Macro and Credit - The Armstrong limit

"Men go abroad to wonder at the heights of mountains, at the huge waves of the sea, at the long courses of the rivers, at the vast compass of the ocean, at the circular motions of the stars, and they pass by themselves without wondering." - Saint Augustine

Watching with interest the Japanese Nikkei index touching its highest level in 27 years at 24,245.76 points, with US stock indices having rallied strongly against the rest of the world during this year, and closing towards new highs, when it came to selecting our title analogy we decided to go for another aeronautic analogy "The Armstrong limit". The Armstrong limit also called the Armstrong's line is a measure of altitude above which atmospheric pressure is sufficiently low that water boils at the normal temperature of the human body. Humans cannot survive above the Armstrong limit in an unpressurized environment. Above earth, this begins at 18-19 km (59,000-62,000 feet) above sea level. The term is named after United States Air Force General Harry George Armstrong who was the first to recognize this phenomenon. Commercial jetliners are required to maintain cabin pressurization at a cabin altitude of not greater than 2400 m (8,000 feet). The Armstrong limit describes the altitude associated with an objective, precisely defined natural phenomenon: the vapor pressure of body-temperature water.  Back in August in our conversation the "Dissymmetry of lift", we discussed our Quantitative Tightening (QT) amounted to reducing global liquidity and tightening global financial conditions overall as well as less airflow to maintain growth (we are already seeing signs in Europe).  When it comes to airflow and liquidity relating to equity indices we touched in this subject in two previous conversations: "The Coffin corner" in April 2013, the other being "The Vortex Ring" in May 2014. When it comes to our analogy and our reference to the Nikkei and US equity indices we remember clearly that the Nikkei hit its all-time high on 29 December 1989, during the peak of the Japanese asset price bubble, when it reached an intra-day high of 38,957.44, before closing at 38,915.87, having grown six fold during the decade. Sure the S&P 500 has grown six fold during the decade since the collapse of Lehman Brothers but it's within 1% of its all time high. One question investors are starting to ask themselves is what is the "Armstrong limit" for US equities? Bank of America Merrill Lynch in their recent The Flow Show note from the 27th of September entitled "Jay stalking" have two very interesting charts when it comes to equity allocation from Global Wealth and Investment Management (GWIM) into equities and cash allocation levels:

- source Bank of America Merrill Lynch

One might indeed wonder what level is the "Armstrong limit" before boiling point we think...

In this week's conversation, we would like to look at once again at the US consumer which seems to be increasingly relying on his credit card as well as other signs that warrants monitoring at this stage in the cycle.

Synopsis:

• Macro and Credit -  What's the Armstrong limit for the US consumer's confidence?
• Final charts - The "profit" illusion

• Macro and Credit -  What's the Armstrong limit for the US consumer's confidence?

In continuation to our last conversation, we think it is essential for the US growth outlook and forward earnings to continue to focus on the state of the US consumer. After all, the first on the line in any case of trade war escalation is the US consumer who gets the price increase passed onto by corporations facing a surge in costs. With the US consumer confidence index climbing to 138.4 in September from 134.7 in August, the highest since September 2000 we are wondering if it is the absolute Armstrong limit.

On this question we read with interest Wells Fargo's take from their US Consumer Confidence note from the 25th of September:

"In the past 51 years, only 11 times has confidence been higher than it is today. Said differently, roughly 98% of the time confidence is lower than it is now. That’s good news for the consumer, but for how long?

Remember the Sock Puppet Commercials?

The last time consumer confidence was as high as it is today was in the year 2000. A number of financial and economic indicators from that era are similar to where they are today. The stock market was soaring to all-time record highs, the unemployment rate was below 4% and the economy was in its 10th year of uninterrupted expansion. Then, as now, there were few people seeing an end in sight.

While we still think the current expansion has room to run, we would be remiss not to make note of just how rare a thing it is to see confidence at these lofty levels. Only in 11 individual months since 1967 have we seen confidence higher than it is today. Nine of those months were in the year 2000. The other two were in 1999. This is the thin air of the high peaks.

The euphoria is not limited to the consumer sector. The ISM manufacturing index is at its highest level since 2004 and the NFIB Small Business Optimism Index, an indicator of small business confidence, is at its highest level on records that date back to 1974. The fact that these measures are at record highs does not preclude them from going higher, but one characteristic that they all share is a tendency to peak before a slowdown.

No Time Like the Present

There is an interesting dynamic going on between consumers’ assessment of the present situation, compared to expectations for the future. As seen in the middle chart, the present situation measure is running well ahead; in the prior cycle there was a similar divergence late in the cycle.

Some Things That Are Different From 2000

The below chart plots consumer confidence alongside both retail sales (ex-autos) and real income growth on a per-capita basis. Here we see something that Fed policymakers have been wringing their hands over throughout this cycle, which is: if the labor market is so hot, how come income growth is so tepid?

That slower income growth tempers our enthusiasm for the ability of consumer spending to sustain growth indefinitely. We will get the latest read on this when the personal income and spending numbers hit the wire on Friday of this week.

