Macro and Credit - Showdown

"In every battle there comes a time when both sides consider themselves beaten, then he who continues the attack wins." -  Ulysses S. Grant

Watching with interest the lingering Brexit saga playing on in conjunction with the much commented trade war between China and the United States, when it came to selecting our title analogy, we decided to go for yet another poker card game reference (previous ones being "Poker tilt", "Le Chiffre", "Optimal bluffing", the "Donk bet", to name a few in no particular order). In the game of poker, the "Showdown" is a situation when, if more than one player remains after the last betting round, remaining players expose and compare their hands to determine the winner or winners. To win any part of a pot if more than one player has a hand, a player must show all of his cards face up on the table, whether they were used in the final hand played or not. Cards speak for themselves: the actual value of a player's hand prevails in the event a player mis-states the value of his hand. Because exposing a losing hand gives information to an opponent, players may be reluctant to expose their hands until after their opponents have done so and will muck their losing hands without exposing them. Robert's Rules of Poker state that the last player to take aggressive action by a bet or raise is the first to show the hand - unless everyone checks (or is all-in) on the last round of betting, then the first player to the left of the dealer button is the first to show the hand. 

If there is a side pot, players involved in the side pot should show their hands before anyone who is all-in for only the main pot. To speed up the game, a player holding a probable winner is encouraged to show the hand without delay (Brexit comes to our mind). Any player who has been dealt in may request to see any hand that is eligible to participate in the showdown, even if the hand has been mucked. This option is generally only used when a player suspects collusion or some other sort of cheating by other players. When the privilege is abused by a player (i.e. the player does not suspect cheating, but asks to see the cards just to get insight on another player's style or betting patterns), he may be warned by the dealer, or even removed from the table. There has been a recent trend in public cardroom rules to limit the ability of players to request to see mucked losing hands at the showdown. One would probably think a similar rule should be applied to Brexit negotiations but we ramble again...

In this week's conversation, we would like to look at US consumption and consumers, following the significant rally in the high beta segment of asset classes as we believe monitoring the state of the US Consumer in the coming months will be paramount. 

Synopsis:

• Macro and Credit - Secular stagnation or secular strangulation? 
• Final charts - Yes, Europe is turning Japanese

• Macro and Credit - Secular stagnation or secular strangulation? 

With U.S. consumer prices increasing by the most in 14 months in March to 1.9% thanks to Energy prices climbing by 3.5% and accounting for about 60% of the increase, in conjunction with The University of Michigan’s preliminary consumer sentiment survey falling to 96.9 in April, from 98.4 the previous month, one might wonder what is the state of the US consumer.

On a side note, given the recent rise of the MMT crowd we read with interest Dr Lacy Hunt's take in his latest 1st Quarter review. We highly recommend you read it, for those of you in the "Deflationista" camp. The Keynesian camp might be somewhat part of the "Inflationista" camp given their preference for 2% inflation and beliefs in the much antiquated "Phillips curve" (we have said enough on this subject on this very blog). It seems to us the MMT crowd, as rightly pointed out by Dr Lacy Hunt, could make us all fall into the "hyperinflationista" camp with their monetary prowess and "promises".

As well we have seen many recent conversations surrounding the fact that in many instances in Developed Markets (DM) the "middle-class" has been hollowed out. This has been discussed at length by the OECD in their recent paper entitled "Under Pressure: The Squeezed Middle Class".

Back in December 2014, in our conversation "The QE MacGuffin" we pointed out the following Societe General's take from their FX outlook on central banks meddling:

"It’s broken, and they don’t know how to fix it. It is remarkable that after so many years of super easy monetary policy, the global economy still feels wobbly. On the positive side the US continues to recover and the lower oil price will provide a boost to global growth in H1 2015. Yet the growth multipliers seem to be much weaker still than they have been historically, highlighting a lack of confidence, be it because of post-crisis hysteresis, the demographic shock, the excessive levels of non-financial debt, etc.‘Secular stagnation’ is the buzz word. The theory encompasses two ideas: 1) potential growth has dropped; 2) there is a global excess of supply, or a chronic lack of demand. If true, the implications are clear. First, excess supply creates global disinflation forces. Second, to fight lowflation and to help demand meet supply at full employment, central banks may need to run exceptionally easy monetary policy ‘forever’. In other words, real short-term rates need to remain very low, if not negative.

Life below zero. At the ZLB, central banks do what they know: they print money. But such policy seems to follow a law of diminishing marginal returns. It has worked well for the US, because the Fed had a first-mover advantage, and the support from pro-growth fiscal policy and a swift clean-up of the household and bank balance sheet. The BoJ and ECB aren’t as lucky. Let’s consider three transmission channels: 1) The portfolio channel. By pushing yields lower, central banks force investors into riskier assets, boosting their prices. But trees don’t grow to the sky. And the wealth effect on spending is constrained by high private and public debt. 2) The latter also gravely impairs the lending channel. And with yields already so low, it’s questionable what sovereign QE can now achieve. 3) The FX channel. This is where the currency war starts, as central banks try to weaken their currency to boost exports and import inflation. It however is a zero-sum game that won’t boost world growth.-The battle to win market shares highlights a fierce competitive environment, which tends to depress global inflation. Adding insult to injury, oversupply in commodities, especially oil and agriculture, currently add to the deflationary pressure. That leads central banks to get ever bolder, when instead they’d need to be more creative (e.g. a bolder ABS plan from the ECB would be far more effective than covered and government bond purchases) and get proper support from governments (fiscal policy, structural reforms)."  -source Societe Generale

High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates but, low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." source Macronomics, December 2014

The central banking "Showdown" is still going on we think. The "Global Savings Glut" (GSG), has been put forward by many defenders of Keynesian policies. 

