Macro and Credit - The Ultimatum game

"Never accept ultimatums, conventional wisdom, or absolutes." -  Christopher Reeve, American actor

Looking at the United Kingdom under the guidance of Prime Minister Theresa May moving towards "hard BREXIT", we decided this time around, when it comes to selecting our title analogy to go for the "Ultimatum game", which is a game in economic experiments. In this game, the first player (the proposer) receives a sum of money and proposes how to divide the sum between the proposer and the other player. The second player (the responder) chooses to either accept or reject this proposal. If the second player accepts, the money is split according to the proposal. If the second player rejects, neither player receives any money. The game is typically played only once so that reciprocation is not an issue.  Given our fondness for behavioral economic and psychological accounts, our title analogy and the aforementioned experiment suggest that second players who reject offers less than 50% of the amount at stake do so for one of two reasons. An altruistic punishment account suggests that rejections occur out of altruism: people reject unfair offers to teach the first player a lesson and thereby reduce the likelihood that the player will make an unfair offer in the future. Thus, rejections are made to benefit the second player in the future, or other people in the future. By contrast, a self-control account suggests that rejections constitute a failure to inhibit a desire to punish the first player for making an unfair offer. The ultimatum game is important from a sociological perspective, because it illustrates the human unwillingness to accept injustice. The tendency to refuse small offers may also be seen as relevant to the concept of honour. The extent to which people are willing to tolerate different distributions of the reward from "cooperative" ventures results in inequality that is, measurably, exponential across the strata of management within large corporations. Some see the implications of the ultimatum game as profoundly relevant to the relationship between society and the free market, with Prof. P.J. Hill, (Wheaton College, Illinois) saying:

"I see the [ultimatum] game as simply providing counter evidence to the general presumption that participation in a market economy (capitalism) makes a person more selfish."

Given the rise in inequality in conjunction with populism, there is a rising drift between the have and the have not, which is leading for some politicians to somewhat embrace or envisage rebalancing Wall Street towards Main Street in order to avoid capitalism's own demise. As of late we find of interest that, as we posited in our previous musing, the cozy relationship between politicians and central bankers is waning as illustrated by rising criticism coming out from German leaders and directed towards the ECB. But, moving back to "Brexit" and the "Ultimatum game" currently being set in motion, as we posited in our conversation "Optimism bias" from June 2016 from a game theory perspective we indicated at the time:

"For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe..." - source Macronomics, June 2016

While having correctly guessed in 2016 both Brexit and the US election (which earned us some nice bottles of wine from "optimistic" friends), given the English common law system is UK's best export (Singapore, Hong Kong, etc.) as well as its best business friendly feature, we do think that the United Kingdom benefit from first mover's advantage to that respect. Why so?

"Common law as a foundation for commercial economies

The reliance on judicial opinion is a strength of common law systems, and is a significant contributor to the robust commercial systems in the United Kingdom and United States. Because there is reasonably precise guidance on almost every issue, parties (especially commercial parties) can predict whether a proposed course of action is likely to be lawful or unlawful, and have some assurance of consistency. As Justice Brandeis famously expressed it, "in most matters it is more important that the applicable rule of law be settled than that it be settled right." This ability to predict gives more freedom to come close to the boundaries of the law. For example, many commercial contracts are more economically efficient, and create greater wealth, because the parties know ahead of time that the proposed arrangement, though perhaps close to the line, is almost certainly legal. Newspapers, taxpayer-funded entities with some religious affiliation, and political parties can obtain fairly clear guidance on the boundaries within which their freedom of expression rights apply." - source Wikipedia

 "Assurance of consistency" - try to have this in France. It is totally the opposite. As per our previous conversation: 

"The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them." - source Macronomics, January 2017

Hence our long term more favorable view for the United Kingdom and the Common Law premia that needs to be taken into account when it comes to assessing the prospect for the country and its currency we think. 

Furthermore, the Ultimatum game is clearly being played out by president elected Donald Trump with US corporations in his quest to "make America great again". Again, the ultimatum game is profoundly relevant to the relationship between society and the free market economy. As we posited in our conversation "The Great Wall of China hoax", global rise in populism, came hand in hand with lowering the living standards of the average American, and hearing the inaugural speech from president elected Trump on the 20 of January makes it clear to us, that this will have a significant impact on allocations as the Ultimatum game will be starting in earnest:

Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response": 

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

So you already might be asking yourself where we are going with all this, well, we have long argued the following as per our conversation "The Grapes of Wrath" back in October 2016:

"In terms of validating the "recovery mantra", we believe that meaningful wage inflation is a necessary condition. When it comes to inflation expectations, demographics and additional components in different parts of the world such as Japan, the United States and Europe have to be assessed differently.

For instance, in the United States, the recent decline in apartment rents in some big cities points towards near term "inflation headwinds" for the stagflationary camp.

As a reminder, rising rents have been an important factor in keeping US inflation expectations alive given the importance of the shelter component in US CPI calculations which represents one third of headline CPI and 42% of core CPI. When it comes to assessing some of the drivers of inflation, labor demographics are a key driver of real long-term fed funds. Also the question of productivity growth is paramount we think, particular when one looks at the quality of the jobs created since the onset of the Great Financial Crisis (GFC)., mostly of low quality.

Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June this year in our conversation "Road to Nowhere":

"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.

While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016

We concluded at the time:

"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016

Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street"." - source Macronomics, October 2016.

While the inaugural speech of the newly elected President Trump did focus on bringing jobs back to America and making America first, on that subject we read with great interest our former esteemed colleague David Goldman's take in his latest column published in Asia Times entitled "Donald Trump, American hero" and his take on "productivity":

"The problem is how to protect Americans. The global supply chain is so closely integrated that it is hard to discourage some imports without doing real damage to American industries. The border tax proposed by House Republicans would prevent corporations from deducting imported inputs as costs for tax purposes. For industries like oil refining, that would create enormous distortions, while providing windfalls elsewhere. My own preference would be to use selected tariffs for products that benefit from government subsidies overseas, which is entirely permissible under World Trade Organization rules.
Ultimately, no government can protect American workers unless productivity growth resumes. American productivity growth has fallen to zero for the first time since the stagflation of the 1970s. Without productivity growth, American living standards will fall, irrespective of whether the government pursues protection or free trade. I have argued elsewhere in this publication that reviving military and aerospace R&D is the key to productivity growth." - source David Goldman, Asia Times,  20th of January 2017

There lies the crux of the problem, to make "America great" again, you need CAPEX growth and more importantly, "productivity" growth.

