Macro and Credit - Alprazolam

"Anxiety does not empty tomorrow of its sorrows, but only empties today of its strength." - Charles Spurgeon British clergyman

Watching with interest the historical defeat of Prime Minister Theresa May relating to Brexit, in conjunction with the Chinese central bank injecting a net 560 billion yuan ($83 billion) into the Chinese banking system, the highest ever recorded for a single day given the weakening tone of the economy, when it came to selecting our title analogy we decided to go for a medical reference to "Alprazolam". "Alprazolam", also the trade name for Xanax among others, is the most commonly used benzodiazepine in short term management of anxiety disorders, specifically panic disorder or generalized anxiety disorder. It seems to us that the Chinese authorities have decided to act decisively on the very weak tone taken on their economy and the slowdown in global trade and its impact. Due to concern about "misuse", some strategists like us would not recommend "Aprazolam" as an initial treatment for panic disorder such as the MSCI China index down 23% over the past year. With the University of Michigan’s consumer confidence index falling to a more than two-year low of 90.7 in January, down from 98.3 in December, and well below expectations of 97.5, we wonder if our quote above is correct in asserting that anxiety does indeed empties today of its strength, namely consumer confidence. After all, clinical studies have shown that the effectiveness of Alprazolam is limited to 4 months for anxiety disorders but we ramble again...

In this week's conversation, we would like to look at the rising cost of attrition on the global economy, with the continuation of the stalemate in Brexit, US vs China trade/tech war, yellow jackets in France and of course the government shutdown in the United States. While Alprazolam has brought some solace to the December angst for investors, it remains to be seen how long the effect will last on the recovering "patients".

Synopsis:

• Macro and Credit - Does A for attrition equate R for recession?
• Final charts -  Mind the liquidity shock...

• Macro and Credit - Does A for attrition equate R for recession?

As we indicated in our previous conversations, "Bad News" has been the new "Good News" at least for asset prices in general and high beta in particular, the rally seen so far this year appears to us as more of a respite than a secular change to the overall picture. 

We indicated more downside risk at least from a European perspective and we continue to have a very negative view on France given the continuation of the unrest and the "yellow jackets" movement not giving any respite to president Macron. 

In our conversation "The European crisis: The Greatest Show on Earth", we indicated:

"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."

In the AFTE latest survey, there is now a clear trend in the deterioration in their operating cash situation showing up:

- source AFTE

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).

On this "attrition" subject we read with interest Bank of America Merrill Lynch's take from their Cause and Effect note from the 18th of January entitled "Investing in the age of the attrition game":

"Attrition bites in Europe

The “yellow vest” protest in France, which has resulted in the “worst riots since 1968” is now its 9th week. Not only it has shown no sign of ending, the number of demonstrators rebounded sharply over the past two weeks (Chart 6).

What began as a protest against fuel hikes has morphed into a broader movement of discontent with the government. President Macron has so far has refused to restore the wealth tax, one of the key demands of the protesters. This could turn into another war of attrition, especially with the fast approach of the EU parliamentary elections (May 23-26). French consumer confidence has tumbled sharply and is approaching levels reached during the Eurozone crisis (Chart 7).

The slowdown within the Eurozone is spreading. Both Italy and Germany are already in a recession (“the “R” club is recruiting”, January 11). For Italy, despite the passage of the 2019 budget bill, our European economics team has observed that the busy electoral calendar and decrees (not least those implementing pension reform and an income support scheme) could challenge the current ruling majority in the first half of the year. In Spain, a new far right party is emerging and the government lacks parliamentary support to pass a 2019 budget. The latest manufacturing PMI surveys show that new orders for Germany, France, Italy and Spain, the four largest economies in the Eurozone, were all below 50 (contractionary) in December, the first time in four years (Chart 8).

In our view, the greatest risk facing Europe is that the slowing economy fuels further populist discontent, creating a vicious circle." - source Bank of America Merrill Lynch

The numerous "attrition wars" being fought on a global scale are indeed clear headwinds regardless of the latest injection of "Alprazolam". As we indicated in our previous conversation "Respite",

"As we stated in various conversations including our last, we tend to behave like any good behavioral psychologist in the sense that we would rather focus on the flows than on the stock. On that note we continue to monitor very closely fund flows when it comes to the validation of the recent "Respite" seen in the market and it is not a case of confirmation bias from our side. 

We think that a continued surge in oil prices will be supportive to US High Yield. As well, any additional weakness in the US dollar will support an outperformance of selected Emerging Markets. Sure we might be short term "Keynesian" but overall, at this stage of the cycle we do remain cautiously medium-term "Austrian". 

A flattening curve in our book is not positive for banks and cyclicals such as housing and autos have already turned.  Also as briefly pointed out, a sustained shutdown is likely to be another drag on US growth which will therefore push the Fed's hand further into "dovish" territory". In that context, and if inflows return into credit markets, then high beta credit as well as Investment Grade could continue to thrive in the near term given Fed Chair Powell indicated in the latest FOMC minutes a willingness to be patient with future rate hikes. 4Q US GDP might disappoint we think." - source Macronomics, January 2019

We also discussed in our conversation the importance of the return of "macro" and the need to "monitor" fund flows for any signs of stabilization in "credit markets" as well as the need to track oil prices relative to US High Yield given its exposure.

Flow wise, Bank of America Merrill Lynch in their Follow The Flow note from the 18th of January entitled "Just a bounce?" question the most recent positive tone in financial markets given the weakening mood coming out from the macro data:

"Light positioning and known-unknowns

This year started on a positive note. Despite further weakness on the macroeconomic data front across the globe (more here), risk assets have staged a strong bounce higher. This is not because everything is in the price and we already know that macro is slowing and that the synchronised recovery has turned to a synchronized slowdown. It is the fact that positioning has been very light at the end of last year and thus cash balances have been put to work in January. With slower primary and tighter spreads last week it feels that the outflow trend is slowing down. However we are skeptical for how long markets can keep ignoring the continuing deterioration in macro. We feel this rally will not last, and thus we would use this bounce higher to reduce risk.

Over the past week…

High grade funds suffered another outflow, making this the 23rd week of outflows over the past 24 weeks. However, this week’s outflow is the smallest observed over that period. High yield funds recorded another outflow, the 16th in a row, but also the smallest in a while. Looking into the domicile breakdown, Globally-focused funds recorded the lion's share of outflows while US-focused funds outflow was more moderate. Actually Europe-focused funds have recorded small inflow, the first in 15wks.

Government bond funds recorded a small outflow this week. Meanwhile, Money Market funds recorded an outflow as risk assets moved higher. All in all, Fixed Income funds recorded an inflow, the second in a row.

European equity funds recorded another outflow this week, the 19th consecutive one. During the past 45 weeks, equity funds experienced 44 weeks of outflows.

Global EM debt funds continued to record inflows, the second weekly one. This confirms the improving trend observed recently as a dovish Fed has weakened the dollar. Commodity funds recorded another (albeit marginal) inflow, the 6th in a row.

On the duration front, short-term IG funds led the negative trend by far. Mid-term funds saw a small outflow while long-term funds experienced a decent inflow, continuing the recent trend of strength on the back-end of the curve." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch that, the significant rally in high beta should entice you to become more "defensive" and favor "quality" (rating) over "quantity" (yield). In the ongoing attrition game, it is more a question of capital preservation than capital appreciation we think.