We would like to add a couple of comments to the above  relating to the GSG theory put forward by former Fed president Ben Bernanke relating the reasons for the Great Financial Crisis (GFC). Once again we would like to quote our February 2016 conversation "The disappearance of MS München" on this subject:

"The "Savings Glut" view of economists such as Ben Bernanke and Paul Krugman needs to be vigorously rebuked. This incorrect view which was put forward to attempt to explain the Great Financial Crisis (GFC) by the main culprits was challenged by economists at the Bank for International Settlements (BIS), particularly in one paper by Claudio Borio entitled "The financial cycle and macroeconomics: What have we learnt?":
"The core objection to this view is that it arguably conflates “financing” with “saving” –two notions that coincide only in non-monetary economies. Financing is a gross cash-flow concept, and denotes access to purchasing power in the form of an accepted settlement medium (money), including through borrowing. Saving, as defined in the national accounts, is simply income (output) not consumed. Expenditures require financing, not saving. The expression “wall of saving” is, in fact, misleading: saving is more like a “hole” in aggregate expenditures – the hole that makes room for investment to take place. … In fact, the link between saving and credit is very loose. For instance, we saw earlier that during financial booms the credit-to-GDP gap tends to rise substantially. This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income." - source BIS paper, December 2012

Their paper argues that it was unrestrained extensions of credit and the related creation of money that caused the problem which could have been avoided if interest rates had not been set too low for too long through a "wicksellian" approach dear to Charles Gave from Gavekal Research.

Borio claims that the problem was that bank regulators did nothing to control the credit booms in the financial sector, which they could have done. We know how that ended before." - source Macronomics, February 2016

Indeed, conflating financing and savings is the main issue when it comes to the GSG theory. But, returning to the wise note of Dr Lacy Hunt, he puts another nail in the coffin of this "Savings Glut" theory put forward by Dr Ben Bernanke:

"Secular stagnation is basically the rebirth of the over-saving theory. However, after WWII the U.S. balanced the budget, contrary to Keynes’s recommendation, and the economy boomed, permitting the U.S. to rebuild and open U.S. markets to the world’s exporters. What Keynes missed is that the national saving rate averaged over 10% during WWII, and the U.S. had a strong balance sheet. The private sector drew down their saving, and this propelled the economy higher. In 2018, the national saving rate was 3%, less than half the long-term average since 1929 and one-fifth the level of 1945. There is no excess saving to be drawn down (Chart 5)."

- source Hoisington, Dr Lacy Hunt

Given the worrying trend for the middle-class in DM countries, you probably understand by now our chosen title of "Secular strangulation". For instance the "yellow jackets" (gilets jaunes) movement in France is an illustration of the fear of downgrade for many middle-class families which have been eviscerated by continuous fiscal pressure over the years. End of our parenthesis on the GSG.

Returning to the paramount subject of the state of the US consumer, with the volte-face made by the Fed, mortgages rates have fallen in sympathy giving some much needed respite to the US housing market. Existing-home sales climbed nearly 12% in February from the month before, reaching an annual rate of 5.5 million, according to the National Association of Realtors, which attributed the growth partly to interest rates. Of course lower interest rates for home mortgages buoy the housing market. In 19 weeks since November, the rate on a 30-year mortgage dropped from 4.94% to 4.06%, the most rapid decline since 2008. But, given "Shelter" comprises 40% of the Consumer Price Index, we might see some erratic readings in the coming months. 

As illustrated recently by Bloomberg, an excess of 7 million Americans were at least three months behind on their car payments at the end of 2018:

- graph source Bloomberg

Given the rapid deterioration in financial conjunctions in conjunction with housing headwinds thanks to rising mortgages rates in the final quarter in 2018, we think that this conjunction of factors on top of falling equity prices managed to spook enough the Fed to generate the aforementioned volte-face.

Obviously this welcome respite has managed to trigger an incredible rally for high beta thanks to global dovishness from central banks overall. Yet, we do think that the current housing bounce we are seeing is only temporary and providing some short term relief to the US consumer increasingly using revolving credit aka it's credit card to maintain his consumption. On top of that, rising oil prices might be good news for US High Yield but, should gas prices continue to surge, it might start again to become a slight headwind for US consumers. This would point to overall weaker growth for the remainder of 2019 in the United States we think.

When it comes to the US Housing situation we read with interest Bank of America Merrill Lynch's take from their Housing Watch note from the 12th of April entitled "A brief housing pop":

"Get ready for some good data…for now

All signs are pointing toward a short term boost to housing activity following a difficult end to last year. At the end of last year, mortgage rates were the highest since early 2011, the stock market was selling off and confidence in the economy was declining. Prospective homebuyers sat on the sidelines, uncertain about their future finances and concerned about affordability.

