Macro and Credit - Hypertonic surroundings

"The advancement and diffusion of knowledge is the only guardian of true liberty." - James Madison

Watching with interest the numerous convolutions in Emerging Markets, with Gold taking the proverbial sucker punches thanks to the bloody rampage of "Mack the Knife" (King Dollar + positive real US interest rates), when it came to selecting our title analogy, we decided to return to a biology one, namely "Hypertonic surroundings" given our global macro reverse osmosis theory we discussed in our conversation "Osmotic pressure" back in August 2013 seems to be playing out for the weakest EM "cells" out there:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

 This is the theory we put forward in terms of biology analogy at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.

We also added in our July 2015 conversation the following: 

"More liquidity = greater economic instability once QE ends for Emerging Markets. If our theory is right and osmosis continues and becomes excessive the cell will eventually burst, in our case defaults for some over-exposed dollar debt corporates and sovereigns alike will spike." - Source Macronomics July 2015.

A good illustration of our "reverse osmosis" and "hypertonic surrounding in our macro theory playing out in true Mack the Knife fashion has been the pain in EM most recently with the usual suspects such as Turkey and Argentina being first in the line of the murderous rampage of "King Dollar". 

Nota bene: Hypertonic

"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia

What we are seeing in true "biological" fashion is indeed tendency for capital outflows to flow out of an Emerging Market country in order to balance the concentration not of solutes, but in terms of "real interest rates" (US vs rest of the world). Animal cells lack rigid cell walls. When they are exposed to hypertonic environments, water rushes out of the cell, and the cell shrinks. The resulting cells are dehydrated and lose most or all physiological functions while in the shriveled state. If cells are returned to isotonic or hypotonic environments, water reenters the cell and normal functioning may be restored. Cells without cell walls (capital controls) can burst when in a hypertonic condition. Too few solutes (US dollars) and the environment will become the hypertonic solution. There goes our reverse osmosis global macro analogy for you.

In this week's conversation, we would like to look at the main reasons for the start of the "unwind" of the carry trade and the pain inflicted to EM macro tourists, namely that Mack the Knife is a consequence of financial conditions tightening for many leveraged global players. 

Synopsis:

• Macro and Credit - The Fed is tightening its financial conditions tourniquet 
• Final charts - So you want to be bearish? Oil-price spikes have preceded most recessions

• Macro and Credit - The Fed is tightening its financial conditions tourniquet 

While every pundits around the financial sphere are pointing the rise of the US dollar as the main reason for the ongoing bloodbath in the EM space, we think that the rise in the greenback is a manifestation, not the main cause of Mack the Knife's rampage. The reality as pointed out by David P. Goldman in Asia Times on the 16th of August is that financial conditions are getting tighter as per his article entitled "It’s all about financial conditions":

"The collapse of the copper price by 20% from its June peak evidently is not an economic phenomenon driven by demand. Rather, it is an expression of risk aversion.

The world has gotten riskier during the past few months, for two primary reasons:

1. There is a low-level trade war between the US and China underway that could turn into a high-level trade war; and
2. The Italian elections put a bunch of unpredictable firebrands in charge of an economy with US$2.3 trillion in foreign debt and a dodgy banking system.

Heightened risk translates into a greater desire to hold cash balances (and that means a higher dollar, because most people pay bills in dollars and therefore hold cash balances in dollars). To get higher cash balances, market participants sell things like raw materials.

Turkey is utterly irrelevant to this shift towards risk aversion. The Turks may make the mistake of thinking that they matter but no-one else should encourage them. Turkey’s whole stock market is worth about US$30 billion at current prices, roughly the market capitalization of Monster Beverage Co. The big issues are European disintegration and Italian dyspepsia, and the US-China trade war." - source David P. Goldman - Asia Times

Because of fears of dollar scarcity, thanks to QT and the Fed turning off gradually the monetary spigot, the commodities rout has been about raising dollar cash/playing defense as indicated by David P. Goldman. As well there are the usual "known unknowns" everyone and their dog have been talking about, namely the risk of trade war escalation and of course the potential brewing internal rift between the European Commission and Italy. It's going to be interesting to say the least to see how Le Chiffre at the helm of the ECB aka Mario Draghi is going to deal with the Italians and their budget which will no doubt necessitate some helping hand in buying their bond issuance. This is what we wrote in our October 2015 Le Chiffre conversation:

"While in the movie Le Chiffre pretty much made a game out of it with nothing on his cards in the first game, in similar fashion Mario Draghi made a game out of it with his "OMT" and "Whatever it takes" July 2012 moment. In the movie it made Bond surmise that Le Chiffre was in desperation to get the money and resorted to bluffing (It was exactly our thought at the time). Le Chiffre and Mario Draghi share the same trait, both are poker prodigies hence our title analogy." - Macronomics, October 2015

 But, hey whatever it takes...as we wrote as well in the same conversation:

"While Le Chiffre has been a prodigious  Poker player when it comes to "bluffing" his way out of the "bond vigilantes" in Europe setting their sights on weaker European government bonds, when it comes to both "credit growth" and "inflation expectations", we think Le Chiffre has indeed been "overplaying" it." - Macronomics, October 2015

So while the US dollar is indeed on everyone's mind when it comes to EM woes and the Turkish side show, still the big European elephant in the room remains Italy. The current Fed normalization process is making Le Chiffre's balancing work even more complicated we think if he intends to remain a "forced" marginal buyer of Italian BTPs with of course Merkel's German consent.

But, moving back to our recurring themes in recent conversations, we discussed rising dispersion and large standard deviation moves. This late cycle phenomenon is attributable we think to liquidity being withdrawn thanks to QT and global financial conditions being tightened. As we saw earlier one the short-vol pigs house of straw blown away, obviously the next levered candidate were the macro-tourist pigs house of sticks such as Turkey and Argentina. 

In our March 2017 conversation entitled "The Endless Summer" we concluded our missive at the time asking ourselves how many hikes it would take before the Fed finally breaks something. As well we commented the following in our February missive "Buckling":

"The difficulty for the Fed in the current environment is the velocity of both the rates rise and inflation, because if indeed the Fed hike rates too quickly then it will trigger some other avalanches down the capital structure (short-vol complex being the equity tranche or first loss piece of the capital structure we think). If inflation and growth rise well above trend, then obviously the Fed will be under tremendous pressure to accelerate its normalization process. It is a very difficult balancing act." - Macronomics, February 2018

The Fed is still relentless on its hiking path, particularly in the light of US CPI coming at 2.9% year-over-year, unchanged from June; the fastest pace in more than six years. As we repeated in numerous conversations, for a bear market to materialize you would need a significant pick-up in inflation for your "buckling" to occur and to lead to a significant repricing of risky asset prices such as equities and US High Yield. In recent conversation "Bracket creep", which describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation, we indicated that with declining productivity and quality with wages pressure building up, this could mean companies, in order to maintain their profit margins would need to increase their prices. To repeat ourselves "Protectionism", in our view, is inherently inflationary in nature. At some point there might be a confrontation between the Trump administration and the Fed we think.