Moving back to the "attrition game" and Bank of America Merrill Lynch's note from their Cause and Effect from the 18th of January entitled "Investing in the age of the attrition game", regardless of the positive liquidity injection from the PBOC and dovish tilt of the Fed, earnings as well are slowing down and there is more risk to US consumer confidence with the shutdown:

"Shutdown raises trade war risk

What does a destabilizing gridlock in Washington mean for the US-China trade war? Given the peril of fighting two battles at the same time, it seems reasonable to assume that the incentive for Trump to close a deal with China sooner than later has gone up. The fact that he has been talking up the prospect of a deal with China in recent weeks (“I think we’re going to be able to do a deal with China,” January 14) is consistent with this hypothesis. The market has taken these upbeat remarks at face value and has been driving up EM assets, the main casualties of the US-China trade war last year.

However, it takes two to tango. Trump’s loss of full control of Congress may be viewed by Beijing as justifying a less conciliatory stance. With the shutdown in Washington and growing expectations that the Mueller report will be out soon, Beijing may decide that it is not in a hurry to close a deal. Trump set a precedent by agreeing to a 3-month extension for the next round of US tariff. Beijing might think that the Americans could be forced into giving another extension if there is no deal by March 1.

The recent US slowdown could be giving China another reason to wait. Despite the reductions in reserve requirements to decade lows (Chart 3), Chinese credit growth has so far shown no signs of picking up (Chart 4).

Beijing might have eased monetary policy even more aggressively last year if it weren’t for the fact that rate hikes by the Fed was pushing down the renminbi (Chart 5).

A much weaker renminbi might have further complicated the US-China negotiation. The fact that the Washington shutdown is increasing the chance of a Fed pause, giving China a wider window to ease policy, could also reduce the urgency for Beijing to close a deal with Trump." - source Bank of America Merrill Lynch

Unless there is a rapid resolution between the United States and China on the trade/tech war narrative which has led to a significant rally in Emerging Markets so far this year on the back of a weaker US dollar, then indeed there is a high probability that the effect of the "Alprazolam" will fade and the bounce experienced so far could end rapidly and abruptly.

Bank of America Merrill Lynch added the following in their report:

"Market implications

Developments over the past two months suggest to us that political risks are rising.
This puts us at odds with current market consensus.

The contrast between our views and those of consensus is giving us confidence in our investment thesis for 2019:

The USD is vulnerable. We view the escalation of the gridlock risk in Washington as posing the greatest risk to the decoupling trade and to the USD. We are soon approaching a key support level that, if broken, will usher in further USD weakness (USD topped and target reached, but is this it? January 16). We like selling the USD especially against the JPY and the CHF. The EUR has been unable to capitalize on the USD’s retracement this year, reflecting concerns about the growth outlook for the Eurozone. If Eurozone political tension continues unabated, we may have to revisit our bullish EUR/USD forecasts.

EM rally won’t last forever. EM is rallying on Trump’s upbeat comments on the prospect of a trade deal with China. We think the risk of a no deal by March 1 is higher than expected. We also think that the inability of the EUR to gain against the USD will limit the room for further gains in commodity prices and EM. We think EM investors should not wait too long before taking some money off the table. We continue to believe that in 2019 investors need to think strategically but act tactically.

US rates vol looks cheap. Rates vol has fallen sharply year-to-date as risky assets stabilized (Chart 9).

We see the sell-off as possibly overdone given the binary nature of the political risks we highlighted in this report and the increasingly binary decision the Fed is facing. The worsening supply-demand dynamics as we head into possibly debt ceiling crisis #2 will likely provide strong support to rates vol." - source Bank of America Merrill Lynch

Any spike in rates volatility would obviously be negative for asset prices given carry players, risk-parity investors and other pundits love one thing, and that's low rates volatility. Any return of volatility on the aforementioned would definitely trigger another bout in "risk-off" rest assured.

How convinced are we with the strong rally seen so far from the December "oversold" situation? Not very much, we would argue. Sure, we have seen a welcome respite with the central banking cavalry arriving late, once again to an already damaged macro situation. Given the amount of known "unknowns" and the weaker tone in the overall macro picture, yes bad news are good news again for asset prices, but, we do think that buying some protection to the downside with potential bouts of volatility is a wise move.

Remember 2018 has marked the return of "cash" in your allocation toolbox and it should be used more extensively in 2019 given the risk for even more volatility events than in 2018. Bank of America Merrill Lynch in their High Yield Strategy note from the 18th of January entitled "When Cash Becomes King" makes some compelling arguments about the current tactical rally we are seeing:

"Low-risk yields appear compelling in this macro setup

The rally in leveraged credit has taken a pause in recent sessions, with our DM USD HY index oscillating around 450bps, more or less where it stood a week ago. The same could be said of rates as well, where the 10yr remained range-bound over the past week, spending most of its time around 2.70-2.75%. Even equities exhibited low volatility, by recent standards, with S&P500 moving 10-20pts in most sessions, a sea-change from 80-100pt sessions around year-end.

So, can this be considered an all-clear signal? Perhaps. It undoubtedly adds one reason to think so, although it is hard to make it sound convincing in and of itself. We prefer to rely on more tangible events, something that would not be forgotten tomorrow if volatility were to return.

Among such new developments, we counted the following:

• China: has responded strongly to apparent signs of weakness in its economy by cutting bank reserve requirements, policy rates, and business taxes. The extent of cuts in reserve requirements now exceeds those witnessed in 2008 and 2015. Business taxes were cut to the tune of $30bn/year; for some perspective US corporate tax cuts of 2017 amounted to $600bn/10yrs, or $60bn/yr for an economy that is 1.5x larger. In other words, very meaningful policy actions out of China.
• Earnings: banks opened the reporting season with a bang despite notable shortfalls in FICC results; their other businesses appeared to be doing well. Tax-reform bump is likely to begin coming out of numbers only next quarter, and will potentially reach its peak in Q2-Q3 of 2019. So US earnings could stay artificially elevated for a couple more quarters, in our view.
• Sectors: financials led, while utilities and staples trailed in the whole S&P500 round-trip between Dec 14-Jan 15. The argument goes that financials underperform and defensives outperform into a downturn. And yet the fact that utilities underperformed through a potential PCG bankruptcy does not help the case of this not being a cyclical turn.

On the other side of the ledger, the following reasons support continued caution:

• China: would probably not be throwing this much stimulus if its economy was performing in an acceptable way. The leadership there must know something we don’t know, in our view.
• Earnings: our model for US EPS has experienced further deceleration in recent weeks, and points to +6% growth over the next year. While this is not a level consistent with a cyclical downturn, we note that earnings went from 20%+ actual yoy growth rate in Q3, to earlier estimates around +10-12% to +6% today (Figure 1). So the trajectory and the remaining cushion are a concern.

• Wide IG: with spreads elevated in the IG space, HY looks tight. BBs offer only 100bps premium over BBBs (Figure 2). While not unheard of, we think this is too tight in today’s market environment given the shift in risk sentiment that has occurred over the past several months. Historical relationship between BBBs and BBs implies the latter should be 60bps wider given where the former is, ex PCG.

• Illiquidity gap: while liquid bonds have rallied and retraced a good chunk of Dec losses, illiquid paper remains marked at discounted levels (Figure 3 and Figure 4). This behavior is inconsistent with a sustainable turn in market sentiment, i.e. investors must become comfortable bidding for illiquid stuff to demonstrate their conviction. Buying HYG does not cut it.