It has all changed since then. Mortgage rates have tumbled, returning to levels last seen in January 2018, the stock market has recovered and confidence has returned. If buyers were hesitant last year, this environment has lured them back into the housing market. Indeed, mortgage purchase applications have climbed, pending home sales have improved and existing home sales in February were very strong. Survey measures, including our own proprietary survey, show more favorable perceptions around housing with people noting that buying conditions have improved (Chart 2, Chart 3).

Similarly, homebuilders feel more confident with the NAHB housing index improving and realtor confidence surveys ticking higher. In our last housing watch in January, we argued that we would see a “brief period of stronger housing data.” We are doubling down on that view and now revising up forecasts for home sales in 2Q (Table 1).

Why are we looking for just a short-term boost to home sales rather than a more persistent recovery? Importantly, affordability challenges still remain. While the drop in mortgage rates provides a jolt to housing, housing is still overvalued given the strong rise in prices over the past several years (Chart 4). In addition, we see evidence that existing home sales have reached an equilibrium level based on the historical relationship between sales and the labor force. Of the people in the work-force, we are
at a historically “normal” rate of existing home sales (Chart 5).

There are greater opportunities for new home sales than for existing given that the recovery for new construction has been lackluster. Builders have been shifting away from the high-end of the market where inventory is higher toward the more affordable part where there is still incremental demand. This can be seen through the average size of a new single family home slipping lower and a drop in new homes sold over $300,000
(Chart 7, Chart 8).

Of course, housing dynamics are going to differ by region. A good way of understanding the relative strength or weakness in housing conditions is to track migration.

We find that people continue to leave Northeast, the Midwest and the California to move to Texas, Colorado as well as other areas in the West and South." - source Bank of America Merrill Lynch

Given affordability is stretched, we agree with Bank of America Merrill Lynch, namely that the recent fall in mortgage rates is only providing some short term respite. When it comes to Main Street  it has had a much better record when it comes to calling a housing market top in the US than Wall Street. If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising in recent quarters. Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder. Housing activity is leading overall economic activity, housing being a sensitive cyclical sector.

The big question was that rising interest rates were starting to choke the US consumer hence the dovish tilt from the Fed following the horrific final quarter of 2018. 

On the state of the US consumer we read with interest Wells Fargo's take from their note from the 2nd of April entitled "U.S. Recession? How Do We Count the Ways?":

"Are Consumer Finances in Good Shape?

Household leverage generally, and mortgage debt specifically, was at the epicenter of the last downturn. Although the severe repercussions of consumers getting over-extended a decade ago may still be fresh in the minds of borrowers, lenders and regulators, overall household leverage has fallen substantially over the past decade (Figure 1). As Mark Twain said, however, history does not repeat, but it often rhymes. Are there other areas in consumer balance sheets that pose a risk to the economy from an extensive build up in debt and deterioration in lending standards?

While mortgage debt has fallen over the past decade, Figure 1 also shows that leverage of other types of consumer debt, including autos, credit cards, and student loans, is at an all-time high.

 - Source: Federal Reserve Board and Wells Fargo Securities

Yet unlike housing debt in the 2000s, the increase has not been exponential. Leverage for consumer credit is also only a quarter of the size of housing-related leverage at the height of the housing bust. What’s more, debt service remains exceptionally low. Historically low interest rates and longer repayment terms have kept households’ monthly financial obligations ratios near levels last seen in the early 1980s (Figure 2).

- Source: Federal Reserve Board and Wells Fargo Securities

Notably, the most significant driver of the increase in consumer credit has been student loans. Given that educational debt is nearly impossible to discharge and primarily backed by the federal government, we view student loans as a sustained, long-term headwind to other types of spending rather than a mass credit event that could cause the financial system to seize up like the subprime mortgage crisis. In short, we do not think that consumer debt problems will trigger a recession in the foreseeable future.

Corporate Sector Debt: Keep an Eye on This Space

Where leverage may be more concerning is in the non-financial corporate (NFC) sector. As measured as a percent of GDP, debt in the NFC sector is at a record high. With corporate profit growth slowing, the ability to service debt likely will deteriorate somewhat over the next few quarters. At the same time, a shift in investor sentiment could weigh on asset values, which up until recently had been keeping pace with debt.

The financial health of the business sector has deteriorated since 2015, and significant further deterioration would be worrisome (Figure 3).

  - Source: Federal Reserve Board and Wells Fargo Securities

Firms that are stretched financially may be more reluctant to invest and hire. In addition, if companies start having trouble servicing their debt due to slower growth and/or higher interest costs, rising charge-offs and loan losses could disrupt credit growth. However, the current health of the non-financial corporate sector does not seem particularly dire at present when compared to the late 1980s or ahead of what we consider to have been the business-led recession of 2001.3 Interest rates have been rising from a historically low level and are unlikely to rise much further this cycle, while companies have locked in historically low interest rates by holding more long-term debt.

One segment of business sector debt that bears particularly close watch is the leveraged loan market.

  - Source: Federal Reserve Board and Wells Fargo Securities

Leveraged loans are made to companies with high debt-to-cash flow ratios that are typically rated less than investment grade. Loans outstanding in this sector have grown 35% since 2016, twice as fast as total NFC debt. Slower economic growth this year could make servicing that debt more difficult and lead to weaker demand from investors, which would weigh on credit growth to the business sector and therefore the broader economy. Yet leveraged loans are floating-rate instruments, and, with the Fed currently on hold, interest costs are not expected to shoot markedly higher. As a result, we do not see the leveraged loan market as an immediate threat to the economy.

