Macro and Credit - The Sokal affair

"Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things." -  Isaac Newton

Looking at the recently released minutes of the Fed's latest FOMC and its dovish impact on the US dollar in conjunction with the new US administration war of words, not only validating our solitary contrarian stance so far against the US dollar bullish crowd but, as well rewarding us for our late December gold/gold miners positioning, made us reminder for our chosen title analogy the Sokal affair, 

Given our fondness in recent musings in anything relating to hoaxes, the Sokal affair, also called Sokal hoax, was a publishing hoax perpetrated by Alan Sokal, a physics professor at New York University and University College London. In 1996, he submitted an article to Social Text, an academic journal of postmodern cultural studies, to test the intellectual rigor and, specifically to investigate weather "a leading North American journal of cultural studies - whose editorial collective includes such luminaries as Fredric Jameson and Andrew Ross – [would] publish an article liberally salted with nonsense if (a) it sounded good and (b) it flattered the editors' ideological preconceptions". The article, "Transgressing the Boundaries: Towards a Transformative Hermeneutics of Quantum Gravity", was published in the Social Text spring/summer 1996 "Science Wars" issue. It proposed that quantum gravity is a social and linguistic construct. At that time, the journal did not practice academic peer review and it did not submit the article for outside expert review by a physicist.  On the day of its publication in May 1996, Sokal revealed in Lingua Franca that the article was a hoax, identifying it as "a pastiche of left-wing cant, fawning references, grandiose quotations, and outright nonsense ... structured around the silliest quotations [by postmodernist academics] he could find about mathematics and physics."

The hoax sparked a debate about the scholarly merit of "humanistic commentary" about the physical sciences; the influence of postmodern philosophy on social disciplines in general; academic ethics, including whether Sokal was wrong to deceive the editors and readers of Social Text; and whether Social Text had exercised appropriate intellectual rigor. In response to the heavy criticism received by the editors of Social Text, Sokal said that their response illustrated the problem he highlighted. Social Text, as an academic journal, published the article not because it was faithful, true, and accurate to its subject, but because an "Academic Authority" had written it and because of the appearance of the obscure writing:

"My goal isn't to defend science from the barbarian hordes of lit crit (we'll survive just fine, thank you), but to defend the Left from a trendy segment of itself. ... There are hundreds of important political and economic issues surrounding science and technology. Sociology of science, at its best, has done much to clarify these issues. But sloppy sociology, like sloppy science, is useless, or even counterproductive."

You are probably asking yourself once again, where we are going with this analogy of ours, but, it appears to us that the Fed, and other central bankers, are "making it up" as they go along. Given most of them are "Academic Authorities", so, when it comes to the Fed's FOMC latest statement we reminded ourselves of the "wise" words of former Fed supremo Alan Greenspan:

"I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant"

In similar fashion, in relation to our central bankers and their hoaxes, sloppy economics beliefs based on sloppy "science" is useless, even counterproductive to paraphrase Sokal.  On that very subject we recommend you read John Mauldin's recent article "Post-Real Economics". 

As one of our loyal readers "kertch" commented in our recent musing "The Woozle effect" on Seeking Alpha, more and more "Academic Authorities" in central banks are indeed making claims that are entirely contrary to the basic principles of economics:

"Wozzle is a much more specific and descriptive term. It was revealed recently that the entire decades-long crusade against saturated fat was based on a Wozzle and has no basis in fact. I also now see economists make claims that are entirely contrary to the basic principles of economics. When will we see scientists make claims that are entirely contrary to the laws of physics? (Actually that has already begun - don't get me started!) It seems that the principles of logic and mathematics (statistics) that apply to basic research have become irrelevant relics of another time and social paradigm. Scientific method in our culture is badly in need of a Renaissance."

By now you probably understand where we are going with our Sokal affair analogy given that the same "Academic Authorities" which are at the helm of central banks are less and less challenged in their economic assertions by the Mainstream Media (MSM). Furthermore, on our recent musing "The Ultimatum game", same reader "kertch" made some very interesting points in relation to principles of economics and scientific rigor that is badly lacking in economics nowadays:

"I think once again economists have jumped to the same mistaken cause/effect conclusions with the idea of "Aging Nations Like Low Prices Over High Incomes" as they did with the Phillips Curve. They go on to link the phenomenon to a decreased demand for durable goods and property. I have seen no evidence of this in countries with an aging population. In fact the opposite appears to be the case. First, it is premature to conclude that demographics is the culprit. It is more likely that economic development drives demographic trends and the accumulation of capital assets, as every nation that has achieved a high level of economic development develops almost the exact same trends. Perhaps when economists stop seeing the economy as some rigid machine where moving a lever causes a knob to turn, and turning the knob causes said lever to move, they will start paying attention to cause and effect, and asymmetric, non-reversable functions. As I've said before, it's a field were logical and scientific rigor is sadly lacking."

Exactly, in similar fashion, one could argue that Thomas Piketty much vaunted book "Capital in the Twenty-First Century", lack logical and scientific rigor but we would be rambling again in that instance...

In this week's conversation, we will look again at what the rise of protectionism entails in terms of allocation and risk and why so far we think our solitary contrarian stance (short US dollar, long gold/gold miners, long volatility) and defensive stance has more to run.

Synopsis:

• Macro and Credit - Trump told you so folks
• Final charts - Deglobalize me

• Macro and Credit - Trump told you so folks

In recent musings we have delved into the "optimism bias" of the "consensus crowd" being long the US dollar, long oil, short volatility, short US Treasury notes to name a few. We have argued we were not "buying" it, hence us playing the "devil's advocate" or as some left wing pundits would argue the "Trump advocate". 

As reality settles in given "Mack the Knife" aka King Dollar + positive real US interest rates is year to date down 4% and our gold mining stance up around 16% (GDX) as we type, we think it is high time you reconsider the risk of trade war escalation and what it entails for a variety of asset classes.

On the rising risk posed by US protectionism we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 2nd of February entitled "Playing with fire - the FX implications of US trade protection":

"He told us so

What if Trump does what he has said on trade policies? The so-called Trump trades, and particularly the USD, have seen a correction this year, as President Trump’s rhetoric has shifted toward trade protection. Our baseline assumes the US will avoid such policies, but we also see risks and markets could get more concerned in any case. This is consistent with a volatile but still upward USD trend. However, it is worth discussing the possible market reaction to potential US trade protection and how to hedge. This is just a first look, as a lot would depend on policy details and the potential reaction of the rest of the world.

We recommend hedges that could do well even in our baseline scenario of no trade protection. We consider three main scenarios of de-globalization: higher US trade protection; a global trade war; and a major repatriation of flows. Our analysis suggests that JPY, USD, and NOK would benefit in most cases, particularly against AUD, CAD, MXN and KRW—USD/JPY would weaken. However, for investors who do not expect such extreme scenarios but would still like to hedge their long Trump trades, our analysis supports being long the USD against AUD and CAD in G10, and against KRW in EM.

