Macro and Credit - From Dysphoria to Euphoria and back

"Fear and euphoria are dominant forces, and fear is many multiples the size of euphoria. Bubbles go up very slowly as euphoria builds. Then fear hits, and it comes down very sharply. When I started to look at that, I was sort of intellectually shocked. Contagion is the critical phenomenon which causes the thing to fall apart." - Alan Greenspan

Looking at the very strong rally experienced so far this year in the high beta space nearly erasing the pain inflicted in the final quarter in 2018, when it came to selecting our title analogy, we reminded ourselves about "Dysphoria" being a profound state of unease or dissatisfaction. In a psychiatric context, dysphoria may accompany depression, anxiety, or agitation, whereas the opposite state of mind is known as "Euphoria". As well, this post is a continuation of our November 2016 conversation "From Utopia to Dystopia and back", given the continuing reversal of the 1960s utopian revolutionary spirit towards a more populist and conservative political approach globally which we think will materialize even more in the upcoming European elections next month. But, from our much appreciated behavioral psychologist approach to macro and credit perspectives, we reminded ourselves the wise words of our friend Paul Buigues in his 2013 post "Long-Term Corporate Credit Returns":

"Even for a rolling investor (whose returns are also driven by mark-to-market spread moves), initial spreads explain nearly half of 5yr forward returns." - Paul Buigues, 2013

Returns are related to starting valuations and are more volatile during transitional states  regimes, this is a very important point for credit investors we think going forward: 

"Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates.

As a consequence, spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors."  - Paul Buigues, 2013

Also, "dysphoric and euphoric" moves in markets are regular features we think in late cycles:

"Spreads moves between June 2007 and October 2008 (from 250bp to 2000bp in just 16 months) were a great illustration of this manic-depressive behaviour (which can also be related to Minsky’s model of the credit cycle). " - Paul Buigues, 2013

Another great illustration of this manic-depressive behaviour from credit investors was the very significant rally in high beta credit during the second part of 2016 and in particular in the CCC bucket in US High Yield thanks to its exposure to the energy sector and to the rebound seen in oil prices at the time.

In this week's conversation, we would like to look at the start of the deleveraging in US corporate credit and what it entails, a subject we already approached in January 2019 in our conversation "The Zeigarnik effect" as well as in April 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets".

Synopsis:

• Macro and Credit - Under reconstruction
• Final chart - In the short term, clearly a dovish Fed marks a return of "Goldilocks" for credit markets

• Macro and Credit - Under reconstruction

Given "Deleveraging" is generally bad for equities, but good for credit assets, one might wonder if indeed credit might in the near term start outperforming equities with CFOs become more defensive of their balance sheet. This would of course lead to less support to some US equities with reduced buybacks and even dividend cuts in some instances. Obviously buybacks have been highly supportive of the ongoing rally seen in US equities over the years thanks to multiple expansion. When companies turn conservative and start reducing debt, credit holders benefit and equity holders lose out, that simple.

An illustration of the above was pointed out by Lisa Abramowicz from Bloomberg on the 24th of April relating to AT&T:

"What's good for AT&T's bond investors is bad for its stock holders. The company is losing subscribers as it cuts debt, leading to a stock slump. Its bonds, however, are soaring." - source Bloomberg

This is exactly the risks we highlighted back in January 2019 in our conversation "The Zeigarnik effect"

"If there is indeed a slowly but surely rise in the cost of capital, yet at more tepid pace thanks to the latest dovish tone from the Fed, then indeed, this could be more supportive for credit, if companies choose the deleveraging route in the US to defend their credit ratings. In this kind of scenario, it would be more "bond" friendly than "equity" friendly from a dividend perspective we think." - source Macronomics, January 2019

While the rally in high betas have been very significant so far this year with even the CCC bucket for US High Yield delivering around 8.8% return YTD, flows points towards "quality" (Investment Grade) over "quantity" (US High Yield) it seems as indicated by Bank of America Merrill Lynch in their Follow The Flow report from the 26th of April entitled "Reaching for quality yield":

"IG funds flows continue uninterrupted

Another week of the same it seems. Fixed income investors continue reaching for “quality yield” via high-grade paper, while reducing risk in the government bond market. With government bond yields still close to the lows, it comes as no surprise to us that investors are looking to source non-negative yielding instruments. At the same time the lack of clarity on global growth is deterring investors from adding risk in equities.

Over the past week…

High grade funds saw an inflow for an eighth week in a row, extending the longest streak of inflows since 2017. We note that the slower pace w-o-w could be attributed to the short week due to the Easter holidays. Should we adjust this week’s inflow (for only three business days) it is almost at the same level as the inflow seen a week ago.

High yield funds recorded an inflow last week, the third in a row. Looking into the domicile breakdown, European-focused funds recorded the bulk of the inflow followed by Globally-focused funds. US-focused funds saw an outflow.

