The growth rate is broadly in line with the levels seen in mid-2011, ahead of the euro crisis, but less than half the peaks in 2001 (ahead of the 2002 bear market) or 2007/8 just before the US-led global financial crisis. The level of borrowing is not striking, but the composition is more noteworthy. While borrowing for short-term needs is now stable year-on-year, and borrowing to finance property investment has dipped, the borrowing for other forms of capital investment is running at 7% per annum, well above the 2011 peaks.

This suggests that companies are borrowing to invest, and explains some of the rise in balance sheet leverage noted in our earlier study.

Seen at a pan-European level, however, the trend looks far less significant. Chart 3 shows the growth in borrowing from the ECB for corporates and households (with the latter split into consumer credit and house purchases).

Corporate borrowing is not only growing less quickly than household borrowing, but the year-on-year growth rates have decelerated recently.

On balance, then, the macro data is rather less alarming than the bottom-up figures, which do show that leverage is rising. As we noted in our earlier study, however, this could be because of the increase in high yield borrowing and issuance in euro-denominated debt from issuers outside the eurozone. The bank lending figures themselves are more likely to be biased towards domestic borrowers." - source Sociéte Générale.

While on balance the macro data seems less alarming, there is no doubt that leverage is creeping up and that covenants are being loosened, even in Europe, which seems to indicate rapid credit expansion in some instances. No surprise some central banks including the Bank of England are wary about these developments. As shown in a recent article by the Wall Street Journal, leverage loans are coming back at a rapid pace, as indicated in their article from the 24th of September entitled "Leveraged Loans Are Back and on Pace to Top Pre-Financial Crisis Records":

"Lending to the most highly indebted companies in the U.S. and Europe is surging, a development that investors worry could pressure financial markets if the global economic expansion starts to fade.

Volume for these leveraged loans is up 53% this year in the U.S., putting it on pace to surpass the 2007 record of $534 billion, according to S&P Global Market Intelligence’s LCD unit.

In Europe, recent loans offer fewer investor safeguards than in the past. This year, 70% of the region’s new leveraged loans are known as covenant-lite, according to LCD, more than triple the number four years ago. Covenants are the terms in a loan’s contract that offer investor protections, such as provisions on borrowers’ ability to take on more debt or invest in projects.

Toys ‘R’ Us offered a reminder of the risks of piling on debt when the company filed for bankruptcy protection on Monday. The toy seller’s chief executive said in court papers that Toys ‘R’ Us had been hampered by its “significant leverage.” Its $5.3 billion in debt included a large number of leveraged loans and high-yield bonds" - source Wall Street Journal

Given in the US a third of loans to private-equity backed companies this year are leveraged six times or more, according to LCD’s calculations of companies’ debt to earnings before interest, tax, depreciation and amortization and despite 2013 guidelines from U.S. regulators, including the Fed, on loan underwriting stating that leverage of more than six times "raises concerns for most industries", you probably understand why the Fed is envisaging "Rescission" from its generosity, and draining some of the alcohol out of the credit punch bowl. In similar fashion, credit expansion and loose covenants have become more aggressive in Europe as indicated in the Financial Times on the 20th of September in their article "Aggressive term in Stada bond sale causes outcry":

"Analysts and investors are crying foul at an aggressive term in the bond sale backing the €4.3bn buyout of Stada, which they say creates a new way for the drugmaker’s private equity owners to strip cash out of the business.

The €825m high-yield bond deal is being sold alongside a €1.95bn syndication of leveraged loans, in order to finance Bain Capital and Cinven’s acquisition of German generic drugmaker Stada. The acquisition is the largest leveraged buyout of a European-listed company in four years." - source Financial Times

European companies are indeed getting more risky. This another indication of the lateness of the credit cycle, even in Europe, although one could argue that US is ahead of Europe when it comes to its rapid credit expansion phase as pointed out by JP Morgan in their note from the 20th of September entitled "Age isn't everything -  Gauging the DM business cycle":

"The US looks modestly more vulnerable

On balance, most indicators suggest that the DM as a whole is not close to its next recession, despite having returned to full employment. While this case can be made for the DM as a whole, the picture is more mixed for the US—the economy farthest advanced in its cycle. Our US team’s recession risk tracker places the risks of a recession in the next twelve months at a relatively low at a 1-in-4 chance. However, the risk profile rises sharply to a 3-in-4 chance at the two to three year horizon.

Two factors appear to differentiate the US from other DM economies. First, falling productivity growth and weak pricing power has led to a significant decline in corporate profit margins from the highs. Some of this margin compression owed to the hit to the energy sector in recent years. With oil prices having bounced from the severely depressed levels in early 2016, and also with productivity growth having recovered, US corporate margins are staging a bit of a recovery. Still, with labor markets continuing to tighten, the pressure will be for some compression in US corporate margins.

Second, there has been a large increase in nonfinancial corporate credit with debt/asset leverage at the 85th percentile of its nearly four decade average. It is important to recognize that our US recession probability model does not account for the fact that rising corporate leverage and falling margins have usually been accompanied by other late cycle pressures that push interest rates up. With US interest rates low and the Fed unlikely to tighten policy significantly over the next year, forces magnifying problems due to tight labor markets and lower corporate margins do not look likely to intensify soon. Still, US shocks generate powerful reverberations through the rest of the world, and it is important to track the factors generating US vulnerabilities alongside our assessment of DM risks in the aggregate." - source JP Morgan

One thing for sure, the Fed might be in "Rescission" mood when it comes to its balance sheet and the credit punch bowl, the US Yield curve is still not buying their "Jedi tricks" as it is getting flatter even after the latest FOMC. So overall credit is becoming stretched and productivity is remaining low in the US. Meanwhile business investment remains very low as well in this unusual "recovery" cycle as per our final chart below.

• Final chart - "Broken" asset investment in Developed Markets

Although the Fed is lost in "inflation" translation, and with the ongoing low productivity seen so far in this cycle, there has been as well a notable imbalance such as the downward trend in business investment. Our final chart comes from JP Morgan report quoted above and displays the trend in Fixed asset investment in Developed Markets (DM):

"With regard to imbalances, there are few signs of an overstretched durables spending cycle. Even accounting for a downward trend, the level of outlays for business investment remains relatively low by historical standards (Figure 18).

Similarly, DM spending on housing and motor vehicles remains low relative to GDP or to population growth. At the same time, household balance sheets are quite healthy even if corporate balances are beginning to look somewhat stretched. 