Trade protection and the Trump trades

The so called Trump trades, and particularly the long USD trade, have seen a correction this year. This is to a large extent because President Trump has gone back to his tough pre-election rhetoric against free trade. In one of his numerous recent tweets on the subject, he warned that “car companies and others, if they want to do business in our country, have to start making things here again. WIN!” In his inaugural speech, he said "we will follow two simple rules: buy America and hire America," adding "protection will lead to great prosperity and strength." This week, Trump and members of his administration accused Germany and Japan of manipulating their currencies to keep them weak. Indeed, the market correction started after President Trump’s first press conference after the elections, on 11 January, where he used strong rhetoric against US companies that invest abroad and then export to the US. This contrasts with his speech after he won the November elections, when he focused on fiscal stimulus and other market-friendly policies.

Our view is that the market is still pricing a benign scenario, in which the new US administration delivers fiscal stimulus and deregulation, but does not go ahead with trade protection. The market remains long the USD, despite the recent adjustment. The VIX index is at historically low levels, despite its latest increase. Global equities remain at historical highs, even after its correction this week. EM FX has been somewhat volatile, but without a clear trend this year. If anything, our flows reflect some buying in EM FX.

This is consistent with our baseline as well, but we do see risks. We have been arguing that the balance between fiscal stimulus and trade protection in the first 100 days of the Trump administration will determine the outlook of the Trump trades and of the USD. We remain constructive on the USD, as we expect President Trump to deliver on fiscal policy and not turn to trade protection. However, even in this scenario, we do not expect a substantial further USD rally, as the USD is already strong and the US government would also push against an excessively strong USD. Moreover, we have been flagging high uncertainties, as we are increasingly concerned about the strong rhetoric against free trade and free FDI coming from the US. Our baseline expects a volatile USD path upward. USD bulls should be more tactical, in our view.

In this context, we discuss which of the G10 and major EM currencies could be at risk in a scenario where we are wrong and President Trump does what he has said on trade policy and increases protection. Of course, a lot would depend on the details and on how the rest of the world reacts in this case. This is a first and very basic approximation but one that can provide insights even for a scenario in which the US does not increase trade protection but markets get more concerned about such a risk.

“What-if” scenarios of trade protection

Global trade is already on a declining trend. Following an almost smooth upward trend in recent decades, the share of global trade to GDP is now below what it was 10 years ago (Chart 1). After a V-shaped move following the global crisis, it has been falling recently.

This is a concern, as empirical evidence suggests international trade and economic growth reinforce each other. A move toward trade protection in the US could lead to a further decline in global trade, making everyone worse off.

Focusing on US trade policies, trade protection would hurt Mexico and Canada the most. China and the Eurozone export more to the US (Chart 2).

However, as a share of their GDP, Mexico and Canada stand out (Chart 3).

We believe MXN already reflects Trump policy risks, but we have been arguing that CAD underestimates such risks.

If we consider a very adverse scenario, in which protectionist trade policies in the US potentially trigger a global trade war, KRW, MXN and CAD could be affected the most.
• Looking at openness to trade as defined by the share of total exports and imports to GDP, the countries most vulnerable to a potential pull-back of global trade include Hungary, Czech Republic, Switzerland, Korea, Poland, Sweden and the Euro zone (Chart 4).

However, most of the European trade is intra-regional and it is safe to assume that protection within Europe will not increase—the region could still suffer if global supply chains get significantly disrupted. Excluding Europe, Mexico and Canada also stand out.
• Looking at the FDI net inflows as a share to GDP, the countries that will be affected the most by a pull-back include Switzerland, the Euro zone, Hungary, Brazil, Australia, Canada and the Czech Republic (Chart 5).

• Combining these two measures, this analysis will suggest negative risks for CAD, MXN and KRW, particularly against USD and JPY (Chart 6).

HUF, CZK, CHF, PLN, and EUR could also be at risk if global protectionism affects European exporters—our CEE baseline is bullish, as these currencies are undervalued and will benefit from a hiking cycle.

Considering an even worse scenario, in which trade protection triggers a repatriation of flows, Norway, Switzerland and Japan would receive most of it as a share of their GDP (Chart 7).

These are the economies with the largest net international investment positions relative to GDP by far. We would therefore expect NOK, CHF and JPY to appreciate in such a scenario, particularly against NZD, AUD, MXN and TRY.

Bottom line

Putting everything together, our analysis suggests investors who would like to hedge a tail risk scenario of a move away from globalization and toward trade protection should be long JPY, USD, and NOK against AUD, CAD, MXN and KRW. USD/JPY would also weaken in this case.

As the scenarios we have considered are extreme and mostly tail risks, we would prefer to focus on hedges that can do well even if these risks do not materialize and the USD rally continues. In this context, we would be long the USD against AUD and CAD in G10 and against KRW in EM. We remain constructive in CEE and we would avoid shorting MXN, as it could do well in a free-trade scenario." - source Bank of America Merrill Lynch

Obviously our contrarian stance sits opposite to Bank of America Merrill Lynch's baseline scenario and the "optimism bias" of the long US dollar "herd mentality". In prolongation to what we posited in our last missive, we would tend to agree with their tail risk scenario, in the sense that the dislocation in volatility between EURJPY versus USDJPY has been at the cheapest levels relatively in past decade as indicated by Bank of America Merrill Lynch previously quoted FX Vol trader note entitled "USD vols are relatively overvalued". Regardless of the Fed's monthly FOMC "Sokal" hoax, we tend to focus on what is "cheap" from a "relative basis" perspective to what is "crowded" such as long US dollar from a positioning perspective. As we pointed out last week:

"If indeed the current account balance in the US deteriorates, then the US dollar should weaken as it generally happens in the late stage of a 10 year credit cycle, hence our contrarian stance versus the bullish US dollar crowd. The credit cycle is therefore deterministic we think" - source Macronomics, January 2017.

While at this juncture, FX wise we have recommended going against the dollar bullish consensus, in relation to the "Big Short" aka the short US Treasury speculative short positioning, we have yet to fall meaningfully enticed to the other side for the time being, at least until we see the Japanese GPIF, Lifers and others coming back to play in size, but obviously this is depending on some adjustment in the currency basis.

Moving on to "credit", as we pointed out in last week's final chart, it seems to us that currently High Yield is indeed "priced for perfection". As we indicated, we will be tracking very closely what credit spreads will do in the coming weeks. Yet, flows remain supportive for now and so does the shape of the CDX High Yield CDS index, a proxy for High Yield in the derivatives space. As pointed out by Bank of America Merrill Lynch in their Follow The Flow note from the 3rd of January entitled "So far so good...inflows across the board", investors have continued playing the "beta" game:

"YTD flows – inflows across the board

So far this year, amid a rising rates environment, investors have favoured higher yielding pockets of the fixed income world. Both EM debt and HY funds recorded strong inflows YTD. However, the ECB QE backdrop remains positive for IG and government bond funds; at least for now. Equities have started on the positive territory, but the pace is still slow (Chart 1).

Over the past week…

High grade funds continued on a positive trend for the second week in a row. However the flows trend remains below what we have seen before tapering fears emerged. High yield funds saw inflows for the ninth consecutive week, and the asset class has accumulated more than $4bn of inflows since the start of the year. However, looking into the domicile breakdown, as Chart 13 shows, the inflow last week came only from US domiciled and globally-focused funds, while the European-focused funds inflows were very marginal.