I Don’t Know Why I Go to Extremes

For now, the surge in retail sales cannot be denied and we would be foolish to bet against the consumer with such a solid backdrop for consumer confidence. The official write-up that accompanied the release stated that “Consumers’ assessment of current conditions remains extremely favorable, bolstered by a strong economy.” We would not disagree, but what takes the shine off the apple for us is that extremes, by definition, imply “reaching a high, or the highest degree.” If this is the extreme, there is nowhere to go but down." - source Wells Fargo

With US Personal Income rising 0.3% in August, slightly less than expected (0.4%) last Friday, then indeed slower income growth should indeed temper slightly your enthusiasm we think.

As a reminder from last week's conversation, and as per the below Macrobond chart, the University of Michigan Consumer Confidence turning points tend to coincide with significant S&P 500 12 months return. It is worth remembering this from an Armstrong limit perspective:

- graph source Macrobond (click to enlarge)

Also, keep that in mind when looking at the significant rise of the S&P 500, because we think that we are in the melt-up "euphoria" phase and have yet to touch the "Armstrong limit":

- graph source Macrobond (click to enlarge)

Or you could also ask yourself as well what is the "Armstrong limit" when it comes to the S&P 500 Profit Margins in this long in the tooth credit cycle:

- graph source Macrobond (click to enlarge)

You could as well ask yourselves when will we reach "peak" M&A, which is also a sign you generally see in late credit cycles:

- graph source Macrobond (click to enlarge)

In last week's conversation, "White Tiger" we indicated that although everyone is focusing on the flattening of the yield curve, from an inflationary expectations perspective we worry a lot for asset prices about a spike in oil prices if we do get geopolitical flares up in November between the United States and Iran:

"The issue of course for the stretched US consumer would be if Core PCE inflation continues to pick up slightly faster than core CPI if healthcare service price inflation accelerates while rent inflation gradually slows. This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further, not to mention the issue with gas prices at the pump should oil prices continue as well to trend up. Remember that the acceleration of inflation is a dangerous match when it comes to lighting up/bursting asset bubbles." - source Macronomics, September 2018

So for us, from an Armstrong limit perspective, we are closely watching the evolution of oil prices:

- graph source Macrobond

An inflation spike is very much on our radar. Oil has extended its gains after the longest quarterly rally in a decade thanks to a slowdown in American drilling as well as supply concerns. The U.S. and Saudi Arabia have discussed market stability yet it seems there are some questions relating to spare capacity with traders highlighting a potential surge towards $100 a barrel at some point. 

From an Armstrong limit perspective relating to the state of the US consumer, oil prices matter because not only retail has been sustained by the rise in credit card use but housing is seeing headwinds already thanks to rising mortgage rates. The issue at hand is the size of energy costs for the US consumer relative to his consumer spending. On that subject we read with interest Wells Fargo's take from their note from the 28th of September entitled "What Good is a Bigger Paycheck if it All Goes to Gas Money?":

"Wages and salaries posted the largest monthly increase since January, but increasingly higher gas prices and other energy costs are commanding a larger share of consumer spending.

Income Gets Boost from Wages

Personal income increased 0.3% in August, which was a bit shy of the 0.4% that had been expected by the consensus.

More than two thirds of the increase was due to the fact wages and salaries notched a solid 0.5% gain. That was the best monthly increase since January and the latest indication that the hot job market is at last translating into meaningful improvement in wages.

Personal interest income, which comprises less than a tenth of overall income, was down for the second straight month and was in fact the only category of personal income that declined during the period.

Energy Costs Taking up Larger Share of Consumer Spending

Despite the slightly softer print on the income side, spending did not disappoint with the 0.3% pick-up in outlays, matching the consensus expectation. The fact that wages and salaries drove much of the increase explains why the saving rate was able to remain unchanged at 6.6%.

Consumer durable goods outlays slipped 0.1%, but every other major category of spending was either flat or positive to varying degrees. Echoing one of the themes from the August retail sales report in which gas stations reported faster sales than other types of stores, the biggest category gainer in terms of price was energy goods and services, up 1.9% on the month. This category includes spending on gasoline but also includes energy goods delivered to the home through utilities like electricity and natural gas. The takeaway is that higher energy prices in August might have been holding back spending in other categories. Excluding food and energy, spending was flat in August.

Inflation Dynamics

People are not suddenly buying a lot more gasoline. Prices, of course, are largely to blame. The energy prices category within the price indices has seen double-digit percentage gains in each of the past four months. Mercifully for consumers, prices for durable goods have also been lower in each of those past four months, ameliorating the impact of higher energy prices. The headline measure for the personal consumption expenditures deflator, the Fed’s preferred inflation gauge, slowed slightly to 2.2% from 2.3% on a year-over-year basis in July.

Existing tariffs on a variety of imports totaled roughly $100 billion in August; with this week’s additional tariffs on $200 billion going into effect, the price effects for consumers might become more tangible. The nation’s largest retailer this week warned that it might be forced to charge higher prices.
In its statement earlier this week, the Federal Reserve noted that “inflation on a 12-month basis is expected to move up in coming months” before eventually stabilizing near the Fed’s 2% target rate." - source Wells Fargo

Tariffs and rising gas prices do not bode well for the euphoric US consumer we think in the near future. Sure US equities, consumer confidence and even US High Yield have had a very good run in 2018 (CCCs have outperformed higher quality by a wide margin: +5.6% of excess returns) in comparison to the rest of the world, so it's highly likely that the "risk-on" euphoric mood will continue given financial conditions are still fairly accommodative (as per the most recent Fed SLOOs), but we think that 2019 could start becoming much more challenging as QT accelerates and depending on the Fed's hiking path as we are officially out of negative real rates for now.

