Macro and Credit - The Roots of Coincidence

"Coincidence is God's way of remaining anonymous." -  Albert Einstein

Watching the unabated inflows into Investment Grade funds, the 44th in a row, with pundits reaching for quality yield other quantity (High Yield), hence our "Great Rotation" narrative, when it came to selecting our title analogy we reminded ourselves of the 1972 book "The Roots of Coincidence" by Arthur Koestler. In his introductory book to parapsychology, including extrasensory and psychokinesis, Koestler postulates links between modern physics and their interaction with time and paranormal phenomena. His book was influenced by the work of Carl Jung and the concept of "synchronicity" which on a side note gave the title of the fifth and final studio album of English rock band the Police, the band's most successful release (the album Ghost in the Machine was also inspired by another Koestler's book). In his book, Koestler claims that paranormal events could be explained by theoretical physics. According to him, distinct types of coincidence are linked to serendipity aka "luck". You might be wondering already where we are going with this but we find it rather surreal to read the following essay by the New York Fed entitled "The Low Volatility Puzzle: Are Investors Complacent?" on the 13th of November in which the authors discuss the low volatility conundrum without a single time indicating the reason number one of the low volatility regime, namely their main employer and their buddies in other central banks being the main culprits in price manipulation on a grand scale. Overall this is akin to a circular reference pushed towards paroxysm we think, only for them to come to the conclusion in their paper that maybe central banks are responsible, maybe they are not hence our "Roots of Coincidence reference. No offense to the authors of the above Fed of New-York article but the low volatility regime is not a "paranormal phenomena" and the "Roots of Coincidence" has been the action of the central banks acting in "synchronicity". Whenever you have the S&P falling by 1% it seems you immediately get a Fed board member reassuring investors about the "free put" offered to them. The situation is similar in Europe and even worse in Japan where the Bank of Japan (BOJ) has become shareholder "numero uno" of many Japanese large caps via their ETFs guzzling. Maybe we are indeed not that intelligent and we don't really "get it", but when we read articles such as these, we are starting to question ourselves about the sanity of our central planners but we ramble again...

In this week's conversation, we would like to look at "roots of coincidence" in the ongoing "Goldilocks" given observable market conundrums that makes this current low volatility regime "paranormal" and therefore unsustainable.

Synopsis:

• Macro and Credit - The incidence of  central banks' "coincidences"
• Final chart -  Cracks in the credit narrative - are we there yet?

• Macro and Credit - The incidence of  central banks' "coincidences"

Last week we rebuked the "Minsky" moment in the High Yield market but, we did indicate we were starting to see cracks in the credit narrative thanks to rising dispersion at the issuer level as well as growing negative basis credit index wise. Yet the "roots of coincidence" have solely been based on central banks intervention in "price manipulation" leading to acute financial volatility repression and severe distortions. There is not a single day when there isn't the usual "permabear" pointing out to the severity of the distortion as we wait for that famous "Minsky" moment. To repeat ourselves, in our book, the match that will light the bear market narrative will simply be a significant rise in inflation expectations. We are not there yet. We don't pretend to have extrasensory  powers but we do believe that 2018 could mark the end of Goldilocks and lead to a significant rise in volatility, and we are particularly cautious for the second part of 2018, at least that's what our credit antennas are telling us but we digress. We have continuously been beating the credit drums about switching from quantity (High Yield) towards quality (Investment Grade). We continue to believe that when it comes to credit risk premia when it comes to European High Yield, we think that now there are more risks than rewards (Altice and their SFR woes being a case for caution), particularly when one looks at the flattening of the US Yield curve. Duration wise we'd rather own 5 year US Treasury Notes than an equivalent 5 year European High Yield fund or ETF. Sure, some pundits would probably like to point us towards convexity risk in Investment Grade, at least in the US you have somewhat more of an interest rate buffer than Europe (Veolia latest three year issue at negative yield anyone?). Also we started the year being US Dollar bears, and our contrarian stance has been validated so far regardless of the recent dead cat bounce. We continue to see headwinds for the US dollar even with tax cuts kicking in. This means that we would rather favor EM equities still over US equities in 2018. 

To add more fuel to the "roots of coincidence" relating to the overall complacency in volatility we read with interest Société Générale's take from the Multi Asset Portfolio note from the 28th of November entitled "Be ready for the end of Goldilocks":

"Low volatility and liquidity withdrawal are key concerns

In a goldilocks scenario of low interest rates, abundant liquidity, stable growth and a focus on the “positive” Trump, investors continue to push asset prices, volatility and leverage to historical extremes. Yet, a low volatility carry environment with rather extreme positioning is a dangerous combination, which we recently likened to dancing on the rim of a volcano. 