Is There Overbuilding in Construction?

The bursting of the U.S. housing market bubble precipitated the Great Recession but it does not seem that lightning will strike twice, at least not in the current cycle. As noted above, households have de-levered over the past ten years. The value of mortgage debt outstanding among households is down 4% relative to its peak in early 2008. But disposable personal income is up 50% over the past ten years, giving households better ability to service that mortgage debt than they had at the height of the housing bubble. Furthermore, single-family housing starts are roughly 50% lower than they were at the height of the housing boom (Figure 5).

  - Source: Federal Reserve Board and Wells Fargo Securities

Although the level of multifamily starts is a bit higher today than it was a decade ago, apartment vacancy rates are low and rent growth remains solid.

Despite indications of robust activity in commercial construction, we do not think that commercial real estate (CRE) is an accident waiting to happen, at least not in the foreseeable future. As we wrote last autumn, the underlying fundamentals in the CRE market appear to be strong. Despite appearances of robust construction activity, the level of real non-residential construction spending is only 16% higher today than it was before the economy tumbled into recession in late 2007. At the end of the expansion in the 1980s, real non-residential construction spending was more than 60% higher than its previous peak. Commercial banks hold nearly $1.7 trillion worth of commercial mortgages, an all-time high. However, this amount represents less than 11% of their total financial assets, which is not out of line in a historical context (Figure 6).

  - Source: Federal Reserve Board and Wells Fargo Securities

Whereas it might be a little premature to call for a decisive turn of the credit cycle, to repeat ourselves, the next Fed Quarterly publication of the Senior Loan Officer Survey will be extremely important to monitor.

For now the US consumer is still holding on apparently. This is indicated by Bank of America Merrill Lynch in their BofA on USA report from the 11th of April entitled "The consumer spring into Spring":

"Strong consumer spending in March

The long-awaited rebound in consumer spending has arrived. According to BAC aggregated credit and debit card data, retail sales ex-autos jumped 1.5% month-over-month (mom) seasonally adjusted in March, partly reversing the decline over the prior three months. This recovery supports our view that the recent drop was largely due to temporary distortions rather than a fundamental weakening in consumer spending.

We see evidence that the timing of tax refunds pushed spending from February into March, specifically for lower income households. Those households receiving the Earned Income Tax Credit saw a significant delay in tax refunds, resulting in lower spending in February. Once tax refunds were received at the end of February, these households were able to spend, boosting activity in March. We see this notable swing in the data in the Chart of the Month.

It was the most apparent in the “discretionary” spending categories such as clothing, furniture and lodging. Interestingly, we did not see a big gyration in spending in restaurants which is typically sensitive to income changes. To be expected, spending at grocery stores was fairly steady over the prior two months (Chart 2).

We examine our tax refund data to see if the tax legislation, which capped state and local tax (SALT) deductions, altered refunds across the different states and income tiers. We focused on the top 10 states in terms of the SALT deduction and found that tax refunds were indeed down sharply for upper income households in these states – down 10% year-over-year (yoy) vs. an average of 1.7% increase over the three years prior (Chart 4).

In contrast, upper income households in the states with the most favorable tax laws saw little change in tax refunds relative to prior years. How does the decline in tax refunds among the upper income population in high SALT states impact spending? It isn’t obvious that it will have much of an impact since the upper income population tends to have more disposable income and are therefore less dependent on tax refunds to finance expenditures. Nonetheless, it could possibly weigh on confidence and curb purchases of bigger ticket items.

Bottom line: the consumer finally showed up in March, offsetting part of the decline at the turn of the year. We think we should see further improvement in spend going forward as consumers respond to higher wage growth amid solid job creation.

- source Bank of America Merrill Lynch 

While it's difficult to validate yet a bounce as per Bank of America Merrill Lynch's internal data, while University of Michigan Consumer Confidence remains high, it remains to be seen if there is indeed a change in the narrative:

- source IBT - University of Michigan

Something as well worth of interest when it comes to US Consumers given they make 70% of US GDP, has been the rise of Millenials and change of consumer habits as pointed out by another interesting report from Bank of America Merrill Lynch BofA on USA from the 17th of April entitled "Consumer, my how you have changed":

"Two numbers: age and income

The Millennials - who are currently aged 23 to 38 – make up 28% of retail sales ex-autos based on BAC internal card data, slightly outpacing the 26% from Baby Boomers. The wallet of Millennials is growing, with the average number of monthly transactions up 16% from 2012 vs. the 5% increase of Boomers. Millennials also live differently, with 51% of food consumption done at restaurants vs. Boomers at 34%.

There are also differences by income, as we find that 30% of spending is made by the >$125k income cohort while the <$20k group only constitute 10% of total retail ex-auto spending." - source Bank of America Merrill Lynch

Overall, while it is too early to turn negative on US consumers, in the coming months ahead it will be essential to monitor closely the situation we think.

We have long posited that Europe was becoming more and more "Japanese" hence our frequent use of the word "Japanification". Our final charts below goes more into the similarities.