In continuation to our “macro” long conversation “The Money illusion”, where we concluded that liquidity is a coward and where we repeated what we indicated back in June 2015 from our conversation "The Third Punic War", bear markets for US equities generally coincide with a significant tick up in core inflation, given the amount of buybacks since with the issuance of debt in many instances in our final charts below, we are wondering if there could be as well a "profit illusion" when it comes to the US markets.

• Final charts - The "profit" illusion

Sure, liquidity is a coward and as many have pointed out, with dwindling inventories on banks balance sheet and the very significant rise in corporate debt issuance in credit markets, one can indeed ask if "liquidity" is an illusion. On the question of the "profit illusion" our final charts come from our esteemed former colleague David P. Goldman who now writes in Asia Times and ask if buybacks are creating the illusion of profit in his article from the 28th of September entitled "Something strange is happening with US corporate profits":

"Are companies creating the illusion of higher profits through stock buybacks? 

It was reported earlier this week that S&P 500 companies bought back a record US$189 billion of their own shares in the first quarter of this year. The buybacks make results look better than they really are, as The Wall Street Journal reported.

The charts below show that raw, unadjusted US corporate profits actually FELL year on year, and corporates are creating the illusion of higher profits by buying back shares.

This is the rawest, simplest measure of profits, before tax and inventory/capital consumption adjustments, which are model driven. This is basically what corporations report on their income tax, and it doesn’t look terribly strong.

Are profits rising or falling? 

- source Asia Times - David P. Goldman

One could contend that the boiling frog which is a fable describing a frog being slowly boiled alive, could be related to the Armstrong Limit looking at the altitude reached by equities and some valuation metrics. As a reminder, the premise of the fable is that if a frog is put suddenly into boiling water, it will jump out, but if the frog is put in tepid water which is then brought to a boil slowly, it will not perceive the danger and will be cooked to death. The story is often used as a metaphor for our inability or unwillingness to react to or be aware of sinister threats that arise gradually rather than suddenly such as the markets we are seeing one could argue. Though some would add that "thermoregulation" by changing location is a fundamentally necessary survival strategy for frogs and other ectotherms, rendering the legend a "myth". From an Armstrong Limit perspective, we certainly hope that some investors have their "g-suits" on given the lofty levels reached in some instances. Also we do not know yet what is the Fed's own "Armstrong limit" in their current hiking path but we ramble again...

"There can be no rise in the value of labour without a fall of profits." -  David Ricardo

Stay tuned !

Macro and Credit - Critical threshold

"If you wish to be a success in the world, promise everything, deliver nothing." - Napoleon Bonaparte

Watching with interest the violent rotations in fund flows with Emerging Markets debt funds recording a $6.64 (-1.9) billions of outflows last week, the largest ever in terms of $AUM thanks to "Mack the Knife" (King Dollar + positive real US interest rates) while financial-sector funds experienced as well some monster flows to the tune of $7.2 billions, in effect validating somewhat our "macro reverse osmosis" discussed again in our previous conversation, we reminded ourselves for this week's chosen title as an analogy the definition of "critical threshold". Critical threshold is a notion derived from the percolation theory, which by the way ties up nicely when it comes to fluid movements and osmosis and refers to a threshold, that summons up to a critical mass. Under the threshold the phenomenon tends to abort, but, above the threshold, it tends to grow exponentially hence the risk for osmosis and flows to become at some point excessive, which would mean deflation bust and defaults for some. In cases the phenomenon is not sudden and take times to operate (such as a gradual surge in the US dollar) we would have used a critical phase or phase transition as a title for this week's musing but not this time around given the violence of the moves we have seen as of late.

In this week's conversation we would like to look at the violent flows rotations and what it entails in terms of critical threshold and risks as we move towards 2017 given the on-going killing spree of "Mack the Knife" on gold and US Treasuries and EM as well.

Synopsis:

• Macro and Credit -  Is reverse osmosis finally playing out?
• Final chart - The dollar is their currency but our problem for 2017

• Macro and Credit -  Is reverse osmosis finally playing out?

While last we week we reacquainted ourselves with our reverse osmosis macro theory relating to the acceleration of flows out of Emerging Markets, the latest raft of data relating to flows of funds clearly points out to a buildup in "Osmotic pressure" and a risk to break through the "critical threshold" and a significant "margin call" on the huge US dollar shortage that has been building up. On our twitter feed in fact we recently joked that the Fed was not behind the curve, but, that the curve was behind the Fed (watch the flattening...). The acceleration in the rise in US yields and in particular real yields have accelerated as of late, putting additional pressure on gold, Emerging Markets alike. If indeed the dollar rally continues to run unabated then, in continuation to our previous conversation, there is no doubt in our mind that trouble will be the outcome for the leveraged "macro tourists" carry players in the Emerging Market space. When it comes to trends, we do follow funds flows as indication of rising instability. To that effect, we read with interest Deutsche Bank's Weekly Fund Flows note from the 21st of November 2016 entitled "The great unwind?":

"Expectations of a looser US fiscal policy added fuel to the reflationary fire, triggering a bond sell-off across regions and classes on the one hand while also arranging for a strong return of equity inflows on the other hand. investors moved away from bonds at the highest weekly pace since the taper tantrum in 2013, as rising inflation expectations prompted outflows in both credit and sovereign bond fund categories, with US mandates bearing the brunt. In tune with the market, last week’s post-election flow data also saw a renewed appetite for DM equities as the reception of Trump's plans on tax cuts and infrastructure spending resulted in the highest weekly inflows for US equity funds since Dec’14 (see chart below).