It is difficult to be precise about the timing of recessions,which are inherently coordination failures among millions of economic actors. The historical record on slack underscores a wide range of outturns once full employment is reached, and there is sufficient evidence to suggest that the typical vulnerabilities associated with recessions are not currently present. However, as vulnerabilities rise, they can be amplified by unforeseen shocks, often coming from financial or commodity prices. It is worth noting that every US recession (except one) was preceded by a material increase in oil prices and every oil market disruption (except one) was followed by an economic recession (“Historical Oil Shocks,” J. Hamilton, 2011). The fact that oil prices have witnessed a spectacular supply-led collapse since 2014 and continue to struggle is encouraging in this regard. While the direction of causation is widely debated, it is arguably the interaction between the various vulnerabilities noted above, along with tightened economic conditions, with financial and commodity prices that becomes the catalyst for recession." - source JP Morgan

As we pointed out last week, for a bear market to materialize, you would need a buildup of inflationary pressure that would reignite the volatility in bonds via the MOVE index. We also pointed out in a previous conversation in similar fashion to JP Morgan that past history has shown that what matters is the velocity of the increase in the oil prices. A price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years. No need to press the "panic" button yet, but it is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation. The Fed might be in "Rescission" mode when it comes to its bloated balance sheet, the US Yield curve remains oblivious to its Jedi tricks and continues to flatten. This does indicate that "Rescission" could eventually lead to "Recession" in 2018, but that's another story...

"Expansion means complexity and complexity decay." - C. Northcote Parkinson, British historian.

Stay tuned !

Macro and Credit - Ouroboros

"History is about loops and continuums." - Mike Bidlo, American artist

Reading with interest a summary of the paper co-authored by top-ranking Philadelphia Fed economist Michael Dotsey indicating "no evidence for relying on the Phillips curve", we felt indeed that our latest musing title had been more than appropriate We were amused to see a Monty Pythonesque title from Bank of America Merrill Lynch title when it comes to the Phillips curve: "The Phillips curve: it’s not dead, it’s sleeping" on this subject. Of course this relates perfectly to the Norwegian blue parrot we mentioned in our previous conversation:

- source Bloomberg

You might already ask yourselves why we choose "Ouroboros" as a title analogy. The Ouroboros is an ancient symbol depicting a serpent or dragon eating its own tail. Via medieval alchemical tradition, the symbol Orobouros entered Renaissance magic and modern symbolism, often taken to symbolize introspection, the eternal return or cyclicality especially in the sense of something constantly re-creating itself (like credit cycles). It also represents the infinite cycle of nature's endless creation and destruction, life and death (creative destruction à la Schumpeter comes to mind). The first known appearance of the ouroboros motif is in the Enigmatic Book of the Netherworld, an ancient Egyptian funerary text in KV62, the tomb of Tutankhamun, in the 14th century BC. Also, the alchemical textbook, Chrysopoeia (gold making) of Kleopatra contains a drawing of the ouroboros representing the serpent as half light and half dark, echoing symbols such as the Yin Yang, which illustrates the dual nature of all things, but more importantly, that these opposites are not in conflict. No matter how many tricks (ZIRP, QE, NIRP) used by our modern alchemists, aka central bankers, they cannot alter cyclicality of credit, that simple. Let's be very clear about that. When it comes to our assessment of the credit cycle, it's getting late in the game, and capital preservation is becoming essential. This means starting moving to higher grounds credit quality wise we think.

In this week's conversation, we would like to look at the importance of wages for signs of inflation as we discussed last week. In our previous conversation we indicated that we thought that real wage growth mattered for inflation expectations. Could we be wrong? We will also look at the unintended consequences in liquidity thanks to regulation and the Volcker rule.

Synopsis:

• Macro - Real wages growth? The "deflationistas" have won the war.
• Credit - Credit Supply is cyclical, so is liquidity...
• Final chart - Japanese support for credit - The boys are back in town

• Macro - Real wages growth? The "deflationistas" have won the war.

As we pointed out in our previous conversation, we indicated that the most important point for a rise in inflation expectations had been real wages growth. We also posited in our conversation "Perpetual Motion" in October 2014 that real wage growth would indicate the US would be reaching "escape velocity":

"In fact the Fed's conundrum can be seen in the lag in wage growth given nominal wages are only up 2% yoy whereas real wage growth remains at zero. Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, October 2014

Obviously the latest disappointing Nonfarm payroll for August, still point towards weak real wage growth and it isn't the time for clamoring victory for the Fed. 

In our previous musing we pointed out the amazing work of Jean Fourastié on the subject of real wages, real prices and productivity (which in our humble opinion should have been worthy of a Nobel prize). True capitalism is inherently "deflationist" when it comes to prices. While any aspiring economist and/or central banker should get acquainted with the work of Jean Fourastié, same goes with the work of BCG's founder Bruce Henderson seminal work on the Experience Curve.

For us, there are three main reasons why the Phillips curve is a Norwegian Blue parrot, simply resting in a Monty Pythonesque way:

1. Demographics: as population ages, there are more pressure on aggregate demand and total consumption. 
2. Globalization: real wages have come under pressure thanks to offshoring of labor in different parts of the world, leading to good solid wages jobs in the industrial sector being replaced by low qualification low paying jobs in the service and hospitality sectors.
3. Technology: As per Henderson's work and recent progress in technology, pressure on prices as been appearing thanks to the Experience curve. The fight between Amazon and the retail sector comes to mind we think about it. Technology has been holding down costs overall and facilitated rapid price competition in some sector (internet on retail).

This is why we think the Phillips curve is obsolete, for structural reasons. On the subject of the relationship between inflation and wages we read with great interest Wells Fargo's take from their note from the 31st of August entitled "Do Wages Still Matter for Inflation?":

"Executive Summary

Wage growth has garnered increasing attention in the heavily watched monthly employment reports. The scrutiny reflects the emphasis many Fed officials have placed on the critical link between slack in the labor market and inflation. With wages accounting for a significant share of costs in most industries, it makes intuitive sense that rising labor costs would soon develop into higher inflation. The reality, however, is that wage growth tells us little about future inflation. If anything, the relationship runs the other way, with inflation leading wage growth.

The limited influence of wage growth on inflation reflects the changing structure of the U.S. economy. Technology is making it easier than ever for consumers to compare prices, intensifying price competition. At the same time, globalization has diminished the role of the domestic labor market with a larger share of goods consumed imported from overseas. Finally, the inability of many firms to adjust prices frequently generates the need to set prices in anticipation of future costs, making inflation expectations a more significant driver of inflation than wages.

Watching Wages for Signs of Inflation

The PCE deflator has only briefly brushed the Fed’s 2 percent target since the start of the

expansion (Figure 1).

Nevertheless, most FOMC members remain confident that inflation will move higher from here. In the Committee’s most recent economic projections published in June, the median estimate for where inflation would end the year was 1.6 percent and 1.7 percent for headline and core inflation, respectively, while both measures were projected to end 2018 at 2.0 percent (Figure 2).

Although those estimates will likely come down a tick or two following recent months’ softness, the path remains upward and is a key factor in the Committee’s baseline outlook to further raise interest rates over the next year.