Volatility remains low across asset classes, on the verge of further monetary policy normalisation

It is true that volatility is relatively expensive for some asset classes, as realised volatility is now lower than implied volatility. But overall, we still observe low volatility across asset classes. With asset prices reaching record high levels, and pushing volatility down, we as investors run the risk of reliving the parable of the boiling frog: the gradual heating is so comfortable that the frog does not perceive the danger and ends up cooked. It seems that markets for now are unwilling or unable to perceive the gathering threats.

We don’t believe that it is sustainable. Additional rate hikes from the Fed over the next two years in order to reach the 2.8% neutral rate should start putting pressure on the VIX, as has been the case historically, with contagion effects across asset classes.

Liquidity withdrawal will be the main story next year – switch from equities to bonds

Growth in both developed and emerging markets will continue to creep gradually higher, with the US setting the tempo but likely reaching a peak sometime during the course of next year. In this context, we expect the main central banks to further reduce the size of their balance sheets. A direct consequence will be liquidity withdrawal from the financial system, which will put upward pressure on sovereign bonds yields, especially at the back end of the curve through some normalisation of abnormally low term premium. We prefer sovereign bonds to equity, especially in the US.

Indeed, the last 50 years have been characterised by the secular downward trend in developed markets sovereign bond yields, exacerbated by the post-crisis waves of QE. The equity space benefited significantly from the lower interest rate environment, which pushed index prices up, and from the add-on from dividends in a recovering economy while investors searched for yield. Low bond yields pushed investors into riskier asset classes to enhance returns.

Going forward, as UST yields normalise, especially at the back end of the curve (we see 10y USTs reaching 2.80% by 3Q18), the competitive advantage of US equities will start to fade.

Positioning is stretched

Another sign of complacency can be found in positioning. Having a closer look at hedge funds’ net positioning across 24 assets, we try to understand throughout the years – in January of each year – the percentage of assets with extreme positioning. We define extreme positioning as a net position level higher or lower than one standard deviation away from the historical average.

The chart on the following page shows that in January 2017, 54% of hedge funds’ net positioning on the pool of assets under review can be considered extreme (currently at 54.2%). The main culprits are: VIX, as being short VIX future volatility has delivered tremendous return since 2016; US 5y, reflecting the anticipation of further Fed hikes and improved fundamentals; crude oil; and copper. The last time positioning was stretched on such a similar share of the assets under review happened to be in January 2007, or a few months before the global financial crisis.

Low correlation within assets can exacerbate a sell off

The low level of correlation within assets is also worrying in our view. For now, as mentioned previously, the goldilocks environment – lukewarm growth and contained inflation expectations – favours the expression of idiosyncratic risks or fundamentals versus big macro drivers. The average cross asset correlation has been on a downward trend, while the average equity correlation is reaching 20%, near its lows.

The low correlation is good as of now, as it brings some diversification benefit within a multi-asset portfolio – for example, the decorrelation between EM and global equity markets observed last quarter persists and partly justifies our 7% allocation within the multi-asset portfolio, alongside the supportive growth, yield and US dollar outlooks. However, it also gives a false sense of security, as the correlation regime can quickly reverse in case of risk-off events in the markets and exacerbate a market sell-off." - source Société Générale

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

As we move towards 2018, the big question on everyone's mind should be the sustainability of the low volatility regime which has been feeding the carry trade and the fuel for the beta game. The "Roots of Coincidence" thanks to our central bankers has led to some markets conundrums as highlighted by Deutsche Bank in their Global Financial Strategy note from the 28th of November entitled "Markets upsets: Rationally explaining five conundrums":

"Five market conundrums

Question 1: Japanese stocks' divergence from our approximation model (US stocks/forex)

90% or more of Japanese stock movements through August were explainable via a multiple regression model using US stock prices and forex. Forex movements could mostly be explained by US interest-rate movements.

Since Japan's 22 October Lower House elections, Japanese stocks including financials have diverged upward from our approximation model (see our 7 November Global Financial Strategy, “Rates declining after Lower House election; share prices remain high”). Japanese stocks fell sharply following the 9 November volatility shock, and by 15 November had returned to near our approximation model (Figures 3).

At that point, we noted that the focus was on whether stocks would revert to the trend implied by our model or diverge again (see our 16 November report, “Back to normal? Japanese equities return to model after volatility shock”). Recently volatility decreased, and stocks have begun to diverge upward from our model again.