If such stimulus in combination with reduced business regulation were to lead US GDP growth higher (as our US economists expect), we could finally see a normalisation of flows whereby money rotates out of over-allocated bond funds ($1tn of inflows since 2009) and into DM equities ($400bn of inflows since 2009). Last week’s bond-to-equity pull was strong in the US, and if rates continue rising this should go on.
Meanwhile another rotation seems to be in the making, as a rising dollar accompanied by fears of trade renegotiation spelled panic over emerging market fund flows. The run for EM bonds, which already looked increasingly  tired the past two weeks, took a big hit with highest redemptions since Jul’13 (see chart below) and the highest outflows in dollar terms since 2004.

EM equity fund redemptions also climbed to a one-year high. We remain particularly worried about intensifying EM capital flight on the back of a stronger dollar, and think EM redemptions are likely to continue." - source Deutsche Bank

If indeed when it comes to "credit" we look at the "credit impulse", in order to gauge the strength of economic growth, when it comes to flows and financial markets we like to look at Deutsche Bank's liquidity pulse, being the standard deviation from the mean of the relative between the current flow (4-week average as % of NAV) and the average size of flows in the last 13 weeks to get a better idea of the "critical threshold". Below are a couple of charts relating to equities and pointing towards a rotation from EM to DM with US equity funds talking the bulk of the flows:

- source Deutsche Bank

Whereas so far US equity funds have been receiving most of the inflows whereas EM has been on the receiving end of the "reverse osmosis" theory, given the surge in "Mack the Knife", it looks to us that once again a weakening Japanese yen against the dollar should go hand in hand with a surge of the Nikkei index, currency hedged. particularly in the light of the liquidity pulse which has yet to surge meaningfully.

When it comes to bonds and flows it is a different story as the velocity in the surge of US yields has translated into outflows from bonds funds and particularly EM funds towards equities for the time being:

- source Deutsche Bank

If indeed the pressure from "Mack the Knife" continues to build up, then obviously "de-risking" will be de rigueur, which should lead to additional significant outflows. So all in all not only we should be seeing additional capital outflows from EM under pressure but, in the financial sphere, if the trend is indeed your friend, there is further pain ahead in this "Great rotation" currently playing out. Furthermore, while there has been some additional pressure in the High Yield space seeing $3.8 billion of outflows, marking a third straight week of leakage for the asset class. A continuation of both a flattening of the yield curve and a surge in the US dollar will eventually start hurting credit and spreads could start widening at some point. As pointed out from a recent BIS paper entitled "The dollar, bank leverage and the deviation from covered interest parity" (H/T fellow blogger Nattering Naybob) we quoted recently on our tweeter feed:

"The highly significant coefficient on the US dollar index is -0.49, which implies that a one percentage point (aggregate) appreciation of the dollar is associated with a 49 basis point decline in the growth rate dollar-denominated cross-border bank lending. The estimated coefficient for lending to banks is even larger in absolute value (-0.61), implying that the decline is even stronger for interbank lending." - source BIS

In their long report the BIS indicated that a strengthening of US dollar has adverse impacts on bank balance sheets, which, in turn, reduces banks’ risk bearing capacity. An appreciation of the dollar entails a widening of the cross-currency basis and a contraction of bank lending in dollars. So all in all, our "exuberant" equities friend should be wary of outflows, the surge of "Mack the Knife" and a flattening of the yield curve, because in our book, once you've passed the critical threshold, there is more pain ahead with contraction of credit and consumption, if our murderous friend continues its rampage. If you forgot what a global credit crunch looks like, then you should be concerned by the devastation that can bring in very short order a US dollar shortage. 

When it comes to the aforementioned "risk bearing capacity for banks" think about rising hedging costs because as per the below chart from a Nomura note from the 17th of November entitled "Japanese investors' foreign bond buying (Oct 2016)", since late October, USD/JPY basis has been widening again. So, dear investors you can not only expect rising hedging costs going forward but a higher cost of capital, which entails credit spreads widening at some point:

"USD basis costs fell after the adoption of new MMF regulations in the US, but …
We attribute the rise in USD basis costs until early October to new MMF regulations, which were implemented on 14 October. The valuation method for prime MMFs (primarily investing in commercial paper issued by corporates) held by institutional investors was revised in such a way that these instruments could incur losses.
This likely prompted a shift from prime MMFs to government MMFs (which invest more than 99.5% of their funds in cash, government bonds, and government bond repos). This made Japanese banks USD funding via commercial paper more difficult. USD Libor also rose on expectations that USD funding would become tighter for Japanese banks, which led to a widening of USD/JPY basis.
Once the new regulations were implemented, the tightening of USD funding materialized, and USD/JPY basis began to narrow. Since late October, however, USD/JPY basis has been widening again. Moreover, USD Libor may rise if a Fed rate hike at the December FOMC meeting becomes more likely, which could translate into higher currency-hedging costs, in our view." - source Nomura

USD libor, dear friends, will rise if the Fed hikes in December FOMC meeting (100% certainty according to market pundits). This will accentuate even more currency-hedging costs. So what could be the consequences given Japanese Lifers and their investment friends have been large buyers in 2016 of foreign bonds, this could lead Japanese investors to look back into domestic issues or switch some of their appetite towards cheaper alternatives such as Euro denominated bonds longer than 10 years.