The FOMC’s confidence that inflation will head higher over the next year and a half hinges critically on the assumption that as resource slack is absorbed, upward pressure on prices follows. While resources include both labor and capital, the link between slack in the labor market and inflation garners more widespread attention. As unemployment declines, firms need to pay higher wages to attract and retain workers, and those costs in turn generate the need to raise prices. Over the past couple of years, the unemployment rate has fallen to where it is now below many estimates of full employment, while inflation—headline or core—has remained stubbornly below 2 percent. The result has been to closely watch wage growth as a sign of future inflation.

Wage growth has remained frustratingly low for workers and policymakers alike. After increasing only about 2 percent a year in the early years of the expansion, average hourly earnings began to strengthen in 2015. The uptrend has fizzled by multiple wage measures this year, however, and wage growth remains weak by historic standards (Figure 3).

There are some signs that higher pay may be in the offing. Job openings are at an all-time high, underemployment is shrinking, and the share of small businesses raising compensation is hovering near cycle highs (Figure 4). But even if we see stronger wage growth, will it lead to more inflation?

Wages as a Driver of Inflation: Not What It Used to Be

The relationship between labor market slack and inflation, known as the Phillips Curve, has had its share of critics over the years as it appeared to break down completely (as in the 1970s) or at the very least weaken in recent decades. Nevertheless, Fed Chair Janet Yellen has made comments over the years indicating she is a subscriber of the Phillips Curve and that short-run fluctuations in labor market slack affect inflation. As indicated in the most recent FOMC meeting minutes, however, doubts seem to be emerging among more FOMC members about the link between labor market slack, wages and inflation. Research by Federal Reserve economists has found that the impact of labor costs on inflation has diminished in recent decades.

A simple regression of our own shows that an increase in wages is associated with a smaller rise in inflation than in previous decades. For this we look at the “nominal” component of wage growth, or average hourly earnings growth minus labor productivity since productivity drives real wages. While a one percentage point rise in the year-over-year rate of productivity-adjusted average hourly earnings was consistent with a 0.4 percentage point rise in CPI inflation from 1985 to 2000, that relationship has fallen by half since 2000. Moreover, when determining if in recent decades changes in wage growth cause changes in inflation and are not simply associated with these, we find no statistically significant support. If anything, inflation drives wage growth.

Domestic Labor Costs Only Part of the Story

For most businesses, labor represents a sizable share of costs. This is particularly true for service sector industries, where labor compensation accounts for at least 30 percent and often more than half of input costs. Why then do wages provide so little information about inflation if labor is such a big input cost? Labor conditions have increasingly taken a backseat in inflation dynamics in recent years as the U.S. economy has evolved. Technology has changed the way consumers shop and the way in which businesses offer goods and services. At the same time, globalization has opened up new sources of labor beyond the domestic workforce. And while workers may think about future inflation when negotiating wages, businesses are also thinking about future inflation when setting prices.

Technology: Holding Down Costs and Facilitating Price Competition

Technology seems to have infiltrated every corner of life so it is not a leap to believe it has affected inflation. Technological improvements have always held down inflation by improving the production processes or lowering the input costs of existing goods and services. By making it cheaper to produce products, firms can raise margins without increasing prices. It’s tough to argue, however, that technology in this way is playing a bigger role today in holding down inflation given the weak rate of productivity growth in the last decade. Instead, competitive forces unleashed by new technology have been pointed to as a recent factor holding down prices. The internet has made it easier than ever for consumers to compare prices of goods and services. Nowhere though has competition been more intense than in the retail sector as e-commerce has grown to nearly 10 percent of sales. Yet while increased competition should pressure margins, margins for retailers have held up over the past decade as the shift to online sales has limited the need for costly brick and mortar stores (Figure 5).

The upshot is prices for core consumer goods have been falling for the better part of the past 15 years (Figure 6).

The service sector has not been immune to competitive pressures either. The recent drop in the cost of cell phone services offers a relevant example. However, part of the decline since the start of the year is traceable to quality adjustments made by the Bureau of Labor Statistics (BLS). When the quality of a product improves, the BLS imputes the value of the improvement and downwardly adjusts the product “price” to account for the fact that while the listed price may be unchanged or higher, consumers are getting a better product.

Globalization: Not Just a U.S. Labor Market

Of course, the decline in core consumer goods prices has coincided with increasing global trade. The start of the North American Free Trade Agreement (NAFTA) in 1994 and China’s entrance to the World Trade Organization in 2001 both opened up significant sources of global labor. In 1992, only about one-third of U.S. consumer goods were imported from overseas, but that share has grown to about 55 percent today (Figure 7).

Although goods only account for one quarter of the core CPI, global price dynamics have had a significant, albeit small, impact on U.S. inflation. With foreign-made goods accounting for a larger share of consumption, the cyclical state of the U.S. labor market has lost importance in price setting.

Expectations: Firms Get Ahead of Cost Pressures

Inflation expectations play a more crucial role for inflation than wages. Expectations of future inflation affect firms’ decisions in price setting. As price changes can be costly in their own right, many businesses change prices infrequently. The stickiness of prices generates the need for businesses to make assumptions about future costs, including labor.7 As a result, price changes can precede wage growth, rather than wage growth leading to inflation. While a Granger- Causality test as previously noted shows wages do not drive inflation, the same test shows that inflation expectations are a significant driver of realized inflation.

Conclusion: Don’t Look to Wages for Early Signs of Inflation

The payroll figures and unemployment rate have typically been the focus of the closely-watched Employment Situation report each month, but increasingly those figures have taken a backseat to average hourly earnings. Market participants have been closely watching wage growth for signs of inflation in order to anticipate future policy decisions by the FOMC. Despite the emphasis placed on labor market conditions as a as a driver of inflation, average hourly earnings contain little information about inflation. Changes in wage costs are often already anticipated by businesses, meaning there is not much new information contained in them from an inflation perspective. Moreover, the ability and need to raise prices has been altered by technology and globalization, making the state of the domestic labor market less important.

We continue to watch wage growth as a source of household income and, therefore, spending power. In conjunction with aggregate hours worked, average hourly earnings remain a useful guide of near-term income for consumers (Figure 8).

As a signal of future inflation, however, the emphasis on wage growth appears misplaced."  -source Wells Fargo

Why wage growth has remained frustratingly low for workers and policymakers alike? You have the answer, there are structural changes at play. Therefore using a Norwegian Blue parrot aka the Phillips curve in the expectation of changes in the inflation outlook is at best misplaced by the FOMC, at worse plainly wrong because of the inherently "deflationist" bias of capitalism with innovation, technology and globalization. The model might have been working in a less open world but in today's globalized world, it's just not working anymore, it's not "resting" put it simply, it's broken.