A clear sign of financials conditions tightening we think has been the unwind of the EM carry trade to the benefit of our friend "Mack the Knife" aka the US dollar. This is clearly indicated by Bank of America Merrill Lynch in their Liquid Insight note from the 16th of August entitled USD in the FX carry driver's seat:

• "USD has been a top yielder in G10; a fundamentally-strong USD with asset status supports FX carry and further dollar gains
• USD on the asset side and SEK on the funding side has upended correlations; FX carry beta risk is low and investors own vol
• After the momentum surge in February-April, FX carry looks poised for another leg higher; will AUD & NZD stand in the way?

The shifting dynamics of FX carry

The US dollar resides firmly on the asset side of the FX carry spectrum, currently occupying the top yield rank (Chart of the day).

Its presence atop the yield ranking is historically atypical and a reflection of a robust US economic cycle and a steadily hiking Fed, attributes that have supported USD higher since 1Q18. USD asset status alongside SEK liability status (displacing JPY) has also sharply shifted historical FX carry correlations, resulting in long carry positions now having very low traditional “beta” (risk-on/risk-off) exposure as well as long exposure to implied volatility. FX carry investors now actually get paid to own tail risk in a robust economic cycle, which has traditionally supported carry returns. These are important shifts that enhance the attractiveness of both FX carry as an investment approach in an uncertain world as well as support the USD as principal currency beneficiary. After a strong surge in momentum through mid-April, event analysis suggests FX carry is poised to make another run higher in the weeks ahead. Of key importance will be whether recent sharp depreciation in AUD and NZD – the two other asset currencies aside from USD – moderates.

FX carry revisited

Traditional FX carry strategies involve going long currencies offering the highest yields, funded in currencies offering the lowest yields. The number of currencies on respective asset and funding sides can vary but often is symmetrically three (particularly in G10). For the sake of simplicity, our analysis uses Bloomberg’s G10 FX carry index, which uses a simple top three/bottom three construction and, in our view, is representative of the approach used by many FX carry-themed investors.

The general historical pattern of FX carry positions should be unsurprising to those familiar with the strategy. On average, since 2000, the highest ranking carry currencies have been NZD, AUD and NOK, in that order. The lowest ranking carry currencies have been CHF, DKK and JPY. Historically, USD, EUR, GBP and CAD have been positioned somewhere in the middle.

The carry spectrum today: What’s wrong with this picture?

Chart 1 shows the current FX carry spectrum based on implied three-month yield. A simple top three/bottom three FX carry strategy would currently be long USD (2.32% yield ), NZD (2.31%) and AUD (2.19%), funded in CHF (-0.80%), DKK (-0.59%) and SEK (-0.49%).

The position of USD on the asset side of G10 FX carry clearly represents a major departure from the past (Chart 2).

Moreover, its position at number one represents a full five rank positions above the historical average (about number 6). This is by far the greatest discrepancy with respect to current FX yield rank vs historical average across G10.

Additional anomalies worth highlighting are SEK, currently squarely on the funding side and two positions below its historical average; and JPY, now approaching middle-of-the pack status and two positions above its historical average (no longer a funder). Nonstandard monetary policy measures and forward guidance put in place by the ECB are responsible for low European yields, in particular that of SEK. Indeed, the Riksbank responded with aggressive measures of its own aimed at preventing unwanted exchange-rate appreciation, the practical result being relegation of SEK to the FX funding bin. Negative funding yields have clearly enhanced the spread of high yielders.

Factors affecting carry performance

FX carry has traditionally been a risk-on and implicitly short volatility strategy, essentially a reflection of relative yield providing compensation for relative perceived risk (Chart 3).

High yield also provides an incentive to fund external deficit currencies, often on the asset side of an FX carry strategy historically. Conversely, low (currently  negatively) yielding funding currencies usually exhibit safe-haven status, often due to external surpluses and correspondingly high international investment positions (IIPs). FX carry investors earn a positive return in one of two ways: (1) exchange rates remain stable or decline by less than the yield spread between the asset and funding currencies; or (2) asset currencies increase in value relative to funding currencies, hence producing capital appreciation additive to the positive carry differential. The latter scenario is the ideal one for carry seekers. FX carry investors lose money (ie, experience negative total return) when depreciation in asset currencies vs funding currencies exceeds the positive carry earned. Losses have been severe at times, as was the case during the Global Financial Crisis (GFC), when financial markets convulsed and global growth dove into recession.

Investors are likely aware that FX (forward) markets are priced such that the expected rate of depreciation in high yielding currencies relative to low yielding ones equals the positive carry earned (interest rate parity), meaning long carry investors implicitly think the FX market is incorrectly priced (generally too ‘pessimistic’). This is a key reason why FX carry traditionally suffers when risk tolerance takes a dive. With global risk appetite heavily influenced by global growth (Chart 4), FX carry performs well in periods of cyclical strength.

This makes tepid performance of the strategy all the more perplexing, particularly considering strength of the US cycle, particularly this year.

Carry momentum to re-assert

FX carry experienced a surge in momentum back in mid-April. After a protracted four month consolidation period, history suggests another leg higher in the weeks ahead. Back on 13 April, the 50-day information ratio of FX carry returns rose above 4.0, a two standard deviation event indicative of a significantly high level of carry momentum (Chart 5).

Readings of this magnitude have only happened 19 times since 2000. Of those 19 instances, 17 were higher after 100 trading days for an average total return of about 3% (vs currently only about 1% after day 87) (Chart 6).

Within this sample, 26 November 2012, stands out as having strikingly similar price action to today. This instance is 70% correlated over the last 60 trading days and 80% correlated over the last 20 trading days and suggests an impending 4% surge higher in the FX carry index to peak levels over the next few weeks. 

Carry caveat: will the antipodeans cease plummeting?