• High dispersion: only 1/4 of all HY bonds trade within +/-100bps of overall index level; under normal circumstances, 40-50% of them trade this way. High degree of dispersion could be a function of illiquidity gap described above. Regardless of its origin, dispersion tends to increase (percent trading at index levels drops) at times of market downturns. The current levels of dispersion are consistent with 500- 525bps HY spreads and 1,300-1,400bps CCC spreads.
• Default estimates: With most factors now fully refreshed with Dec levels, the model continues to point towards 5.5% issuer-weighted and 4.25% par-weighted default rates. Such credit losses, if materialized, imply meaningful pickup over realized levels (2.8%) and point towards wider HY spreads (500bp as a risk-neutral level).

While these data points are not yet known, and could change our thinking as they come in, we remain mindful of a scenario where this episode eventually proves itself to be a cyclical turn. As such, we find current HY valuations to be somewhat out of balance, in terms of likely ranges going forward, i.e. we think probability is higher to see spreads in high-500s rather than low-300s; these two are otherwise equal distance away from here. Given this view, we are reducing our model portfolio beta to a modest underweight at this point, which we intend to move towards a more substantial underweight if  spreads continue to grind tighter from current levels.

Think about what you believe are reasonable return expectations from here, and compare them to low-risk alternatives: Libor is at 2.75%, short-duration IG is at 3.70% yield, and short duration BBs are at 5.20%.

In the environment where the next few months carry a reasonable chance of marking the turning point in this credit cycle, we find such yields increasingly attractive. Even if the cycle overcomes all obstacles and rolls on, you can blend-average the above into 3.5-4% portfolio, with a strong likelihood of actually realizing this return, in our view.

So we are probably entering a period of time when cash is becoming king again. HY may end up showing bouts of strong performance during this time, just as it did in early January, and we remain open-minded to tactically shifting our views when opportunities present themselves. We just struggle to see how it could happen from 450bps overall index levels or from 100bps BBs-BBBs differential." - source Bank of America Merrill Lynch

Being underweight high beta is we think indeed a good recommendation at this stage. Stay nimble and get tactical. Buying HYG might not cut it for Bank of America Merrill Lynch from a "liquidity" perspective, but, from our side and as a useful "macro" defensive tool for credit exposure "hedging", we believe synthetic exposure through credit indices such as Itraxx Main Europe 5 year and CDX IG for the lucky few of you benefiting from an ISDA agreement provide sufficient liquidity to sidestep any Investment Grade liquidity concerns. The US equivalent to the European CDS investment Grade index, namely the CDX, does not include banks as a reminder. The Itraxx Main Europe 5 year index is therefore a good "macro" hedge instrument for investment grade exposure to more turmoil with "European" banks, though we do not expect Mario Draghi to rock the ECB boat before his departure and it is highly likely the ECB will provide additional LTRO funding to the ailing banks in the European banking system, some more "Alprazolam", one would opine.

On that note, if indeed we are back into a "macro" world when it comes to "trading" then, using the rights "macro" instruments such as synthetic credit indices and options on credit indices might provide mitigation to heightened volatility over the course of 2019 and sufficient liquidity if indeed there is a "liquidity shock" when the "Alprazolam" effect will truly fade.

• Final charts -  Mind the liquidity shock...

While as we pointed out like many pundits that "liquidity" is a concern given how credit markets have swollen in recent years thanks to buybacks supported by very large issuance levels, then looking at the CDS market as a proxy for risk ahead is again warranted as pointed out by Bank of America Merrill Lynch in their Credit Derivatives note from the 16th of January entitled "The basis for a correction" with the below chart pointing out to the underperformance of bonds relative to the CDS market:

"Macro data continue to disappoint; we remain cautious

The globally synchronised bullish macro backdrop markets enjoyed in 2017 and the early part of 2018 is now firmly behind us. A year later, European data weakness continues while US strength is losing steam, fairly sharply. Chinese data are not improving either as PMIs are now at recessionary levels.

Despite the somewhat better start to the year for risk assets, we think that volatility will remain a key theme for another year. Large swings and lack of clarity underpin our bearish stance on spreads and beta in the following months; we continue to advise a defensive positioning. The deterioration in macro indicators will keep market sentiment fragile, in our view.

It feels like 2015-16

2018 is likely to be remembered as the worst year since the 2008 crisis. Performance was poor and funds suffered outflows. The performance over the past 12 months resembles that of 2015-16. However, this year started on a much more upbeat note than. 2016. Nonetheless, we are concerned that several factors are reminiscent of the drivers that pushed spreads wider in January and the early part of February 2016. A macro slowdown, lack of inflation in Europe and tightening conditions that risk assets were dealing with back then are still adversely affecting markets.

Gap risks and basis

We also think that CDS is too tight to cash bond spreads and negative basis is supportive for more downside risk in the synthetics space. The “gap” wider risk for the CDS market makes us less comfortable at current levels and, as we see fewer catalysts to reverse this market weakness we would use the recent move tighter as reason to reset shorts, especially by selling receivers to own payers. We also screen for negative basis opportunities.

The globally synchronised bullish macro backdrop markets enjoyed in 2017 and the early part of 2018 is now firmly behind us. A year later, European data weakness continues while US strength is losing steam, fairly sharply. Chinese data are not improving either as PMIs are now at recessionary levels.

Despite the somewhat better start to this year, we think that volatility will remain a key theme in 2019 too. Large swings and lack of clarity underpin our stance to remain bearish spreads and beta in the coming months; we continue to advocate defensive positioning. We expect the deterioration of macro indicators to keep markets sentiment fragile, and until we see the cycle trough, we remain skeptical on how well higher risk/beta pockets will perform." - source Bank of America Merrill Lynch.

So enjoy "Alprazolam" effects while they last as we concluded in similar fashion our previous conversation. Remember that those taking more than 4 mg per day of Alprazolam have an increased potential for dependence. This medication may cause withdrawal symptoms upon abrupt withdrawal or rapid tapering, which in some cases have been known to cause seizures, as well as marked delirium.  The physical dependence and withdrawal syndrome of Alprazolam also add to its addictive nature. Alprazolam is one of the most commonly prescribed and misused benzodiazepines in the United States, benzodiazepines are recreationally the most frequently used pharmaceuticals due to their widespread availability. Alprazolam, along with other benzodiazepines, is often used with other recreational drugs such as QEs but we ramble again...

"A crust eaten in peace is better than a banquet partaken in anxiety." - Aesop

Stay tuned !

Macro and Credit - The Decoy effect

"In a time of universal deceit - telling the truth is a revolutionary act." - source unknown

Looking at our home team (France that is) getting away with the Football World Cup for a second time in 20 years (1998-2018) hence our lack of recent posting, 8 being a lucky number it seems, we were drawn again to the parallel with 1998 with the ongoing Emerging Markets (EM) woes, whereas this time around, Asian countries are in much better shape, including Russia, while the usual suspects (Turkey, Argentina and Brazil and even South Africa) are still feeling the summer heat from the Fed's liquidity drain thanks to QT. With the escalating rhetoric of trade war between China and the US and the strong arm negotiating tactics from the Trump administration, when it came to select our title analogy, we decided to go for a marketing one, namely the "Decoy effect". In marketing, the decoy effect (or attraction effect or asymmetric dominance effect) is the phenomenon whereby consumers will tend to have a specific change in preference between two options when also presented with a third option that is asymmetrically dominated. An option is asymmetrically dominated when it is inferior in all respects to one option; but, in comparison to the other option, it is inferior in some respects and superior in others. In other words, in terms of specific attributes determining preferences, it is completely dominated by (i.e., inferior to) one option and only partially dominated by the other. When the asymmetrically dominated option is present, a higher percentage of consumers will prefer the dominating option than when the asymmetrically dominated option is absent. The asymmetrically dominated option is therefore a decoy serving to increase preference for the dominating option. The decoy effect is also an example of the violation of the independence of irrelevant alternatives axiom of decision theory. Of course, it is a great tool to use when one relates to trade negotiation we think but we ramble again...