If the PhDs at the Fed had closely studied both Fourastié and Henderson, they would have stopped making wrong assumptions and discarded their obsolete models as pointed out by our friend "Polemic" recently who runs the excellent blog "Polemic pains" in relation to the Phillips curve:

"Real problem is it is used for local policy using local employment/inflation when really, with globalisation, its inputs are global not local. Take UK, falling unemployment doesn't mean labour supply diminishes.. just suck in more from Europe/RoW. So wage inflation stays low but number of employed rises. Then screw it all up again with FX rates flying around altering actual wages for migrant labour relative to their spending location and it gets really confusing. I guess it will only work if free migration of labour is stopped so we no longer have a 'spare tank' of labour that sits outside the Phillips curve measure of unemployment" - source Polemic, 24th of August 2017

Exactly. It might be fun using it locally but in a globalized world, it is just isn't working anymore dear FOMC. That's the main issue with your Norwegian Blue parrot. If indeed everyone is focusing on real wages for a change in inflation expectations, then obviously we are wrong like so many others and the US will not reach that easily escape velocity. Also, the FOMC should look more closely to the Experience curve as it refers to the ability to produce existing products more cheaply and deliver them to an ever-wider audience. Could we call this the Amazon factor? We wonder.

• Credit - Credit Supply is cyclical, so is liquidity...

When it comes to "Orobouros", as we pointed out at the beginning of our conversation, no matter how many tricks (ZIRP, QE, NIRP) used by our modern alchemists, aka central bankers, they cannot alter cyclicality of credit, that simple. If they do not believe us in similar fashion to the many points we have made when it comes to the state of their Norwegian Blue parrot, they could indeed look at the work of Bo Becker and Victoria Ivashina (link above) and their working paper from 2011 published at Harvard Business School:

"Theory predicts that there is a close link between bank credit supply and the evolution of the business cycle. Yet fluctuations in bank-loan supply have been hard to quantify in the time series. While loan issuance falls in recessions, it is not clear if this is due to demand or supply. We address this question by studying firms’ substitution between bank debt and non-bank debt (public bonds) using firm-level data. Any firm that raises new debt must have a positive demand for external funds. Conditional on issuance of new debt, we interpret firm’s switching from loans to bonds as a contraction in bank credit supply. We find strong evidence of substitution from loans to bonds at times characterized by tight lending standards, high levels of non-performing loans and loan allowances, low bank share prices and tight monetary policy. The bank-to-bond substitution can only be measured for firms with access to bond markets. However, we show that this substitution behavior has strong predictive power for bank borrowing and investments by small, out-of-sample firms." - source HBS, Bo Becker and Victoria Ivashina, 2011

The provision of credit is highly pro-cyclical in the sense that not much new credit is issued during recessions. As shown in Europe with the "credit crunch" in 2012 thanks to the collapsing of loan books leading to disintermediation, from loans into new bonds issues, to paraphrase Bastiat, there is what you see, and what you don't see. In their paper Bo Becker and Victoria are showing that credit is pro-cyclical because banks have not been willing to lend (supply shift = Economics 101). In very simple terms, the contraction in bank credit supply has been offset by bond issuance on a grand scale. They conclude their paper by adding that a strong predictor of overall contraction in credit is when firms cannot tap into the bond market, hence the importance of monitoring the weaker part of the bond market namely the CCC bucket.

Obviously there have been other impacts than loan contraction in Europe when it comes to dis-intermediation and bonds issuance. At least in the US the impact of financial regulation and Volcker Rule has had an impact on liquidity. This is particularly important we think with the rise of passive investing and the growing use of ETFs in the fixed income space. This of course will have serious implications when the markets turn, particularly when one takes into account the "liquidity" factor. On this subject we read with interest Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 25th of August entitled "When the tide goes out":

"When the tide goes out… the unintended consequences of financial regulation are revealed. High grade corporate bond trading has doubled over the post-crisis years (Figure 1).

However, because the size of the market tripled that means the overall market has become less liquid - due to a number of post-crisis changes - including financial regulation and most prominently the Volcker Rule, but also less leverage in the system. For example, while annual trading volumes in the HG corporate bond market were 135% of the size of the market back in 2006, we estimate that statistic is tracking only 86% for 2017 (Figure 2).

However, counterintuitively in this environment, market-based measures of liquidity – such as off-the-run/on-the-run spread premiums are back to pre-crisis levels. This is true for bid/ask spreads as well, although we are no fan of them as measures of liquidity as we have no information on the true cost to trade more than just a small block of bonds. Moreover quality data on bids and asks naturally is concentrated in what is liquid and trades. In contrast liquidity almost by definition has to be measured where there is liquidity risk, which in many market environments is not quoted actively by traders.

Market based measures are back to pre-crisis levels because of the unique post-crisis environment of extremely low global yields that has led to an unprecedented reach for yield in US HG corporate bonds. In recent years, yields have dropped so much that investors have been forced to enhance yields by reaching into normally illiquid off-the-run names and maturities, which naturally compresses the off-the-run/on-the-run liquidity measures. That means liquidity is OK because dealers are happy to use their  lean balance sheets to not only buy liquid on-the-runs that turn over quickly, but also normally illiquid off-the-runs because there is an army of investors waiting to buy them in short order.

In other words, in the post-crisis years the unprecedented reach for yield engineered by global central banks has likely mitigated the unintended consequence of financial regulation, which is diminished liquidity in the corporate bond market. This means everything is OK until it is not. Only when interest rates go up significantly, and we get large outflows, will we see just how illiquid the corporate bond market can be in the new regulatory regime. Initially liquid names and maturities would likely underperform as investors have to sell what they can. Then later when investors find they can no longer sell the vast majority of bonds they own – the off-the-runs – at meaningful prices we get a big widening in liquidity measures. This could get ugly, we think.

Rates vs. liquidity

To illustrate, Figure 3 shows our preferred measure of market liquidity - the percentage difference between credit spreads on 9-year and 10-year bonds (adjusted for the on-the- run curve).

The idea is that on-the-run 10-year bonds are issued and traded actively and are liquid. Then liquidity declines over time and they become off-the-runs. We use the 9-year maturity point for that, as the bonds have not become too illiquid for pricing to be somewhat accurate.

We plot this liquidity premium over time against interest rates to show the normal environment, which we saw for example around the US downgrade and European sovereign crisis in 2011, where there was an inverse relation. In such risk-off environment, Treasuries rally and liquidity dries up. But fast forward and starting in 2015, there has been a strong positive correlation between interest rates and the liquidity premium. The reason for this shift is very simple – as we described above – that interest rates had declined so much that further declines force investors to reach for yield in off-the-runs, while with increasing rates they are able to return to on-the-runs. Hence, the big decline in interest rates has compressed the liquidity premium to pre-crisis levels.