We believe USD will contribute to another leg higher in FX carry for fundamental reasons (strong cyclical position, monetary policy divergence). Our confidence in AUD and NZD – the other two currencies currently on the asset side of the strategy – is lower. Recent sharp slides in the antipodeans have been amplified by elevated global trade war, China and EM-related uncertainty. At a minimum, the pace of depreciation needs to moderate. So far, our LCBF flow data, which show four-week flows recently crossing into negative territory, for now do not support potential cessation of selling pressure. That said, speculative positioning as measured by CFTC and other data sources is very short AUD and NZD, potentially helping to contain a continued downside slide.

Note that in the recent February-April FX carry upswing, AUD and NZD trended moderately lower. But because of sharp USD strength and SEK weakness the strategy produced strong positive returns anyway. Resumption of AUD and NZD strength against SEK would clearly bode well for the FX carry strategy looking forward.

On a relative basis, our views are constructive AUD vs NZD (Greater AU and NZ divergence 15 Aug 2018). Of the three currencies currently included on the asset side of FX carry, NZD is clearly the weak fundamental link" - source Bank of America Merrill Lynch

There you go, if the USD is on a rampage, not only do we have rising dispersion among asset classes such as credit and equities but, now there is indeed a "hypertonic surrounding" situation when it comes to the swelling US dollar carry. This of course is the manifestation rest assured of QT hence the reason for the commodities bloodbath with many players busy raising their USD cash levels for protective measure.

While in our previous conversation we indicated we remained short term "Keynesian" and starting to become "Austrian" from a medium perspective, there is no doubt in our mind that there are clouds lining up on the horizon that warrants close attention. For instance from a "flow" perspective the latest Follow The Flow note from Bank of America Merrill Lynch from the 17th of August is aptly entitled "Nowhere to hide":

"Outflows from IG, HY, govies, EM and equities

It seems that investors have nowhere to hide. Almost all the asset classes we follow recorded outflows last week. We saw outflows from IG, HY, Govies and EM debt. Same in equities and even in money market funds. Higher risk assets volatility, EM FX sell offs, trade wars and Italian political risks have instigated a risk off trend in flows across risk assets. Will risk aversion abate any time soon? Should the aforementioned risks not disappear, we struggle to see a structural shift in flows back to Europe especially amid dollar strength and global interest rate differentials.

Over the past week…

High grade funds flows dipped further into negative territory. Further euro weakness (vs. the dollar) has pushed more outflows out of euro funds over the past week. High yield funds were hit again by outflows, erasing the inflows we have seen over the previous two weeks. Looking into the domicile breakdown, Global and European-focused funds have recorded outflows while US-focused funds recorded inflows.

Government bond funds recorded a strong outflow over the past week; almost reversing the inflow we saw a week ago. All in all, Fixed Income funds recorded a sizable outflow; the largest in eight weeks and the first after three consecutive weeks of inflows.

European equity funds recorded outflows for the 23rd consecutive week. $55bn has left the asset class over that period.

Global EM debt funds recorded another outflow last week, amid a rapidly weakening
trend in EM FX land. Commodity funds recorded a small inflow.

On the duration front, there were outflows across all parts of the curve. It feels that outflows were more sizable on the back-end of the curve." - source Bank of America Merrill Lynch

No wonder, the winner take all mentality is taking its toll flow wise and the US powering ahead in true "Dissymmetry of lift" fashion. But good news might indeed be history as we move towards the fall. While we recently wondered about MDGA (Making Duration Great Again) from an exposure point of view, we think that it is the time to reduce some risk and starting playing defense we think. On that specific point we read with interest Bank of America Merrill Lynch's take in their Securitization Weekly Overview from the 17th of August entitled "Risk off stew: QT, rate hikes, refi's dead, declining breakevens, expensive housing":

"Risk off stew: QT, rate hikes, refi’s dead, declining breakevens, expensive housing

Risk off signals are escalating. In our view, the only positive note this week was the trade war news that China will send a delegation to the US to try to resolve differences. We’re doubtful that a meaningful “fix” to a situation that has been brewing at least since China’s entry into the WTO in 2001 will be reached, but we’ll see. The Shanghai Composite closed the week at 2669, the lowest level in over two years, so market skepticism about trade war resolution appears intact. Meanwhile, the list of negatives for markets, away from trade, is getting longer, creating a risk off stew in our opinion.

QT has been accelerating: the Fed’s balance sheet is now down by $219 billion in 2018 and the 4-week rolling change of $64 billion is by far the largest decline in a 4-week period since the unwind started. 10 years after the crisis led to dramatic expansion of the Fed’s balance sheet, the unwind is picking up steam; we look for another $175-$200 billion by YE 2018. On top of that, another rate hike in September seems fairly certain, consistent with our Economist’s views. Jackson Hole or the upcoming Fed minutes seem unlikely to offer any meaningful change from the Fed’s somewhat autopilot policy tightening plans. But these events will be worth watching, as a dovish shift could alter the risk off conditions.

Another negative is recent declines in the 10-year breakeven inflation rate, which has dropped down to 2.08%. While the breakeven rate has stabilized above 2.0% in 2018, the Fed’s continued policy tightening may well challenge that stability. BofAML technical strategist Paul Ciana is now highlighting that the 10y breakeven rate is at risk of a bearish breakdown to 1.91%-1.98% in the months ahead. Based on our breakeven inflation valuation framework for securitized products, this would be consistent with our view that spread widening risk now dominates for the sector. In mortgages and housing, things are not great either. The MBA Refinancing index dropped to an 18-year low this week. Long gone are the days that increased refinancing activity provided a savings stimulus to the household sector. Instead, declining refinancing activity is consistent with policy tightening from the Fed. Meanwhile, the latest UMich consumer sentiment reading reported “home buying conditions were viewed less favorably in early August than any time since August 2006.” This is consistent with the recent sharp drop in the MBA purchase index and is even more negative than the affordability index, which is back to 2008 levels, would suggest; given the changes in mortgage credit availability since the pre-crisis era, affordability is probably more constrained than the nominal time series suggests.

As we noted in “Soft housing data piling up: prepare for risk-off,” the mortgage/housing market could use a 10Y rally back to the 2.25%-2.50% range over the near term. If the trade war and Fed remain on their recent, market-unfriendly paths, the chances seem increasingly good that a sharp risk off rally in bonds is coming, as is more pronounced spread widening in securitized products. We’ll watch for change in the coming weeks, but, in our view, now is the time to become more defensive. We doubt either the Fed or China will meaningfully change course without more pronounced market turmoil as motivation. Most likely, spread widening in securitized products has only just begun."  - source Bank of America Merrill Lynch

From a contrarian perspective, two things stand out, not only the consensus short US Treasury Notes is stretched but if indeed we are starting to see a fall in breakevens, there could be a potential for a rebound in gold which has been relentlessly impacted by the surge of "Mack The Knife" though one could argue that given the momentum in USD FX carry, it might be still difficult to time your entry. 