As a reminder from our July 2016 conversation "Eternal Sunshine of the Spotless Mind", Bondzilla the NIRP monster has been more and more "made in Japan":

"As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan"." - source Macronomics, July 2016

Unfortunately for the "macro tourists" out there, playing the leveraged carry trade, if there is something that carry players hate most is bond volatility! It is therefore difficult for us to envisage some stability in the Emerging Markets space until US interest rates stabilize. We have yet to see some sort of stabilization.

Also, we believe that the most predictive variable for default rates remains credit availability and if credit availability in US dollar terms vanishes, it could portend surging defaults down the line for stretched EM dollar denominated leveraged players. Right now, when it comes to the US, the latest Senior Loan Officer Opinion Surveys (SLOOs) point to some easing as of late as indicated by Bank of America Merrill Lynch in their HY Wire note of the 21st of November entitled "Don't be a hero":

"We use three main criteria to forecast HY default rates: the Senior Loan Officer Opinion Survey (SLOOS), credit migration rates, and real rates in the economy. When combined, these three inputs have an 85% correlation over the next 12 month trailing default rate at any given point in time. This makes sense because looser lending conditions, a higher proportion of upgrades, and lower real rates all make it easier for an issuer to secure funding and hence maintain balance sheet liquidity. For Loans we use a two factor model - rates don’t have a meaningful impact on the asset class, especially since they are floating in nature.

"Our HY model is most sensitive to the lending standards as reported by senior loan officers on a quarterly basis- a measure that has declined from a relative high of 11.6% in April of this year to 1.5% today (Chart 18). The survey reflects the ability of medium sized enterprises (annual sales greater than $50mn) to get funding from regional banks. Since HY issuers fit this criterion, this survey is also well correlated with their ability to tap the bank lending market. Another way to assess issuer access to funding is by tracking the proportion of risky companies that have been able to tap the HY capital markets on a trailing 12-month basis. While this too has a high predictive power of defaults (Chart 17), it doesn’t add enough incremental explanatory power to justify adding an additional variable. Further, the lead time of the risky issuance model is less consistent than the lending survey. Hence we choose to rely on SLOOS for the purpose of our model. Just like for bonds, SLOOS is a good indicator of the level of default rates for loans a year later. However, in the case of loans, the default rates are more sensitive to the asset class’s migration rates than the lending survey, quite the opposite of bonds.

Another interesting point to note about the SLOOS report is that it does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. On the other hand, it undershoots when defaults are driven by idiosyncratic events in individual sectors such as what we witnessed in the 2015 commodity bust. Our forecasted default rate for 2015 thus happened to be lower than the realized headline default rate but higher than the ex-commodity rate" - source Bank of America Merrill Lynch

The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years has ended.

Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...). With rising interest rate volatility, one would expect leveraged players, carry traders and tourists alike to start feeling nervous for 2017.

Also, rising rates can easily curtail the US consumer which would ultimately disappoint earnings growth and sales as the ability to use cheap funding wane with rising interest rates, meaning less potentially less buybacks regardless of the US repatriation factor vaunted by some pundits. This leads us to our final chart as in the end, for us Europeans, the US dollar might be their currency but our collective problem in 2017 we think.

• Final chart - The dollar is their currency but our problem for 2017

The continuation of a surging US dollar and a flattening of the US yield curve could represent a significant headwind for 2017. This is as well indicated in the final chart we selected from Bank of America Merrill Lynch HY Wire note of the 21st of November entitled "Don't be a hero" displaying the USD appreciation versus YoY EBITDA growth (ex-Energy):

"Given the strengthening dollar, a fall in earnings growth and a pickup in treasury yields, we’re concerned that unless sales growth accelerates meaningfully in 2017, ex-Commodity fundamentals may disappoint relative to 2016. And although we were becoming emboldened by what appeared to be stronger revenue growth in Q3, as more companies report we are finding that unfortunately our optimism may have been misplaced; sales growth for Q3 now stands at just 3.7% whereas 11 days ago it was 8%." - source Bank of America Merrill Lynch

If optimism is somewhat misplaced, it could well be that our eternal equities optimists friends could be somewhat getting ahead of themselves in their "reflation" wishes. But that's another story as for now it's rally time in the equity world and we don't want to be the party spoilers for now.

"In politics stupidity is not a handicap." - Napoleon Bonaparte

Stay tuned!

Credit - While My Guitar Gently Weeps

"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." - Mark Twain

Looking with interest at the latest surge in the US 10 year yield to 1.94% in conjunction with the "improved" employment picture in the US as well as the fall to record low level of 1986 for the Baltic Dry index to 559, we remembered one of our favorite song from the Beatles "While My Guitar Gently Weeps" recorded in 1968 for our title analogy. "While My Guitar Gently Weeps" was ranked no. 136 on Rolling Stone '​s list of "The 500 Greatest Songs of All Time", no. 7 on their list of the 100 Greatest Guitar Songs of All Time, and no. 10 on their list of The Beatles 100 Greatest Songs.