Government bond funds registered an outflow for the second week in a row. We note that the pace (despite the short week) has more than doubled w-o-w. Money Market funds recorded a sizable outflow last week, the second largest ever recorded. All in all, Fixed Income funds enjoyed their sixteenth consecutive week of inflows.

European equity funds continued to record outflows; the eleventh in a row. Note that over the past 59 weeks the asset class has recorded only two weeks of inflows.

Global EM debt funds recorded a small outflow, only the second this year, reflecting the appreciation of the USD over the past couple of weeks. Commodity funds saw an outflow last week, the third in 2019.

On the duration front, even though there were inflows across the curve, mid-term IG funds saw the bulk of the inflow." - source Bank of America Merrill Lynch

Back in early April in our conversation "Easy Come, Easy Go", we pointed out to the return of "Bondzilla" the NIRP monster and the returning appetite from Japan's Government Pension Investment Fund GPIF and their friends Lifers, shedding hedging and adding more credit risk in their allocation process. Therefore it is not a surprise to us to see an increase in allocation to Investment Grade credit in terms of fund flows.

The appetite for foreign bonds for Japanese Lifers is indicated by Nomura in their Matsuzawa Morning Report from the 23rd of April entitled "Pension funds continue to build portfolios premised on an economic downturn":

"Lifers continued to buy super-long JGBs at relatively high levels in March. Buying generally tends to increase in January-March, but the fact that they are continuing to buy even as yields drop significantly, suggests that their shift to other assets such as foreign bonds is not sufficient. Four of the nine major lifers had released their FY19 investment plans as of yesterday. They are divided on Japanese bond investments, with two lifers intending to increase and two planning to reduce Japanese bonds. Compared with last year, they are not in favor of hedged foreign bonds (particularly USTs). They mention shifting instead to unhedged foreign bonds and, even among foreign assets, moving out of government bonds to credit and alternative investments, but it is not clear how far these can go as substitutions. Most of the lifers forecast USD/JPY rates around 108-110 at end-FY19, with all expecting rates to be about the same as at present or JPY somewhat stronger. The lifers predict 10yr UST yields in a 2.30-2.70% range, anticipating neither a rate hike nor a rate cut. Given these projections for the overseas environment, we believe lifers are unlikely to reduce the amounts left idle in Japan for lack of other options compared with FY18, but they could increase these amounts." - source Nomura

To repeat ourselves, like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments to take on more credit risk.

Also something to take note is that as dispersion is rising (which is a late credit cycle feature) some investors are playing it more "defensive" hence the reach for "quality". As well as pointed out by another Nomura Matsuzawa Morning Report from the 25th of April entitled "Flows return from EMs to US", it is worth noting what is happening in Emerging Markets credit wise:

"Overseas markets were risk-off overall on Wednesday. While flows were concentrated in the US, it looked to us like money was being pulled out of EMs. In the FX market, DXY increased significantly for a second day and USD/JPY reached the 112 range. At the same time, JPY was strong across the board in cross pairs, indicating that the market’s risk sentiment is weak—emblematic of unfavorable USD strength. EM currencies were also weak. Germany’s IFO came in below forecast, forcing investors to unwind their trades made hastily on the premise of Europe’s economic recovery. This makes sense to us, but we do find it interesting that Australia’s weak CPI not only triggered an AUD sell-off, but devolved into a risk-off flow that spilled over into EM and Japanese markets as well. It seems to us that market sentiment on EMs and resource-rich countries is beginning to deteriorate, so that even a small factor causes a major response in the market.

The CDS spread in EMs widened relatively significantly and reached the highest level since 3 January (Figure 2).

However, spreads on other instruments that act like canaries in a coal mine for the credit market, such as US high-yield bonds and European financial institutions’ subordinated bonds, are relatively stable, which leads us to surmise that these wide spreads can be attributed to an issue specific to EMs (supply/demand? fundamentals?) rather than to a risk-off flow in the entire credit market. In terms of supply/demand, we believe hedge funds locked in profits during the EM rally in January- March and are timing their return to the US to coincide with US companies’ strong earnings results. We see few factors that would prolong and deepen this flow, unlike the flows returning to the US due to the intensification of the US-China trade dispute last year. In terms of fundamentals, Chinese policymakers’ moves toward a more neutral policy stance could be having an impact. Yesterday, the People’s Bank of China (PBoC) injected liquidity via a targeted medium-term lending facility (see the 24 April edition of Asia Insights). This is seen as an alternative to lowering the reserve requirement ratio, and after this supply was announced, additional easing expectations declined, causing short-term rates (SHIBOR) to rise and Chinese equities to fall. If the PBoC were to rush into a more hawkish stance at this point, we believe risk-off flows in EMs would intensify. In any case, during Japan’s 10-day holiday to mark the imperial succession, we expect EMs to be the focus. In addition to Japan’s holiday, China will have its May Day holiday on 1-3 May, and this could restrain the market’s movements. In addition, the release of China’s manufacturing PMI on 30 April could change economic sentiment.