• Final charts - Yes, Europe is turning Japanese

Looking at the trajectory of policy rates and government bond yields in Japan, it looks to us more and more that Europe is becoming more Japanese and we are not even mentioning the slow pace of resolving the issue of nonperforming loans plaguing the European Banking system. Our final charts come from Deutsche Bank Thematic Research report from the 9th of April entitled "How Europe is looking like the next Japan":

"In February this year, the Bank of Japan celebrated an ominous anniversary: 20 years since it first cut interest rates to zero. Despite a few abortive attempts to raise policy rates, they have never again exceeded 1% and remain stubbornly stuck around zero. Likewise, Europe has seen a few false dawns but again looks set for a long period of short-term rates being stuck at or below zero. More recently, long-term bond yields have fallen as well, with ten-year bund yields dipping into negative territory again over the last month. As such there are ever-growing similarities between the Europe of today and the Japan of the past two to three decades.

The consensus forecast is for the ECB to hike its policy rate from zero by the end of next year but this forecast has been repeatedly pushed back and markets are increasingly sceptical. Much like in Japan, there are now increasing concerns that ‘lift-off’ will never actually happen and Europe will be stuck in a world of ultra low growth and negative yields for years to come. Is this realistic? Well, as we know, it happened in Japan and it is therefore worthwhile examining in more detail the similarities and differences between the two economies with a suitable lag." - source Deutsche Bank

Given in a "Showdown", to win any part of a pot if more than one player has a hand, a player must show all of his cards face up on the table, whether they were used in the final hand played or not and that Cards speak for themselves, it is clear to us that any form of normalization by the ECB will be repeatedly pushed back à la Japan.

"In battle it is the cowards who run the most risk; bravery is a rampart of defense." - Sallust

Stay tuned !

Macro and Credit - The Zeigarnik effect

"Both poker and investing are games of incomplete information. You have a certain set of facts and you are looking for situations where you have an edge, whether the edge is psychological or statistical." -  David Einhorn

Looking with interest at the continuation of the rally in both equities and credit, including the high beta space while looking at the continuation in worsening macro data coming out of Europe, when it came to selecting our title analogy, thanks our fondness for behavioral psychology, we decided to go for the "Zeigarnik" effect given most investors are focusing these days on the uncompleted task of the Fed's balance sheet reduction. In psychology, the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks. In Gestalt psychology, the Zeigarnik effect has been used to demonstrate the general presence of Gestalt phenomena: not just appearing as perceptual effects, but also present in cognition. If a task is interrupted, the reduction of tension is impeded. Through continuous tension, the content is made more easily accessible, and can be easily remembered. The Zeigarnik effect suggests that students who suspend their study, during which they do unrelated activities (such as studying unrelated subjects or playing games), will remember material better than students who complete study sessions without a break (McKinney 1935; Zeigarnik, 1927). The results of the study of the "Zeigarnik effect" suggest that a desire to complete a task can cause it to be retained in a person’s memory until it has been completed, and that the finality of its completion enables the process of forgetting it to take place. In similar fashion the desire of the Fed to complete its balance sheet reduction could generate we think, a "Zeigarnik effect" in investors mind. After all it seems to us that the Fed's balance sheet contraction is more influential on assets prices than rates hike, hence the importance of the "Zeigarnik effect" but we ramble again...

In this week's conversation, we would like to look at the state of credit markets and US in particular given the significant rise in leverage in recent years versus Europe, as well as the state of the US consumer. 

Synopsis:

• Macro and Credit - R is for "recession" and D is for "deleveraging". 
• Final charts - Central banks to markets: let's be friends again...

• Macro and Credit - R is for "recession" and D is for "deleveraging". 

The central banking cavalry came late to the rescue with both the Fed and the PBOC coming to support risk assets in general and high beta in particular. Given the even weaker tone coming out of Europe we think it won't take long until we see more support coming from the ECB particularly given the grim growth outlook for the likes of Italy and its continuing ailing financial sector. Given that the European Banking Union remain "unfinished business", it is we think another case of "Zeigarnik effect" as the "doom loop" aka the nexus between the sovereign and the banks is yet to be meaningfully addressed. 

In our previous conversation we pointed out to the more pronounced slowdown affecting Europe including France as well. With French Services PMI at 47.5 in January, at the lowest level in the last 4 years versus 49 in December it doesn't bode well for French GDP going forward:

- graph source Bloomberg

This is what we had to say about France in our last conversation about France:

"The situation for French corporate treasures when it comes to cash flows from operations is deteriorating to a level close to 2012-2013 follow the Euro crisis. This we think, warrants close monitoring, given we think that the ongoing "attrition warfare" between the French government and the "yellow jackets" is taking its toll on the French economy as a whole, which as we reminded you last week is very much "services" orientated relative to other countries of the European Union (80% for France vs 76% of GDP on average)." - source Macronomics January 2019

Sure there is global weaker tone when it comes to macro data, but it is no doubt more pronounced in some places and in Europe in particular hence our concerns and the use of the dreaded "R" word, "R" for recession when it comes to Europe, with Germany coming close to it recently.

But, the latest dovish tone from the Fed is very supportive for high beta, bearish US dollar, bullish Emerging Markets equities, bullish gold and gold stocks as well.

With global "easing" on its way back, following investors fears of a policy mistakes and with a Fed more S&P 500 dependent thanks to the wealth effect, credit could see a return of "goldilocks" thanks to low rates volatility. 