In this week's conversation, we would like to look at the rise in inflation, and trade war escalation and the impact in can have on global growth as well. Also, overweight US relative to Emerging Markets (EM) and the rest of the world, continues to be the trade du jour, with FANG still racing ahead in the rally game. 

Synopsis:

• Macro and Credit - Deglobalization goes hand in hand with inflation
• Final chart - Credit versus Equities - "until death do us apart"

• Macro and Credit - Deglobalization goes hand in hand with inflation

While we thought the ratcheting up of the trade war narrative would be bullish for gold, latest price action with the continuation of the surge in the US dollar has put a dent on this scenario playing out so far. Real interest rate, US dollar strength have indeed been the "out-of sight" jack-knife of our Mack the Knife's murder of gold prices. That simple. 

Given it seems that US inflation expectations are moving upwards it seems, we like US TIPS particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment. At least with US TIPS you can side with the "inflationistas" camp while having downside protection should the "deflationista camp" of Dr Lacy Hunt wins the argument eventually. Also, in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. 

If inflation creeps up, then companies will suffer margin compression and will be forced to raise prices which will lead to wage increases to compensate that higher price level. We have pointed in the past that trade wars could lead to a stagflationary scenario playing out, meaning lower growth and higher inflation. Are tariffs really the culprit leading to higher inflation? On that subject we read with interest UBS Global Strategy note from the 18th of July entitled "What will drive TIPS in the 2nd half?":

"What about tariffs? Do they matter? It matters much more for growth than inflation

As discussed by our economics team and shown in Figure 4, Laundry equipment prices have jumped by 12% above their January level following the implementation of 20% tariffs in early February.

That said, its impact on headline inflation is very small because of its less than 0.08% weight in CPI. Nonetheless, this clearly shows tariff do have an effect on near-term inflation. Since these early tariffs, US has implemented additional 25% tariffs on $50bn of products from China and the President has proposed 10% tariffs on an additional $200bn of imports from China with other investigations going on in parallel. Thus the scope of tariff tensions is much larger now. We estimate that the current set of announced tariffs would push up consumer prices by roughly 15bp, but with notable uncertainty on both the upside and downside. We discussed ramification of various upside tariff scenarios on growth/inflation and financial markets in Trade Wars- What is the impact on growth, inflation and financial markets? A Top Down View. Albeit, we view this document more as the upside risk scenario than our current baseline; based largely on a lower effective autos tariff and smaller Chinese retaliation is somewhat less.

Specifically, in the aforementioned note, we discuss the following scenarios and their impact on GDP inflation. The 1st scenario is ("Escalation") 25% car tariff (US/global retaliation plus an additional 10% tariff on $200bn US-China trade with proportional retaliation. In the 2nd scenario ("Trade War"), we assume 30% tariffs on virtually all US/China trade + earlier car tariff disruption. In Figure 5, we see that under the trade "Escalation" scenario, we would see near-term inflation rise by 31bp and real GDP fall by 100bp.

In Scenario 2 – "Trade War", we see inflation rising by 71bp and real GDP falling by 245bp. A key takeaway is that the hit to real growth is much larger than rise in inflation on trade tariffs. For details on these estimates, please see the Q-Series. Next, we consider what is the TIPS market priced for and how they could react to escalating trade tensions.

Is the TIPS market pricing in trade dynamics correctly?

The TIPS market is right in reacting trade war by not widening breakevens but by lowering long-end real yields. 5y and 10y real yield have declined by 3bp and 9bp since early June while 5y and 10y BEIs barely moved (Figure 6).

On the inflation impact, we think the market already seems to be priced for our escalation scenario. In Figure 7, we see that 2y ex-energy inflation (which is close estimate to implied core inflation) has risen quite sharply this year. It's near 252bp if you assume  240bp as consistent with target CPI inflation.

The market is implying that the US may have up to 10-15bp/annum of trade related inflation over the next two years. In our trade escalation scenario, we see 31bp inflation uptick over 1-year. This would imply about 15bp tick-up in 2-year core inflation and market seems to be pricing such an uptick. Thus, the market is fairly priced for the inflation uptick. For growth hit due to trade "escalation", we should have seen a bigger decline in real yields. 2y yields are basically unchanged over the past few months, which suggest the market is not assuming a growth hit at this juncture. Thus, for increasing trade concerns, we recommend receiving front-end real rates, or set up 2s5s real curve steepeners which we discuss later in the note. In general, the market is not priced for a "trade war" scenario on both real yields and breakevens." - source UBS

It seems to us that the market has been a little bit too complacent for a trade war scenario playing out. At least with TIPS with the embedded deflation floor, you have some downside protection should the global slowdown scenario play out thanks to escalating tensions. With this known unknown, we do think that the long end of the US yield curve (30 years) at current levels remains enticing from a carry and roll down perspective. We have recently started to add exposure to it on a side note.

But, in respect to the inflation risk, US inflation is creeping up, no doubt about it. This is clearly illustrated by Wells Fargo in their Economics Group note from the 11th of July entitled "Producer Prices: More Inflation to Come":

"Producer prices for final demand rose 0.3 percent in June, which was slightly stronger than expected. Core prices continue to climb higher as U.S. producers are facing rising input costs.

Broad Increases in Producer Prices in June

• Inflation continues to gradually climb higher, with the producer price index advancing 0.3 percent in June. Gains were broad based, with food being the only major category to see prices slip.
• Excluding food, energy and trade services (measured by margins), prices increased 0.3 percent. That pushed the year ago rate of our preferred measure of core PPI back to 2.7 percent, which is up from 2.1 percent last June.

Processing Input Cost Increases

• Input costs continue to rise as capacity has become more constrained and businesses are grappling with tariffs. Processed intermediate goods increased 0.7 percent in June and are up 6.8 percent over the past year. While higher energy costs have led the pickup, non-energy materials for manufacturing and construction are up 6.5 percent since last June. Service inputs are up, led by fuel and labor shortages driving transport costs higher.

- source U.S. Department of Labor and Wells Fargo Securities 

June PPI report showed an acceleration in the price appreciation with year over year PPI at 3.4% and year over year core PPI coming at 2.8%. With year over year CPI up to 2.9%, meeting estimate, Core CPI printed at 2.3% beating expectations. It might be the case of the US economy running hotter than anticipated? We wonder. Wage growth are essential to validate this prognosis we think. For some other pundits such as Knowledge Leaders Capital, "The Inflation Story is Alive and Well in Five Charts".

As we pointed out in our previous conversation "Attrition warfare":

"The rise of the US dollar in conjunction with trade war escalation and rising oil prices could indeed decelerate even more global growth and led to a stagflationary outcomes. Some signs are already there. We are very closely looking at the rise of gas prices in the US and monitoring closely the US consumer. If indeed, the US consumer starts retrenching as pointed out recently by another note from David P Goldman on Asia Times on the 30th of June then all bets are off.