In this week's conversation, we will look at jobs, wages and the difference between Japan and the United States, in relation to the "reflation" story or "Trumpflation".

Synopsis:

• Macro and Credit - The wage / productivity paradox
• Final chart - International trade and Nash equilibrium

• Macro and Credit - The wage / productivity paradox

While we recently used Japan as a base case when assessing the negative impact low rates have had on real estate assets, leading some becoming nonperforming in our recent conversation  "The Great Wall of China hoax", what has been plaguing Japan since they have reached effectively full employment is indeed the outlook for wages. Without wage rising, there is no way Japan can truly break its deflationary spiral and the Bank of Japan create sufficient inflation. This is clearly indicative of the malaise of the Japanese economy. On that subject we read with interest Nomura's take in their Japan Economic Weekly note from the 13th of January 2017 entitled "Outlook for wage rises remains bleak":

"Employers and employees deaf to government's calls for wage rises

No sign of a pickup in the rate of wage rises from New Year events

Prime Minister Shinzo Abe has taken the opportunity provided by New Year events such as those organized by Japan's economic associations to reiterate his calls for companies to raise wages. However, we see no sign from the response of either employers (and their associations) or employees (and their trade union representatives) of any pickup in the rate of wage rises at this year's spring wage negotiations. Any discussion of what is happening to the Japanese economy, inflation, or market factors such as interest rates will have to assume for the time being that there will be no marked increase in wage rises.

Deep-seated reluctance of employers to increase fixed costs

While Japanese business leaders share Abe's positive attitude towards wage rises in general terms, they appear to be slightly less enthusiastic when it comes to putting this into practice. A good example of this is the frequent inclusion by Sadayuki Sakakibara, Keidanren chairman, of the provisos "companies that enjoyed earnings growth last year" and "on an annual pay basis" when expressing his desire for wage rises. We see this as reflecting a deep-seated reluctance by business leaders to increase fixed costs. With companies facing increasing uncertainty, they may well be more reluctant to increase the base pay of their regular employees as this would amount to an increase in fixed costs.

The unions are also cautious about demanding wage rises

A certain reluctance of some trade unions to demand wage rises also appears to be an impediment to a pickup in the rate of wage rises. We think that the cautious attitude of the trade unions probably reflects the less optimistic view that companies now have of their growth prospects as well as the increasing uncertainty they face and that workers and their trade union representatives may tacitly prefer the stability of a job for life to a bigger increase in base pay (see our 21 October 2016 Global Research report Why is wage inflation so low despite a shortage of labor? - The ''base pay wall'' facing the Japanese economy).

Limits to how far working practices can be reformed without freeing up the market for regular employees

In view of the attitude of employers and employees, the only way to overcome obstacles to speeding up the rate of wage rises would be to free up the market for regular employees to make the cost of employing full-time employees a variable cost. Similarly, safety nets such as vocational training and greater provision of unemployment benefits would be needed to overcome the concerns of workers and trade unions about freeing up the labor market for full-time employees. It seems that, as freeing up the market for full-time employees touches on the system of lifetime employment that forms the cornerstone of Japanese employment and working practices, it is off limits for those seeking to reform working practices such as the present government." - source Nomura

Indeed, the cornerstone of the Japanese employment system has long been lifetime employment and a clear impediment in freeing up the market. There is no way the Bank of Japan on its own can fill its inflation mandate without the government stepping in and playing out the "Ultimatum game" with Japanese business leaders. When it comes to the "Ultimatum game" and reflationary policies in the United States, we think that the recent raft of corporations folding under the pressure exercised by Donald Trump is clearly a sign that the new US administration is clearly being serious on its willingness to focus on America and Americans. Obviously this will have significant implications in terms of allocations. Put it simply as displayed by our friend Cyril Castelli from Rcube, rising wage pressures imply lower profit margins:

- source Rcube

End of the day, earnings revisions matter, as they are according to our friend, the best leading indicator for expected cash flows momentum. Negative earnings revisions always imply weakening cash flows and inversely. Also, "Mack the Knife" aka King Dollar + positive real US interest rates is tightening financial conditions globally. Cheap dollar funding has been exported to many Corporate Emerging Markets as highlighted in recent studies completed by the Bank for International Settlements (BIS). 

When it comes to Japan, clearly as indicated by Nomura, the Japanese wage paradox is weighing heavily on inflation, when the country is getting close to full employment (which is not the case in the US regardless of the much vaunted 4.7% unemployment rate put forward by the Fed).  Japan has been a productivity laggard for many years. Japan's labor market is a two-tiered market. There is one group of Japanese workers, called "seishain" which has retained its privileged, old-style jobs comprising job security, benefits and regular raises while the other group is made up of low-security, low-pay, low-benefit, dead-end jobs. These individuals have very little chance of ever jumping up to the "seishain" track. In similar fashion, if someone digs deep into the BLS, one can argue that the US employment market has been facing similar issues since the Great Financial Crisis (GFC). 

On the Japanese conundrum, we read with interest Bank of America Merrill Lynch's take from their Japanese Economics Viewpoint note from the 19th of January entitled "Jobs, wages and the BoJ":

"The biggest medium-term macro surprise?

We believe that the re-acceleration of wage growth could provide one of the biggest macro surprises for Japan in 2017. Investors appear to be increasingly coming around to our view that the Japanese economy is due for a solid, 1.5% pick-up in 2017, up from 1.0% in 2016. However, skepticism around the potential for higher wage growth—the key to Japan’s reflation efforts—runs deep.