Government bond funds had their second week of outflows amid rising rates; albeit very small. Money market funds weekly flows were negative for the third week in a row, while the outflow trend is strengthening. Overall, fixed income funds recorded a strong week of inflows, the highest in 27 weeks and the sixth positive in a row.
European equity funds flows were positive for a second week showing signs of moderate strengthening. Last week’s inflow was the highest in 11 weeks. However note that this pace is much slower than the inflows strength seen during 2015.

Global EM debt fund flows flipped back to positive territory after a brief week of outflows. Last week’s inflow was also the strongest in four weeks. Dollar weakness has been beneficial for the sector. Commodities funds flow remained positive for a third week in a row, but the inflow pace has slowed down.

On the duration front, inflows continued in short-term IG funds for the seventh week in a row. However the pace of the inflows has slowed down notably over the past weeks. Mid-term funds’ large outflow couple of weeks ago was partially reversed recording the biggest inflow in 13 weeks. On the other hand, flows into long-term funds remained downbeat recording an outflow for a second week." - source Bank of America Merrill Lynch

It is no surprise to see, credit investors playing "defense" and rotating into shorter duration funds given that last year, during the second part they had increased both credit risk and duration risk as well. As we mentioned earlier, we are very wary about Japanese flows and appetite for foreign bonds which have been dwindling as of late following a record 2016 take up. Data from Japan’s Ministry of Finance confirmed this week that Japanese investors sold around ¥1.3 trillion ($11.54 billion) in foreign bonds between Jan. 21 and Jan. 28, taking net sales for the last 12 weeks to over ¥3.7 trillion, the largest amount since April 2014 according to the Wall Street Journal. This is as well confirmed by the latest Nomura JPY Flow Monitor note from the 2nd of February 2017:

"MOF international weekly capital flow data (22 - 28 Jan)

Japanese investors were net sellers of foreign bonds again last week for the second week in a row. The net selling accelerated to JPY1359bn ($11.9bn) from the previous week (JPY538bn), recording the biggest net selling since March 2016.

Uncertainty on the US policy stance remains high, while US yields have been rising again since mid- January, which has likely discouraged Japanese investors from increasing their foreign bond investment for now. Seasonally, foreign bond investment by insurance companies tends to slow in Q1 too, as the fiscal year-end approaches. January foreign portfolio investment by investor type data are scheduled next Wednesday, which will show the major contributors to the relatively large net selling of foreign bonds last week.

Japanese investors resumed their purchases of foreign equities for the first time in two weeks. They bought JPY125bn ($1.1bn) of foreign equities last week. This suggests the underlying Japanese appetite for foreign assets remains strong, although they had been large net sellers of foreign bonds over the past two weeks.

Foreign investors continued selling Japanese equities for the second week in a row (JPY144bn or $1.3bn), although the pace slowed from the previous week (JPY376bn). Their fixed income investment was mixed, purchasing long-term Japanese bonds (JPY446bn or $3.9bn) while selling short-term bonds (JPY586bn or $5.1bn)." - source Nomura

This could have serious implications should this trend continue. It represents not only a headwind for immediate further compression on US Treasuries yield, but, as well, it is adding pressure on the US dollar and could as well generate, contrary to what is expected by many, a rebound in the Euro in short order.
Furthermore, when rates move up, while it can be even more supportive for Euro High Yield, it represents a significant headwind for already expensive European Investment Grade thanks to the convexity factor credit wise. In conjunction with rising inflation, it is in short a bad recipe. This is clearly explained by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 1st of February entitled "When rates move up":

"Rising rates are supportive for high yield credit

Fixed income investors embrace higher yielding (with same quality/rating) instruments when rates decline. This has been the case over the past decade as flows into high grade funds were accelerating vs flows into govies. We find that there is a strong correlation between the rates trajectory vs. the flows differential between high-grade and government bond funds. We also find that flows tend to exhibit a “barbelling” trend, when rates advance, and vice-versa. Amid a rising rates backdrop, we see that the balance of flows in the fixed income market will likely favour high yield and govies more than flows into high grade funds.
High yield credit tends to beta-outperform its high grade counterpart in a rising rates environment. We prefer to be long European high yield via synthetics more than via cash bonds, post the recent underperformance of Crossover.

Rising peripheral risks are under-priced in credit

European credit spreads have always been well correlated to peripheral risks (chart 1). The recent move higher in BTPs vs Bunds has not been unprecedented; it has been experienced before the PSPP-era, but also briefly in late November 2016. The common ground in both cases was that credit spreads were a lot wider. Even compared to last November levels, credit spreads were ~10bp wider, when Italian 10y yields were at the wides vs Germany. We feel that the move in rates is under-priced in credit spreads at these levels. This is also taking place as Greek government bond yields are rising again over the past couple of days.

Rising rates and credit performance

The world economy is in sync mode. Global QE across the Fed, ECB, BoJ and BoE, have resulted in a well synchronised rebound in economic data. Surprise indicators are also pointing to the strongest rebound globally. The reflation trade is strong across Europe and US with rates moving higher. The global QE is reaching “peak strength” this quarter. However, the reflation knock on effect is ultimately negative for credit, according to our analysis. Credit spreads tend to react negatively in periods of rising inflation. Fund flows are also pointing to the downside, as higher rates hit high-grade fund flows more than flows into government bond funds and high-yield debt. Barbelling your portfolio in risk-terms can be the solution. High yield credit tends to beta-outperform its high grade counterpart.

Can a policy mistake be the driver of a trend shift?

Inflation is picking up; but unfortunately it is not the core inflation trajectory that is trending higher. Headline inflation is picking up over the past months on the back of higher commodity, and more importantly oil prices. As our economics team has been highlighting this is the “bad” inflation that is decoupling and surprising to the upside. Low and sticky nominal wage growth means that purchasing of consumers suffers again very soon; and populism continues to rise. 

The recent ECB meeting highlights the discrepancy between a very dovish message and a hawkish monetary policy (QE tapering from April), we think. Should headline inflation keep trending higher on the back of higher energy prices; we see higher risks of another policy mistake.

The credit market has historically been very well correlated to inflation trends.
• In chart 7, we find that the year-on-year changes in core inflation across Eurozone countries and the year-on-year changes in iTraxx Main non-fins 5y spreads are well synchronized. This has been the case especially in the period since the GFC were the central banks started unleashing their quantitative easing programmes.

• The same stands for headline inflation trends. However, should one look at the trend of headline inflation, there is a clear decoupling over the past year from that of credit spreads (chart 8).

 

It is notable that the credit market is still focusing on core rather than headline inflation. But at current levels, we fear that a policy mistake, like the one of the forthcoming April tapering decision, will ultimately be negatively received by credit investors.

Credit is mispricing the current headline inflation pick up

Chart 8 is depicting the decoupling between inflation and credit spreads trajectories.

To normalise these moves we employ a z-score analysis, presented in chart 9.

We find that the current “richness” of credit spreads trend vs. that of headline inflation is the highest it has been in almost a decade.

Looking back in times when this dislocation - between credit spreads and HICP - has been that strong, we find that the future credit market performance was not that positive. The previous peaks in “richness” have been in October-07, March-10 and March-11, as per chart 10. Remember that subsequently post reaching these peaks, credit spreads have always moved wider over the following months.