To repeat ourselves, rising energy prices could be the match that lights the bear market. Continued inflationary pressure coming from energy prices will eventually lead to financial markets "repricing" accordingly. We are already seeing blood in some selected EM with rising inflation in double digits (Turkey for example). It is probably understandable why the Trump administration is reaching out to OPEC for them to slowdown the steady rise in oil prices with elections coming later this year.

While escalation in the trade war would no doubt affect Developed Markets and Europe in particular, Emerging Markets which have been more recently on the receiving end of tighter liquidity and rising US dollar would as well be seriously impacted by a stagflationary income."- source Macronomics, July 2018

This raises the question about inflation and the US consumer in general and the price at the pump in particular. What is the pain threshold one might rightly ask? On that subject we read with interest Bank of America's take in their US Economic Watch from the 11th of July entitled "High pain tolerance at the pump":

"Higher gas prices a partial offset to tax cuts benefits

Gasoline prices are up around 50 cents since the start of the year and currently hovering nationally around $3, owing to tightening global oil supply and demand balances. Our calculations suggest that the recent rise in gasoline prices increases the average cost to the consumer by $30 per month. So far, this has had limited impact on overall consumer spending as most consumers have been able to offset higher prices at the pump with the extra income from tax cuts. According to the Tax Policy Center, the median consumer is receiving roughly an extra $78 per month due to tax cuts this year.

The breakeven price: $4/gallon

At what point would higher gas prices fully offset the tax cuts? We would likely need to see oil prices jump another $60 per barrel (bbl), adding about $1 per gallon to gasoline prices. This would increase the cost of gasoline almost $60 per month, effectively wiping out the extra income from tax cuts for most consumers.

Of course there could be effects beyond these simple calculations. A common rule of thumb from Hamilton (2008) is that an oil “price shock” is when prices go above the highest level in the last three years. That seems to be happening now, although we are still below the highs of 2011-14 (Chart 1).

Francisco Blanch and team see upside risk to their crude oil price outlook should sanctions on Iranian oil exports prove binding. Higher gasoline prices could lead to “sticker price shock” at the gas pump, causing consumers to pull back spending more than one-for-one. An additional downside risk comes from the fact that the “gasoline tax” is regressive and has a bigger percentage impact on low income families (Chart 2).

From the oil rig to the gas station

Translating moves in crude oil prices to gasoline prices is fairly straight forward. According to the Energy Information Administration, crude oil represents about half the retail cost of gasoline. Indeed, looking at the relationship between the % mom in Brent oil prices and % mom in gasoline prices, we find a coefficient of roughly 0.5 suggesting that a 10% increase in the price of crude oil would be associated with a 5% increase in the price of gasoline (Chart 3).

Currently, a $60 boost would amount to a 75% increase in crude oil or 37.5% increase in gasoline prices. With gasoline currently near $3, such a shock would increase prices at the pump by over an additional $1.

From the gas station to the consumer’s wallet

Vehicles on the road in the US consumed, on average, 55 gallons of fuel per month in 2016 according to the Federal Highway Administration (Chart 4).

To put this into context, for a compact car or a medium size sedan, this works out to be a full tank of gas per week. Demand for gasoline is relatively inelastic so we can safely assume no demand response from an oil price shock in the short run. Therefore, the run up in gasoline price since the start of the year would cost the average consumer around $30 per month.

We think most consumers have been able to offset the latest increase in gasoline prices. According to the Tax Policy Center, with the exception of the bottom quintile, taxpayers are receiving at least a $30 tax cut per month due to the Tax Cuts and Jobs Act (Table 1).

However, further boost in gasoline prices could ultimately offset most of the tax cut benefits. For example, another $1 per gallon at the gas pump would cost another $60 dollars per month. All told, the extra $90 per month spending at the gasoline station would be enough to offset tax cuts for majority of consumers.

From the consumer’s wallet to consumer behavior

While demand for gasoline is relatively inelastic, marginal propensity to consume out of gasoline (dis)savings is likely greater than 1. That is, a rise in gasoline prices will force consumers to substitute away from other categories more than one-for-one and vice versa. For example, Gicheva et. al. (2007) find that gasoline expenditures rise one-for-one with gasoline prices but consumers substitute away from food services toward  groceries in order to partially offset higher gasoline expenditures. Moreover, they find that even within grocery spending, consumers substitute away from regular price products and towards promotional items. On the flip side, Alexander and Poirier (2018) calculate that the marginal propensity to consumer out of the gasoline savings in 2014- 15 was greater than 1 with most of the spending going toward discretionary spending. The upshot is that most consumers have so far absorbed higher gasoline prices in stride but further increases at the gasoline stations could start to broadly hurt consumer demand." - source Bank of America Merrill Lynch

While everyone and their dog is focusing on the flattening of the yield curve, we would rather focus on inflation creeping up and in particular oil prices as a potential lethal trigger for asset prices and a bear market to ensue. Clearly we are not there yet, but we think that the "decoy effect" of the flattening of the yield curve hides the fact that trade war rhetoric is weighting on both consumer sentiment as well as leading to higher PPI. At some point these factors will weight on growth. The continuous surge in the US dollar means that EM are still in a painful situation. In that context, cash has returned as a valid yielding tool in the allocation toolbox and so are US Tips. As we stated above the long end of the US yield curve remains enticing.

Maybe the second part of the year will favor the return of the duration trade versus the high beta. This is what Bank of America Merrill Lynch mentions in their Credit Derivatives Strategist note entitled "A bull and a bear" on the 19th of July:

"European growth headwinds, trade wars and Italian risks are taking over last year’s goldilocks. With manufacturing PMIs in Italy, Spain and France at 53 and inflation risks to the downside, this is still an environment of a patient ECB on rates. Investors are concerned about an inflation shock; we think we are far from there. The potential for an
“Operation Twist” and slower macro can flatten the curves both in cash and synthetics. We think that the CDS market is offering an attractive entry point for longs on the backend of the curve. We screen for the best singles to sell protection.

To offset our bullish view on duration we hedge the market direction with bearish risk reversals in Crossover. If trade wars escalate, growth could be hit more, and higher beta pockets would be more exposed. The recent flattening of the implied vol skew and spread tightening finds bearish risk reversals (own puts/payers vs. selling calls/receivers) attractive to own.

Softer macro = lesser risk of a hawkish ECB

Macro indicators have slowed down in Europe this year versus the high run-rate of last year. In particular, manufacturing PMIs across Europe have headed lower and inflation is only slowly recovering.

But what a slower macro backdrop means for yields and yield curves more specifically? We are using the OECD Major 7 Leading Indicators and we try to define the relationship between the economic cycle and the cycle of yield curve. In chart 3 we present a z-score analysis (in order to normalise patterns for the underlying vol and levels) and we find that there is meaningful correlation between the macro cycle and the cycle of the yield curve.

When the macro indicators improve (deteriorate) yields tend to steepen (flatten). This reflects the higher growth potential and thus the stronger outlook for inflation going forward and that ultimately is priced in via higher back-end yields and steeper curves. Should the ECB remain dovish, yield curves are more likely to continue to be under pressure, we think." - source Bank of America Merrill Lynch

Whereas the first part of the year has been great for high beta in credit and US equities, with Investment Grade lagging. There could be a possibility if the trade rhetoric escalates to see lower growth, meaning a return of the duration trade in the second part we think. One thing for sure 2018 has seen a clear divergence between equities and credit as we shall see in our final chart.