Tackling Japan’s wage paradox

The doubts may be warranted, given that wage growth has remained stagnant over the past few years despite the unemployment rate plunging post-bubble lows and business surveys pointing to record tightness in the labor markets. We think the relative weakness of the wage indicators reflects both cyclical and structural factors. On the demand side, the slowdown in the economic recovery after the 2014 tax hike reduced wage pressures. On the supply side, the reserve of lower-paid, part-time and “non-regular” workers meant that there was still some “invisible” slack in the labor sector.

Approaching full employment

However, 2017 could mark an important inflection point as both demand-side and supply-side factors drive the economy towards full employment. We forecast the unemployment rate to drop to 2.9% by the end of 2017, and 2.7% by the end of 2018, from 3.1% today. There is already evidence that remaining labor market slack is quickly diminishing. Moreover, demographic headwinds will begin blowing much harder in the coming years, resulting in tighter labor supply.

Wages growth to double in FY17, reach 2% in FY18 

The FY2017 Shunto spring wage negotiations are unlikely to result in significant base pay increases. But we still see the combination of tight labor supply and stronger demand lifting nominal per worker wages to around 1.4% in FY2017, and close to 2% in FY2018, up from the 0-0.5% pace of the past three years. Adjusting for job growth, we see nominal employee compensation holding steady between 2-2.5% and real employee compensation of around 1.2% over the next two years. This should support consumption.

But patient BoJ to keep rates on hold

Our optimism on the outlook for labor markets and wage growth underpins our above consensus inflation forecasts. We see Japan-style core inflation rising 1.2% in FY17 (0.9% on a CY basis), and 1.5% in FY18 (1.4% on a CY basis). If our forecasts are correct, the risks of early BoJ policy normalization, including rate hikes, may become an important theme in the markets in the second half of this year.

However, we remain of the view that the timing of BoJ “lift-off” remains far away and that the central bank will keep its rates targets under its Yield Curve Control (YCC) framework unchanged through FY2018. Running a “high pressure” economy is the best shot the BoJ has at re-anchoring inflation expectations and reducing future deflation risks." - source Bank of America Merrill Lynch

Re-anchoring inflation expectations can only come from increasing wage growth and some significant labor market reforms in Japan. Not only wage growth is still eluding the Japanese economy, but, productivity has been yet another sign of "mis-allocation" of resources which has therefore entrenched the deflationary spell of Japan in recent years.

As put forward by Bank of America Merrill Lynch's note, there is a disconnect between job growth and wages in Japan:

"Disconnect between job growth and wages

Investors are often perplexed by the disconnect between Japan’s headline wage data and the relative strength of its labor market indicators. As of November 2016, Japan’s unemployment rate stood at 3.1%, down from 4.1% at the beginning of the Abenomics recovery phase (November 2012). Meanwhile, the job-offers-to applicant ratio has been climbing steadily, reaching the highest level since 1991 (Chart 2). 

Various business surveys also point to record labor market tightness. The employment conditions indices in the Bank of Japan Tankan reflect deep labor shortages, especially among non-manufacturing SMEs (Chart 3).

Despite robust job growth, total cash earnings data in the Ministry of Health, Labour and Welfare’s Monthly Labour Statistics (MLS) have been disappointingly weak. This measure, which tracks nominal wages on a per worker basis—picked up in the initial phase of the Abenomics recovery but has recently weakened and is stuck at around 0.4%, while hourly wage growth is tracking around 1% (Chart 4).

Digging into wage growth by component, the slowdown in 2015-16 was in part due to a collapse in bonuses (which is linked closely with corporate profits) (Chart 5).

But more importantly, the combination of aggressive fiscal tightening, coupled with a downturn in the global export cycle caused Japan’s economic recovery to stall, reducing cyclical wage pressures.

That being said, structural factors may be in play as well. Over the years, wage growth— in both per worker and per hour terms--has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.

Part of this reflects a trend rise in lower paid, “non-regular” workers, which include various forms of part-time and temporary employment (Chart 8).

The main split in Japan’s dual labor market is defined by job status. “Regular” workers generally work full time, are directly hired by the employer, and receive bonuses along with a wide range of employee benefits.1 While regular workers enjoy an upward sloping wage curve, reflecting regular, seniority-based pay promotions, the wage curve for non-regular workers is virtually flat, resulting in a huge pay gap—average lifetime income for non-regular workers is about 60% of “regular” workers’ levels (Chart 9).

Please note that due to differences in classification of workers between the MHLW Monthly Labor Statistics and the Ministry of Internal Affairs’ (MIA) monthly Labor Force Survey (which does not cover wage data), from here on out we focus on employment and wage developments of part-time workers, which are a decent proxy for the broader “non-regular” category.

Based on MLS data, the part-time employment doubled from around 15% in March 1990 to about 30% today (Chart 8). The good news is that the pace of increase in the part-timers’ employment share has been slowing, with the rise limited to a relatively modest 1.6ppt between Q3 CY2012 and Q3 CY2016. But even such a small drag represents a powerful drag on headline per worker wages since part-timers receive lower pay and work fewer hours by definition (Chart 10).

On average, the continued shift towards part-time employment has subtracted about 0.5ppt from growth in total cash earnings per worker (Chart 11).

Had the part-time share stayed neutral, per worker wages would be tracking closer to 0.8%YoY—about double the headline figure.

Reasons for optimism

The popular view in Japan seems to be that the Phillips curve is dead and that the weakness in wage growth will remain entrenched. There is also a strong belief that the secular shift in non-regular/part-time employment is unlikely to be reversed any time soon, keeping wage pressures contained. We disagree, and believe that growth in total cash earnings per worker will pick-up from around 0.5% in FY16, to around 1.4% in FY17, before rising to around 2% in FY18." - source Bank of America Merrill Lynch

The reason we have to disagree with Bank of America Merrill Lynch and their reason for optimism comes from our discussion from June 2013 in our post "Lucas critique":

"Robert Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:

"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes.