Downside risks on credit flows as rates move higher

The forthcoming “peak” of the QE positive backdrop is not our only source of concern. Fund flows into high-grade funds are negatively impacted amid a rising rates environment too. In our analysis we find that the higher the yield one can source from the government bond market - deemed as “risk free” - the lower the need to hunt for “quality yield” via the IG credit market.

We compare cumulative flows trends in high-grade and government bond funds vs. the level of “risk-free” rates. For the fund flows we use EPFR data as per our weekly Follow the Flow publication, and we use the 5y bunds generic yield to track the trends in the European rates market.

Historical evidence shows that:

• Fixed income investors embrace higher yielding (with same quality/rating) instruments when rates decline. This has been the case over the past decade according to our analysis (chart 11).

Note that there is a strong leading indication (6 months) of the rates trajectory vs. the flows differential between high-grade and government bond funds (in relative terms, % of AUM).

• There is a critical level in the rates market that prompts a shift into “quality yield” (i.e. high-grade credit) we think. This force kicks in when 5y bunds dip below the 1% handle (chart 12) it seems.

At the end of 2011, at the heights of the sovereign crisis, the lack of yield in the “risk-free” market (i.e. bunds) and the subsequent OMT moment, six months later, prompted a strong reach for “quality yield” and inflows accelerated into IG bond funds. We are still far from that level, but the trend is clear from here.

The solution to higher rates = barbell your portfolio

In 2016 we saw the lowest in yields and spreads. We doubt that we will see these levels again, especially post the recent strengthening of economic data across the globe. We expect that as rates will continue higher from here in the years to come (more in the latest Global Rates weekly) this will have a strong effect on flows across fixed income pockets. We think that flows  into govies and HY credit funds will fare better than flows into high-grade ones." - source Bank of America Merrill Lynch.

While both the Fed and the ECB might continue with their Sokal hoaxes, it appears to us that the recent shift from investors towards shorter duration is clearly a manifestation of a defensive stance, which could be further validated by the weakness in the support from overseas investors such as Japanese investors. Where we slightly disagree with Bank of America Merrill Lynch's take is that, if indeed there is some short term correction in equities, it is hard for us to expect that a move wider in European High Yield could be avoided thanks to its inherent strong correlation to stock movements. Though, from a convexity perspective, High Yield should be less immune than Investment Grade with rising sovereign yields, should equities remain stable in the coming weeks.

As a reminder from our August 2013 conversation "Alive and Kicking":

"Moving on to the subject of convexity and bonds, how does one go in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":

"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

The downside protection offered by the CDS market as well as the better liquidity provided by the CDS market can indeed mitigate the damages.

Nota bene: Liquidity in the CDS market tends to be greatest at the 5 year point, making the 5 year single name CDS contract a more viable alternative than other CDS maturities.

Conclusion:

With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger... " - source Macronomics, August 2013

Therefore you now understand why Bank of America Merrill Lynch prefer to be long European high yield via synthetics more than via cash bonds, post the recent underperformance of Itraxx Crossover. We totally agree on this and it makes perfect sense.

Finally for our final chart, rising populism has gone hand in hand with protectionism (that 30s feeling we talked about...) hence renewed inflows into the "barbaric relic" aka gold which, we hinted, we had been adding since late December.

• Final charts - Deglobalize me

In numerous convcrsations we have mused around the rise of populism in conjunction with protectionism, which represents clearly a negative headwind for global trade and is therefore bullish gold. The rhetoric of the new US administration has gathered steam and there are already mounting pressure to that effect. Our final charts come from Bank of America Merrill Lynch from their European Credit Strategist note from the 2nd of February and entitled "Unwinding globalization". The first chart displays the eerie calm in the VIX index while gold inflows have been surging. The second chart shows the growing theme of protectionism in Developed Markets (DM):

"Unwinding Globalization

Protectionism has been the buzzword over the last few weeks, and much of the narrative has been emanating from the US. Since President Trump’s inauguration, executive orders have been signed to repeal free trade deals and to temporarily restrict certain forms of US immigration. Add to this the growing comments from the Republican administration around foreign countries’ weak currencies, and perhaps the post-Lehman vision of globalization has never felt more challenged. And as the rest of the world looks on, the risk of retaliatory protectionist rhetoric – or actions – grows.

While stocks and corporate bonds have rallied year-to-date, we see a very “incongruous” kind of calm in the markets at present. Note, that while equity volatility is still hovering around record lows, inflows into gold funds year-to-date in Europe have surged (chart 1).

In reality, the trends of protectionism – or “deglobalization” – have been bubbling for a while. Plenty of protectionist measures have in fact been put in place by countries around the world in the aftermath of the Global Financial Crisis – albeit ones not as dramatic as directly repealing free trade agreements. Rather than just tariffs and trade defense measures, governments appear to have become more imaginative in avoiding WTO disciplines. And over the last few years, more overt trade spats and protectionism have been seen (such as the EU’s and China’s issue over solar panels in 2013).

Chart 2 shows the countries that have implemented the most protectionist measures since 2005. Note that the US and the EU head the list. Moreover, the WTO’s trade monitor from June last year highlighted that for the 2015-2016 reporting period, trade restrictive measures had jumped to the highest monthly average on record.

Yet protectionism, in our view, is inherently inflationary in nature. As Chart 3 shows, just as globalization is being challenged by leaders, the world is more “connected” than ever at present.

Corporate supply chains have branched out across the globe over the last 10 years. And free movement of goods, services and labour have been an additional boon for corporate profit margins.

But if protectionism cuts back the tentacles of global supply chains – be it through higher tariffs, border checks or restricting worker migration – then corporates stand to be made less efficient via a rising cost base. Thus to preserve corporate margins, output prices will need to rise…" - source Bank of America Merrill Lynch

So, all in all, regardless of the Sokal monthly hoaxes from our central bankers, can you spell "stagflation"? Because we certainly can...

"Truth emerges more readily from error than from confusion." -  Francis Bacon

Stay tuned!

Macro and Credit - The Great Wall of China hoax

"The secret of life is honesty and fair dealing. If you can fake that, you've got it made." -  Groucho Marx

Looking at the Chinese currency falling against "Mack the Knife" aka King Dollar + positive real US interest rates, moving in sympathy with Bitcoin sailing through the 1000 threshold, with 2016 closing on arguably the epic failure of Mainstream Media (MSM) being the most prominent feature as pointed recently by Ray Dalio from Bridgewater Associates, we reminded ourselves for our title analogy of the Great Wall of China hoax faked newspaper story concocted on June 25, 1899 by four reporters in Denver, Colorado about bids by American businesses on a contract to demolish the Great Wall of China and construct a road in its place. The story was reprinted by a number of newspapers. We found it interesting that this hoax was created at the height of imperialism during late 19th Century when Great Britain obtained its 99 year lease for the New Territories, extending the Hong-Kong colony that had been ceded in 1841 while Germany seized the Chinese port of Kiaochow and used it as a military base, and French leased Kouang-Tchéou-Wan from China. Of course, this hoax coming at the very height of imperialism is reminiscent of our October 2016 musing "Empire Days" in which we pointed out that the "status quo" was failing:

"It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "status quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us." - source Macronomics, October 2016

The hoax began with four Denver newspaper reporters, Al Stevens, Jack Tournay, John Lewis and Hal Wilshire, who represented the four Denver newspapers - the Post, the Republican, the Times and the Rocky Mountain News. met by chance at Denver Union Station where each were waiting in hopes of spotting someone of prominence who could become a subject for a news story. Seeing no celebrities and frustrated with no story in sight and deadlines due, Stevens remarked: 

"I don't know what you guys are going to do, but I'm going to fake it. It won't hurt anybody, so what the Devil." 