In their notes Bank of America Merrill Lynch highlights the different factors pleading for a more cautious stance in the weeks ahead of us:

"This week, we survey a number of factors that argue in favor of a more pronounced risk off phase for markets in the period ahead. We began warning of this phase back on July 27 in “Soft housing data piling up: prepare for risk-off.” This week provided a hint of what we think is in store for markets in the next 2-3 months. In our view, spread widening risk in securitized products now dominates. We think defensive positioning is warranted.

Two factors could change this: a sudden change in tone from China on the trade war and the Fed on tightening policy. We think more downside in markets is likely need to create such changes, but we will watch in the weeks ahead, particularly in the upcoming Fed minutes and Jackson Hole, for signs of a shift.

Factor 1: the trade war

The simple trade war gauge we have been watching is the Shanghai Composite index. While it is heading lower, we see risk that weakness in China spills over and increases global recession risk, which will be reflected in wider credit spreads. Chart 1 shows the index closing this week at the lowest level since 2016, down 25% since the January high.

Chart 2 shows the index inverted against the IG corporate index spread. Our point with this chart is that at least some of the trade-related weakness in China is spilling over to the US.

As we write, there is a report of a possible high-level US-China trade summit in the months ahead. While this is positive news, it is a long way from resolving a host of issues that date back at least to 2001, when China entered the WTO. More downside pain in markets may be necessary to lead to true resolution.

Factor 2: the Fed balance sheet and rate hikes

It’s almost 10 years since the financial crisis led the Fed on a path of significant balance sheet expansion. 2018 has seen the start to the unwind (Chart 3): down $219 billion YTD in 2018, with the last 4 weeks seeing a drop of $63 billion.

The unwind is accelerating, as the balance sheet should see another $175-$200 billion decline by YE 2018. On top of this, the Fed maintains ambitious rate hike plans relative to the market (Chart 4).

The upcoming minutes release and Jackson Hole meeting provide opportunities for the Fed to offer new views on policy. Our rates and economics colleagues Mark Cabana and Joe Song suggest the Fed will provide “updated guidance on the longer-run operating framework, which will have implications for a potential end date to the balance sheet unwind.” See “The week in fedspeak,” 17 August 2018. Whether this will be enough to signal a meaningful shift in tightening plans remains to be seen. For now, as with trade, we’re skeptical.

Factor 3: breakeven inflation rates are declining once again

The combination of trade war and tightening policy has reversed the rise in the 10yr breakeven inflation rate (Chart 5).

We’ve seen this movie before in the past few years (2015 and 2016-2017): inflation expectations move higher and then roll over. This year has seen more stability above the important 2% threshold, which is why we have retreated from frequent discussion of our breakeven inflation valuation framework for securitized products.

Now, as the breakeven rate has dropped to its 200d moving average, BofAML technical strategist Paul Ciana is highlighting that the 10y breakeven rate is at risk of a bearish breakdown to 1.91%-1.98% in the months ahead. Our valuation framework suggests this is consistent with spread widening risk for securitized products.

Essentially, it appears as if the market has reached a critical, potential break point on factors 1 and 2 above, the trade war and Fed tightening. If there is no capitulation by either the Chinese or the Fed, the chances are good that breakevens will indeed head meaningfully lower, undoing the work that has been done to stabilize inflation expectations above 2%.

Factor 4: mortgages and housing – refi’s are dead and housing is expensive

This week saw the MBA refinancing index drop to the lowest level since 2000 (Chart 6), nearly 18 years ago.

Gone are the days when an increasing refinancing incentive created a savings stimulus for household. Instead, the Fed’s policy tightening is showing one additional sign of stimulus withdrawal, in the form of declining refinancings. Higher rates have mattered.

Similarly, the MBA purchase index has rolled over sharply in recent weeks (Chart 7), as high home prices and high mortgage rates have hurt affordability.

Confirming this, the latest University of Michigan consumer sentiment reading reported “home buying conditions were viewed less favorably in early August than any time since August 2006.”

The sentiment is interesting, as affordability is currently at 2008 levels, which were actually better than 2006 levels. Chart 8 shows affordability along with the MBA’s mortgage credit availability index.

2006 was the lowest level of affordability in the history of the index. But it was also the year of maximum credit availability that acted as an “offset” to low affordability.

While we see potential for some loosening of mortgage credit, we see little chance of a return to pre-crisis levels of availability. The best solution to low affordability is lower rates. As we noted in “Soft housing data piling up: prepare for risk-off,” the mortgage/housing market could use a 10Y rally back to the 2.25%-2.50% range over the near term. Given the risk off stew that is brewing,  a risk off move in markets may give the mortgage and housing market what it needs." - source Bank of America Merrill Lynch

Sure housing would indeed get a respite from lower yield no doubt. It's all about Wall Street versus Main Street. Given the amount of known unknowns in these "hypertonic surroundings" we would rather take a more cautious tone and raise cash levels in dollar terms within our allocation tool box, given cash in the US thanks to the rise of the front-end is appealing again.

Finally, as per our final charts below, what could really trigger a more recessionary and bear market outlook to the current scenario would be rapid rise in oil prices with an escalation with Iran we think. As we pointed out earlier one, for a bear market to materialize you would need a significant pick-up in inflation and oil could be the match that triggers the lot. 

• Final charts - So you want to be bearish? Oil-price spikes have preceded most recessions

What matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years.  It is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation with Iran. Our final charts come from Bank of America Merrill Lynch Global Economic Weekly note from the 17th of August entitled "the law of large numbers". The first chart displays the surge of the US dollar since tariffs were imposed in March and the second chart displays the risk posed by oil shocks in post-war recessions:

"Since the steel and aluminum tariffs were imposed on March 1, the dollar has strengthened against many currencies (Chart 1).

Iran: oil slick?

Oil sanctions against Iran pose an almost equal risk to global growth. Recall that oil shocks have played a role in most post-war recessions (Chart 2). Given the steady shrinkage in Venezuelan supply, the large gyrations in Libyan supply, and the fact that OPEC and US fracking supply is already high, a cut-off in Iranian oil could have a major impact on prices. Iran currently exports about 2.3mn barrels of crude oil per day (b/d). Francisco Blanch and team estimate that a reduction of 1mn b/d in Iranian supply would increase Brent prices by about $17/barrel. This means that if the Trump administration pursues its stated goal of cutting Iranian oil exports to zero, Brent could rise above $100/barrel. This would be a major headwind to global growth, especially since dollar strength is pushing the non-dollar price of oil up even faster.