For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. But a change in security policy, such as eliminating the guards for example, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies." - source Wikipedia

So, as one can infer from the point made above and in continuation to the points made in our conversation "Goodhart's law", Ben Bernanke's policy of driving unemployment rate lower is likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  

In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:

"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - source Wikipedia

In similar fashion to what we posited in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is as we recently discussed.

The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed." - source Wikipedia 

As we posited at the time, when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it on Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion.

On this occasion, we think's Bank of America Merrill Lynch's optimism is indeed leaning towards naivety because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property. As per our conversation "The Great Wall of China hoax" like in Japan, at some point low-yield assets such as real estate become nonperforming.

Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":

"He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.
By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.

“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg

So if the "old" like in Japan still predominates the economy, we have a hard time believing the Bank of Japan will be able to control economic outcomes and it appears clear to us that their monetary policies have truly become ineffective.

In similar fashion and as highlighted above in our quote from David Goldman, the United States need to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that mattes in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again.

Finally for our final point and given our chosen title, we would like to look at a simplistic international game.

• Final chart - International trade and Nash equilibrium

Given we started our conversation mentioning a game relating mostly to BREXIT, we thought we would end this conversation by looking at the known unknown of what the new US Trump administration stance will be when it comes to international trade. To that effect, our final chart or diagram, comes from Bank of America Merrill Lynch's Credit Market Strategist note from the 20th of January and entitled "The times they are changin' "and looks at international trade from a game theory perspective:

"International Trade game

Consider the following simplistic game of International Trade. Suppose there are two countries that can each choose between the two policies “Free Trade” and “Protectionism”. Because international trade in most circumstances boosts global growth it follows that protectionism is growth negative. Put differently, while in isolation a country can boost economic growth by playing the “Protectionism” card, the associated costs to the other country outweigh these gains. There are four possible outcomes (Figure 2). 

One equilibrium is that both countries agree to play “Free trade” (NW corner of figure), where we say that both have GDP of 10 (arbitrary units). Suppose now that Country 1 unilaterally plays “Protectionism”, in which case the outcome in the short term is the SW corner of the chart where this country boosts GDP by 2 to 12 at the expense of Country 2 that sees a 3 decline in GDP to 7. Note that world GDP declined by 1 as protectionism is distortive and thus creates inefficiencies.

However, the SW corner is not a sustainable equilibrium as Country 2 stands to benefit from playing the “Protection” card as well – i.e., retaliate – as they can increase GDP by 2 at the expense of country 1. That moves us to the SE corner – the “Trade Warfare” outcome - where each country has GDP of 9, a loss of 1 from the “Free Trade” equilibrium. Hence there are only two sustainable equilibria in this international trade game – “Free trade” in the NW corner, if both countries agree and commit, or trade warfare in the SE corner if they do not.

What this means is that the new administration’s intentions to restrict international trade are almost certainly negative for US economic growth in the longer run. Of course what prompted the coming US pushback against imports is that, even though trade boosts the economy, there are winners and losers. Thus we are unable to say unambiguously that the country is better off in utility terms just because that is the case in dollar terms." - source Bank of America Merrill Lynch

If the second country rejects protectionism, like in our case of the Ultimatum game, then neither countries receives any money, and this dear friends means to us lower global trade which is indeed bullish gold, in the end (hence our  recent positive stance), but we ramble again...

"The philosophy of protectionism is a philosophy of war." -  Ludwig von Mises

Stay tuned!

Macro and Credit - From Utopia to Dystopia and back

"For other nations, utopia is a blessed past never to be recovered; for Americans it is just beyond the horizon." - Henry A. Kissinger

Hearing about the passing of Cuban leader and revolutionary Fidel Castro also an accessory ambassador to the Rolex brand, and given the continuous rise in government bonds yields, while thinking about what should be our title analogy, we thought about the current situation. Our current situation entails we think a reversal of the 1960s utopian revolutionary spirit towards a more populist and conservative political approach globally. Also, it seems as of late that there has been somewhat since the Trump election an opposite movement in the financial sphere from financial dystopia aka financial repression from our central bankers towards utopia aka a surge in inflation expectations leading to large rotations from bonds to equities and rising "real yields". Also, another reason from our chosen title is the recent UK bill requiring internet firms to store web histories for every Briton's online activity. The most famous examples of "Dystopian societies" have appeared in two very famous books such as 1984 by George Orwell and of course Brave New World by Aldous Huxley. Dystopias are often portrayed by dehumanization, totalitarian governments, environmental disasters or other characteristics associated with cataclysmic declines in societies. Dystopia is an antonym for Utopia after all, used by John Stuart Mill in one of his parliamentary speeches in 1868. Dystopias are often filled with pessimistic views of the ruling class or a government which has been brutal or uncaring. It often leads to the population seeking to enact change within their society, hence the rise in what is called by many "populism". What is important we think, from our title's perspective is that financial repression goes hand in hand with dystopia given that the economic structures of dystopian societies oppose centrally planned economy and state capitalism versus a free market economy. One could infer that central banks' meddling with interest rates with ZIRP, NIRP and other tools is akin to a dystopian approach also called financial repression. Right now we think that on the political side, clearly, the pessimistic views of the ruling class has led to upsetting the outcomes of various elections this year such as Brexit and the US election thanks to "optimism bias" from the ruling class. So all in all, Utopia has led to political Dystopias, creating we think inflationary expectations for now and therefore leading to euphoria in equities or what former Fed supremo Alan Greenspan would call "irrational exuberance" when effectively, it is entirely rational given market pundits expect less "financial repression" to materialize in the near future but we ramble again...

In this week's conversation we would like to look at what to expect in 2017 from an allocation perspective, while since our last conversation there has been some sort of stabilization in the rise of "Mack the Knife" aka King Dollar + positive real US interest rates, it appears to us that the first part of 2017 could get complicated.