The other three men agreed to concoct a story and walked on 17th Street toward the Oxford Hotel to discuss possible ideas and came up with a story in which the Chinese planned to demolish the Great Wall, constructing a road in its place, and were taking bids from American companies for the project. Chicago engineer Frank C. Lewis was bidding for the job. The story described a group of engineers in a Denver stopover on their way to China. That's how the hoax began and spread like wildfire, even making a comeback in 1939 as an urban legend due to Denver songwriter Harry Lee Wilber claiming in a magazine article that the 1899 hoax had ignited the Boxer rebellion of 1900. The cultural historian Carlos Rojas comments that the original hoax being perpetuated by a second hoax, a "metahoax," illustrates the ability of the Great Wall to "mean radically different things in different contexts."

By now, you are probably asking yourselves where are we going with our analogy? Have we already lost the plot early on in 2017? Recent geopolitical events have clearly shown that in some instances MSM like to fake it. This of course can have some unintended consequences leading to a hoax becoming a metahoax as pointed out by Ray Dalio from Bridgewater Associates in his latest missive:

"If you have a society where people can't agree on the basic facts, how do you have a functioning democracy?" Distorted pictures lead us to make bad decisions. In my opinion, if people don't correct such inaccuracies and don't fight against this problem, continued distortions in the media will prevent the public's accurate understanding of what is happening, which will threaten our society's well-being. We in the financial community now openly talk about fake or distorted media being used to manipulate market prices to the harm of many, and similar conversations are taking place in most areas.
This is not just a fringe media problem; it is a mainstream media problem. And while it is widely recognized, there is no discussion underway about how to rectify it." - source Linkedin Pulse, Ray Dalio, Bridgewater Associates

Fake news and fake prices thanks to central banks meddling with interest rates for too long can obviously lead to "unintended political" consequences as we have seen last year. Given 2017, is the 100th anniversary of the Russian revolution, we will not be surprised to see some more "sucker punches" being delivered in various asset classes and issuers (such as what we have seen with French issuer Vinci in 2016, Japanese Toshiba, UK retailer Next as of late). Both the MSM and central bankers are losing their aura, this will have some "unintended consequences" on asset prices rest assured.

Before we go into the nitty gritty of this year's musing, we would like to extend dear readers our best wishes for 2017 and we are looking forward to more discussions and comments. Moving to what we will cover in this conversation, we would like to turn our attention to the impact "Mack the Knife" is going to have on housing demand, and therefore gradually and most probably putting a dent into the much vaunted "Trumpflation" story. While the feel good effect on the year might be lasting some more thanks to better macro data from PMIs overall, it remains to be seen how long hope and complacency will trump reality...

Synopsis:

• Macro and Credit -  Japan as a base case - when low yield assets become nonperforming assets
• Final chart - Chinese credit is currently under-pricing rising risks in CNH

• Macro and Credit -  Japan as a base case - when low yield assets become nonperforming assets

In numerous conversations we have pointed out about our difficulty in embracing the recovery mantra story playing out in the United States thanks to lack of solid evidence in wage growth which would as well confirm the reflation story playing out, in a world awash in debt which, is no doubt weighting on growth prospect. As an illustration of political hope versus economic reality, no offense to ex French Prime Minister Manuel Valls but, his 1.9% GDP growth hypothesis in his just published political program for the presidential run of 2017, where he indicates that he will reduce the budget deficit while increasing public spending by 2.5% is hogwash. It just doesn't add up when public spending is already close to 58% of GDP (we are still laughing about this). No matter how ambitious a political program is, even with the benefit of the doubt, that market pundits seems willing to give, it seems to us that expectations are going to get at some point a reality check in 2017. 

When it comes to fake prices and fake inflationary expectations, Japan comes to our mind given its prolonged monetary easing stance and its consequences, leading to a vicious cycle of low growth where Europe seems to be heading thanks to a similar "japanification" process, and unresolved nonperforming loan issues in large swath of the European banking system. Japan is as well of interest, not only due to poor demographics (as in Italy these days) but also from the perspective of low-yield assets becoming nonperforming. To that instance Japanese real estate is a good illustration of the process as highlighted by Deutsche Bank in their Real estate sector note from the 4th of January entitled "Investment strategy for 2017: time to heed warnings of intellectuals":

"Heading for a world predicted 150 years ago

We believe the election of Donald Trump as US president and the UK's Brexit decision are outcomes of overly successful capitalism instead of heightened populism. These events expose the risks of capitalism that were predicted by Karl Marx, Adam Smith, and other intellectuals in the past. Japan has not recognized the trend changes, and we expect Japan’s real estate market to worsen in 2017.

Karl Marx, Adam Smith, and other intellectuals from the past predicted these risks 150 years ago. Continuing deregulation leading to a world dominated by "survival of the fittest" naturally breeds success for those with capital and intelligence. It fosters dominance by the elite. Capitalism is fundamentally aggressive. Various regulations have been enacted for dampening this aspect of it. However, continuous deregulation has created a "winner takes all" world and expanded disparities between rich and poor.
Several intellectuals understood the risks of capitalism. For example, Karl Marx warned that "successful capitalism means victory for those with capital and knowledge, and when left unaddressed, creates a society with large disparities and monopolies and leads to higher prices." Adam Smith, known for the "invisible hand," wrote "The Theory of Moral Sentiments" in 1759 prior to the "Wealth of Nations" (1776). In this book, he acknowledged that competition is important, but explained that the spirit of fair play and consideration for others is an essential premise. Even Max Weber, who argued that making money is good, noted that capitalism requires high moral sensitivity in order to succeed.
In Japan, Sontoku (Takanori) Ninomiya famously stated that "economic activity that ignores morality is a crime, and morality that forgets economic activity is nonsense." Japan also had the “Sanpo Yoshi” spirit exemplified by Omi merchants that calls for benefits to the buyer, seller, and local communities together. In other words, risks of capitalism were predicted in both the east and the west.
However, it is getting difficult to find a new frontier beyond extension of the frontier to the middle class through deregulation. Capitalism appears to be reaching its limits in its current form. Natural redistribution (trickle-down theory) has failed, and calls for redistribution are making headway among the middle class. We believe this sentiment is behind the results seen in the election of Trump as US president and the UK's Brexit decision. The world may be entering a chaotic age as it seeks new types of capitalism.
Important elections will take place in Europe in 2017, including legislative elections in the Netherlands in March, presidential votes in France in April and May, legislative elections in France in June, and a general election in Germany in September. Results in Italy's national referendum in December 2016 forced the resignation of Prime Minister Matteo Renzi. We believe people may follow the Italian case in quite a few countries and expect disruptions and crises to pick up momentum worldwide in 2017. 