As far as the above Mark Twain quote goes, it's indeed what we know for sure when it comes to global economic growth which is of concern to us, regardless of the supposedly "deflation escape velocity" reached by the US economy and its latest Nonfarm Payroll figures. We still sit tightly in the deflationary camp for the time being and remain extremely cautious about the risk posed by the velocity in the rise of the US dollar.

The Baltic Dry Index indicative that all is not good in global economic growth - graph source Bloomberg:

"Baltic Dry Index down to levels not seen since 1986" - source Bloomberg

You might therefore be wondering why we have used such a title as an analogy. Georges Harrison's musical masterpiece had an initial incantation, which we think, resonates well with the current investment environment and global central banks meddling in asset prices:

"I look at the trouble and see that it's raging,
While my guitar gently weeps.
As I'm sitting here, doing nothing but ageing,
Still, my guitar gently weeps."

There was as well an unused line in the very beginning of his initial writing which was eventually omitted:

"The problems you sow, are the troubles you're reaping,
Still, my guitar gently weeps."

And when it comes to QE and Central Banks, an early acoustic guitar and organ demo of the famous song had a slightly different third verse which we find interesting for the sake of our analogy with our central banks "money" games:

"I look from the wings at the play you are staging,
While my guitar gently weeps.
As I'm sitting here, doing nothing but ageing,
Still, my guitar gently weeps."

In 2004, Harrison was inducted posthumously into the Rock and Roll Hall of Fame as a solo artist. "While My Guitar Gently Weeps" was played in tribute by Tom Petty, Jeff Lynne, Steve Winwood, Steve Ferrone, Marc Mann, and Dhani Harrison, and concluding with arguably one of the most  memorable guitar solo by fellow inductee Prince but we ramble again.

In this conversation we will re-assess current trends and "rotations" and "look at the trouble" to see if it is indeed "raging" while our guitar gently weeps as well as musing around the impact QE has had in Europe so far.

Synopsis:

• Lower expected returns and higher expected volatility
• "Great rotation" not from bonds to equities but, from US equities to European equities in early 2015
• European equities lift-off akin to the move seen on the Nikkei  (hedged) in 2013but with less firepower!
• Rising divergence between volatility and credit spreads in Europe

• Lower expected returns and higher expected volatility

When it comes to the outlook for returns, we agree with Nomura's latest Strategic Outlook note from the 6th of February 2015, namely that we are going to see lower expected returns and higher expected volatility. We also share their concern on the US economy. We think it is more fragile than currently assumed:

"A common view is that the US economy is in good shape – effectively immobile against a stronger USD or lower energy prices or low productivity. With most of the rest of the world (ex Brazil) loosening monetary conditions (FX and rates) another view is emerging that EM growth will recover. And the ECB’s QE announcement should, it is argued, hedge downside inflation and hence growth risks in the euro area. These views rest squarely on the assumption that the US will not and never has slowed down from above trend growth without the intervention of the Fed via tight monetary policy. In contrast we see increasing evidence that the US profit cycle is in fact maturing rapidly and that profit growth is likely to disappoint through H1. If this is the case then slower capex and employment follow – regardless of the Fed. This would constitute a major surprise to global forecasts that are more clustered than they have been since 2007.

Given the starting point for inflation this scenario would generate further upside pressure on real yields across the curve. How risk aversion would respond is critical to predicting the outcomes for returns. By contrast the bullish growth scenario would, we think, lead to a rapid repricing of Fed hikes back toward June given the stage of the US cycle. Our unpalatable strategic conclusions are that growth estimates for H2 will probably need to come down, that real yields or nominal yields are going back up under most scenarios, and that risk aversion will continue to trend higher." - source Nomura

While we have taken the proverbial "beating" on our ETF ZROZ long duration exposure losing 7% since the 30th of January, we are sticking with our position, given our lower entry level in the trade (we have also exposure to a long term macro short term trade offsetting the short term pain via ETF YCS, being short JPY for disclosing purposes...). The recent widening in US Treasuries make a good entry point for those who missed out, we indeed, expect, the data in the US, from a contrarian perspective to be weaker than previously expected, regardless of the most recent NFP.

On that specific point we would like to point out to Reorient Group's latest note on a US premature rate hike from the 8th of February 2015:

"Individual components of the employment report are at odds with other data. One of the fastest-growing components of employment, for example, was construction, with total head-counts up 5.5% year-on-year as of January. Construction spending adjusted for the construction Producer Price Index was flat year-on-year. Either the spending numbers were wrong (but unlikely because construction activity is easily counted) or the employment numbers are suspect."

 - source Reorient Group

We agree with the above, that all is not what it seems and it demands a more inquisitive mind when it comes to taking the data at "face value".

• "Great rotation not from bonds to equities but, from US equities to European equities in early 2015

From an allocation point of view, what we find of great interest has been the continued inflows into the bond sphere (59 straight weeks of inflows to Investment grade bond funds with $8.7bn) as indicated by Bank of America Merrill Lynch's Follow the Flow note from the 5th of February entitled "The Bond Capitulation":

"On Flows and Markets
Bond is Back: massive inflows to bond funds ($21bn – 7th largest weekly inflow on record – Chart 1); outflows from equity funds ($7bn).