The Iran story is not just about global oil supply. It has created yet another split between the US and many of its allies. The sanctions could also worsen US relations with major importers of Iranian oil, including China and India, which together have purchased nearly 60% of Iranian crude oil exports this year. Although the sanctions have been imposed unilaterally by the US, they would apply to any shipping or insurance company that deals with Iranian oil. This gives the US the power to effect substantial cuts in Iranian exports globally, should it choose to do so.

A final striking aspect of the sanctions is their timing. Full sanctions on Iranian oil go into effect on November 5, just one day before the US midterm elections. In our view, this is a sign that the Trump Administration views getting tough with Iran as a winning political issue. The timing argues against a common view that the Trump Administration will moderate its policies—and reduce the risks to the markets and the economy—in the run-up to the election." - source Bank of America Merrill Lynch

We do live indeed in interesting "hypertonic surroundings" times, with of course many known unknowns to keep us entertained for the weeks ahead. What's always more worrying is the unknown unknowns but that's another story and we ramble again...

"Knowledge is not simply another commodity. On the contrary. Knowledge is never used up. It increases by diffusion and grows by dispersion." - Daniel J. Boorstin, American historian

 Stay tuned!

Macro and Credit - Dissymmetry of lift

"Risk is trying to control something you are powerless over." -  Eric Clapton

Watching with interest the latest US GDP rising at an annual rate of 4.1 percent in the second quarter of 2018 while seeing Europe decelerating, with France kissing goodbye to its 2% annual growth target, when it came to selecting our title analogy we decided to go back to using our much liked  aeronautics/aerodynamics themes given it had been a while we didn't on that blog (our previous favorite one was "The Coffin corner" in April 2013, the other being "The Vortex Ring" in May 2014). The "Dissymmetry of lift is used in rotorcraft and refers to an uneven amount of lift on opposite sides of the rotor disc. It is a phenomenon that affects single-rotor helicopters and autogyros in forward flight. Balancing lift across the rotor disc is important to a helicopter's stability (or economic growth). The amount of lift generated by an airfoil is proportional to the square of its airspeed. In a zero airspeed hover the rotor blades, regardless of their position in rotation, have equal airspeeds and therefore equal lift. In forward flight the advancing blade has a higher airspeed than the retreating blade, creating unequal lift across the rotor disc. When dissymmetry causes the retreating blade to experience less airflow than required to maintain lift, a condition called retreating blade stall can occur. This causes the helicopter to roll to the retreating side and pitch up (due to gyroscopic precession). This situation, when not immediately recognized can cause a severe loss of aircraft controllability. You are probably asking yourselves already where we going with this but QT, in our book amounts to less airflow required to maintain growth in Emerging Markets and Europe. Dollar liquidity is being reduced, hence the risk for a stagflationary outcome, in essence stalling growth can and will occur.  To reduce dissymmetry of lift, modern helicopter rotor blades are mounted in such a manner that the angle of attack varies with the position in the rotor cycle. However, there exists a limit to the degree by which "Dissymmetry of lift" can be diminished by this means, and therefore, since the forward speed "v" is important in the phenomenon (like "v" for velocity), this imposes an upper speed limit upon the helicopter or for our central bankers of this world and their "helicopter money".

In this week's conversation, we would like to look at the rise in stagflationary risk, particularly in Europe with signs as well of a global slowdown.

Synopsis:

• Macro and Credit - Is a stagflationary outcome looming?
• Final chart - Coming soon - bids by appointment only...

• Macro and Credit - Is a stagflationary outcome looming?

The latest growth data coming from Europe and with the continuation of some Emerging Markets woes for the usual suspects such as Turkey many pundits have been pointing out towards a stagflationary outcome. The increasing pressure coming from the trade war narrative which has been prevailing has so far been translating in an increase in PPIs, which could put some pressure on already elevated corporate earnings, no matter how good some recent earnings have been except of course for some darlings of the Tech sector namely the FANG group including our much used Twitter which have been on the receiving end of some nasty price action recently (Facebook was after all a 4 sigma event).

As we indicated in various conversations of ours, in our book, positive correlations always led to larger and larger standard deviations move. 2018 is no exception on the contrary and indicates brewing instability thanks to growing concerns over liquidity. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis and given central banks are somewhat trying to extract themselves from the price meddling/setting game, this mark a return at the forefront of "global macro" we think. Rising dispersion and the return of volatility makes active management "fun" again. For instance according to Nomura and as pointed out by Zero Hedge: 

"The collective three-day move in U.S. “Value / Growth” has been the largest since October 2008 - a 4.3 standard deviation event relative to the returns of the past 10 year period." - source Nomura/Zero Hedge

As we pointed out in the past, as per above link, large moves are more frequent in 2018. On this subject we read with interest Morgan Stanley's take in their Cross-Asset Dispatches note from the 22nd of July entitled "Yes, Large Moves Are Happening More Often":

"It's not your imagination. Surprises (large moves relative to expectations) are becoming more common across asset classes.

Defining a 'large move': Large moves matter to the extent that they surprise expectations. We define a 'large move' as a 3-sigma one-day move in price relative to what was implied by options markets at the time across global equities, rates, FX and commodities.

Large moves are becoming more common: 2017 was remarkable. Despite low levels of volatility that made the bar for a large move relatively low, few occurred. 2018 is very different, with more large price swings versus market expectations than any post-crisis year.

A sign that liquidity can be fleeting, even as markets climb: Tightening monetary policy and geopolitical risks may explain part of this uptick. But we think that it is also suggestive of constrained market liquidity, with growing markets supported by the same (limited) dealer balance sheet. This isn't the problem of a single asset class. It's everywhere.

Investment implications: Options markets should at least price in a steeper skew across asset classes and especially so in a less liquid asset class like credit. On a broader note, investors should be cautious about using the low realised volatility environment of 2017 as a parallel for the year ahead." - source Morgan Stanley.

In conjunction to late cycle M&A rising activity, these large standard deviations move are also typical of being in a late cycle we think.

This as well indicated into more details by Morgan Stanley in their interesting note:

"Large moves are becoming more common

2018 has seen a meaningful uptick in large moves relative to option-implied expectations across most asset classes. The contrast with previous years is most pronounced in global equities, which are on pace to see the highest number of such moves since 2008.

However, when aggregated across asset classes, the trend is clear. 'Large moves' are becoming more common in 2018, and are running at the highest rate since 2008.

This result holds at different thresholds. Below, we show the same combined chart over time, but counting the instance of 2 standard deviation moves. It shows a similar recent uptick.