NIRP transforms low-yielding properties into non-performing assets

We believe that lowering nominal interest rates via the NIRP (negative interest rate policy) weakens the financial intermediary function and leads the Japanese economy to deflation. As a result of the prolonged monetary easing in Japan, companies have accumulated low-yielding investments, leading the country into a vicious cycle of low growth. We see the risk of low-yielding assets becoming non-performing and triggering a significant setback to the NAV in Japan during 2017 in light of the approaching limits to monetary easing amid increased uncertainty in global political and economic conditions.

String of failures

Measures such as monetary easing that exceeded market expectations, a consumption tax hike amid a recovering economy to spur fiscal structural reform, and a strong ROE emphasis on shareholders have been adopted by the BoJ, the government, and the private industry, with each of them considered optimal. However, all have contributed to deterioration in Japan's economy and its real estate market. This is a classic example of the proverb, ‘the road to hell is paved with good intentions’. Excessive monetary easing has increased the risk of a surge in real interest rates and deleveraging, an excessive bias towards ROE has led to lower wage growth for general employees and reduced capex, and the consumption tax hike has caused consumer spending to stagnate.

To avoid the extreme ultimate decision

As countries worldwide reconsider their positions due to widened disparities driven by overly successful capitalism, Japan has yet to reflect on this. It remains one step behind, as it moves forward with minor government and deregulatory policies. Japan should realize that it needs to foster stronger ethics and morals and pursue policies that break away from excessive focus on ROE and encourage long-term investment and higher wages for employees. Unless these changes are adopted, we see increasing likelihood that Japan will be faced with the ultimate decision.

Bursting of "quiet bubble" to accelerate in 2017

In 2016, the real estate market started heading towards the end of the “quiet bubble”. We see this move picking up pace in 2017. We see hardly any factors supporting optimism. We determine our target prices for the real estate sector by using a residual income model. We also take NAV into account. Downside risks include: 1) a rise in risk premiums due to a decline in bank lending to the real estate sector; 2) the hasty implementation of a hike in consumption tax and/or income tax, or a decline in government spending due to a rush toward fiscal restructuring; and 3) deepening NIRP amid another monetary easing. Upside risks include: 1) significant salary increases in private sector companies, and 2) consumption tax and income tax cuts as well as large-scale fiscal spending." - source Deutsche Bank

As clearly highlighted by Ray Dalio in his latest missive, playing a hoax for too long, ultimately has unintended consequences and bring about political instability. The impact of globalization have been clearly leading to some political discontent given it has fostered dominance from the elites as highlighted by Deutsche Bank in their note. We touched on the impact of globalization back in February 2015 in our conversation "The Pigou effect" and we indicated Populism was bound to happen as predicted by the maverick Sir James Goldsmith and his 1993 insightful book The Trap which was followed by The Response:

"We also took into interest in the wise but gloomy comments from Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February 2015: 

“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey. “And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian 

This struck a chord with us as it indeed reminded us of Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. 

He violently criticized the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais. 
In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided above): 

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith 

While MSM is still wondering why there is a global rise in populism and why Trump got elected, for us it  fairly is very simple, the social contract between society and the economy has been truly broken. 

So the poor "schmucks" or "deplorables" as some politicians were calling them that were initially sold the "greatness" of "globalization" are now realizing they have been fleeced and obviously they are not happy about it:

U.S. Wage Growth Since 1973* Upper / High Income: +52% Everyone Else: -4.6% 

Distribution of U.S. Household Wealth to the Bottom 90% 

2016: 22% 2005: 30% 2000: 31% 1995: 32% 1985: 37%

Young Americans living w Parents*

2016: 40%2000: 31%1990: 30%1980: 30%1970: 23%1960: 23%1950: 22%

*18-34 yr olds - H/T Lawrence McDonald

This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"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, 22nd of July 2014

Clearly the latest spat between president elect Donald Trump and Ford might be an illustration of the US administration's trying to counter the fundamental aggressiveness of US capitalism that strongly benefited from the Fed's generosity. Put it simply, it might look as an attempt (or a hoax) to favor Main Street against Wall Street. It remains to be seen what the new US administration will set in motion and to paraphrase Groucho Marx, maybe faking is making it after all and the deplorables might have once again been conned, we shall see.

But, moving back to low yields becoming nonperforming, we remain very wary of the destructive trail of "Mack the Knife". 

While we continue to see pressure building up on China and capital outflows, we are eagerly waiting for the 7th of January where we sill the publication of the latest state of Chinese FX reserves. On that subject Bank of America Merrill Lynch in their Asia FX Strategy Watch note from the 4th of January anticipates that China FX reserves have fallen by $25 billion in December:

"We forecast China’s FX reserves to fall by USD 25bn in December to USD 3,027bn. Our forecast is less than the Bloomberg consensus forecast for a fall of USD 42bn to USD 3,010bn in FX reserves.

We estimate an intervention effect of USD -15bn in December, which is less than the USD -40bn reading for November (Chart 1). Onshore FX volume rose from USD 670bn to USD 740bn in December; an increase in onshore FX volumes are associated with a larger estimated intervention effect. Some of that impact on the estimated intervention effect may have been offset by the narrower average CNH-CNY basis of -55bps in December, from -167bps in November, leading to our smaller than consensus forecast decline in China’s FX reserves.

Our estimate of the valuation effect in December is USD -10bn. While the USD continued to strengthen against the EUR, GBP and JPY, the rate of USD appreciation
was less than the previous month.
As China’s FX reserves falls towards the USD 3trn level, we believe officials may act to contain RMB depreciation expectations because:

1. The USD 3trn could be of psychological importance to investors and officials. We show in our year-ahead report that this will ultimately be crossed in 2017, though capital controls are being engaged to sure-up credibility.
2. Capital outflows from China picked up to USD 205bn 3Q 2016, especially through trade credits and the use of CNH.
3. Inflation has maintained its upward trend in 2016, especially according to the PPI measure, raising concerns over FX inflation pass-through.

Indeed, the USD/CNY fixing rate has been notably lower than that implied by the 16:30 closing rate and the basket implied change throughout December 2016. Furthermore, FX purchases by individuals are now under greater scrutiny than before as the annual USD 50,000 limit was reset on 1 January 2017." - source Bank of America Merrill Lynch

On top of the unabated outflows from China thanks to "Mack the Knife", US rate hikes envisaged by the Fed will no doubt have an impact not only on US housing but, on the US economy as a whole as pointed out in Deutsche Bank aforementioned note:

"Are there any adverse impacts from the US rate hike?

We view 2017 as the start of major changes in trends as we mentioned above. The FRB increased the interest rate in December 2016 despite the increased possibility of major changes in global tides. We agree that conditions are healthier in the US than in Japan and Europe, which have adopted negative interest rates. However, the US rate hike may weaken its economy.

We are particularly concerned about auto loans and student loans in the US, which are now at all-time highs, having increased to $1.1tr and $1.3tr, respectively. Home mortgage loans have not recovered to the level before the Lehman collapse but are substantial. We believe that the US rate hike holds the risk of causing a downturn in housing demand.