Why, you may ask, did investors not compress the liquidity premium back in 2H12/1H13 when interest rates were also low? Well remember that the dominant investor reaching for yield in US HG corporate bonds nowadays is the foreign investor. Back then, there was still some yield to be had in foreign fixed income (Figure 4) and foreign investors did not have to reach for yield in US corporate bonds (Figure 5).

Of course, with the collapse in foreign interest rates that has changed, and over the past few years foreign investors have had no choice but to buy US corporate bonds. To make things worse, the cost of dollar hedging has risen sharply for foreign investors, due in part to all the foreign buying of US fixed income (Figure 5).

Combined with the decline in US yields that means foreign investors are that much more pressed to reach for yield in off-the-runs." - source Bank of America Merrill Lynch

Obviously when it comes to "liquidity" and credit, when it comes to the supportive "bid", you need to pray the ECB but more importantly the Bank of Japan have your back with their NIRP and QE policies when it comes to "liquid" US credit markets that's a given as per our final chart.

• Final chart - Japanese support for credit - The boys are back in town

As we pointed out in many musings, the bid in US credit has been "Made in Japan". Back in July in our conversation "The Butterfly effect" we indicated that Japan had been heavily supporting US dollar flows but US credit as well. At the time we indicated:

"Where we disagree with UBS is that according to their presentation, because of a divergence in short-term rates is increasing hedging costs, they believe that the yield advantage of FX-hedged US IG credit is eroding and therefore the foreign bid is set to unwind due to these dollars hedging costs. As we posited above, during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk." - source Macronomics, July 2017.

And even with prolonged US dollar weakness they have been wrong, no offense to their credit team. When it comes to Fixed Income flows, we keep saying this but, matters Japan and matters a lot. For instance we read with interest Bank of America Merrill Lynch Liquid Insight note from the 23rd of August 2017 entitled "Japan's outward portfolio investment resurging; diverging implications":

"Key takeaways

• Japan's outward portfolio investment is resurging led by banks' buying of US and French bonds.
• The rapid increase partly reflects a reversal of earlier unwinding, adding to structural demand for non-yen assets.
• Expect Japan investors to dip buy USD, continue buying AUD & NZD. EUR/JPY demand to remain subdued unless, until a deeper dip

Japan’s outward portfolio investment resurging

Although it may have gone unnoticed as the market has much to focus on elsewhere, the return of Japan’s outward portfolio investment since May has been notable. The purchase of foreign securities by Japanese investors hit a seven-year high on a 13-week base at ¥13.4tn in July (Chart of the day). This came after a period of net selling in the spring when we thought Japanese investors were resorting to a “wait-and-see” stance due to heightened external risks. We explore diverging implications across relevant markets." - source Bank of America Merrill Lynch

When it comes to the support provided by the Japanese investment crowd, which where there in force in 2016, particularly with Lifers, it remains to be seen how long these guys are going to stay in town. Just ensure you have a good view of the credit saloon's revolving doors, because when it comes to "liquidity", as Mark Yusko, Morgan Creek's CIO put it, it's a feeble creature:

"Liquidity is a coward, it only exists when you don't need it..." - Mark Yusko

In the current "Ouroboros" credit game, liquidity seems indeed to be plentiful particularly in the passive investment game, it remains to be seen, if it will be present when the tides goes out...

"The only relevant test of the validity of a hypothesis is comparison of prediction with experience. " -Milton Friedman

Stay tuned!

Macro and Credit - The Dead Parrot sketch

"Fake is as old as the Eden tree." - Orson Welles

We read with interest the latest minutes from the FOMC and in continuation with our previous themes of revivals of defunct model, obviously once again their "beloved" Phillips curve model came to the forefront of their discussions, not only at the Fed but at the ECB as well. Therefore, when it came to selecting this week's title analogy, we could not resist but use a reference to Monty Python's flying Circus Dead Parrot Sketch which first aired on the 7th of December 1969. The sketch portrays a conflict between disgruntled customer Mr Praline (played by Cleese) and a shopkeeper (Michael Palin), who argues whether or not a "Norwegian Blue" parrot is dead. It pokes fun at the many euphemisms for death used in British culture. Obviously, one could be disgruntled at our central bankers and the lack of inflation within their inflation mandate. In the meantime some sell-side pundits and most recently central bankers have continued to discuss if the Phillips curve is "dead" or simply "resting" like a "Norwegian Blue" parrot. We rest our case. We find it amusing that a joke dated c. CE 400, recently translated from Greek, shows similarities to the Parrot sketch. It was written by Hierocles and Philagrius and was included in a compilation of 265 jokes titled Philogelos: The Laugh Addict. Probably yet another case of "barbaric relic" given the affection for gold from our central bankers but we ramble again...

In this week's conversation, we would like to look at the ongoing 2007 party like in credit that keeps going while there is indeed the need to be more discerning (beta wise that is) we think at this stage but first we will take another potshot at the Phillips curve cult members.

Synopsis:

• Macro - The Norwegian Blue parrot really DID exist but not anymore...
• Credit - Smarten your beta
• Final chart - Credit Mad Men

• Macro and Credit - The Norwegian Blue parrot really DID exist but not anymore...

The latest FOMC notes from the July minutes do indicate how puzzled our central bankers have become on the validity and efficiency of their Phillips curve framework. Back in May this year in our conversation "Wirth's law" we discussed the wage conundrum in the US, pointing out that real wage growth had so far eluded the Bank of Japan and are still eluding the United States, hence the dismal prospects for inflation expectations given high qualification jobs in many instances have been replaced by low qualification jobs (yes training matters...). Also, back in our January conversation "The Ultimatum game" we looked at jobs, wages and the difference between Japan and the United States in relation to the "reflation" story or "Trumpflation". We argued that what had been plaguing Japan in its attempt in breaking its deflationary spiral had been the outlook for wages. Without wages rising there is no way the Bank of Japan can create sufficient inflation (apart from asset prices thanks to its ETF buying spree) on its own.

Following our recent musings our friend Kevin Muir, the author of the excellent and very entertaining blog the Macro Tourist reached out and asked several questions relating to the Norwegian Blue parrot aka the Phillips curve:

"Hey Martin.  I just your latest two pieces.  I really enjoyed them.  

What is your belief about the Phillips curve?   Is it dead?  Shifted down?  

I know you discussed your views about the mismatch in skills, but the curve does indeed seem to be obsolete.

I know to some extent it doesn't matter what we think- the Fed's reaction function is what matters.  But I am curious about your personal thoughts.  

I am beginning to think that Yellen's training as a labour economist is making her more hawkish than she should be.  As you point out, they think inflation is coming.  So they are tightening.  

I realize you are probably more bearish on the economy than me, so it is easier to say the Phillips curve is not kicking in, and the economy is rolling over, so the point is moot.