Question 2: Ongoing stock rally (rise in P/E due to decline in risk premium)

Japan and US stock prices continue to rise. This reflects the impact of (1) fundamentals, in the form of strong Jul-Sep results announcements, and (2) a rise in P/E amid the Goldilocks market conditions created by low interest rates and USD weakness.

Obviously, share prices are equivalent to EPS x P/E, and the inverse of P/E is earnings yield. As shown in Figures 7, the earnings yield in Japan, the US, and Europe can mostly be explained by the term premium observed in bond-market (the yield premium for long-term bonds due to price fluctuation and illiquidity risk) and the risk neutral rate (average forecast short-term interest rate over the next 10 years).

A one standard deviation decline in term premium causes stock prices to rise 2.5% in the US, 1% in Europe, and 5% in Japan. A one standard deviation increase in forecast short-term rate results in increases of 2%, 2.75%, and 7.8%. The recent decline in term premiums have led to a rise in P/E via a decline in risk-free rate and equity risk premium.

Question 3: Ongoing yield-curve flattening

Flattening European and US yield curves are a source of frustration for investors who had forecast steepening. Fed fund rate hikes amid structurally low interest rate conditions have (1) raised the average forecast short-term rate, but (2) have conversely lowered the term premium (Figure 11).

Dominic Konstam from our Rates Strategy team estimates 2.25% as the fair end-2017 level for 10y yield.

Francis Yared from our Rates Strategy team sees US tax reforms as the main driver over the next 2-3 months. Our base scenario is for the passage of a mid-sized tax cut (increasing the fiscal deficit by $1.5trn) in early 2018. We expect long-term rates to rise due to the above factor and above-trend US economic growth. Matthew Luzetti from our US Economics research team estimates a neutral real short-term rate (neutral for economy) of 0.3% and a neutral real 10-year rate of around 1.5% (Figure 13).

If we assume the Fed achieves its 2% inflation target, this would imply a neutral nominal 10-year rate of around 3.5%, suggesting ample room for long-term rates to rise.

Peter Hooper from our US Economics research team, does not expect the change in Fed Chair to have a significant impact on monetary policy. Chair-designate Powell is likely to be strongly opposed to the Taylor Rule or other limitations on Fed behavior. Powell lacks the specialist economic and monetary policy knowledge of previous Fed Chairs, but has front-line financial and capital market experience. He may also be more receptive to arguments about a structural decline in inflation than Chair Yellen. However, it is unclear whether he would continue to support an approach that combines a regulatory and supervisory response to monetary disequilibrium (excessive risk-taking) and monetary policy to optimize inflation and employment. Also, his biggest point of difference with Yellen is likely his stance on deregulation for largest banks.

Question 4: Ongoing decline in interest-rate and stock-price volatility

As shown in Figure 17, interest rate and stock-price volatility are both at all-time lows.

In Figures 15-16, US interest-rate volatility is approximated using (1) the percentage of MBS held by general investors (other than the Fed or banks), (2) neutral interest rate minus real Fed funds rate, (3) net inflows to bond funds minus net inflow to stock fund, and (4) repo positions on dealers versus debt securities outstanding.

In our view, this model suggests that the fall in interest-rate volatility was led by (1) a decline in general investors' ratio of MBS holdings (they tend to buy volatility to hedge convexity risk), (2) a narrowing gap between the neutral interest rate and real Fed funds rate (which implies the required level of rate hikes; a contraction reduces future interest-rate policy uncertainty), and (3) fund inflows to bond funds (signifying expansion in bond index funds due to a graying population seeking stable income). Conversely, the decline in (4) due to tighter regulation should act to increase volatility.

In the stock market, we think a structural decline in volatility has resulted from (A) an increase in investors adopting a volatility targeting strategy (following volatility trends), (B) an increase in hedge funds and individual investors seeking option premiums and capital gains from selling volatility (shorting VIX or selling various option types) (Figure 19), (C) the shift of capital from active to passive funds (including AI funds), and (D) an increase in minimum variance investing as an alternative to bonds.

While we recognize the structural factors that are depressing volatility, we are also concerned about the risk of a sudden spike. We have noted a historical pattern of moderate volatility decline followed by sudden dramatic increase (normalization) in volatility (Figure 17).

There is possibility of greater volatility amplitude than in the past because of the participation of less-experienced retail investors in addition to traditional volatility selling entities of hedge funds.

Question 5: Ongoing tightening in credit spreads

Since late October, widening corporate bond and CDS credit spreads (Figures 28-29) have been a subject of market debate. This trend has recently receded due to an excess liquidity and investors' search for yield.