Many explanations, but liquidity looms large

There are many ways to explain the recent uptick in these large moves, especially in hindsight – tightening policy, extreme sentiment towards equities and USD to start the year, trade tension and geopolitical risks. The fact is that volatility has remained generally low in 2018, lowering the hurdle for a large move.

All are likely at work. But the explanation we find most worth discussing is liquidity (or, more accurately, the lack thereof). The fact that constrained liquidity is present across major markets mirrors the broad-based uptick we've seen in outsized moves.

Markets have grown. Dealer capacity has not

It may not feel like it, but financial markets are significantly larger than they were a

decade ago. Consider the following, comparing July 2008 and today:

• S&P 500 market cap: US$11.5 trillion in July 2008. US$24.8 trillion today.
• EUR sovereign bond market: €4.6 trillion in July 2008. €7.5 trillion today.
• USD aggregate bond market: US$10.7 trillion in July 2008. US$20.1 trillion today.
• EM sovereign bond market (this includes EMBI-eligible sovereigns and quasi-sovereigns and excludes private corporates and non-EMBI sovereigns): US$288 billion in July 2008. US$894 billion today.

Yet while markets have grown steadily over the last decade, the means to trade them have not. The last 10 years have seen a historic deleveraging of bank balance sheets globally, a response to the clearly overextended state of balance sheets prior to the crisis.

Credit markets provide one of the most directly measurable, and stark, examples of this. On the left-hand axis of Exhibit 10, we plot the total size of US credit markets, as proxied by the combined size of the Bloomberg Barclays IG and high yield indices. On  the right axis, we plot total dealer holdings of US corporate bonds – a significantly larger market with a lot less inventory on the shelves.

Dealer holdings of corporate bonds have shrunk from 3% of the market to just 0.3% today. While this means that dealers themselves have less to liquidate, their capacity to move risk to a new buyer may be limited and require larger repricing of the asset class in times of stress.

Central bank dominance

As traditional banks pulled back, central banks became significant market players, accumulating quantities of assets over the last 10 years. Central banks hold 28% of the Agency MBS market (the Fed), 22% of the European sovereign market (the ECB), ~10% of the European IG credit market (the ECB again) and ~42% of the JGB market (the BoJ).

As central banks built these positions, liquidity in the affected assets was excellent. It's hard to imagine anything better for liquidity than the presence of a steady, deep, well telegraphed bid. But these forces are now swinging in the other direction. The Fed's purchases have already begun to reverse, the ECB's are likely to over the next six months, and with close to half of its bond market already owned by the BoJ, it will eventually face a constraint." - source Morgan Stanley

On top of that we are seeing weaknesses in global PMIs in conjunction with trade war escalation risk between China and the US. As discussed in our long June conversation aptly called "Mercantilism", liquidity, is indeed a coward. Also, in April this year in our conversation "Dyslipidemia", we pointed out that "credit markets" is one very large area where liquidity has been falling as pointed out as well above by Morgan Stanley's note:

"If you want to play the "bond bears" at some point down the credit cycle road then obviously, you should look at credit markets. As we posited in our previous musing, given the size of the ETF complex in that space and dwindling inventories since the Great Financial Complex, you don't need to be a genius to figure out, that the ETF Fixed Income complex dwarfs the "exit" door.

As a reminder:

This is what we wrote in our November 2017 conversation "The Roots of Coincidence":

If liquidity is a coward, then obviously reducing the illiquid beta part of your portfolio would be a sensible thing to do" - source Macronomics, April 2018

“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“

This is what we wrote in our November 2017 conversation "The Roots of Coincidence": 

"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" - source Macronomics, November 2017

Sure, performance wise, credit has regained some allure during the month of July with both high beta credit and even CCC high yield and also US Investment Grade and fund outflows for High Grade funds have stabilized. Yet this rebound happens when fundamentals relating to growth on the macro side have been deteriorating. With the U.S. planning to propose a 25% tariff on $200 billion in Chinese imports, in the latest rumors, this could no doubt lead to "Dissymmetry of lift", with a stagflationary outcome, with the US currently pulling ahead but with Europe and the rest of the world facing headwinds.

Markets are less liquid in that context and more fragile than most are anticipating we think. On that subject we read with interest Bank of America Merrill Lynch's take in their European Credit Strategist note from the 25th of July entitled "The economics of fragility":

"Summer carry” often proves to be a misnomer. Over the last few years there has invariably been something that has gone awry between July and August. This year though, so far so good for market calm. Note that US rates vol (MOVE index) and European equity vol (V2X index) are hovering near their start-of-year levels, despite the plethora of macro shocks that 2018 has already witnessed. And there remains plenty on the event risk front that could still emerge given heightened geopolitical tensions, commodity weakness, attacks on central bank independence and a China slowdown.

Trade wars and the unravelling of synchronised growth

Out of all the current macro risks, though, the one that we believe will be the most market moving is trade. As we argued in our last Strategist, an intensification of US-EU trade tensions could drive fears of “Quantitative Failure”. After all, the Eurozone is a large, open, economy and the ECB has – for political reasons – recently announced the end of QE. But conversely, any hint of a simmering in tensions will likely be taken well by investors, in our view. As the chart on the front page shows, uncertainty over global trade policy has now risen to levels last seen in late 1994, which was around the time of NAFTA’s inception. Therefore, much concern regarding trade is already in markets.

For us, the outlook for global trade is supremely important, and the current trade skirmish should not be seen as just another “fly in the ointment” for markets. Trade tensions put at risk one of the big secular themes of the last few years – namely that of global synchronised growth.

Chart 2 shows the distribution of annual GDP changes across OECD countries since 2004. Note that last year was the first time since 2006 that all OECD countries posted positive economic growth rates. The consequence of this was that market volatility fell to unprecedented levels. Economic certainty effectively bred market certainty.

Although global growth is likely to be strong this year – at just under 4% – signs are emerging that the recovery has become less synchronised, a concern echoed by the IMF over the weekend at the G20 Finance Ministers meeting. As a consequence, markets have become more fragile in 2018.

The signs

What are the signs of less synchronised growth? Chart 3, for instance, shows the extent to which US equities have decoupled from EM equities since May this year.

Trade tensions have depressed global growth proxies, such as Emerging Markets. Yet, the US economy continues to be buoyed by Trump’s significant fiscal stimulus (and note the near record EPS surprise stats from the current US earnings season).

In Europe, after the impressive 0.7% quarterly GDP print at the end of last year, growth slipped to 0.4% in the first quarter of 2018. Emerging Market weakness – in particular China – likely explains some of the loss of Europe’s economic momentum lately, especially given Germany’s export focus.