The "R" word has been rising as of late thanks to the global deceleration in global trade on top of a flattening yield curve, but when it comes to credit markets in general and US credit markets in particular, it seems that the "D" word, "D" for deleveraging is staging a comeback as indicated by Bank of America Merrill Lynch in their Situation Room note from the 29th of January entitled "The (soft) floor on credit fundamentals":

"The (soft) floor on credit fundamentals

Our view is that large capital structures in the corporate bond market will go to great length to defend their IG ratings as it could become prohibitively expensive to operate in high yield. That (soft) floor on fundamentals remains one of the reasons we are overweight BBB-rated names. We make a couple of timely observations. First, although the situation remains evolving, we note that General Electric – the 6th largest BBB-rated issuer - is now again trading like the BBB-rated name it currently is, which is a remarkable turnaround after trading in line with BB-rated names during its weakest period last October/November (Figure 1).

Second, when Verizon – the second largest BBB - reported earnings this morning they managed to disappoint and the stock declined more than 3%. However with the company’s emphasis on deleveraging credit investors where not disappointed as spreads tightened about 2bps. AT&T – the largest BBB – was downgraded to BBB-flat in June last year. We would argue that for very large issuers BBB-flat is effectively the floor on ratings, as with further downgrades Fallen Angel risk would be too high for many investors. Since June 30, 2018 – when AT&T became BBB-flat rated in the indices – credit spreads in the Telecom sector, which is dominated by Verizon and AT&T, have tightened 12bps even as the overall IG market widened 10bps (Figure 2).

While we appreciate the longer term challenges to the Telecom industry from technological change, for the next several years we are comforted by relatively stable cash flows and the financial flexibility to support BBB ratings afforded by high dividend yields in the 4.5%-6.6% range. Hence our overweight stance on the Telecom sector." - source Bank of America Merrill Lynch

If there is indeed a slowly but surely rise in the cost of capital, yet at more tepid pace thanks to the latest dovish tone from the Fed, then indeed, this could be more supportive for credit, if companies choose the deleveraging route in the US to defend their credit ratings. In this kind of scenario, it would be more "bond" friendly than "equity" friendly from a dividend perspective we think.

In addition to a potential "D" for deleveraging story playing out for the US, Europe as well could also see a more defensive balance sheet stance coming from CFOs given the weakening growth outlook more pronounced on European shores. On that very subject we read some interesting additional points made by Bank of America Merrill Lynch in their note mentioned above:

"Credit Strategy/Equity Strategy: Who are the refi “losers”?

From the era of hubris… to the reality check

Between 2012 and 2017, European corporates basked in ever-declining debt costs, thanks to unprecedented support from the ECB. The result was a steady boost to Earnings Per Share estimates. Buoyant credit markets thus led equity markets higher. But now the tables have turned, and the equity market should be prepared for a reversal of this symbiotic relationship. European credit spreads have doubled over the last year and companies are finding that they must now pay large concessions on bond deals to attract the requisite demand. Moreover, bond refinancing is a pressing need for a number of companies that failed to term-out their debt maturities during the good times. We think that credit markets now signal that EPS downgrades lie ahead.

A walk into the future - who are the refinancing "losers"?

Table 1 screens for European issuers that could see the greatest EPS downgrades from refinancing their 1-5yr debt. Based on today's credit landscape, we calculate EPS hits of up to 4%. Which names tend to be captured by our screen? Those with plenty of frontend debt still, and those where credit markets have already priced-in steep credit curves.

While Table 1 highlights a variety of names, reflecting these mix of themes, (peripheral) utilities, autos, industrials and telecoms feature prominently. And while there may be mitigants to EPS hits for utilities (regulatory regimes) and autos (financial debt), if debt costs continue to rise in Europe, these sectors would be impacted in other ways.

The canary in the credit mine for stocks

At the height of ECB QE, interest costs for European companies had dropped to 20yr lows. However, interest expenses returning to pre-QE levels will likely become a reality, and will be a further headwind to an already slowing profit cycle. EPS Revision Ratios have been trending down since 2017, when credit spreads turned, and our top-down profit cycle model is predicting 0% EPS growth this year. While operational leverage is undoubtedly the key profitability driver, a 100bps rise in interest costs could lead to a ~2% hit to European EPS. Our strategic view on equity styles and sectors is to focus on quality companies with higher profitability and lower leverage - names that we think will be less vulnerable to rising interest cost and widening credit spreads.

Defend the debt…not the dividend

Companies manage to shareholders, not bondholders. That is the unspoken rule. But we believe that this narrative may no longer hold in today's world of tougher debt rollovers. Equity investors should be prepared for companies to "defend" their debt more than their dividend going forward. Equity investors should therefore be mindful of companies with a high quantum of front-end bonds, and with high dividend payout ratios.

Who are the refi "winners" still?

The silver lining for equity investors is that while debt costs are rising everywhere, some companies have been relatively slow to refinance their bonds over the last few years, and are thus paying higher-than-market coupons on their existing debt. When refinancing time comes, we believe these companies (Table 2) will likely see a small EPS boost.

- source Bank of America Merrill Lynch.

Whereas 2018 was not a good vintage for European stocks, then indeed there might be more additional pain for some equities holders should CFOs in Europe as well embrace a more defensive balance sheet stance, though, leverage in Europe has been creeping up at a much slower pace with the exception of France, being the outlier when it comes to corporate credit leverage overall.