Synopsis:

• Macro and Credit -  Erring on the wider side
• Final chart - Gold could shine again after the Fed

• Macro and Credit -  Erring on the wider side

As we have pointed out in recent musings, credit investors since the sell-off in early 2016 did not only extend their credit exposure but, also their duration exposure, which as of late has been a punishing proposal thanks to convexity particularly for the low coupon / long duration investment grade crowd. While total returns have still been surprisingly strong in the second part of 2016, particularly in High Yield in both Europe and the US, the "beta" players should be more cautious going forward. 

We think that the goldilocks period for credit supported by a low rate volatility regime has definitely turned and slowly but surely the cost of capital is rising. 

For instance, in the US while the latest Senior Loan Officer Opinion Surveys (SLOOs) has pointed to an overall easing picture as of late as per our previous conversation, in the US, Commercial Real Estate is already pointing towards tightening financial conditions as indicated by Morgan Stanley in their CRE Tracker note from the 18th of November:

"CRE Lending Standards Tighten For the Fifth Straight Quarter in 3Q16

•The Federal Reserve’s Senior Loan Officer Opinion Survey showed CRE lending standards continued to tighten in 3Q16, marking the fifth straight quarter of net tightening.

•Overall, standards tightened at a stable pace, with 29.5% reporting net tightening compared to 31.3% in 2Q16. Large banks have been tightening more than other banks, but the 3Q16 release shows that large banks’ tightening pace has slightly slowed.

•Tightening has been most pronounced in multifamily loans, and in 3Q16 other banks upped their tightening pace in this category.

•Loan demand continues to strengthen but has decelerated quarter-over-quarter: only 5.8% reported a net increase in demand compared to 12.0% in 2Q16. Demand is stronger for construction loans relative to the other two types.

•Our studies have shown that tightening lending standards and/or decreasing loan demand tend to lead to declining CRE property prices.

- source Morgan Stanley

While we have tracked our US CCC credit canary issuance levels as an indication that the credit cycle was slowly but surely turning, the above indications from the US CRE markets is clearly showing that the Fed is about to hike in a weakening environment, should they decide to fulfill market expectations in December. Obviously while the market is clearly anticipating their move and has already started a significant rotation from bonds towards equities, the move from Dystopia to Utopia and Euphoria will have clear implications for credit spreads in 2017, and should obviously push them wider we think. 

This thematic is clearly as well the scenario being put forward by most of the sell-side crowd when it comes to their 2017 outlook for credit. For instance we read with interest Morgan Stanley's take on the macro backdrop for credit for the US entitled "From Cubs to Bears":

"We are cautious on US credit for 2017: Across the spectrum, credit markets will likely finish 2016 with the best returns in many years – certainly better than we anticipated. If we had to boil the rally from February-October down into two factors, we think the recovery in oil/energy explains the first half, and the massive global reach for yield driven by low rates and easy central bank liquidity explains the second. In our view, fundamental risks are still very elevated, and while sentiment has become bullish around the impact of a Trump presidency, any way we look at it, credit is moving out of the 'sweet spot'. Specifically, the days of ultra-low rates, ultra-low volatility, and ultra-easy Fed policy are in the rear-view mirror. All while valuations are considerably richer than this time last year – not a great setup for 2017.
More specifically, our cautious call on US credit is based on three key points, which we expand on in the first section below:

1. A less benign environment: We would not underestimate the impact central banks have had on markets. Now, eight years into a cycle, we expect inflation to rise, the Fed to hike quicker, and the dollar to break out. Fiscal stimulus helps growth, but there are clear offsets, like tighter financial conditions. This is a backdrop where mistakes are more likely and costly.
2. Fundamentals are weak, late-cycle risks have risen, and the Fed could push us to the edge quicker: Markets anticipate defaults one year in advance. Lower defaults in 2017 are in the price. Rising defaults in 2018 are not.
3. Credit is priced for a benign environment as far as the eye can see: IG spreads adjusted for leverage and HY default-adjusted spreads have rarely been tighter. In addition, higher Treasury yields make the 'reach for yield' argument for US credit much less compelling.

Adding everything up, we do not think this is the point in the cycle to reach for yield, and most of our recommendations are up-in-quality as a result. And we note that better growth does not always equal better returns. In the second half of cycles, negative excess return years come more frequently than you might expect, and we expect to see one in 2017.

Moving Out of the Macro 'Sweet Spot'

The US economic environment is becoming less supportive of credit markets. Our economists forecast US GDP to grow at 1.9% in 2017, 0.3pp higher than the baseline, given our expectations around fiscal stimulus. Why not a bigger number? First, it is important to remember that the underlying headwinds to growth that have driven a subpar expansion for eight years have not gone away just because Trump was elected. Second, our economists assume that a material tightening in financial conditions offsets some of the benefits of fiscal stimulus. For example, we now expect the Fed to hike twice in 2017 and three times in 2018, the dollar to rally by 6%, and 10Y Treasury yields
to hit 2.75% in 3Q, (2.50% at year-end), very different from our prior forecasts of low rates and ultra-accommodative Fed policy. These risks may rise further later in 2017, if markets begin to worry that Yellen will be replaced with a much more hawkish Fed chair. Third, right now investors seem to be focused on all the benefits from stimulus, but downplaying the risks to Trump's policies that were so concerning in the run-up to the election. It doesn't take much for sentiment to swing back in the other direction or for current lofty expectations around fiscal stimulus to disappoint.

Either way, there is much greater potential variability around our forecasts, given all of the unknowns. For example, in our bear case where we assume Trump takes a hard line on trade, GDP growth is hit by 0.6pp, even assuming material tax cuts and infrastructure spending.

~2% growth by itself is manageable, but unlike earlier in this cycle, the Fed is not adding stimulus, but instead withdrawing liquidity. And remember, even with fiscal stimulus, the Fed is still tightening into a much more anemic growth environment than inpast rate hike cycles (Exhibit 3), significantly later in the cycle, and with profits growing considerably slower.