• Final chart - Credit versus Equities - "until death do us apart"

In 2018 US high beta has had a better success than US Investment Grade credit which has been punished. EM equities have suffered as well relative to US equities in stark comparison to what unfolded in 2017. Our final chart comes from Bank of America Merrill Lynch Situation Room note from the 18th of July entitled "Going separate ways":

"Credit and equities are two sides of the same coin. However, while equities by now have rallied to within 2% of the highest close of the year (S&P 500), high grade credit spreads are 33bps, or 37%, off the 90bps tights from earlier in the year (Figure 1).

Given the timing of the beginning of this decoupling in May, clearly one of the drivers was the Italian risks that developed during the month. Given the outsized importance of the financial sector in credit, and the reliance on funding markets and bank balance sheets in fixed income, such sovereign risks should intuitively drive a wedge between debt and equity market performance. However, we think the most important driver of credit market underperformance is the shift in US monetary policy from quantitative easing – QE – toward quantitative tightening - QT (see: On the road from QE to QT, redux 15 June 2018). Mechanically that means less demand and associated widening pressures on credit spreads during times with supply pressures, as we have seen a number of times this year. From that perspective we consider the wider credit spreads an early indicator of more struggles to come as the level of global monetary policy accommodation declines in coming years." - source Bank of America Merrill Lynch

So the big "decoy effect" might be at play, are equities too high relative to credit or credit too wide relative to equities? We wonder.

"It is discouraging how many people are shocked by honesty and how few by deceit." -  Noel Coward, English author

Stay tuned ! 

Macro and Credit - The recurrence theorem

"Some things never change - there will be another crisis, and its impact will be felt by the financial markets." - Jamie Dimon

Looking at the elevated volatility in Emerging Markets in conjunction with continued outflows and pressure on the asset class, on the back of rising US yields and a strengthening US dollar marking the return of "Mack the Knife", with losses not limited to the currencies but with Emerging Markets Yields continuing surging throughout, when it came to selecting our title analogy we reacquainted ourselves with French mathematician Henri Poincaré's 1890 recurrence theorem building on the previous work of fellow mathematician Simeon Poisson. In mechanics, Poincaré recurrence theorem states that an initial state or configuration of a mechanical system, subjected to conserved forces, will reoccur again in the course of the time evolution of the system. The commonly used example to explain the theorem is that if one inserts a partition in a box, pumps out all the air molecules on one side, then opens the partition, the recurrence theorem states that if one waits long enough that all of the molecules will eventually recongregate in their original half of the box. The theorem is often found mixed up with the second law of thermodynamics to the effect that some will loosely argue that there exists a very small probability that an isolated system will reconfigure to a more ordered state (thus effecting an entropy decrease).The theorem is commonly discussed in the context of dynamical systems and statistical mechanics. When it comes to pressure and outflows, as we mused in our last conversation, one would argue that continued capital outflows pressure is contained until it isn't. 

In this week's conversation, we would like to look at the return of "Mack the Knife" in conjunction with rising oil prices and what it entails. 

Synopsis:

• Macro and Credit - US yields - It's getting real!
• Final chart - US core CPI tends to rise in the two years leading up to a recession

• Macro and Credit - US yields - It's getting real!

While US 10yr Real Yields are a key macro driver, the US dollar so far in 2018 has dramatically diverge from yields. "Mack the Knife" aka the King Dollar also known as the Greenback in conjunction with US real interest rates swinging in positive territory has recently put some pressure on gold prices marking the return of the Gibson paradox which we mused about in our October 2013 conversation:

"When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - Macronomics

With the start of an unwind in global carry trade,  "Mack the Knife" aka King Dollar is making a murderous ballad on the EM tourists and carry players alike. Back in July 2015 in our conversation "Mack the Knife" we indicated the following as well:

"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

The question for continued pressure on Emerging Markets when it comes to "Mack the Knife" is are we beginning to see a reconnect between the US dollar and yields? The jury is still out there. Rising Breakevens tend to be negative for the US dollar. Also what matters for US equities given they have remained relatively spared so far would be a meaningful widening in credit spreads. This would be accompanied of course by higher volatility.

Right now, as we pointed out last week, dispersion is the name of the game in both credit and Emerging Markets with the usual suspects and weaker players getting the proverbial trouncing as of late such as Turkey and Argentina. We also indicated recently that the continuous rise of volatility in Emerging Markets would lead to additional outflows given the Hedge Funds were the first to reduce their beta exposure. Some investors might follow suit and follow a similar pattern of "derisking" it seems. On the subject of continuous volatility on EM assets we read with interest Barclays take from their Emerging Markets Weekly note from the 17th of May entitled "Shaken and stirred":

"Volatility in EM assets remains elevated. As 10y UST yields have moved further above 3% and the USD has resumed its strengthening trend, total returns in EM assets have taken a further hit – which in turn continues to weigh on flows: YTD returns in EM credit and EM local markets now stand at -3.7% and -2.4%, respectively (Bloomberg Barclays USD EM Agg and EM local-ccy government bond indices), while EM dedicated bond and equity funds had their worst week of outflows last week since the volatility spike in February (see EM flows: Outflows materialize, 11 May 2018). Economic data has hardly helped to improve sentiment, with weaker European and Chinese activity data feeding concerns about weakening global growth momentum.

The market’s focus remains firmly on those countries with external vulnerabilities and financing needs, especially Turkey and Argentina. Even though current account balances can only provide a partial reflection of external positions and vulnerabilities, there has been an interestingly clear correlation between current account dynamics (changes, rather than levels) and asset performance both in EM credit (Figure 1) and local markets (Figure 2).

Although we have argued in the past that aggregate vulnerabilities have improved in EMs since the 2013 ‘taper tantrum’, they have deteriorated over the past year (see the EM Quarterly Outlook: The going gets tougher, 27 March 2018). Furthermore, the confluence of Fed balance sheet reduction, increased UST issuance, effect of US tax law changes on the repatriation of offshore USDs alongside a wider US CA deficit has implied a potentially more challenging capital flow environment for EM.

As the flow environment for financing in international markets has become more difficult, countries’ plans (or necessity) to tap primary markets have also been in the spotlight. While EM sovereign Eurobond supply has run at a record pace in January to April, recent issuance volumes have fallen short of expectations (including the recent Ghana and South Africa bond issues). We would interpret the latter point as a market positive, however. Given the frontloading of issuance in Q1, there are few countries with sizeable issuance needs for the remainder of 2018. Based on our updated supply expectations for individual countries shown in Figure 4, we now expect an additional USD 41bn of supply in 2018.

Given that c.USD104bn has been issued YTD already, this would result in 2018 full-year supply of USD155bn. In this context, we think there is an interesting divergence between Turkey and Argentina: Argentinean authorities have indicated that they do not want to issue any more in international markets in 2018. Remaining financing needs for this year are c.USD5bn on our estimates, which could potentially be covered by an initial disbursement of the requested IMF programme, or by local currency issuance. In contrast, Turkey’s fiscal measures (including this week’s announcement to reduce the special consumption tax on fuel products) will likely keep incentives to raise financing in international markets in place, even in a less receptive market.