 (click to enlarge)

We expect the rate hikes to gradually have a negative impact on the US economy and thus force a rate reduction in 2017 rather than further increases in rates. Hence, we believe investors should consider the potential for a shift back to yen appreciation. The risk of the economies in the emerging countries needs to be closely monitored as well. Even if faced with such conditions, the BoJ lacks additional options as it is already approaching limits of monetary easing.

The only possible action by the BoJ is widening negative interests. However, this may further undermine financial intermediation in the economy and accelerate a deflationary trend. We believe widening the negative interest rate would be a critical failure that adversely affects not only the real estate and stock markets but also the entire economy.

We expect a new era of global disruption over the long-term horizon, while we believe it will become apparent in 2017 that the US rate hike will have an adverse effect on the global economy and that Japan will not be able to cope with the impact. The environment for the Japanese real estate market is likely to present even stronger headwinds, in our view." - source Deutsche Bank

Of course, if the reflationary story turns out to be a hoax in a world where growth is stifled by high levels of debt, it will materialize itself at some point in 2017 and one would expect, the bond bears to retrench and yields to resume their downward trajectory during the course of the year. While hope is the ongoing "winning" strategy", at some point reality could reassess itself. On a side note, we have turned slightly positive on gold and gold miners over the course of December.

But moving back to Japan being a case study for monetary experiments, the impact of monetary policies have clearly shown their effect on real estate as pointed out by Deutsche Bank in their long interesting note:

"When expanded low-yield properties become nonperforming assets

As a result of the prolonged monetary easing in Japan, companies have accumulated low-yielding investments, leading the country into a vicious cycle of low growth.

In fact, Mitsubishi Estate's yield on leased properties has slumped from over 9% (FY3/00) to the 5% range, and Sumitomo R&D’s yield has fallen below 5%. A flurry of designation of special economic zones led by deregulation has created incentives for investment in low-yield assets. Low-cost finance also enables it.

Cumulative free cash-flow deficits at Mitsui Fudosan, Mitsubishi Estate, and Sumitomo R&D totaled ¥1.9tr from FY3/00 to FY3/16, due to continuous excessive investments over a long period (free cash flow: operating cash flow -
capex).

As long as the current level of large investments continues, these companies cannot buy back shares or raise dividends significantly because they simply do not have the necessary funds.

Locations that previously did not have offices have suddenly transformed into cutting-edge office districts, further heightening supply. The office stock in Tokyo's 23 wards has increased 1.7x since 1991. Rents, meanwhile, are at all-time lows following repeated ups and downs over economic cycles because of flat demand.

Alongside excessive investment in rental assets, inventory assets have risen sharply and the turnover ratio has dropped to an all-time low. For example, Sumitomo R&D's inventory assets have increased by ¥720bn, from ¥128.3bn in FY3/00 to ¥846.7bn as of end-FY3/16.

Meanwhile, Sumitomo R&D's real estate sales rose modestly from ¥150.5bn in FY3/00 to ¥274.8bn in FY3/16, reducing the turnover rate from 1.17 to 0.32, an all-time low. Similarly, Mitsui Fudosan's turnover ratio dropped to an all-time low of 0.4.

Low-yielding assets have been accumulating in Japan due to the prolonged monetary easing climate. We believe the BoJ's negative interest rate policy, which lowers nominal rates, is worsening the situation, since the policy further undermines the function of financial intermediation and thereby encourages deflation.

Japan, which is approaching the limits of monetary easing, has limited response options and faces significant risk of low-yield assets becoming nonperforming assets if the yield upswing, yen strength, or other factors create headwinds for the economy amid heightened uncertainty in global political and economic conditions in 2017. We believe this implies the possibility of significant erosion in the NAV." - source Deutsche Bank

Clearly the prolonged downturn of the Japanese economy in conjunction with the implementation of Negative Interest Rate Policies (NIRP) have led to excessive investment in rental assets and inventory assets have risen accordingly.

But, for us, the greater distortion coming out from NIRP is the distortion it is creating in terms of "credit allocation". As we pointed out in our conversation "Goodhart's law", back in June 2013, there is "good credit" (infrastructure and productive investments) and "bad credit" (real estate):

"Credit is like cholesterol, there is bad cholesterol that can’t dissolve in the blood (Low-density lipoprotein) and good cholesterol (High-density lipoprotein).

When too much LDL (bad cholesterol) circulates in the blood, it can slowly build up in the inner walls of the arteries that feed the heart and brain. This condition is known as atherosclerosis, and heart attack or stroke can result.

In 2008, we came very close to a global heart failure. The world had a stroke.

But, what led to the bad cholesterol in the first place? Bad credit. So betting on a government making the right choice of allocation with "fiscal stimulus" is wishful thinking, we think.

Government policies favoring housing bubbles have led to mis-allocation of credit (bad cholesterol), like in the US, the UK, Hungary, Ireland and Spain. Bad cholesterol (the "credit stroke) has led to "Balance Sheet Recession" (Japan).
Government policies favoring infrastructure investment is good cholesterol:
One can posit that President Eisenhower when he signed the 1956 bill that authorized the Interstate Highway System in 1956 was of great benefit to the US. In his parting speech of the White House on the 17th of January 1961, he warned about the risk of bad cholesterol (military complex) but that's another story..." - source Macronomics, June 2013

In terms of Japan, there is clearly indication that NIRP is already leading to "bad credit" as per Deutsche Bank's report:

"Excessive monetary easing has increased the risk of a surge in real interest rates and deleveraging, an excessive bias towards ROE has led to lower wage growth for general employees and reduced capex, and the consumption tax hike has caused consumer spending to stagnate.

The first problem is BoJ’s policy. We believe its monetary easing policy has been excessive. We are not negative about monetary easing, but we believe this has started doing more harm than good.

The worst setback has been the decline in demand for non-real estate loans since the adoption of the NIRP, creating tightening rather than easing effects. Recent data actually show a 7.2% increase in loans to the real estate industry versus a slowdown to 1.4% in other areas (Figure 11).

The NIRP has proved dysfunctional in Japan due to record-low loan-deposit ratios (demand for bank loans is low and has moved little in response to lower interest rates). In addition, the NIRP, which lowers nominal interest rates, promotes deflation by weakening financial intermediation. Slowing loan growth to industries other than real estate is evidence of this.

Furthermore, the BoJ has adopted yield-curve controls because the volume of JGB holdings at banks that can be sold to the BoJ has already reached a limit. This has raised the risk of investors pricing in the limitations of monetary easing. We believe this is a problem too.

The BoJ's introduction of measures to control the yield curve amid NIRP promotion of deflation negates any benefits from lower interest rates. Yield-curve controls that prevent yields from declining are contradictory to the NIRP's reduction of the nominal interest rate. We believe this presents a nightmare scenario for the real estate sector.

Put differently, we see expected revenues declining, risk premiums rising, and risk-free rates trending upward. This means the three key determinants for stock prices in the real estate sector should move into a direction that is detrimental for the sector.

Our worst-case risk scenario would be widening of the negative interest rate by the BoJ that prompts banks to impose account management charges on large deposits. We believe this would start triggering further deleveraging.