We pointed out in our previous conversations that corporate treasurers in France were becoming more cautious given the deterioration they were seeing in their operating cash flows and slowdown in activity. We could therefore see more dividend cuts coming from French local players, if indeed CFOs adopt a more credit friendly approach when it comes to their balance sheet. The French "leverage" is highlighted in the below Barclays chart from their European Equity and Credit Strategy report from the 30th of January entitled "How worried should we be about Credit?":

- source Barclays

In relation to the European situation we read with interest Bank of America Merrill Lynch's Credit/Equity Strategy note from the 29th of January entitled "Who are the refi losers":

"Canary in the credit mine for stocks

The end of all-time lows on interest charges, as QE ends Since the inception of ECB QE in 2015, corporate borrowing costs have been falling up until 2017, when we saw the Euro cost of debt drop to all-time lows (Chart 5).

With ECB QE coming to an end, we have seen widening corporate credit spreads amid a widespread economic downturn and trade tensions. In periods of declining macro conditions, although safe-haven government bond yields tend to fall amid expectations of looser monetary policy, corporate credit spreads tend to widen due to the perception of rising default risks.

Interest expenses returning to pre-QE levels becomes especially important when EPS Revision Ratios in Europe have been trending down since May ’17 (chart 6) and our topdown earnings model predicts 0% EPS growth in Europe over the next 12 months (chart 7).

Unsurprisingly, investors are increasingly demanding that companies preserve cash to pay down debt rather than spend it on dividends or capex (chart 8).

We prefer more defensive High Quality names with lower relative quantities of frontend debt (or flatter credit curves). These are names that are less likely to see a hit to EPS from future debt refinancing, we think. Also similar to the list, we are strategically overweight the Food & Beverages equity sector in Europe.

European stocks dropped 18% last year, peak-to-trough, but have recovered the majority of December’s losses this year. Recent Fed action has clearly brought short-term relief, but so far has failed to generate large inflows back into Euro corporate credit. The key question is whether we can see a repeat of 2016, when the Fed took a long pause – and helped credit markets. However, in Europe, we think the ECB are unlikely to be able to offer new big stimulus, given the political constraints of QE.

We would note that equities have 88% correlation with credit spreads. But credit markets can also serve as useful leading indicators for equity investors. Large declines in EUR HY credit spreads have reliably signaled major troughs in equities in the past. With global growth in question, central banks are the only game in town (chart 9).

The credit market-equity market nexus

Note as well, that our analysis shows that a rise in European high-yield spreads of 100bp leads to an approximate 2% hit to market EPS in Europe (from the current levels). Given that our top-down model for European earnings suggests 0% EPS growth in 2019, we think that this is quite a meaningful number." - source Bank of America Merrill Lynch

If indeed the Fed's dovish pattern has been more positive for US equity holders including the high beta space, we do agree with Bank of America Merrill Lynch that, in Europe, the story might play out differently, with equities benefiting less from the ECB than credit markets overall. With slowing growth we continue to dislike European banks equities. From a credit perspective, it is more on a case by case basis we think but we would rather own selected credit from European banks than their stocks as far as we are concerned regardless of the high beta/cheap valuation put forward by some pundits or "confidence men" out there. 

So does it mean a return for "goldilocks" for credit? Sure they are many external factors such as Brexit and other geopolitical factors that come into play but, given the Fed has been in the driving seat in the most recent "risk-on" mood, there is a potential for a continuation of the rebound but probably not as significant as the one we saw during the second part of 2016 thanks to the rally in oil prices. We have touched this subject before on numerous occasions but when it come to a sustained rally for US High Yield, oil prices do matter a lot given the exposure to the Energy sector. 

With a notable slowdown in global growth on the back of rising angst surrounding the outcome of the trade war between the United States and China, with central banks coming to the rescue there is indeed a potential for credit to continue to perform on the back of the stabilization of fund flows in the asset class. In relation to US corporate credit's potential for pushing the United States into recession, as we stated before, earnings will be essential in 2019. On this subject we read with interest UBS's take from their Global Macro Strategy note from the 28th of January entitled "Credit Perspectives - US Corporate Credit - What we worry about and what we don't":

"While US growth is coming lower, rest of the world growth is still falling even quicker. Much as we think that at the aggregate level there are mitigating factors that imply US corporate debt won't itself lead to a US recession, there seems to be little doubt higher leverage means the US economy is more vulnerable to a profits slowdown, even one that has its origin abroad. The lack of willingness and ability from China to give a major stimulus this time has compromised growth both in Asia and Europe. Given that Asia has been a big driver of the demand for both tech and energy, key sectors for the US LL and HY markets, a slowdown here could have a big impact on US spreads. Energy issuers are still amongst the most vulnerable, even if the breakeven price for shale has fallen to USD 40-50 per barrel on WTI (Figure 24).

At those levels HY energy spreads could rise to 800-1000bps, we estimate. For the IG space, the big risk is European financials, to which US financials display a very tight correlation (Figure 25), and which have widened but less than would have been expected in the face of a sharp growth slowdown in Europe.

However, the decline in credit market liquidity means a sign of relative calm should not be read as a signal of health. Things could change dramatically with a few downgrades, or an uptick in NPLs." - source UBS

Given the significant rally in European credit since the inception of QE in Europe and with the ECB purchasing directly corporate credit, should a new TLTRO materialize in the coming months to continue to support the European financial sector, we do not think the upside will be as significant as seen before. We do have to agree with UBS namely that the "Zeigarnik effect" of our "generous gamblers" will probably be less potent than previously in engineering a significant rebound in credit markets à la 2016.