Gold is Back: largest 3-week inflows ($3.8bn) to precious metals funds since
Aug’11 (Chart 2).

Europe is Back: 4th consecutive week of equity inflows to Europe (Chart 5); contrasts with outflows from US/EM/Japan.

EM Debt is Back (at least for a week): 1st inflows in 9 weeks to EM debt funds ($0.9bn).
Risk Resilience: best explained by ECB & Sentiment (risk has rallied since BAML Bull and Bear Index flashed "buy" on Jan 7th…US HY 1.8%, SPX 3.0%, ACWI 5.4%, WTI 5.5%, SX5E 9.1% (all $-terms).
Risk Resilience: note also significant weekly inflows to bonds and/or gold in past 15 years (i.e. moments of “fear”) have unsurprisingly proved decent entry points into stocks (Chart 4).

- source Bank of America Merrill Lynch

In relation to Bank of America Merrill Lynch and its "Great Rotation" story, it seems that, courtesy of the ECB unleashing a QE of its own, the great rotation has clearly been from US equities into European equities it seems with $4.3bn of inflows for a 4 straight week, whereas the US saw $9.9bn of outflows for a 5 straight week. European assets seems to be a large beneficiary from the ECB's promises to deliver a QE of its own as indicated once more by Bank of America Merrill Lynch's Follow the Flow note from the 6th of February 2015 entitled "Income mania":

"Biggest inflows ever into European assets
Fund flows highlight the chronic shortage of yield in Europe. Last week saw the greatest ever total inflow into European assets (chart 2). 

The reach for yield was in full effect across high-grade and high-yield credit, government bonds, money market funds, equities and commodity funds, according to EPFR. In terms of notable trends:
• Money-market inflows were the 4th highest ever.
• European equity inflows were the 6th biggest ever.
• Inflows into government bond funds were the 3rd largest ever.
• Inflows into all fixed-income funds were the 2nd biggest ever.
• High-grade credit flows were the 8th largest, since data began.
All in all, aggregate risk-on flows in to European assets were huge: almost $40bn!" - source Bank of America Merrill Lynch

At the same time and on a monthly basis, the S and P 500 saw during the month of January $28bn of outflows and equating to 15% of AUM according to Morgan Stanley. In fact, the biggest monthly outflow ever:

- graph source Bloomberg / Morgan Stanley


Also, investors continue to pile into the yield trade as the search for income runs unabated.

For instance IYR (REITS) had its largest daily inflow ever on the 2nd of February ($900 mln or 12% of AUM) according to Morgan Stanley:

- graph source Bloomberg / Morgan Stanley

We believe the great rotation story in 2015 currently playing out is indeed from US equities towards European equities for the time being and we agree with the following comments from Morgan Stanley:

• "US investors are loaded up on US risk:  50% of the entire industry ETF flows since 2009 has gone into US equities ($300 bln).
• The peak in global growth might very well have come in Q1 (US printed 5% GDP in Q3 and Q4 GDP came in 2.6% below the 3% consensus forecast).  Now we have a strong dollar and we are starting to see countries implementing policy stimulus to close the gap in growth." - source Morgan Stanley

So indeed while our guitar is gently weeping, US risk is indeed much less appealing than European risk (Grexit avoided of course...).

Therefore, when it comes to allocation to European equities it is definitely on the "menu du jour" as displayed in Louis Capital Markets Cross Asset Weekly report from the 2nd of January:

"Run Forrest!
No client meeting we have conducted has passed without a question on the relative performance of European equities compared to US equities being posed. European investors are well loaded with European equities as they suffer the classic “home bias”, well known in academic literature. US investors are similarly biased, but the letters Q and E, that recently reared their head in Europe, have broadened their investment universe and a flow of money has poured into European equities. The US ETFs that hedge the currency impact have benefited strongly from this trend as we show in the chart below.

This re-balancing has happened in a context where Wall Street has started to show some signs of weaknesses. We have recently discussed this hypothesis and it seems that US indices have lost their upward momentum (at least, in the short term).
The reversal of the profit trend could be the reason for this weakness. Or perhaps this is simply a profit taking phase, because as we all know these are a regular occurrence in equity markets.
Sarcasm aside, the fact that European equities recorded new highs in this less than favourable context is therefore heroic, because on the profit side there is absolutely nothing new. The charts below illustrate this. We can understand that the impact of the EUR/USD is positive for European companies and negative for US companies, but in the earnings forecasts of analysts there is no change. 

The 2015 EPS of the Eurostoxx50 has been revised down by 2.2% for the sole month of January. 

Although we share the consensual view that the decline of the EUR/USD will support profits of the European index later this year, this 2.2% negative revision is a reminder that on an index level the macroeconomic developments that appear obvious to many investors are not so straightforward when it matters due to its composition/structure.

By sector, the message is consistent with the “currency advantage” as consumer stocks that are quite global have done better than more domestic sectors like utilities or financials. The telecoms sector, with its very strong performance, is the exception in Europe.
However, the difference in performance between the Eurostoxx and the S&P500 since the beginning of the year is broad based and not related to a specific sector. The underperformance of US financials compared to European financials sends a key message here: this is not only a matter of exchange rates.