But if we get a global economic upswing that drags the US along, will we see real wage growth?  

Thanks, Kev." - source Kevin Muir, author of the Macro Tourist

Of course real wages are that's the most important point for inflation expectations, real wage growth matters and matters a lot. We pointed out a few things to Kevin such as the fact that a business owner is always a "deflationista", in the sense that he fights day and night to compress his costs and find smart ways to do more and earn more with less in order to maximize his profits. No offense to our central planners of the world but true capitalism is inherently "deflationist" when it comes to prices. For the simplicity of our reasoning, we are not taking into account oligopolies, cartels and other shenanigans being played these days in many instances (ZIRP, NIRP, etc.). Real prices always fall and inflation is simply organized theft which is willingly pursued and supported by our central bankers, at 2% or even 4% (should they decide to try and fail in tweaking their sacrosanct target).

As well, we pointed out to Kevin the excellent work of (unfortunately little known to so many) French economist Jean Fourastié relating to real wages, real prices and productivity. One particular book comes to mind "Pourquoi les prix baissent - Why prices fall". published in 1984. We do not know if this book is available in English, but, in our humble opinion it is a must read book and should be on the required reading list of any serious central banker or aspiring economist.

For Fourastié, real prices could only be observed by dividing the prices of any product by hourly wages (link in French). The inverse of real prices calculation measures purchasing power parity. What is the most important economic fact in the last 300 years? Most probably the fall in "real" prices for wheat prices with hourly wages on the Y axis:

- source Jean Fourastié

Also in our previous conversation from September 2012 "Pareto Efficiency" we indicated the following when it comes to "wheat prices" and "revolutions":

"Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for  a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops.

  Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.

When it comes to volatility in wheat prices and the ultimate effect of manipulating prices or when "real" prices become "fake" prices or "manipulated" prices, we reminded ourselves with our May 2016 conversation "When Doves Cry" and the fascinating account on the "assignat" which was a type of a monetary instrument used during the time of the French Revolution (money printing on a grand scale with dire consequences...), in a book written by French economist Florin Aftalion in 1987 entitled "The French Revolution - An Economic Interpretation":

At the time of the French Revolution, Pierre Samuel du Pont de Nemours observed that by issuing "assignats", the French nation was not really paying its debts:

"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point". 

The issue with the assignats was that in no way it was capable of facilitating the sale of public lands, that ones does not buy with a currency, which is merely an instrument for the settlement of a transaction, but with accumulated capital. With QE becoming a global phenomenon with South Korea's president indicating that the country needs to look at possible 'selective' QE and Negative Interest Rate Policy becoming rapidly the "norm", one might wonder how on earth "capital" is going to continue to be "accumulated", particularly when one looks at negative yielding assets.

To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB. And when it comes to the "ultimate value" of the "assignat" (and the end result with NIRP...), a simple picture clearly display the trajectory of their final value:

  -source Macronomics, May 2016 

Hence the importance of using observable "real prices" and the impact monetary inflation can have on hourly wages and purchasing power when you want to assess the levels of inflation (Venezuela comes to mind...). We also reminded ourselves of Adam Smith's quote in relation to real "price" formation:

"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased." - Adam Smith

But moving back on the subject of the Norwegian Blue parrot, we read with interest Barclays Global Economics note from the 18th of August entitled "Questioning the reliability of the Phillips curve:

"Inflation discussion dominates July minutes

• The FOMC deliberated at length the risks to the inflation outlook, including the effectiveness of its current Philips curve framework in forecasting inflation.
• Although the minutes reveal increased concern about the inflation outlook, we did not sense that the committee is ready to pause rate hikes at this point.
• The committee sounded confident about labor market progress, but financial stability and further easing in financial conditions were a concern.

Three broad themes that stood out from the July FOMC minutes, in our view, are the increased concern among committee members about the inflation outlook; strong consensus that labor market progress has been significant; and worries about financial stability, given easy financial conditions despite monetary policy tightening. Even if the committee may have wanted to strike a balanced tone between its concerns about inflation (which would argue for a more cautious tightening path) and those about financial stability (which would argue for continuing on its path), markets seemed to read the minutes as dovish and lowered the probability of a December hike significantly, from 44% to 36%.

Also notable in these minutes was the change in tone with regards to federal government policy. Earlier in the year, committee members viewed fiscal policy as a potential upside risk to the growth and inflation outlook, but in the July minutes, those expectations were toned down or reversed. A few in the committee pointed out that “the likelihood of near-term enactment of a fiscal stimulus program had declined further or that the fiscal stimulus likely would be smaller than they previously expected,” while several others commented that policy uncertainty (including fiscal policy, trade, and health care) “was tending to weigh down firms’ spending and hiring plans.” This downgrade on the policy front was balanced to some extent by an upgrade of the external sector, as a brighter international economic outlook was seen as boosting prospects for US exports.

We maintain our call for a December hike, but see recent inflation data and the discussion in the FOMC minutes as having lowered the likelihood of its happening. In our view, continued misses on the inflation front would not make it tenable for the FOMC to hike in December. Further disappointment in this front could pause the path for the federal funds rates until the FOMC feels confident that its price stability mandate is within reach.

Some in the FOMC question the validity of its current inflation framework

The committee recognised continued misses on its inflation forecast and suggested that it would likely remain low over the second half of the year. But it also continued to assign much of the recent decline to idiosyncratic factors. While the discussion about the near-term outlook seemed broadly unanimous, there was more disagreement about the medium run. “Many” participants saw risks that inflation would remain below 2% for longer than they currently expected, and “several” saw risks to inflation as tilted to the downside. Similarly, while the committee agreed on the importance of long-term inflation expectations, not all agreed that they remained stable, and “a few argued that continuing low inflation expectations may have been a factor putting downward pressure on inflation”.

But perhaps a bigger surprise came when a number of participants challenged the way in which the Fed analyzes and forecasts inflation. They argued that “much of the analysis of inflation used in policymaking rested on a framework in which, for a given rate of expected inflation, the degree of upward pressures on prices and wages rose as […] employment of resources increased above long-run sustainable levels” – basically, a description of a Phillips Curve (PC) type of framework. A few participants argued that it was not particularly useful in forecasting inflation, while most said it remained valid despite its recent flatness. While we would agree with the latter group, we find the very opening of this discussion as evidence that concerns about the persistent misses on the inflation mandate are starting to weigh on the committee. While many have criticised the PC before, no clear candidate has emerged as a way to analyze inflation in a monetary policy setting, a fact that will, in our view, limit how far this discussion can go within the committee.