Moving back to the subject of earnings and risk-on/Goldilocks, we think there is limited upside in 2019 and we did warn in 2018, that when it came to earnings estimates, analysts were being overly optimistic in their outlook. December has clearly set the tone for vicious EPS revisions and cuts in many instances. If indeed CFOs become much more defensive of their balance sheet, then we could see more dividend cuts in 2019, which would be more credit positive, no wonder we suggested to seek higher quality in US Investment Grade versus high beta credit, performance wise, it has been more supportive to play quality (ratings) over quantity (high beta/yield) as highlighted in the below charts from Bank of America Merrill Lynch from their Credit Market Strategist note from the 25th of January entitled "High grades to IG":

"High grades to IG

While equities and high yield ended this week roughly flat (Figure 1) the strong rally in investment grade continued with credit spreads tightening at a roughly 5bps weekly pace (Figure 2).

This makes sense as the key economic data release this week – Jobless Claims – at the best level since the 1960s (Figure 3) confirms recession risk remains remote. Moreover, the Fed remains clearly on hold for an extended period of time (Figure 4) on the negative GDP impacts of tighter financial conditions and uncertainties surrounding trade war and the government shutdown.

For IG, the material decline in rate hiking risks in reaction to just some tenths cuts to economic growth is a good tradeoff. Being relatively more sensitive to economic growth for high yield and equities the tradeoff is a bit different.

The most likely scenario for how this year plays out, in our view, is continued improvement in the macro – US government reopens, Brexit resolves, US–China relations de-escalate and the US economy continues to grow above trend. As financial conditions ease this environment eventually puts the Fed in a position to resume its rate hiking cycle – probably sometime in the middle part of the year – which is going to be a more formidable challenge for IG. For now, we expect tighter credit spreads – although obviously the first big step has already been taken – but over time IG outperformance fades and turns to underperformance. We remain overweight IG corporate bonds." - source Bank of America Merrill Lynch

So yes, clearly, there is room for slightly more tightening with the Fed's dovish tilt and lack of interest rates volatility with falling inflation expectations. In terms of upside, it is a question of not having "great expectations" and being very selective hence the return of global macro and active management at this stage of the cycle with continued rising dispersion. 

Our final charts below clearly highlight the importance of central banks and in particular the Fed in driving asset prices, with its balance sheet policy reduction being the most important factor at play when it comes to the "Zeigarnik effect".

• Final charts - Central banks to markets: let's be friends again...

With the most recent dovish tilt coming out of the US Federal Reserve, no surprise "risk-on" lives on. It is all about after all a question of "growth sensitive assets" as indicated in our final charts from Bank of America Merrill Lynch The Inquirer note from the 30th of January entitled "Wanted: Monetary easing, not Verbal flexibility":

All indicators point to weak global growth, and suggest EASING monetary policy

1) Only 5 out of 38 economies are seeing rising OECD leading economic indicators (LEI). The net proportion of countries with rising LEI is in the bottom decile of its history since 1988. 2) The world's monetary base shrunk 1.7% YoY in November, only the sixth time since 1980. All prior five occurrences of a shrinking monetary base were associated with recessions in Asia/emerging markets, and ALL were eventually associated with global monetary easing. The Fed's plan to "watch paint dry" and shrink its balance sheet by USD50bn/month this year, is likely to shrink the global real monetary base by 5% YoY by end-2019. Global central banks are implying a massive rise in the money multiplier to counteract this, and/or a rise in monetary velocity to keep nominal GDP growth humming. We think these assumptions are heroic. 3) The global 1m earnings revisions at 0.5 (i.e. for every upward revision there are two downward revisions) is in its bottom decile. 4) Asset prices that have an opinion on global growth (Dr Copper, Dr Sotheby's, Dr. Halliburton etc.) are in their lowest decile. Again, prior instances of such analyst pessimism and weak asset prices were followed by monetary easing. Policymakers seem to be flexible, and the markets like this flexibility if data weakens. Next stop easing?" - source Bank of America Merrill Lynch

Given the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks, it seems that markets are more than happy to remember an incomplete balance sheet reduction from the Fed at this stage but, we ramble again...

"An educated person is one who has learned that information almost always turns out to be at best incomplete and very often false, misleading, fictitious, mendacious - just dead wrong." - Russell Baker, American journalist.

Stay tuned!

Macro and Credit - The Armstrong limit

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

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

- source Bank of America Merrill Lynch

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

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

Synopsis:

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

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

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

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

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

Remember the Sock Puppet Commercials?

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

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

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

No Time Like the Present

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

Some Things That Are Different From 2000

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

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

I Don’t Know Why I Go to Extremes

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

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

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

- graph source Macrobond (click to enlarge)

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

- graph source Macrobond (click to enlarge)

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

- graph source Macrobond (click to enlarge)

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

- graph source Macrobond (click to enlarge)

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

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

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

- graph source Macrobond

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

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

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

Income Gets Boost from Wages

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

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

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

Energy Costs Taking up Larger Share of Consumer Spending

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

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

Inflation Dynamics

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

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

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

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

• Final charts - The "profit" illusion

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

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

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

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

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

Are profits rising or falling? 

- source Asia Times - David P. Goldman

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

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

Stay tuned !