Due to this subpar recovery, markets have become very dependent on central banks, and when the liquidity spigot turns off, credit has consistently had problems. In fact, over the past two years, the Fed has struggled to get in even one hike a year. We would not dismiss the impact on markets if the Fed has to step on the brakes more quickly, given how much central bank policy may be supporting valuations, given the starting point on growth, and with the US economy much later in a cycle than when the Fed has begun hiking in the past.

In addition, less easy liquidity could become a global theme next year. Our economists expect the ECB to announce tapering at its June meeting, and a shift in the BOJ's 10Y yield target in 4Q17 – very different from the risk-supportive environment from central banks immediately post Brexit.

Lastly, even with this rate rise, the market is still only pricing in ~1.5 hikes in 2017 – thus risks are asymmetric. If growth disappoints, the Fed has little ability to release a verbal dose of monetary stimulus like this past year, when rate hike expectations quickly dropped from 3 to almost 0. Alternatively, if this is the year where inflation starts rising, there is plenty of room for rate hike expectations to rise. In addition, with IG and HY spreads 37bp and 204bp tighter vs. when the Fed hiked last December, credit markets also do not have the same shock absorber as last year." - source Morgan Stanley

The last point is particularly true given that the second half rally saw credit investors piling on more duration and more credit risks, meaning more instability in credit markets at the time where "Dystopia" has been fading in financial markets. As we pointed out in our previous conversation, we think the market is trading ahead of itself when it comes to its expectations and utopian beliefs. Like any good behavioral therapist we tend to focus on the process rather than the content and look at credit fundamentals to assess the lateness of the credit cycle. 

There is no doubt in our mind that we are moving towards the last inning of the credit cycle and there has been various signs of exhaustion as of late such as our CCC credit canary issuance indicator or as above tighter lending conditions for CRE which is trading at elevated valuation levels, but on these many points we agree with Morgan Stanley's take that fundamentals are clearly showing signs of deterioration in the credit cycle that warrants caution we think:

"Elevated Fundamental Risks Late in the Cycle

Markets are very late cycle, according to our indicators, and even compared to this time last year, fundamentals are weak. To provide a few examples on the first point: The Fed is expected to continue hiking, and looking at the shadow fed funds rate, has already tightened policy by a similar amount as in past cycles. Lending conditions have tightened (measured by the % of banks tightening C&I, CRE, auto, and now consumer loans), and leverage is very high. Margins, M&A, and auto sales look like they have possibly peaked. In addition, leading economic indicators have rolled over, employment has slowed from the peak in early 2015, and productivity has declined. Along similar lines, looking at our cross-asset team’s indicator, the US may have entered the 'Downturn' phase of the cycle earlier this year.

The deterioration in corporate balance sheet quality also indicates elevated cycle risks.
For example, as we show below, leverage is at or near record levels across credit markets. In addition, the leverage increase has been broad-based (outside of financials), and the ‘tail’ in the market has grown substantially. For example, the highly leveraged tail has doubled since 2011 in high yield (two-thirds of this tail is ex-commodities) and 30% of the IG market is levered over 4x today, compared to only 11% in 2010.

This deterioration in credit quality should not come as a surprise – low rates and ultra-easy liquidity for eight years have had negative side effects. What should be concerning is that, historically, the sharpest rise in leverage tends to occur in recessions when earnings collapse. Hence, the fact that leverage is this high in a growing economy means that it will likely peak at a much higher level than in the past when a downturn finally hits. We would also note that leverage is not the only area of concern, with interest coverage and cash/debt also trending lower in most markets.

In an environment of higher rates and better growth, as markets are seemingly anticipating, could leverage come down? We think it is possible, but unlikely. First, better growth should, if anything, encourage more aggressive corporate behavior, which is why historically, the biggest declines in leverage come after a credit cycle. Second, we would not dismiss the underlying headwinds to a big pickup in earnings at this stage in the expansion, especially if the dollar rallies 6% as we expect. Yes, corporate tax cuts could help, although even there we need to wait for the details – if tax cuts are paid for in part by getting rid of tax preferences and there is a tighter noose around what is considered domestic income, the aggregate benefit may be lower. But bigger picture, weak productivity and rising wages are a few of the many headwinds to profitability that probably aren't going away. Lastly, even if leverage does drop modestly, higher rates are an offset when thinking about future defaults. Ultimately, we think the damage has been done looking at fundamentals, and better growth, higher rates, as well as faster rate hikes if anything, push us to the cycle edge more quickly. We note that the later years in an equity bull market when growth is strong are often not bullish for credit. For example, in 2000, HY excess returns were down 16.3%. 

Assessing credit quality in aggregate, we think the fuel for a default/downgrade cycle is clearly present. And with banks tightening lending standards now across C&I loans (albeit only modestly per the latest survey), CRE, and autos, and no longer easing for consumer lending, this credit cycle is actually playing out as one would expect in a long, slow default wave. Yes, the defaults so far have been predominantly commodity focused, but in our view, it is normal for the problem sector to drive the stress early on.

The key question of course is one of timing – when do default/downgrade risks start to spread beyond commodities in a bigger way? In our view: Sooner than most think. We discuss our default and downgrade expectations in more detail in the forecasts section below. But in short, default rates will likely drop in 2017, which we think is in the price, with the HY energy sector 955bp tighter since the wides in February.

However, according to our numbers, defaults will start rising again in 2018, likely peaking in 2019. Without going into the details, we base our assumptions on the lag between when the indicators we track have turned historically and when defaults have subsequently spiked, as well as the status of those metrics today.

If our estimates are correct, this default wave will last ~4.5 years in total (having begun in 2016), similar to the 1999-2003 cycle. And we think there are logical reasons to assume a prolonged cycle. For example, the prevalence of cov-lite loans and somewhat elevated interest coverage will not make overall default volumes lower, in our view, but could mean defaults take longer to materialize. In addition, if a recession occurs while rates are still generally low, the tailwind of falling yields will not be there this time around, which could slow the bounce off the bottom.