Supply-redemption dynamics in EM credit are not the only silver lining for markets. While recent China data has been weak, we see signs of a shift in priorities towards growth, with deleveraging de-emphasised (see China: Softer FAI and retail sales; signs of pro-growth priority and trade tension de-escalation, 15 May 2018). This should in turn support commodities and while well-supported oil and commodity prices have not been able to prevent the sell-off in EM assets, they should at least provide some fertile ground for differentiation.

With regard to oil prices, Venezuela’s election on Sunday 20 May may be of particular importance (see The ship is taking on water, 15 May 2018). Even if President Maduro is reelected, against a backdrop of the main opposition parties boycotting the process and the government’s control over the electoral system, the vote could still be a catalyst for fractures within the regime. Meanwhile, Venezuela oil exports have been disrupted, amid legal action against PDVSA and a broader decline of oil production – one of the likely drivers of the recent increase in oil prices, in addition to US sanctions on Iran.

EM oil exporters naturally benefit from the surge in oil prices. In Iraq, however, this is overshadowed by uncertainties following last week’s legislative elections (and we recommend switching out of Iraq and into Angola and Gabon in our top trade recommendations this week). Full results are yet to be announced but the partial count indicates a clear defeat of current PM al-Abadi favouring cleric Muqtada al-Sadr who has called for the end of corruption and opposed both the US and Iran. The emergence of the Saeroun and Fateh coalition as winners would complicate political negotiations to form a coalition government and it is still unclear whether PM Abadi will be able to secure a second mandate. Ultimately, we believe coalition talks may be protracted, adding uncertainty to the outlook, also with respect to the IMF talks to finalise the third review under the three-year Stand-By Arrangement. The 2018 budget and transfers to the semi-independent region have represented contentious issues which could be exacerbated by negotiations between Kurdish political parties and Baghdad over government formation." - source Barclays

When it comes to "dispersion" we continue to view favorably Russian local bonds in that context, thanks to the support of oil prices on the ruble and central bank easing that will continue.  On the subject of "dispersion" and weaker players in the EM space, we read with interest UBS take from their EM Equity Strategy note from the 18th of May 2018 entitled "This is not a 'Crisis': It is Rising Yields + a Strong $":

"The central story here, in our view, is that the recent 'less friendly' global market environment has allowed investors to 'pick away' at some of the weaker EM stories, especially via FX (Figure 5 below), as the dollar has continued to rebound. These are the EMs that typically do well when the dollar is weak, as the 'carry trade' holds sway. In the face of recent dollar strength, the result has been significant localized EM FX weakness (Figure 6).

Further, several of these so-called 'weaker' markets have also faced idiosyncratic domestic concerns:

• Turkey (-25% in USD, year-to-date): fears over central bank independence, concerns around monetary policy, widening current account deficit;
• Brazil (+1.7%): weaker than expected economic recovery, uncertainty ahead of the October elections;
• India (-6.8%): higher oil prices and higher inflation with residual concerns over whether Prime Minister Modi's BJP will be re-elected in 2019;
• Indonesia (-16.7%): current account worries and a slow policy response by the Bank of Indonesia;
• The Philippines (-12.6%): domestic overheating.

To this list, we could add South Africa (-6.3% year-to-date, on a minor hangover from the euphoria of Ramaphosa's elevation to the presidency as the market begins to understand the substantial policy challenges ahead) and Mexico (also - 6.3%, as the July 1st 'first-past-the-post' Presidential election approaches with a shift to the left seeming almost inevitable now).

Further, the dramatic weakness of financial markets in Argentina in recent weeks has added to the sense of 'crisis' in emerging markets, even though technically (from an equity perspective) the country is still, for now anyway, in the MSCI Frontier index. MSCI Argentina is down just over 25% so far this year, almost entirely due to the plunge in the peso (from ARS/USD18.35 to 24.40), which has forced a double-digit rise in interest rates to 40%.

However, the major theme of this report is that, in our view, this is far from being an EM 'crisis'. Several EM equity markets continue to do well such as China, by far the biggest EM with a weight of over 31% in the EM benchmark (+5.1% year-to-date, aided by a resilient CNY, even as other EM currencies have fallen sharply), Taiwan (+2.2%), Russia (+4.1%, which has become a relative 'safe haven' again recently as Brent oil prices hover close to $80/bbl) and parts of the ASEAN and Andean regions, notably Colombia (+10.8%) and Peru (+7.7%).

As with the equity markets, the dramatic differences in currency performance across EM so far this year are very clear from Figure 6.

By de-composing the drivers of 2018 total returns in individual markets in Figure 7 below, we partly combine the results from the two previous charts. The blue bars below show the contributions of currency movements to total returns; these are significantly negative for many markets, especially Turkey, Brazil, Russia, India, Poland and the Philippines.

It is also notable how, for most markets, there has been a negative contribution to returns from the P/E ratio, showing the breadth of the de-rating of EM equities so far this year; Peru (given very strong earnings expansion) is a small but truly remarkable example. In the other direction, sharply lower earnings in Greece and Egypt have translated into a significant re-rating in both this year. For EM as a whole, decent earnings growth (+6%) has been fully offset by currency weakness and a lower P/E ratio to leave the 2018 total return close to zero.

'Correction Counter' Update: The Dollar Rears its Head

With the recent minor break of the early-February post-correction low for MSCI GEMs, we update our 'correction counter' from earlier in the year (Figure 8).

The interpretation of this data is more important than the actual figures themselves. In our February report, we noted that the fall in the EM Currency Proxy accounted for a smaller share (14%) of the early 2018 correction in EM equities than its average share (22%) in previous bull market corrections back to 2003. Therefore, one reason, in our view, why the early 2018 correction (-10.2%) was less severe than the average of previous 'bull market corrections' (-17.2%) was the lack of a major USD rally or, alternatively, the resilient behaviour of EM currencies.

This is no longer true, given that the recent action involves more FX weakness in EM, compared to the initial correction. The updated table shows that this FX factor now accounts for much more (28%) of the newly-defined correction (-10.8% to May 5th). Even more tellingly, after EM rallied to an interim peak in mid-March, MSCI GEMs is down 5.6% since then and, with the EM Currency Proxy down by 2.8% over this period, FX weakness has accounted for exactly half of the EM pullback over the past two months. The US dollar has 'reared its ugly head' for EM equities in recent weeks." - source UBS

There goes the murderous propensity of "Mack the Knife" on EM equities. In similar fashion to the recurrence theorem, the US dollar has indeed "reared its ugly" head and reoccurred again in the course of the time evolution of the "financial system" or, to some effect our macro reverse osmosis theory once again playing out as discussed in our recent ramblings. Add to the mix rising oil prices, and if oil stays above $80/bbl (Brent) this will clearly hurt growth in all major net oil importing countries. That's a given.

Moving back to the subject of US yields and real rates, we think they matter a lot for the direction of the US dollar. On this subject Nomura published a very interesting Rates Weekly note on the 18th of May entitled "Did UST sell-off awaken bond vigilantes?":

"10yr Treasuries break 3% with conviction

The 3% level on 10s has been frustrating to break through of late, having failed once in late April and again last week. However, as with all things related to three, the third time is usually a charm as 10yr USTs are now clearly on the other side of 3%.

All along through this process to higher rates we have sensed a great level of investor skepticism about how high rates could go and how long they would stay at higher levels. This is one reason why we are not overly concerned that spec accounts have a historical short in place. For once, as far as we can recall, specs are being proven right; so why cover now unless the economy and/or financial conditions unravel? The bigger risk we think is that those under-hedged and exposed to convexity start paying rates now.