Chart 4 shows the extent to which financial conditions in China have tightened. Looking at Total Social Financing as a percentage of China M2, one can see that the measure has fallen to a record low.

Moreover, with the US powering ahead economically vis-à-vis the rest of the world, and trade tensions rising, the broader EM complex has suffered. Chart 5 shows the performance of a number of EM currencies versus the US Dollar. We compare two periods: the 2013 Taper Tantrum and this year’s trade spat. 

As can be seen, it’s not just those counties with obvious current account imbalances (Turkey, for instance) that have seen worse currency performance this year compared to the Taper Tantrum. Plenty of EM currencies have depreciated more vs. the USD in 2018 than in 2013." - source Bank of America Merrill Lynch

 As we pointed out in our most recent conversations, EM are more exposed to a trade war escalation which would be detrimental to growth. Europe as well has significant exposure to EM through the European banking system. Therefore "Dissymmetry of lift" or to put it another way, a stagflationary outcome is a strong possibility. Sure some pundits would like us to distinguish between cyclical inflation from an inflationary trend. From our perspective, as we have repeated so many times, for a true bear market to materialize you need inflation as the trigger match, regardless if it is cyclical or not. This would lead to additional "repricing" in asset classes.

On the risk for a stagflationary outcome to play out, we took note of Nomura's take in their Economic Perspectives paper from the 27th of July entitled "Bicycles, bumps and brakes":

"Or why stagflation risks are rising

A well-functioning world economy is like a bicycle moving rapidly along a path. The rider represents central banks and governments making adjustments, left and right and via the brakes, to keep the bicycle on a steady path. However, an even greater force keeping the bike upright is the torque created by the spinning wheels, which is analogous to the private sector’s inclination to borrow and spend. As long as the bicycle (i.e., the economy) moves at a sufficient pace – but not too quickly – only small (policy) adjustments are needed to keep it moving steadily forward. Mostly, however, it is the torque (i.e., the private sector) that keeps the bike upright and moving. Problems arise though if the bicycle starts moving downhill too rapidly and, particularly, if bumps then start to appear on the road. If the rider does not know whether there are bumps on the road – and more importantly – whether more of them lie ahead, there is a greater likelihood that the bike will come to a stop, either because the brakes are deliberately applied by the rider or – upon hitting one of these bumps – because it has veered out of control and crashed.

In our view, several bumps have appeared in recent months that are either already destabilising the world economy or, at the very least, threaten to do so in the coming months. That list – perhaps obviously – includes heightened protectionism and the growing threat of a global trade war. However, it also includes a supply-driven rise in oil prices, an unexpected reboot of populist politics in a number of developed and developing economies, growing financial strains from deleveraging pressures in China and a stronger US dollar. In the meantime, our bike (i.e., the world economy) has been heading downhill more quickly, as late-cycle pressures have gathered pace and are now triggering tighter monetary policies from a number of central banks. In short it is time to turn more cautious on the global macro outlook and expect greater volatility. - source Nomura

We like their analogy because it ties up nicely to "v" we mentioned above when it comes to avoiding stalling when encountering "Dissymmetry of lift". With their analogy Nomura is adopting a much more cautious tone going forward:

"It is with that analogy in mind that we are now holding a more cautious view toward the global economic outlook. As we wrote in Darker Clouds, we believe the annual pace of global GDP growth has now peaked (Figure 2) and that a deceleration phase now lies ahead.

The risks to consensus forecasts for global growth moreover are, in our view, now tilted to the downside. Absent major financial imbalances and other overheating pressures, we still think that a recessionary phase for the world economy can be avoided, but a sub-trend growth phase is now much more probable as we head through the next year.

Why is that bicycle analogy of so much relevance to this? With reference to our schematic in Figure 1, it is because several bumps have appeared in recent months that either are already destabilising the world economy or, at the very least, threatening to do so in coming months.

That list – perhaps obviously – includes heightened protectionism and the growing threat of a global trade war. But it also includes a supply-driven rise in oil prices, an unexpected reboot of populist politics in a number of developed and developing economies and growing financial strains from deleveraging pressures in China. In the meantime, our bike (i.e., the world economy) has been heading downhill as late-cycle pressures have gathered pace triggering tighter (or less restrictive) monetary policies from a number of central banks. A stronger US dollar has been one manifestation of these pressures insofar as US Fed tightening has been much more intense relative to the rest of the world. However, a stronger dollar has equally helped apply a brake on other emerging economies that have high USD-denominated debt levels and, by the same token, generated some hard-to-spot bumps in the road ahead.

The protectionist threat

We look at some of these factors in more detail, starting with arguably the most important: protectionism. We think this is important for a number of reasons. Firstly, it appears to already be having some impact on global economic activity. In Figures 5 and 6 below, we look at the recent deceleration of the leading indicators of global growth (manufacturing PMIs) in a number of major economies relative to their respective exposure to global protectionism (proxied by their current account position) in Figure 5 and to their exposure to oil (proxied by oil trade) in Figure 6. The correlation in Figure 5 is admittedly far from perfect but nevertheless suggests that those economies which have relatively high trade surpluses (e.g., Germany and the broader Eurozone) have been hit harder in recent months than those that have trade deficits (e.g., the US).

In other words, greater trade protectionism seems to be exerting some impact on relative growth patterns. This contrasts with high oil prices which, as Figure 6 suggests, do not yet seem to triggering the same (relative) response.

Digging into the details of more recent flash manufacturing PMI surveys (from Markit) leads us to a second reason why greater protectionism is important, namely the supply response and the (relative) inflation impact, which we believe are underappreciated. The details of the latest US manufacturing PMI, for example, revealed that trade frictions have become a major cause of concern, with July showing the steepest rise in prices charged for goods and services yet recorded as firms passed costs – frequently linked to tariffs – onto customers (Figure 7).

The same survey revealed that supply chain delays reached a record high amid rising shortages of key inputs. To put more simply, the US economy seems to have been on the receiving end of a negative supply shock.

Simulations on the Oxford Economics model from a full-blown trade-war scenario between the US and China – shown and described in Figure 9 below – suggest significant damage to the world economy.

Depressed confidence in the US and tighter financial conditions add to supply-side “stagflation” effects already described above and which could – according to the model – lower GDP growth by 0.7 percentage points below baseline in 2019 and by a cumulative 1% by 2020. The hit to China would be even more significant, given its greater dependence on exports with GDP growth some 0.8 percentage points lower than baseline in 2019 and 1.3% by 2020. Since this simulation mostly concerns trade channels between the US and China, the simulated response in Europe is a little weaker, but global supply chain damage and tightening global financial conditions would still lower GDP in the Eurozone by 0.4% points in 2019 and by a cumulative 0.5% points in 2020.