The default rate (Figure 30) clearly shows that the corporate credit cycle reversed.

The recovery in energy prices and stiffer competition for bank lending (relaxed lending conditions) are supporting a turnaround in bad corporate loans and credit costs. The SLOOS data released on 6 November showed that banks' lending stance has eased (Figures 33-35).

Nevertheless, corporate debt levels remain high. There are signs in areas such as subprime auto loans, credit-card loans, and CRE (commercial real estate collateral) loans that credit and economic growth may be nearing an end."  -source Deutsche Bank

While financial conditions remain loose as indicated by Deutsche Bank, the hiking path of the Fed is the "Roots of Coincidence" in the start of some tightening of some lending standards. The question in relation to the change of the narrative is how long until the Fed breaks something? We wonder. Also, there is a heightened probability that the Fed finds itself once more behind the curve should renewed inflationary expectations materialize in 2018. It's not only the Fed which is in a bind of its own, the ECB should be worried from the heat coming from Germany and it's not only in real estate...

Credit wise for 2018 low spreads means potential negative excess returns in 2018 at least for European High Yield, making it particularly vulnerable to exogenous factors of the geopolitical type. There is no "Roots of Coincidence" once you reach the lower bound in credit spreads in the "beta" game, yet rising dispersion means better alpha generation from pure active credit players, particularly in the light of rising M&A activity in 2018 and the need to reach for your LBO screener to avoid potential sucker punches in the form of sudden credit spreads blowing out in your face. As we pointed out in our previous conversation, dispersion is indicative of the lateness in the credit cycle and the beta game, and it means, as we posited that active managers should outperform in 2018. This is also indicated by Société Générale in their Credit Strategy Outlook for 2018 published on the 28th of November and entitled "The sword of Damocles unsheathed":

"Markets follow a predictable pattern in the relationship between dispersion (alpha risk) and direction (beta risk) as summed up Table 8 below.

We see dispersion rising in 1H 2018. At the beginning, this dispersion is not likely to drive spreads wider as a whole, but soon the market will go from phase 2 to Phase 3, with higher dispersion pulling spreads as a whole wider too." - source Société Générale.

There is no "Roots of Coincidence" there, dispersion as we posited last week is indicative of credit cracks in the narrative.

For our final chart, one might wonder what would be a better leading indicator to rising problems in credit markets.

• Final chart -  Cracks in the credit narrative - are we there yet?

So you have tightening credit standards for some segments of US consumer credit, while overall financial conditions remain loose, yet rising dispersion in conjunction with negative basis are a sign that some cracks are starting to show up in the credit narrative making many investor pundits wondering what would be a useful indicator for spotting additional problems coming up. Our final chart is from Société Générale Market Wrap-up note from the 27th of November entitled "The one leverage ratio that tells you when spreads will widen" and displays balance sheet leverage figures as an indicator of rising problems in credit markets:

"While focusing on EBITDA is useful, there is a better leading indicator for problems in credit markets – balance sheet leverage figures such as debt/equity or debt/assets. Chart 5 shows the non-financial debt/assets ratio in the US relative to spreads: the average ratio weighted by the market cap of the debt is shown in blue, the median ratio is shown in brown, and US corporate spreads using the Moody’s series are shown in grey.

"The high levels of leverage in 1999 on a weighted average basis preceded the spread widening in 2001-2002. The rise in leverage from 2005-2007 was a warning ahead of the credit sell-off of 2008. Since 2013, balance sheet leverage has been widening and has continued to rise despite the 2015 spread widening (which has now been fully reversed). Credit investors should focus on this leverage ratio when considering how markets will perform in 2018." - source Société Générale

There you go, no offense to the musings of the New-York Fed and their paranormal questioning relative to the low volatility regime issue, the credit mouse trap has been set by our central planners and they are indeed at the "Roots" of the everything has a low volatility "coincidence". We don't need extrasensory and psychokinesis powers to determine the main culprit we think but we are rambling and ranting again it seems...

"The worst possible turn can not be programmed. It is caused by coincidence." -  Friedrich Durrenmatt

Stay tuned !

Macro and Credit - The Ghost of Christmas Past

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

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

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

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

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

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

 - source of the table - Société Générale 

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

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

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

Synopsis:

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

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

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

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

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

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

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

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

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

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

"Futures positioning across asset classes (CFTC data) 

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

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

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

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

 - source Bank of America Merrill Lynch

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

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

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

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

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

 - source Bank of America Merrill Lynch

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

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

• The EM 2016 outlook - its weaker than you think

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 - source LCM, Bloomberg

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

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

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

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

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

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

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

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

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

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

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

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

- source Société Générale

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

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

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

Stay tuned!