Last and most importantly, if defaults start rising again in 2018, the market should price that in next year. As we show below, years when defaults rise more than 2%, spreads tend to widen by 283bp on average the year prior, as the market prices in those risks. Or said another way, the fact that defaults will drop in 2017 should have little bearing on spreads in 2017.

As a result, the only way to rationalize today’s valuations is to assume a benign default environment for several years, which we believe is a low probability. Looking back in time, we only have one good example of when defaults rose temporarily due to one sector and then subsequently dropped without a near-term recession. That took place in 1986, yet even then, defaults only fell for two years, and subsequently rose into the 1990 recession. Also we would note the Fed was not hiking at the time, but instead cut rates by ~200bp in 1986 to cushion the blow – very different from today." - source Morgan Stanley

Furthermore, a continuation in the rise of "Mack the Knife" aka the US Dollar and real rates, then again US earnings could come under pressure and financial conditions will no doubt get tighter and hedging costs for foreign investors pricier, which could somewhat dampen foreign appetite from the like of the Japanese investor crowd and Lifers in particular, leaving in essence very little room for error when it comes to credit allocation towards the US, hence we would favor quality (Investment Grade) and low duration exposure until the dust settle, meaning some sort of stabilization in current yields gyrations from a US allocation perspective.

Obviously for Europe, in terms of credit, the story is slightly different given the on-going support from the ECB but clearly the risk lies more into a rise in political "Dystopia" rather than financial "Utopia" given the on-going deleveraging process of the European banking sector. To that effect, whereas there has been a very significant rally in the European banking sector when it comes to equities as of late in conjunction with the US sector thanks to less "Dystopia" and rising yields, we still favor high quality European financials credit in the current environment. Even European High Yield is more enticing thanks to lower leverage than the US. To illustrate the "japanification" process in Europe and the reduced "credit impulse" largely due to peripheral banks being capital impaired thanks to bloated balance sheets due to nonperforming loans (NPLs), we would like to point out once more to the difference in terms of deleveraging between Europe, the US and Japan when it comes to their respective banking sector as highlighted as well by Morgan Stanley in their European Credit Outlook note from the 28th of November entitled "As Good As It Gets":

"In our base case, we expect bank credit to outperform non-financials because valuations are less distorted, technicals remain supportive, fundamentals at the system level continue to improve (albeit at a slower pace) and regulatory pressures on the sector are easing. The earnings squeeze on account of negative rates and flat curves is also likely to ease, at least in some parts of the system, on account of recent moves in bond yields. Moreover, the possibility of ECB purchases (while lower now) is still an important source of optionality.

Banking on favourable technical and valuations: 

Delving into some of the factors listed above, we note that the positive, but subdued, lending impulse has been a favourable set-up for bank credit. It has helped to ease concerns of financial conditions and at the same time has kept the supply technical supportive. As shown in Exhibit 28, net issuance
of senior unsecured paper and covered bonds from European banks are barely positive. The need for funding is modest and the avenues are many, with the ECB still an attractive alternative to bond markets. Against this backdrop, we expect senior bank supply to remain muted in 2017. Another important factor that informs our view is regulations. As our bank analysts have been highlighting for some time now (see The Potential for MREL, September 23, 2016), MREL is likely to be supportive for bank debt. They believe that non-preferred senior/'Tier 3' will be the MREL of choice for most banks, increasing structural protection for opco seniors and far lower needs to issue senior debt." - source Morgan Stanley

We hate being "party spoilers" for our equities friend and their "optimism bias" but, in the current deleveraging and "japanification" process, we'd rather go for financials credit wise thanks to the technical support and lower volatility of the asset class compared to equities. No matter how strong the rally has been as of late in equities, for credit there is a caveat, you need to pick your issuer wisely in Europe. Europe is still a story of subdued credit growth given that the liquidity provided by the backstop of the ECB has not meaningfully translated into credit growth for the likes of Portugal and Italy and in no way resolved the Damocles sword hanging over the Italian banking sector and their outsized NPLs issue.

Overall as "Dystopia" is fading, marking a return of bond volatility, we would be surprised to see a continuation of the strong rally seen in the second part of 2016 for credit markets in 2017. Whereas we have not seen signs of clear stabilization for "Mack the Knife" aka King Dollar + positive real US interest rates, hence our neutral stance for the time being on gold, in our last chart, we would like to point out that gold could shine again following the Fed in December.

• Final chart - Gold could shine again after the Fed

Whereas Gibson's paradox, thanks to  "Mack the Knife" has reversed meaningfully during the month of November, we could have a surprise rally after the Fed's decision in December according to our final chart from Deutsche Bank's "Mining Chart of the Week" note from the 25th of November:

"After five of the last eight US interest rate hikes, gold has rallied

The gold price has declined 7% so far in the month to reach a nine-month low on expectations of a US rate hike in December and improved sentiment that recessionary risks are fading with hopes of a Trump-led fiscal stimulus. The precious metal now looks less shiny; but what’s next? History teaches us that gold can rally after the Fed has hiked. As we show on this week’s chart, since 1976, in five instances out of eight, gold rallied with rising Fed rates.

Reading through the Chart

We find it interesting that even in an environment of flat/rising US GDP growth and rising interest rates, gold can rally – this happened in 1977-78, 1993-95, and 2004-06." - source Deutsche Bank

Whereas investors have been anticipating a lot in terms of US fiscal stimulus from the new Trump administration hence the rise in inflationary expectations and the relapse in financial "Dystopia", which led to the recent "Euphoria" in equities, the biggest unknown remains trade and the posture the new US administration will take. If indeed it raises uncertainty on an already fragile global growth, it could end up being supportive of gold prices again. As a bonus chart we would like to point out Bank of America Merrill Lynch's chart highlighting the relationship between gold and global trade from their Metals Strategist note from the 21st of November:

"Trade is an unknown
Trade, the other cornerstone in US President-elect Trump’s plan, has been discussed contentiously. In our view, measures that would restrict global trade would do a lot of damage to economic activity. Against this backdrop, we note that trade has been subdued anyway, and this may not change imminently given developments including a shift in economic activity from DM to EM has run its course for now. Of course, this raises uncertainty over the strength of global growth, which is supportive of gold (Chart 67).