The dollar, China and late cycle US pressures are additional bumps in the road

Aside from greater protectionism – and as discussed above – there are several additional bumps in the road at present that make steering our bicycle (i.e., the world economy) somewhat hazardous. The charts in Figures 10 to 16 below home in specifically on the US dollar, on China and on monetary and fiscal policy issues:

– Firstly on the dollar, we note that its appreciation in recent weeks has triggered a marked tightening in global financial conditions (Figure 10).

This tightening moreover has moved well beyond what would have been implied by the unwinding of quantitative easing policies by the world’s central banks. And insofar as that unwind implies a further tightening of financial market conditions in coming months this suggests more downside for the world economy than those central banks may have imagined based on domestic (cost of capital) considerations alone. As an aside, we note that a stronger US dollar may trigger more downside to global USD-denominated nominal GDP growth – and thus for the revenue streams of multinational companies – in the period ahead as well (Figure 11). A stronger US dollar is also unlikely to help de-escalate trade tensions.

– On China – and related to those issues concerning the US dollar – we note the growing funding strains for companies that have issued offshore USD-denominated debt and the trend toward rising defaults in the corporate sector in recent months (Figures 12 and 13).

As our China economist notes (see The State Council initiates fiscal stimulus), while there has been a greater willingness to pursue more activist fiscal policies and/or allow the RMB to depreciate to mitigate the impact from these pressures, we think that markets are likely to increasingly focus on the sustainability of this policy action and the deleveraging pressures that still lie ahead.
– On monetary policy, we note the late-cycle pressures that are likely to leave some central banks – and the US Fed in particular – with limited, if any, recourse to loosen monetary policy for the time being and with a line of least resistance that points to more restrictive policies (Figure 14).

The complicating factor here – from a global perspective – is the likely waning of fiscal impulses as we head into next year in the Eurozone, UK and many emerging economies (excluding China) relative to the US, where the fiscal impulse will remain relatively strong (Figure 15).

That obviously could continue to pressure US inflation higher compared with elsewhere, not least if we add into the equation aforementioned issues concerning protectionism, oil prices and late-cycle wage pressures. Even in the face of a negative supply shock, with pro-cyclical US fiscal policy a counter-cyclical monetary policy stance would not be unreasonable.

What’s the bottom line?

Our conclusions from this discussion and analysis are as follows:
– Global growth will slow from its current above trend-rate toward a below-trend rate over the next 12- 15 months and probably disappoint consensus forecasts. By definition, the volatility of growth will rise as well from current historically low levels. It would be highly unusual for asset price volatility to remain as low as has been in this environment (Figure 3).
– The US economy will continue to perform relatively well as global growth cools compared with other major economies. That is by virtue of its relatively low exposure to global trade and to higher oil prices as well as a still-solid contribution from fiscal policy. This will leave Fed tightening in vogue (relative to elsewhere) not least when we add in inflation dynamics and the US economy’s cyclical position.
– On that inflation issue, we think the incoming (global) data are more likely to surprise on the upside than the downside in the immediate months ahead. That is a function of several factors, including a delayed response to the world economy’s cyclical upswing in recent quarters alongside the cost pressures that concern higher tariffs and higher oil prices. Ordinarily those cost pressures might be contained for a while if typical late-cycle pressures from firmer capital investment activity and stronger productivity growth came on stream. Given all the bumps on the road that are now triggering angst about the global growth outlook, we question whether this activity will now be strong enough to meaningfully quell those cost pressures.
– A stagflation scenario – the combination of negative growth surprises and positive inflation surprises – would not be constructive for risk assets. That’s particularly if policymakers – in the face of a trade-off between low growth and high inflation – opt to combat rising inflation. In light of positive output gaps, rising core inflation and pro-cyclical US fiscal policy, this might not be unreasonable. This could invoke a tighter policy response, hampering longer-term growth expectations and speed up curve inversion. Natural hedges in this environment include long US inflation break-evens.
– Finally, the metric that perhaps obviously bears watching most closely in the coming weeks is the US dollar. That holds the key, in our view, for how growth, inflation and monetary policy will evolve in the period ahead and by extension for how risk assets will evolve as well." - source Nomura

Now you probably understand better why our "Dissymmetry of lift" analogy is akin to a stagflationary outcome ("v" for "velocity, not speed in our economic case). Sure we are watching as well what the US dollar will be doing in the coming months like anyone else but trade war escalation and rising oil prices would not do a favor in the usually volatile quarter ahead we think. Liquidity is fading thanks to QT with the US pulling ahead for now from the rest of the world.

Overall liquidity is receding and growth apart from the US (for now) is slowing, in conjunction with heightened trade war risks looming. It is therefore not a surprise to see many pundits like ourselves putting forward the risk for a stagflationary outcome. Liquidity for credit markets is a concern, particularly with swelling passive strategies in the ETF complex in recent years when dealers have been retrenching. Our final chart below is illustrative of the risk in credit markets from a "liquidity" perspective.

• Final chart - Coming soon - bids by appointment only...

As per Lowenstein above, liquidity is always backward-looking yardstick. If anything, it’s an indicator of potential risk, it always is. Our final chart is coming from Bank of America Merrill Lynch Situation Room note from the 30th of July entitled "The chicken, not the egg" and shows that Investment Grade dealer inventories appears to be now negative:

"The chicken, not the egg

With the return of excess demand conditions for corporate bonds, we estimate that IG dealer inventories (superior to 1-year) are now negative (about -$240mn) for the first time ever. The only negative inventory number on record in the Fed’s data is for the week ended October 28, 2015, which was most likely an error due to well-known difficulties tracking long maturity bonds (Figure 1).

This is bullish for credit spreads as dealer inventories tend to be leading indicators for prices. While here it is easy to become entangled in a chicken vs. egg discussion, as one could argue that that the causation runs in reverse with low dealer inventories the result of strong markets – and thus tighter spreads – we find strong statistical evidence that inventories lead spreads historically, not the other way around. Low inventories thus add to the bullish case for IG corporate spreads" - source Bank of America Merrill Lynch

It might be the case that indeed as we pointed out in our last conversation that equities might be too high relative to credit. When it comes to global growth and the US versus the rest of the world, we think it is a case of "Dissymmetry of lift" but we ramble again...

"The investor of today does not profit from yesterday's growth." -  Warren Buffett

Stay tuned !