Macro and Credit - Assumption of risk

"Between calculated risk and reckless decision-making lies the dividing line between profit and loss." -  Charles Duhigg, American journalist

While watching with interest some additional "sucker punches" being inflicted, such as the one delivered as of late to equities and credit investors alike in Spanish company Abengoa and their  "credit" situation (which we already touched back in August in our conversation "The Battle of Berezina"), given it will be a mess to "restructure" thanks to the web of companies with 24,000 employees and close to €9bn of gross debt, we decided for this week's title analogy to steer towards a "legal" one, being the "Assumption of risk" in the US legal system.

The "Assumption of risk" is a defense in the law of torts (in common law jurisdictions, a civil wrong), which bars or reduces a plaintiff's right to "recovery" against a negligent tortfeasor if the defendant can demonstrate that the plaintiff voluntarily and knowingly assumed the risks at issue inherent to the dangerous activity in which he was participating at the time of his or her injury. 

While it was clear to us and some other pundits since August that the Abengoa "credit situation" entailed significant "downside risk", we wonder if indeed the "Assumption of risk" could not be justified for the "defendant" given there were many "red flags" for Abengoa equity and credit investors alike that they should have noticed at the time, but, yet continued "to believe" in a "happy ending" situation in the "credit" related story. At the time we argued:

"As a reminder on how "convexity" can impact the price movement in credit, we followed with interest the situation of Abengoa SA (ABGSM) the Spanish company involved in the Renewable Energy sector which is particularly exposed to Brazil. S&P Capital IQ has an assumed recovery rate of only 30%. As we told you before, we expect recovery rates in the next downturn to be much lower making the 40% overall recovery rate assumption for senior CDS dubious at best. The price action in the bonds are indeed illustrative of how price movement lower can be larger in our days and ages." - Macronomics - 11th of August 2015.

At the time, we also mused:

"No offense taken on Abengoa liquidity situation given we have heard similar denials before in other circumstances:

"Our liquidity is fine. As a matter of fact, it's better than fine. It's strong." Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

We also made some additional comments following Abengoa's  3rd of August "out of the blue" rights issue of €650mn, or 30% of market value prior to the announcement (market cap on the 4th of August €1,335mn):

"What is of course of interest for us "credit players" versus "equities players" is once again the disconnect between the two markets, particularly given that as indicated by the team behind the Datagrapple blog, when ABGSM announced it had won a €600 million contract for a biomass power station in the UK, the stock surged by a cool 20%, meanwhile the CDS was unmoved and the price closed on the 10th of August at a nice 60% upfront +5% running spread over 5 year.
You can probably decide who is right when it comes to "pricing the risk" but we ramble again as it seems credit players are more wary of a potential "Berezina" for the bondholders while "equities players" seems oblivious to the market signals reflected in the 5 year CDS prices and the fast deteriorating macro picture in the 7th largest economy of the world. "

Given that on the 25th of November, Abengoa's both bonds and equities (B shares down by 70%) were "decimated",  thanks to the company seeking "credit protection", one could argue that indeed it is a case of "Assumption of risk" for the investor "plaintiffs" voluntarily and knowingly assuming the risks. And when it comes to "recovery assumptions", while S&P Capital IQ assumed a recovery value in the region of 30% back in August, today the other part of S&P Capital IQ, CMA, only has an assumed recovery rate of 5%, when the CDS is trading at current levels of around 15%. Here is below the price action in the 2016 bond for Abengoa as displayed by CMA part of S&P Capital IQ:

- source CMA part of S&P Capital IQ

As a reminder, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger. With Abengoa, we have yet another demonstration of "instability" and large standard deviation moves thanks to "positive correlations" induced by central banks and their markets' meddling.

In this week's conversation, we will look again at some additional prospects for 2016 and also why European growth is still anemic thanks to very slow loan growth. and on-going deleveraging of the European banking sector à la Japan. Last week we touched on our preference for European banking credit rather than equities.

Synopsis:

• US versus Europe - both clocks have not been ticking at the same pace thanks to "credit availability"
• Our "top-down" views for 2016
• Final chart - In 2016, which is going to bite first Emerging Markets or "illiquidity" in credit
  
  

• US versus Europe - both clocks have not been ticking at the same pace thanks to credit availability

In this conversation, once again we have decided to focus on the "credit cycle" in order to assess where we stand as we move towards 2016. To do so we will look again at the "Global Credit Channel Clock", as designed by our good friend Cyril Castelli from Rcube Global Asset Management:

Whereas we believe the US will be in the upper left quadrant in 2016, we believe Europe is still in the lower right quadrant. Before we look at the allocation "implications" for 2016 we would like to explain why the difference  in growth between the US and Europe comes from the availability of credit and why the "change in credit" growth matters to trigger higher Aggregate Demand (AD) as per textbook macroeconomics literature.