Many Japanese companies are effectively debt-free and take bank loans mainly to maintain friendly relations with banks. If they are charged management fees for those accounts, we suspect many of them would reduce their deposits as much as possible and work to repay their loans.

Banks would then suffer not only a narrowing lending spread but also a drop in the lending balance. Japan would experience credit contraction (deleveraging), and as a result, slip into deflation again, in our view.

It is also important to consider market risk. The BoJ's massive JGB purchases have lowered JGB liquidity. Therefore, we see the risk of a sudden steep rise in interest rates if some type of shock occurs.

Furthermore, dark clouds are gathering over upbeat lending in the real estate industry because restrictions may be imposed on loans to the industry (as reported by some media sources). In fact, banks’ outstanding loans to the real estate industry have climbed to a record high of 14.8% of total loan value. We believe this already exceeds the acceptable level.

Second culprit is excessive focus on ROE

We believe the second culprit is an excessive focus on ROE. The behavior of Japanese corporations changed considerably after the 1997 financial crisis, and companies have stopped increasing employee compensation even with profit growth.
Since then, their more shareholder-centric stance has resulted in a greater tendency to distribute profits to shareholders rather than use them to boost employee compensation. If we assign 1997 a base value of 100, dividends would now be 500 while employee compensation is still 100.

We believe the domestic demand economy cannot grow without corresponding growth in employee compensation. On the other hand, executive compensation has been increasing. This would be understandable if management generated strong results, but in one case, executive compensation increased by more than ¥200m YoY even when the firm made a loss due to failed M&A and other initiatives. This is the tragedy of Japan copying the negative aspects of a shareholder-centric stance.

Shareholders are not a company's only stakeholders. Other stakeholders include clients, employees, and the society to which the company belongs. Although shareholders can easily cut off their ties by selling their shares, clients and employees are unable to end their relationship so easily. From this point of view, shareholders are not even the most important stakeholders.

We are not suggesting that companies ignore shareholders. Rather, we believe that insufficient attention given to employees and other stakeholders could destabilize a society. This is already happening in other advanced nations. In our opinion, it is a big problem for Japanese companies when managements fail to consider the experiences of other nations as related to its own issues." - source Deutsche Bank

The Japanese story, to some extent is clearly indicative of the challenges faced by the new US administration. This is for us the biggest headwind for the Fed, given it has accentuated through its loose policies the rift between the have and the have not. We have reached the limit of what monetary policies can do and the toxicity it has brought in terms of mis-allocation. It remains to be seen how the new US administration can encourage real wage growth and the latest Ford episode, lack for us an essential part to ensure a real recovery taking place and not a hoax, namely that the new Donald Trump administration needs more than having companies investing "in America", because if the new elected president wants to "make America great again", it certainly needs to learn from the Japanese experience and ensure US companies invest "on Americans" we think.

Deutsche Bank's note also clearly makes some solid points relating to the Japanese tragedy:

"Need to avoid ultimate decision

We see voters worldwide are calling into question the widening disparities caused by capitalism's overwhelming success, as evidenced by Trump's victory in the US presidential election, the UK's decision to exit the EU, and the resignation of Italian Prime Minister Renzi as a result of a national referendum in December.

However, the changing trend poses risks that were predicted long ago by intellectuals like Karl Marx and Adam Smith. Continuing deregulation funnels control to the elites, expanding disparities between rich and poor in a "winner takes all" scenario. Furthermore, it is difficult to find new frontiers because they have already been expanded to the middle class, raising the specter that capitalism in its current form will disappear. Natural redistribution (trickledown theory) has failed, and calls for redistribution are making headway among the middle class.

Even as the “quiet bubbles” approached their demise in 2016 and will likely accelerate in 2017, Japan remains mired in a dilemma. Instead, it seems to be standing still as a laggard, unaware of the growing chaos and crisis and the major changes taking place worldwide.

At this juncture, we believe Japan needs to foster a spirit of fair play that takes into account the interests of all parties and cultivates strong ethics and moral values, stop focusing too much on ROE, and enact policies that encourage long-term investment and higher wages for employees, as were outlined in the writings of Adam Smith, Karl Marx, and other intellectuals in the past. Without these changes, Japan may not be able to avoid the ultimate decision.

Specifically, companies are expanding shareholder returns to boost their share prices and increasing M&A because their own R&D reduces ROE. Innovation cannot be achieved this way. Companies should not refrain from long-term investments. Honda's ASIMO, linear-motor bullet trains, hydrogen engines, carbon fiber, and Japan's other impressive technologies obtained through long-term investment would not have been realized in a world focused on ROE.

We also believe that profits should be fairly allocated to employees, not just to shareholders and executives. Unless this happens, the cycle of "widening disparity → excess savings → low rates and low growth → asset price gains → bubble collapse → monetary easing" will continue unabated. Nevertheless, it seems that this cycle is at its limits.

We see need for tighter regulations, not just deregulation. This is particularly important in the real estate industry. Locations that did not have offices are suddenly being transformed into cutting-edge office districts, further heightening supply as a result of continuous deregulation. Therefore, rents are at all-time lows after repeated ups and downs during economic cycles.

We believe it is possible to achieve strong economic growth by ending sluggish consumption and increasing new products through innovation if Japan stops focusing excessively on ROE, and ends wage-curtailment for ordinary employment and restraints on capital investment. It is also time to halt deregulation and restore strong ethics and morality, along with more measured competition.

We believe the "quiet bubbles" started to collapse in 2016, and expect the downturn to accelerate in 2017. The economy and the real estate market will likely remain sluggish because of inadequate policies being pursued in the public and private sectors. We find almost no factors that support optimism. We believe Japan will likely face an ultimate decision unless the reforms we discussed above are enacted." - source Deutsche Bank

The wise words of Sir James Goldsmith from 1993 we mentioned back in June 2013 in our conversation  "The Pigou effect"  still resonate with the above and the risk for capitalism's demise:

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith

The ongoing rise in populism thanks to globalization and aggressive capitalism, in search of maximizing ROE and shareholders return have had the desired effects in leading towards a surge in populism, it remains to be seen how the new US administration will ensure that the economy serves the US society, or put it simply, make sure Main Street gets its fair share of the pie which has been lacking in recent years thanks to the Fed's bold monetary policies which were a boon to Wall Street.

In similar fashion, China is playing a difficult balancing act in trying to deflate its induced credit bubble while ensuring social stability which is illustrated in our final chart.

• Final chart - Chinese credit is currently under-pricing rising risks in CNH

Our final chart illustrates the complacency between upwards pressure on the Chinese currency thanks to "Mack the Knife" and China credit risk and comes from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 4th of January entitled "Let's get technical". It displays the rise of USD/CNH 3 months ATM (At the Money) volatility versus China exposed names 5 year CDS index:

- source Bank of America Merrill Lynch

If "Mack the Knife" continues its unabated run, it remains to be seen how long China related credit is going to be able to hold the line. When it comes to Great Wall and hoaxes, it remains to be seen if indeed The Great Wall of Mexico will be one after all, but we ramble again...

"This nation is notorious for its ability to make or fake anything cheaply. 'Made-in-China' goods now fill homes around the world. But our giant country has a small problem. We can't manufacture the happiness of our people." - Ai Weiwei, Chinese artist

Stay tuned!