Ironically, the concentration of flows in the US as economic conditions there improve has pushed down US bond yields as well, and the market reflects higher Fed rate cut expectations. In fact, Japanese investors seem to be playing a role in this, and the International Transactions in Securities released this morning show that they were major net buyers of foreign bonds for a second straight week in the most recent week for which data is available (week of 15 April; Figure 1).

Expectations for a Fed rate cut by end-2019 rose to 63% (56% on the previous day). Given that US economic sentiment has improved since April, it seems strange to us that a rate cut in 2019 should be part of the market’s main scenario, but as noted above, this can also be seen as a sign that investors are preparing for a credit event stemming from EMs during Japan and China’s national holidays. However, in this case, US bond yields would have room for a reactionary rollback once this period has passed without event." - source Nomura 

The overseas support from Japanese investors to US credit markets should not be underestimated. They provide significant support to US credit markets hence the importance of tracking their investment and flows from a credit and macro perspective. as per the chart below from Nomura FX Insights report from the 24th of April entitled "Lifers still look for foreign assets":

- source Nomura

This is chart we think is very important we think from an allocation perspective as explained by Bank of America Merrill Lynch in their Credit Market Strategist note from the 18th of April entitled "Party like it's 2016":

"Party like it’s 2016

During the years 2015-2017 foreigners and bond funds/ETFs bought all net supply of US corporate bonds (Figure 1), creating excess demand and driving spreads much tighter starting in February 2016.

Then in 2018 the Fed engineered a disorderly rate hiking cycle and a yield shock, as they were the only major central bank hiking and at the same engaged in QT. As a result, the corporate bond market lost the foreign buyer and inflows to bond funds/ETFs plummeted – hence the big 112bps increase in corporate yields during 2018 was necessary in order to attract other buyers, specifically pension funds (the majority of which state and local).

Given the Fed’s capitulation on monetary policy tightening this year we think 2019 will look much like 2016 as far as corporate bond demand goes, with foreigners and bond funds/ETFs once again buying all net supply. While the outlook for demand this year thus is similar to 2016, we expect ~$250bn less net supply ($100bn less gross supply, $150bn more maturities). Hence, we are unable to escape thinking that demand-supply technicals will remain positive and supportive for spreads for a while. Just like in 2016, although spreads this time are tighter so the rally cannot continue as long (Figure 2).

2019 vs. 2016

Foreign buying – as reflected in negative net-dealer-to-affiliate volumes – has been running very strong this year at a pace matching what we saw in 2016 YtD (Figure 3).

Given that peak weakness in 2016 was on February 11, i.e. later in the year than the January 3rd wides this time, not surprisingly inflows to IG bond funds and ETFs are running well ahead of 2016’s pace YtD (Figure 4).

However, on adjusting for the difference in timing within each year clearly inflows this year following the wides is ramping up much faster that we saw following peak spreads in 2016. Finally gross new issuance is running at the exact same pace this year YtD as in 2016 (Figure 5).

For 2016 we originally forecast about $1.2tr of supply and ended up getting almost $100bn more ($1.289bn). For 2019 we are also forecasting about $1.2tr, and with the decline in yields and wide open markets, clearly the risk this year is again to the upside relative to our forecast first published in a very different environment in 4Q18. Should we again get about $100bn up upside, keep in mind that net supply will still be down $150bn this year due to more maturities." - source Bank of America Merrill Lynch

Indeed, we could see a continuation of the "melt-up" at least in credit markets thanks to the strong technical support in conjunction with overseas interest from the likes of Japanese investors.

But, returning to our main story of "Deleveraging" by CFOs, this we think could provide even more support to credit markets and translate into more "sucker punches" à la AT&T as illustrated earlier in our conversation. This would favor even more credit investors over equities investors we think. So, yes we are "bullish" credit. On that very subject of "Deleveraging by CFOs, we read with great interest Bank of America Merrill Lynch's take in their Credit/Equity Strategy note from the 22nd of April entitled "The Age of Balance Sheet Repair":

"A formula for growth in a low-growth environment

Low growth, low interest rates and low equity valuations in recent years have pushed US corporations to search for new drivers of financial performance. Many of them gravitated to a formula of tapping their balance sheet capacity to issue cheap debt and fund M&A and share buybacks. In only the last five years, companies repurchased $2.7trln of shares, paid $3.3trln in dividends, all while increasing their debt by $2.5trln. For some perspective, their combined capex budgets stood at $9.6trln during this time.