Instead, a common theme among policymakers in recent years has been to find exceptions that could have led to a temporary and transitory flattening in the PC. These minutes were no exception, as they listed a number of reasons for the coexistence of low inflation and low unemployment, including less responsiveness of prices to resource pressures (stickier prices), a lower natural rate of unemployment, more slack in the labor markets that may not be captured by the unemployment rate, nominal wage growth and inflation reacting with a lag to labor market tightening, and a loss of firm pricing power from global developments and from technology.

While we do not think the Fed reached the conclusion that its inflation framework was invalidated by the recent softness in inflation, having this discussion at all raises the risk of a shift in the reaction function away from a focus on resource utilization and the PC. But it could also drive the FOMC to look for areas where it may have mis-measured the amount of spare capacity in the economy, for instance in the recent increase in the labor force participation rate of prime age women (see Rising participation among prime age workers, August 11, 2017). As discussed in Wage growth is not as weak as it seems, August 4, 2017, we share the committee’s view that the rate of increase in nominal wages is not low in relation to the rate of productivity growth and the modest rate of inflation. Overall, this shift in emphasis could likely imply fewer rate increases over the forecast horizon, given the weakness in incoming inflation data since earlier this year. We continue to expect an announcement on balance sheet normalization at the September meeting and a third rate increase this year in December, but we have reduced our subjective probability about a rate increase later this year to about 50% (down from 60% previously)." - source Barclays

To be fair to the Phillips curve cult members and also to Monty Python, the Norwegian Blue parrot did really exist as pointed out by a Daily Mail article in may 2008:

"Adding to the absurdity was the fact that parrots - being tropical birds - don't come from Scandinavia.

Or do they? For now, in a development putting the sketch in a completely different light, it turns out that the Norwegian Blue did exist.

Dr David Waterhouse, a fossil expert and Python fan, has found that parrots not only lived in Scandinavia 55million years ago, but probably evolved there before spreading into the southern hemisphere.

His discovery was based on a preserved wing bone of a previously unknown species, given the scientific name Mopsitta Tanta - and now nicknamed the Norwegian Blue.

The dead parrot script, voted Britain's favourite alternative comedy sketch by Radio Times readers in 2004, was written by Cleese and Graham Chapman and first broadcast in 1969.

As he returns the ex-parrot to Palin's pet shop, Cleese is assured it is just resting or stunned, being "tired following a prolonged squawk" and "pining for the fjords".

Cleese bangs it on the counter, trying to wake it up, screaming: "Hello, Mister Polly Parrot! I've got a lovely fresh cuttlefish for you!" But it is definitely expired.

Dr Waterhouse, 29, said of Mopsitta Tanta: "Obviously, we were dealing with a bird that is bereft of life, but the tricky bit was establishing it was a parrot."

He was studying for a PhD at the University of Dublin in 2005 when he visited a museum in Jutland and spotted a fossilised 2in-long humerus - appropriately enough, the funny bone - among bird remains which had been found near an open-cast mine.

Research has now confirmed the bone was part of an upper wing from a bird in the parrot family. Although the mine was in Denmark, the birds would also have lived in what is now Norway."

[ ...]

"However, the Pythons were wrong about one thing...the Blue could hardly have pined for the fjords.

"This parrot shuffled off its mortal coil around 55million years ago, but the fjords in Norway were formed during the last Ice Age and are less than a million years old," said Dr Waterhouse." - source Daily Mail

So dear Kevin, to answer your question we think that the Phillips curve, in similar fashion to the Norwegian Blue parrot did exist but is now simply "resting" in a Monty Python way. Same goes for the ECB's view on the Phillips curve as per Barclays recent note:

"The ECB’s accounts focused on a flat Phillips Curve and financial stability

The ECB’s accounts of the August meeting explored the Phillips Curve relationship in detail. Given the latest data, the accounts “acknowledged the strengthening of the economic expansion and confirmed that the risks to the growth outlook were broadly balanced”. At the same time, the accounts contain a very detailed discussion of the flattening Phillips Curve relationship, including due to labour market reform, hysteresis effects from prolonged high unemployment, the backward looking nature of wages, as well as the deleveraging process in the euro area. Nevertheless, the GC argued that the Phillips Curve relationship likely remained intact, but that “patience, persistence and prudence” were needed as this process would likely take time and be contingent on “very substantial degree of monetary accommodation”. While the statement explicitly mentions firm survey evidence of emerging labour shortages, a decomposition of the euro area wide European Commission survey (Figure 1) suggests that this is mainly driven by Germany (Figure 2), where, despite a 3.8% unemployment rate, wage pressures remain to be seen. Overall, the discussion is in line with underlying inflation on a moderate recovery trend and is unlikely to accelerate in the near term (Euro area inflation: Core improves but doesn't shift gear, 31 July 2017)."

All in all, with "patience, persistence and prudence" like the shopkeeper in Monty Python's sketch, we might see the Phillips Curve come back to life, but for the moment it is pretty much as the Norwegian Blue parrots, they really DID exist - but now they are all 'stiff, bereft of life and ex-parrots'.

This ends our numerous potshots we have taken in 2017 relative to the Dead Parrot aka the Phillips curve. In our credit point below, we have in recent months suggesting rotation towards higher quality credit and also recommended playing more defensively at this stage of the credit cycle while we continue monitoring the trend in credit conditions in particular consumer credit.

• Macro and Credit - Smarten your beta

Back in June in our conversation "Potemkin village", we posited that as the Trumpflation narrative was fading, so was the beta narrative. In fact our tool DecisionScreen told us the same at the time when it came to its signal switching to slightly negative for US High Yield. The aggregated rule we use is made up of the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score) and US GOV 10 year yield (1Y Z-Score). The beta trade is also a function of investors’ perception about the pace of QE. Our central planners might be using a dead parrot for guidance, but, anyone is trying to guess the change of the rhetoric, should the doves finally become hawks in the near term given financial stability matters and matters a lot for this crowd. We continue to remain slightly negative on US High Yield and we monitor closely the shape of the CDX High Yield curve, particularly the front-end, to see whether the curve is starting to flatten or not.

On the subject of smartening your beta we read with interest Barclays US High Yield note from the 18th of August entitled "Choose your Beta Wisely":

"Some of the fear that gripped risk markets due to geopolitical events just a week ago looks to have subsided. But the pick-up in volatility during that episode, has many investors more closely considering the tie between credit and equity markets. On the surface, there appears to be a dislocation between SPX and high yield valuations, but we expect the relationship to revert to its historical beta once the earnings-related volatility subsides.

US HY Still Looks Dislocated Versus S&P 500; Less So Versus Russell 2000

To start in Figures 1 and 2, we simply plot US HY Index spreads versus the S&P 500 ("S&P") and Russell 2000 ("RTY").