We have long argued that the United States have been on "fast forward" versus Europe thanks to the different approach taken when it comes to dealing with their banking sector and their "balance sheet" issues. 

As a reminder from our part 2 of our long September conversation "Availability heuristic",  our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity":

"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."

When it comes to the United States versus Europe. Different approaches have meant different results, particularly when it comes to the European banking sector, which will continue its deleveraging process in 2016. No doubt it will be supported once more by the much anticipated next raft of decisions taken by "Le Chiffre" aka Mario Draghi at the helm of the ECB.

This "deleveraging" can clearly been seen in the below chart from Société Générale "In the mood for loans" report from the 20th of November we think. The deleveraging process has much more to go particularly as we have highlighted last week due to the significant amount of Nonperforming loans still "impairing" a lot of European banks' balance sheets as reflected in the levels in Loan-to-deposit ratios between Europe and the United States:

"European loan-to-deposit ratios structurally still on downward trend."

- source Société Générale

This explains our previous comment from our "Le Chiffre" conversation:

"QE on its own is not leading to credit growth, because as we have repeatedly pointed out in our musings, a lot of European banks, particularly in Southern Europe are capital constrained and have bloated balance sheet due to impaired assets." - Macronomics

We also argued in our long September conversation "Availability heuristic" the following:

"The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.
As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think." - source Macronomics

This can be seen in the very slow change in "credit growth" in Europe (1.5% in H1 2014), which does explain largely the "weak growth" observed in Europe and the disintermediation taking place in the banking sector where large corporates and even smaller issuers have been tapping the bond markets instead of obtaining "new loans" from the European banking sector. This is as well clearly illustrated in the Société Générale report quoted above:

- source Société Générale.

European banks are still depending significantly on the ECB for their funding and support compared to the US. The disintermediation in Europe has been more pronounced, but in no way there has there been a significant  corporate sector "releveraging" in Europe compared to the US.  The below chart from the same Société Générale report clearly shows the difference between the European Market and the US market when it comes to sources of financing.

 - Source Société Générale.

Furthermore, because a lot of Southern European banks are still "capital impaired" and have their balance sheets bloated by nonperforming loans, there is still a significant gap in terms of terms and conditions for new loans for Small and Medium Entreprises (SME) between various European countries has shown in the below chart from Société Générale:

- source Société Générale.

The difference of "monetary policies" between the ECB and the Fed is therefore leading us to our second point namely different "allocation" implications.

• Our "top-down" views for 2016

In terms of "allocations" and in the context of the "Global Credit Channel" clock, with a tightening of the lending standards in the US versus somewhat more favorable lending conditions in Europe we think that the growing divergence since mid-2015 of the CDS-cash Bases between Europe and the US are very illustrative of the difference of paths taken as shown by Barclays in their European Credit Strategy note from the 20th of November entitled "CDS-Cash Basis – The Atlantic Disconnect":

"When thinking about the divergence, it makes sense to understand the driver of the CDS-cash basis in each region. In the US, the primary driver of the significant widening of the basis has been the performance of cash, which widened materially from May to October. Similarly, the CDS-cash basis for Europe has dropped also – although from positive to near flat, with cash underperformance again being the key driver. Notably, in a generally widening market, CDS has outperformed cash, which is atypical – CDS usually leads the move wider, with cash trailing. This speaks to the degree of relative weakness in cash.

When it comes to the decreasing basis in Europe and the US and the growing divergence between US and European cash, both are being driven by cash underperformance. We attribute the majority of the observed differences to differing supply and demand dynamics in Europe and the US. How and why has this divergence occurred? In the US, investment grade supply has been high relative to previous years, driven partly by M&A, whereas supply has been more moderate in Europe. In the US, investment grade demand has been weaker, driven by retail outflows this year and a seemingly reduced institutional bid for bonds at low rates. In Europe, for the first half of 2015, there has been a steady ECB QE-induced bid for credit by corporate treasurers and insurance companies alike.