Having said that, we believe a wholesale crackdown on US and global trade cannot be in the interest of the US president elect and we are cautiously optimistic that outright trade wars may not be the core agenda for 2017, so we track developments in this area mostly as a bullish unknown for gold." - source Bank of America Merrill Lynch

Whereas the markets and US voters have so far embraced the utopian idea that the new US Administration could make America great again, it remains to be seen if this state of euphoria is warranted.

"The euphoria around economic booms often obscures the possibility for a bust, which explains why leaders typically miss the warning signs." -  Andrew Ross Sorkin

Stay tuned ! 

Chart of the Day - European Car Sales and Consumer Confidence

"Confidence is contagious. So is lack of confidence." - Vince Lombardi

As we posited in our conversation "The Regret Theory" back in December 2012, in relation to European Consumption, Consumer Confidence is key (in continuation to our extensive look at car sales in Europe from our conversation of April 2012 - "The European Clunker - European car sales, a clear indicator of deflation"):

"One could also look at car sales and European Consumer confidence since 2007, the relationship seems pretty clear even though the cash for clunkers program have indeed been highly supportive of car sales whenever consumer confidence needed some government "artificial boost"

Strong macro drivers such as consumer confidence set the trends for the demand in the auto sector but for consumption levels as well as per the below Chart of the Day - graph source Bloomberg:

New car registrations in Western Europe have continued their positive trend in conjunction with European Consumer Confidence:
-UK +8.2%
-France +5.8%
-Spain +28.7%
-Italy +1.9%
-Germany -3.4% (slightly off this month)

European's five largest markets for passenger car sales have generated 817,158 units sale, up 4.1% from a year ago. The big winner has been Renault group reporting double-digit growth in sale in Spain (+43.3%) driven by the domestic market France with 18.4% growth according to CreditSights from their European Morning comment of the 8th of May.

"If you have no confidence in self, you are twice defeated in the race of life. With confidence, you have won even before you have started." - Marcus Tullius Cicero

Stay tuned!

Guest post - Global Financing Gaps and Credit Availability - Rcube Global Macro Research

"Most people spend more time and energy going around problems than in trying to solve them." - Henry Ford 

Courtesy of our friends at Rcube Global Macro, please find enclosed their latest publication where Cyril Castelli and Stéphane Alloiteau look at Global Financing Gaps and Credit Availability:

As our readers know, we closely watch corporates financing gaps. To have a better view than the classical capex minus cash flows, we substract the net equity issuance to the formula, since positive equity issuance adds liquidity, and viceversa for shares buybacks. Whereas this changes significantly the picture in the US, where corporate behavior in their own equity is meaningful, it has less of an impact in the rest of the world. Nevertheless, to homogenize the statistical data we are now following it closely in most G10 markets.

In the US, where the data has been available since the 1970s, we have shown how the non-financial

sector financing needs explained with a lead bank lending behavior and thus corporate credit spreads. In the final years before the subprime fiasco, we showed how exploding financing needs (rising capex, massive shares buybacks combined with weaker cash flows) preceded a U-turn in bank lending behavior, which in the end triggered the bust. Very rapidly afterwards, corporates shut down investments, issued equities, while cash flows started to recover. As a result, financing needs collapsed. Banks, reassured by the improved financial health of companies eased their lending standards.

A similar path is visible in the Eurozone.

Currently, Eurozone non-financial corporations financing needs are quite low. Investment has plunged while gross savings have increased.

As a consequence the EU financing gap (adjusted for net equity issuance) is quite low by historical standards, which should, in the end, translate into easier lending standards.

Contrary to the US where the non-financial private sector deleveraging implies an Equity outperformance, in Europe this is not the case.

It is nevertheless important to take into account the fact that financings gaps as we measure them are flow based. And that places where they have improved most significantly recently are also the countries where the stock of non-financial corporate debt remains the highest. France non-financial sector is in a critical situation with the highest financing gap, weakest corporate margins, weakening leverage ratios (debt/operating surplus).

While credit availability is improving for large companies, we all know that SMEs access to capital is much more difficult in southern Europe. Nevertheless, the credit channel in the Eurozone continues to slowly normalize.

In last week’s ECB Lending survey, this normalization process is visible.

On the household front, the same can be said, with demand for real estate loans rising close to turn positive.

In the UK, the credit channel is strengthening further, with credit availability for both households and corporates recently spiking. Demand is also picking up. The BOE survey is by far both in terms of momentum and levels the strongest of all. 

The IIF has just published its quarterly Emerging Markets bank Lending Conditions Survey.

There, the results are more worrying. Following a sharp deterioration in funding conditions, the overall bank lending conditions index moved back below the 50 mark, meaning net tightening.

The sharpest deterioration happened in Asia, where the overall index reached the lowest level since the survey started in Q2 2011. Asia lending index is the lowest of all regions. AFME is now just above emerging Europe in terms of credit availability.

The survey highlights the recent underperformance of EM assets. The credit channel in emerging markets is tightening again. It was our belief earlier in the year that it would improve on the back of easier international funding conditions, monetary easing and stronger global growth momentum. We were wrong.

We are now waiting for the US Senior Loan Officer Survey to be released, but it is unlikely to add significant news flow. It will probably reveal a very healthy credit channel, which has now been the case for a while.

To conclude, it appears to us that, regarding bank lending behavior, we can look at the world in three segmented zones. The US, UK and Japan, where bank lending behavior is strong and strengthening, the Eurozone where it is healing and moving in the right direction and emerging markets (except AFME and emerging Europe) and Asia in particular where it is now tightening again.

"There are no big problems, there are just a lot of little problems." - Henry Ford 

Stay tuned!