While not perfect comparisons, we believe asset allocators and specialists alike often look to the two broader indices to help formulate a first cut opinion on cross-asset performance and relative value. In terms of a short-term signal worth further dissection, we find that US HY spreads look modestly dislocated (wide) relative to its relationship with the S&P since the beginning of 2016. The relationship looks more in line when comparing US HY to the RTY. These findings are consistent with the broader narrative of small-cap equities and other higher-beta risk assets underperforming in August.

What could further explain the divide? Constituents differences and relative sector weightings provide a clue. Among the set of issuers in the High Yield Index, 62 are also in the S&P and 224 are also in RTY, with each group accounting for roughly 18% of par outstanding in the High Yield Index. Not surprisingly, the quality breakdown shown in Figure 3 suggests that the S&P cohort is higher in quality relative to the RTY constituents.

While neither cohort is exactly comparable to the High Yield Index, the quality weights of the High Yield Index align slightly better with the RTY than the S&P, which may help to explain the dislocation seen in Figure 1. That said, higher-quality credits have actually underperformed on a beta-adjusted basis recently, as noted in this week's Tuesday credit call. As a result, we find the magnitude of high yield's underperformance with respect to the S&P somewhat surprising considering that high yield is underweight higher quality.

Figure 4 shows the differences in sector exposures relative to the High Yield Index for both equity index's matched cohorts.

With the exception of energy, the S&P cohort is actually more closely aligned with respect to index weights than the RTY cohort. That said, the S&P's relative underweight with respect to energy has been a key driver of its outperformance relative to both the RTY and US HY in 2Q17, when E&P companies were faced with a litany of issues. However, adjusting for the differences in sector exposures using the weightings of the S&P cohort, we find that the High Yield Index would still have widened by the same 31bp in the aftermath of the recent sell-off despite its outsized energy exposure.

Quantifying How Sensitive Credit Returns Are To Equity Returns Now

While optically, high yield may appear modestly disconnected with respect to the S&P 500, it's worth noting that this relationship is somewhat fickle. In Figure 5, we track the trailing 6-month betas of daily total returns of the US High Yield Index versus the S&P and RTY.

As shown, both have gyrated significantly over time, suggesting that there is not a single best fit to explain the relative performance of credit and equities beyond short periods of time. At the moment, the betas are all generally towards the lower end of their two-year range, though slightly higher for the S&P than the RTY. This likely reflects the relatively more benign macro and volatility backdrop that has persisted for most of the last 12 months now that many of the stresses around weak commodity prices in 2015 and 2016 have become better understood and digested.

While it is true that the credit/equity relationship has been far from stable, it is interesting to note that the High Yield Index has consistently displayed higher sensitivity with respect to the S&P than the RTY. In other words, in order to design a "true" delta neutral portfolio, one would theoretically have to short more units of the S&P than the RTY against a long High Yield Index exposure. Of course, determining the "correct" market neutral hedge ratio is complicated by the changing face of the equity/credit relationship. Nonetheless, using the rolling 1-year historical total return beta to equities as the hedge ratio, we find that the return of the hedged portfolio is closer to zero using the SPX (Figure 6). 

A simple regression of weekly returns of the SPX and RTY against HY returns over the past five years would suggest that high yield displays a marginally better fit with respect to the S&P (R-squared of 36%) than the RTY (33%). Over the past month, however, high yield performance has more or less tracked its beta to the RTY month-to-date total returns through Wednesday's close (0.16x) has been closer to its historical beta to RTY (0.21x). Meanwhile, the ratio of high yield to SPX returns (-6x) suggests that its relationship to SPX (characterized by a total return beta of 0.32x to S&P) has recently broken down. For the reasons stated above, this divergence has less to do with its outsized commodity exposure, and has more to do with idiosyncratic stories and earnings-related volatility. But looking forward, we believe that high yield will perform more in line with its historical beta to the SPX once these concerns subside" - Barclays

Of course it should perform in line with its historical beta to the SPX. It remains to be seen how long US High Yield and the S&P 500 maintain their "elevated" valuation level. This of course, partially depending on the trajectory that will be taken by oil prices in the second part of the year.

As far as US High Yield and the S&P 500 are concerned, correlation between both asset classes remain very strong as per the below chart from MacroCharts.pro we also used in the past (data up to the end of July):

Correlation 0.966, R2 0.933, 139 months in sample - source MacroCharts.pro

In case you are asking, it shows you that High Yield, isn't that much of an "alternative" asset class, as put forward by some pundits.

When it comes to credit, defaults and leverage matters but pointing out the "low default rate" in Europe or elsewhere like some pundits do, it is we think "oversimplistic". Leverage matters more and so does earnings when it comes to High Yield. Looking at default rates is like looking at the rear view mirror. It tells you what has happened, not what is going to happen and maybe indeed looking at the iTraxx CDS credit indices is a cleaner way to look at the pure credit risk, given the greater liquidity in these synthetic contracts versus cash we think should you want to play the "hedging" beta game. Just a thought. When it comes to the maddening crowd our final chart displays WPP cds prices move following their profit warning and the warning it delivered for both credit and equity players.

• Final chart - Credit Mad Men

 Our final chart comes from DataGrapple's latest blog entry entitled "Do as I say, not as I do" and displays WPP CDS 5 year price evolution. The comments they made are very interesting from the point of view of credit investors but as well in the light of  WPP's "forward guidance" and the very challenging situation for retail. One might wonder if the situation will be contained...

"WPP blames “Uncertainty and short-termism reducing investment in favor of buybacks/dividends, although market levels lowering attraction” as a reason for the lack of dynamism of the advertising market. Companies are cutting costs to keep dividends & buy-backs very close to 100% of operating profits. At the same time WPP intends “Use of our substantial cash flow to enhance EPS through acquisitions, share buy-backs and debt reduction”. This was not enough to avoid the 10% drop in WPP’s share price today. WPP credit default swap did not react as much. The CDS is only 3 bps wider at 63 bps. Looking at the attached grapple, we see that the credit market is much more cautious on WPP for some time. The CDS is 40% wider than its lows mid-June. The company intends to use cheap debt to increase its net debt to twice its EBIDTA. The uncertainty of WPP’s EBITDA is a new challenge for credit investors. However, today was more an equity story with an interesting analyst presentation with a lot of data. WPP confirmed for instance the stress on the retail sector which is cutting on ads, -3% yoy.
Meanwhile, the credit index market was quiet. The credit index index option market was busier with some investors looking at options rather than outright hedges for the months to come." - source DataGrapple

As we pointed out recently, credit options are still a cheaper way in hedging your credit bets than going outright long the CDS index from a negative carry perspective. Volatility might indeed return in September thanks to additional US political uncertainties and other exogenous factors. It remains to be seen if contrary to the Phillips curve, volatility is not a dead Norwegian Blue parrot after all, we don't think it is but we ramble again...

"What the eyes see and the ears hear, the mind believes." - Harry Houdini

Stay tuned!