What, if at all, will likely change? For the US, we do not expect supply to increase relative to this year, whereas demand could stabilize if rates go higher. As such, the drivers for US cash weakness could abate. On the European front, we expect a pickup in supply (partly from “reverse Yankee” issuance – US companies issuing in Europe), and on the demand side, we expect the effect from the ECB bid to wane, driven by FRN issuance catering to treasury functions, as well as heightened concerns about idiosyncratic risk in the wake of of Volkswagen and Glencore. This would leave cash technicals in the US and Europe more closely aligned. 

The most obvious conclusion from our analysis is that selling Itraxx Main CDS index and buying its US equivalent CDX IG protection still appears attractive, with the view that Main and IG are likely to diverge even further, although optically it does not look attractive given that Main is already trading inside CDX IG.

One important consideration for this trade is the potential effect of FX moves. Our FX strategists expect the depreciation of the EUR against the USD to continue, with EURUSD trading at 0.95 by year-end 2016. For investors looking to size the trade, one way to take this into account is by selling more iTraxx Main protection than current FX rates imply." - source Barclays

As per last week's conversation, different monetary policies entails divergence in Investment Grade credit between Europe and the US, that simple: 

"This divergence, we think, will continue to play out in credit, from compression and convergence to decompression and divergence. Please find below our illustration on this subject - CDX Investment Grade US versus Itraxx Main Investment Grade Europe (roll adjusted) - data source Bloomberg"

- source Macronomics/Bloomberg 

This "divergence" is leading us to some ideas in terms of "allocation implications", for 2016:

1. We favor US Investment Grade versus European Investment Grade
2. We favor European High Yield versus US High Yield. 
3. We favor European stocks over US stocks
4. In Europe for the banking sector we continue to favor high beta credit versus equities 
5. In the US, we believe you should continue to play a flattening of both the US rates curve as well as the High Yield credit curve (CDX HY index 1 year now up 71 bps in one month...

"Le Chiffre" (aka Mario Draghi) is pushing further into negative territory European government bond yields as well as driving the Euro lower. From a "flow" perspective this is clearly "positive" for US Investment Grade. This will lead more supply in Europe from US corporates (reverse Yankees as per Barclays remarks above as well) and more "yield starving" investors and switching their "Assumption of risk" towards US investment grade. We agree with Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 23rd of October entitled "It’s all about monetary policy":

"Draghi sends more investors our wayOne of the key drivers of our overweight stance on US high grade corporate credit is the outlook for more aggressive global monetary policy easing (see: Strategically overweight US HG credit 02 October 2015), which will have the effects of driving more global investors into the US corporate bond market as well as diverting US supply abroad.

Yesterday ECB President Draghi delivered without actually delivering anything – yet – as he opened up for the possibility of more aggressive monetary policy measures in December, including a rate cut further into negative territory and increased QE.

More negative yielding fixed income assets in Europe (Figures above) and ECB crowding out of private investors, combined with less perceived interest rate risk in the market in the US due to weakening economic data, mean that the global credit investors will find US corporate credit even more attractive." - source Bank of America Merrill Lynch

There are as well some other interesting points made by Bank of America Merrill Lynch, which we agree with from their Global Credit Strategy Year Ahead note entitled "2016 - it's complicated":

" The myth of one credit cycle 

Globally our views across credit markets span a wide spectrum: from the bullish outlook for US high-grade to the bear market that is US high-yield. But we believe that divergence is the norm now in credit, precisely because the fundamental cycles are so disjoint. In US high-yield, corporate leverage is at an all-time high and we expect defaults to rise to around 4% next year. But in US high-grade, we see leverage declining in 2016 after companies releveraged this year ahead of the Fed. And in Europe, paradoxically, we see leverage heading to a record low despite the QE backdrop.

Global weakness => US high grade strength 

Global weakness benefits US credit in two ways. First yield-deprived foreign investors are driven into the US market. Second, global weakness is a drag on US economic growth and that should be considered a good thing for US high grade credit. This is because lower economic growth leads to a much gentler rate hiking cycle and resulting lower risk of destabilizing outflows. 

US high grade the only game in town 

Over the past four years global high grade corporate bond yields have declined about 100bps to current levels just inside 3%. Not only are global corporate yields now incredibly low, but due to global weakness/US strength and resulting divergent monetary policies over the same period of time the US high grade market has grown in relative importance to now account for 75% global corporate yield income, up from 50% in 2011. That means global high grade corporate bond investors have no choice but to embrace the US market, which has led to significant foreign inflows over the past couple of years that accelerated this year. " - source Bank of America Merrill Lynch.