Overall the market seems too dismissive of how high rates could go in this cycle. We think the Fed has conviction and may continue with its quarterly hikes until “something breaks.” Even then, the Fed might have a hard time throttling back if the real economy is doing well but the financial economy suffers a blow that results in lower valuations. Meanwhile, the perfect storm of more UST debt and less foreign buyers may lie ahead.

We explore some drivers that may impact our overall US rates views. Overall we expect duration dynamics to matter more now than the curve; meanwhile spreads and vols will likely have stronger correlations to higher rates and real rates could hold the key ahead.

Even if this sell-off takes a pause, we continue to see 10s moving towards our 3.25% target and are positioned paid on 5y5y US-IRS and in similar conditional expressions.

US rates views update: Still bearish but now real rates hold the directional key

Duration: 3%, besides being a nice round number, has been a hard nut to crack as the last time we crossed this level was during 2013, a year made famous by taper tantrum. For us, a move beyond 3% was always the next logical step as the Fed is hiking rates and shrinking the B/S during a period of decent growth and more UST supply.

The 3% nominal level seems to be all the focus, but in actuality the next big step for US rates is what happens with real rates. Fig. 1 highlights a few regimes for the 10yr real rate vs the real Fed Funds rate (see note for calculation).

Real rates were in a tight range during the last cycle as well, it was only once the Fed was mid-way through its hiking campaign that market real rates began to rise. The past ten years of financial repression (driven by the Fed’s QE and then Global QE) has kept 10yr real rates in a tight range. Just like the 10yr UST was held captive by the taper-tantrum high of 3%, 10yr TIPS have been unable to break and stay above 0.90-1.00% levels. We believe the Fed is on track to deliver many multiple hikes (which could drive real rates higher in the process too).

3%, well specifically the 3.05%, has been a technical level on which markets seem to have been obsessed with. The market cleared that level for the first time on Tuesday this past week and intra-week the 10yr hit an intra-day high of 3.12% before settling into the end of the week around 3.07%. We usually refrain from being super technical, with both what these levels mean and we do not like to be handicapped by chart formations; however markets often pay attention to these wrinkles. Fig. 2 shows that 10s once again broke out of the range and this time term premia is also rising with the move too.

Net net, we believe it will take a serious breakdown in all the trade talks, geopolitical tensions and/or economic data to weaken (where instead our economists are projecting stronger growth and higher inflation ahead) for 10s to start a massive rally now. It is also interesting to see that stocks, although down on the day 10s broke 3%, took it in stride. In Fig. 3 we list the top 3 two-day yield changes in 2018 vs the S&P500 reaction. If stocks do not correct meaningfully, the full UST yield curve should rise as Fed hikes.

Curve: Earlier in the year we opportunistically traded the curve before going neutral on curve spreads in late Q1 (after the last micro-steepening). Recently the sell-off has also coincided with some bear-steepening. We think this is a healthy development that serves as a reminder that the curve is not pre-destined to fully flatten in this cycle, at least not at these yield levels. The Fed is raising rates but also shrinking its bond holdings, at a time when US fiscal stimulus is resulting in a spike in govie issuance. The curve never fully flattened in Japan during its low rate experience (Fig 4).

We argue that we need a higher overall level of rates (and many more Fed hikes) before we go fully flat too.

Spreads: 10yr swap spreads have begun to see a stronger correlation with the level of 10yr USTs in the current cycle, especially since last September (Fig. 5).

In past hiking cycles, 10yr spreads tended to have a positive slope relative to 10yr UST yields. We expect this correlation to be maintained, similar to the dynamics at the end of the ’04-06 cycle. Also with higher yields, 10yr spreads are more likely to widen due to convexity hedging activities from mortgages portfolios. Less need for corporate issuance due to overseas dollar repatriation would also reduce the tightening pressure on belly spreads." - source Nomura

The continued pressure on EMs can only abate if the US dollar finally mark a pause in its recent surge. A toned down trade war rhetoric would obviously continue to be supportive of a rising dollar and support stronger US growth in the process. The trajectory of the US dollar when it comes to the recurrence theorem for EM is essential. Morgan Stanley in their EM Mid-Year Outlook published on the 18th of May reminded us in the below four graphs what to look for when assessing the US dollar in terms of being bearish (their take) or bullish:

"Why USD Is in a Long-Term Bear Market

 - source Haver Analytics, Bloomberg, Macrobond, Morgan Stanley Research

With mid-term elections coming soon in the US, it is clear to US that the administration would not like to rock the boat and therefore would favor "boosting" the US growth narrative. This would entail further gain on both US yields and the US dollar in the near term we think. 

Also of interest when it comes to growth outlook, UBS made an important point in their EM Economic Perspectives note of the 17th of May entitled "EM by the Numbers: Where is EM's growth premium over DM?":

"EM growth spread over DM has fallen close to its lowest decile since 2001

Strong Chinese growth and low US inflation strongly supported EM asset markets over the last two years. But the growth levers have slowly been shifting in the background. Having registered a cycle high in early 2017, EM growth has moderated sequentially since, while DM growth has picked up. The levels were strong enough in both to keep the market uninterested as to how far EM growth was above DM growth. Now, however, sequential EM growth has slowed to 20th percentile of its distribution since 2001, and, more importantly, the premium of EM growth over DM has shrunk to the bottom decile of its historical distribution.

The spread between EM and DM is an important input in the call of relative stock market returns in the two regions. In y/y terms, this spread is now at 15th percentile of its distribution since 2001. In q/q terms this spread has shrunk to the sixth percentile of its historical distribution." - source UBS

Whereas EM equities clearly outperformed DM in 2017, it might be that 2018 could make the reverse with DM outperforming. Reduced carry has obviously been a headwind for EM equities as discussed above. If the US dollar strength can persist then indeed, US equities will continue to outperform EM equities on a relative basis we think.

For our final chart, as we posited in numerous conversation, we have often repeated that for a bear market to materialize, you would need an "inflation" spike as a trigger. 

• Final chart - US core CPI tends to rise in the two years leading up to a recession

Positive shock to inflation would coincide with a negative shock to growth, leading to higher bond yields and lower equities. Moreover, higher inflation will coincide with lower growth, therefore bonds will not be a good hedge for an equity portfolio. As we pointed out in our conversation "Bracket creep" that bear markets for US equities generally coincide with a significant tick up in core inflation, this the biggest near term concern of markets right now we think. Our final chart comes from CITI Emerging Markets Strategy Weekly note from the 17th of May entitled "Fragile 5 now down to Fragile 2" and shows that US core CPI tends to rise in the two years leading up to a recession:

"US rates with more upside. 

After US CPI release last week we had wondered whether or not the EUR was in a bottoming process. While it had been trading better for a few days, the move higher in US rates has led to renewed USD strength. To be clear, we have been expecting higher US rates based on our belief in late-cycle behavior. Figure 4 shows that core inflation typically rises by 50bp in the last two years of an expansion.

Over the same two-year period, 10-year US Treasury yields tend to go up in the first year before retreating as rate cuts get priced by the market. Higher yields are therefore not surprising to us." - source CITI

If indeed a rising US Core CPI is a leading US recession indicator then again, we would have another demonstration of the recurrence theorem one could argue...

"Any idiot can face a crisis - it's day to day living that wears you out." -  Anton Chekhov

Stay tuned!