The herd mentality is strong on equity markets with this run against time to chase European equities that keep a potential for a catch-up if we look at prices. If we look at valuation (without discussing the impact of possible different profit cycles and different profit trend growth) the potential for a catch-up is exhausted. We have updated our table on the valuation of the MSCI EMU if we apply to it the sector composition of the US index. Here, we find a mere 2.2% discount in terms of forward PER.

Last week we started mentioning the valuation aspect of the Europe/US question. To be clear, we stress that profits have to improve significantly to think that European indices can outperform on a sustainable basis its US peers." - source Louis Capital Markets

• European equities lift-off akin to the move seen on the Nikkei  (hedged) in 2013but with less firepower!

This European lift-off in equities hedged is akin to the move seen in 2013 on the Nikkei hedged complex which provided solid performances for "wise" investors. (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro). We have repeatedly highlighted the weakness in aggregate demand in the Eurozone. We argued in the past that the growth divergence between US and Europe were due a difference in credit conditions. Unless there is a significant sustained improvement in credit conditions in Europe, we don't think Europe can deliver more stellar returns than Japan did in 2013 while our guitar gently weeps.

• Rising divergence between volatility and credit spreads in Europe

From an equity to credit perspective, one of the major impact from the ECB's QE has been the rising divergence between Eurostoxx 50 Put/Volatility versus Credit Spreads. This has been for us quite logical for Investment Grade, less so for High Yield. According to Goldman Sachs the spread between Out of the Money Put options on the Eurostoxx 50 and CDS spreads is at its highest level since 2010, and the yield that can be obtained by selling 70% put on the Eurostoxx 50 is 3 times higher than the Itraxx Main Europe CDS 5 year index (Investment Grade proxy for risk with 125 entities):

- source Goldman Sachs

Furthermore, as we indicated in our conversation relating to the growth divergence between the United States and Europe ("Growth divergence between US and Europe? It's the credit conditions stupid..."), it is all about Stocks versus Flows:

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

This major difference can already be seen, we think from the behavior of credit versus equities as discussed by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 6th of February entitled "Catch the basis if you can":

"Central Banks liquidity primarily provides a strong back-stop against funding risks; rather than support earnings, which usually come further down the line. When the Fed announced the first QE program, credit spreads outperformed equities.

On the flip side, the ECB QE announcement has not ignited the same response. This time around credit lagged equities.

One could argue that European credit spreads are already close to the tightest levels in years, and thus should lag post an ECB QE announcement, especially when growth outlook is coming off the lows. At the end of the day the ECB QE is meant to boost growth rather than to reduce funding/default risks, and equity markets have started pricing that.

However, we expected Crossover to follow suit on the strong reaction from equity markets, being a growth proxy in the credit market. We were expecting Main to underperform Crossover in a QE event, also reflecting the same strong growth potential the equity markets are pricing.
However, XO has lagged the risk on move tighter. We think that this was not driven by the lack of yield in credit markets – as government bond yields have continued to rally – but mainly due to the rise of geopolitical risks and the resurfacing of funding risks." - source Bank of America Merrill Lynch

End of the day, it doesn't matter that European stocks have been racing ahead of fundamentals, from a "quality" and "japanification" perspective, it is still a goldilocks period for Investment Grade credit, particularly in a shift towards a new regime of higher volatility.

On a final note we leave you with Nomura's forecast of stock of assets purchased by central banks as a % of national GDP from their Economics Insights note of the 28th of January 2015 entitled "Comparing ECB QE with BOJ, Fed and BOE programmes:

"• BOJ holdings of JGBs are expected to increase from the equivalent of around 40% of Japanese GDP at the end of 2014 to around 60% of GDP by the end of this year. This compares with “only” 14% of GDP in the case of the Fed and just over 20% of GDP for the BoE.
• ECB purchases of sovereign bonds (just over €40bn a month, allocated according to the capital key) will be equivalent to around 4% of GDP by end-2015. These will have grown to about 7.5% of GDP by end-September 2016 (or around 13% of the total stock or 17% of the targeted stock; the latter referring to the maturity parameters of a remaining maturity of 2 years and a maximum remaining maturity of 30 years at the time of purchase).
• Only the Fed has engaged in macroeconomically significant (measured as a share of GDP) purchases of assets other than Treasuries, buying the equivalent of 10% of US GDP of Agency MBS. We estimate the ECB will maintain private sector asset purchases at around €10bn a month, resulting in purchases equivalent to just 1% of GDP by the end of this year and reaching 2% of GDP by the end of September 2016.
• In conclusion, if one believes in the effectiveness of QE (we don’t), then size probably matters. In this context, there are two considerations: (i) the increase in the stock of purchases is going to be gradual, which implies it is going to take some time for the cumulated size to become meaningful, and (ii) the cumulated expected size of the programme by the end of this year will still be only a third of the size of the Fed and BoE programmes, suggesting that, if you believe in the effectiveness of QE, the ECB’s programme will need to grow much more significantly before it has a macroeconomic impact." - source Nomura

 “It's not the size of the dog in the fight, it's the size of the fight in the dog.” - Mark Twain

Stay tuned!