Of course you are going to ask us "what about volatility" given our various iterations around "sucker punches" (large standard deviation moves), rising positive correlations between equities and bonds.  As per the "Global Credit Channel Clock",  we expect "volatility" therefore in 2016 to be "more volatile" as illustrated in Bank of America Merrill Lynch Global Credit Strategy Year Ahead note:

"Vol-of-vol and market implications 

We expect gamma to be a better bid than vega, as investors gradually become more risk averse in a credit market characterised by challenging technicals, deteriorating liquidity and increasing uncertainty around global and most importantly EM growth.
In an era of monetary policy interventions by most major CBs, the vol cycle has changed. In chart 7 we present the measure of Vol-of-Vol; to gauge the volatility of the 1M realised volatility over a period of one month. 

We find that volatility shocks have been rare historically but that their occurrences were detrimental. However, nowadays shocks appear to be more frequent but less damaging." - source Bank of America Merrill Lynch

Where we disagree with their take is that we expect shocks to be not only more frequent but more damaging as illustrated from the "Abengoa" story. We had plenty of "sucker punches" in 2015. We expect more of the same in 2016, particularly given heightened geopolitical tensions, lacklustre earnings growth, rising political risks (Brexit, Portugal, to name a few) and deteriorating overall global financial conditions picture with tightening financial conditions in EM and in the US, except for good old Europe, making it more enticing from a relative value perspective.

This leads us to our final point on our recurring concerns about Emerging Markets and the lack of liquidity in credit, pointed out, as well by many pundits.

• Final chart - In 2016, which is going to bite first Emerging Markets or "illiquidity" in credit

Illiquidity is credit can clearly be seen, at least in Europe from the "dislocation" of the CDS cash bases given CDS has outperformed cash, which is clearly atypical. CDS usually leads the way when it comes to a move wider in spreads., This time around in Europe we have cash trailing.

Our final chart comes from Société Générale Credit Weekly note from the 13th of November entitled "Not as scary as it could be":

"Global credit markets have had a good run since the third week of September, with spreads on European IG, for example, dropping by 72bp from 172bp back to 150bp. European IG has still suffered the biggest percentage widening in spreads this year (while European high yield has seen the smallest widening amongst the major markets), but the performance is better than it was.

Yet several pieces of news this week might worry credit investors in the months ahead. First, European growth is at best tepid, with both France and Germany generating GDP growth of just 0.3% in Q3, and our economists looking for a similar 0.3% number for the eurozone as a whole. Second, commodity prices continued to drop this week, with WTI spot prices reaching their lowest levels since August and LME copper cash prices slithering to $4836 - the lowest level since 2009. This spells further jitters not only for US high yield oil producers (which widened this week) but also for EM corporate bond spreads (which so far have been relatively restrained). 

But perhaps the most worrying news of all this week came from China. Shanshi Cement this week announced that it would not repay RMB2bn of domestic notes, which triggered a cross-default on the offshore bonds. The 2020 issues (which were issued at 99 in March) dropped to a cash price of 65 on the news. The bonds were sold with a letter of support from China National Building Materials, but the documentation specifies that this is not legally enforceable and designed for “comfort only,” but this will be cold comfort to the bond holders. Chinese credit conditions may be tightening, as loan growth in the month to October proved weaker than expected at RMB513.6bn figure (vs consensus of RMB800bn), although the number was depressed by local government debt swap programs.
There are plenty of reasons to worry about emerging market credit in general. In When the EM corporate pain could come, our emerging market strategists highlight the problems facing the EM hard currency corporate markets, which are now twice the size of the EM hard currency sovereign markets. The huge increase in the size of the market has coincided with a sharp increase in balance sheet leverage, which is all the more worrying since the companies in the index have become more cyclical. EM corporate bonds have not widened as much as EM currencies, even when weighting currency baskets by the weights of the EM corporate issuing countries; however redemptions next year could lead to a repricing of the market. This is why in our triannual Fixed Income Portfolio Strategy (Start buying credit but avoid EM), we remain underweight EM corporate bonds and other corporate assets.

Could an EM sell-off drive European credit markets wider? The correlation between the quarterly percentage moves in an EM currency basket and in US corporate spreads since the mid 1990s has been around 50%, so this is a reasonable fear. However, we see a scenario for next year closer to the late 1990s, when EM weakness actually led to inflows into credit.

The impact of emerging market weakness on developed market economies is likely to be one of the most important themes for 2016" - Société Générale.

We have to agree, 2016 should be very interesting as we are running late into the "credit cycle" in the US. Fore sure it ain't going to be "plain sailing", so you better be careful in 2016 dear credit and equities "plaintiffs" in terms of your "Assumption of risk".

"I think there's a difference between a gamble and a calculated risk." - Edmund H. North, American writer

Stay tuned!