About 30% of EPS growth driven by gross buybacks

Buybacks have been seen as the savior of a lackluster profits cycle: US stocks (proxied by the Russell 3000 ex-Financials/Utilities/Real Estate) have seen EPS growth of 45% over the last five years, but gross share buybacks contributed 12ppt, ~30% of that growth (with the net buyback impact about half of that, or 6ppt). Over the same period, net debt doubled. An elevated equity risk premium and a low cost of debt encouraged debt-funded buybacks, and a scarcity of real revenue growth made this more compelling.

The age of balance sheet repair is here

Late 2018 was the turning point in this cycle of expanding debt balance sheets, buying growth and rewarding shareholders, in our opinion. Interest rates have risen and the market dislocation in Q4 played the role of a wake-up call to the largest bond issuers. This message was particularly loud and clear as it related to BBB issuers, many of whom saw their spreads north of 200bps, levels normally reserved for HY bonds. Given their sizes – many in excess of $20bn in bonds, higher than any existing HY issuer – the message was also critical: delever, or else expect material risk premiums if downgraded to HY. We include screens for largest BBB issuers, those with greater ability to delever and those with greater degree of dependence on capital markets.

Reset your expectations lower from here

Today, the game has changed. Three times as many investors want companies to pay down debt than to buyback stocks, and the cost of equity capital reflects this: the relative multiple of levered companies vs. cash-rich companies is now at a 7% discount to history. We expect a return to normalcy: recall that buyback-driven EPS growth was largely a post-crisis phenomenon, and pre- 2009, companies were mostly net issuers. Based on these and other considerations, our S&P 500 EPS forecast for 2020 of $180 (7% growth) incorporates no net buyback effect, and we see downside risk to per share growth going forward from dilution, not net share count reduction. Sectors where buyback activity is most likely to continue (Fins and Tech, where leverage is still historically low) may be unduly rewarded as the buyback theme grows scarce.

Strong balance sheets are good for all investors

The key takeaway here is that times are changing. After years of transferring value from bondholders to shareholders companies may now be forced to instead defend their balance sheets at the expense of shareholders. Our findings suggest that initial negative reaction in share prices is often short-lived, and eventually equities benefit from stronger balance sheets too." - source Bank of America Merrill Lynch

You have been warned, the fourth quarter was a wake-up call for many US CFOs and given the euphoria we have seen as of late in high beta, we would rather side with the "cowards" aka credit markets over "equities" in the second half of this year, particularly given Investment Grade is as well a far less volatile proposal.

The leverage "situation" is described in more details in Bank of America Merrill Lynch's note:

"Low growth, low interest rates, low equity valuations

In the years that passed since the Global Financial Crisis (GFC), many historical norms that were established over previous decades came into question. Economic growth has slowed with the trailing-10yr real US GDP growth bottoming out at 1.5% annualized in 2011-2018, a post-great depression low. This growth pattern also compares to 3.6% 10yr trailing average in the 2003-2006 cycle, and 4.2% in the mid-1990s. Inflation has also dropped to 60-year lows, as measured by core PCE. The Fed responded to this predicament by keeping real interest rates at negative levels for several years in a row.

For US corporations, this backdrop implied two new factors: their earnings were unusually difficult to grow organically, and their debt was unusually cheap (Figure 1).

Their managements have responded to this macro backdrop in a predictable way, by borrowing cheap debt and using its proceeds to buy back shares, thus improving EPS, and funding M&A (Figure 2).

Fast forward to today, and we are looking at corporate balance sheets that are carrying cyclically high levels of debt leverage, a development that usually happens after credit cycle turns and EBITDAs drop.

The large credit expansion over the last decade was supported by both strong demand and ample supply of corporate bonds. On the demand side investors were forced to reach for yield in US credit as a function of inability to achieve their income targets in other fixed income markets. On the supply side companies were put their balance sheets to use by borrowing at the historically low interest rates, while also satisfying the growing demand for their bonds.

While borrowing to enhance shareholder returns and acquire new businesses is not a new phenomenon, it has reached new highs over the past decade (Figure 2). Looking more broadly at US nonfinancial corporate business, corporate bond borrowing covered 58% of net spending on buying equities. This includes both share buybacks and M&A activity (Figure 3).

Reaching the limits of releveraging

The demand and supply dynamics are now turning less favorable to releveraging. On the demand side Fed’s hiking cycle in 2018 made it more difficult for foreign investors to buy US corporate bonds due to higher FX hedging costs. At the same time higher interest rates and the corresponding bond price declines weakened inflows to high  grade bond funds and ETFs. The result was a notable decline in demand for corporate bonds in 2018, although it has improved this year. In terms of supply, higher corporate bond yields mean borrowing costs have increased for US companies.

On top of that after years of cheap credit a number of issuers have reached their balance sheet limits. For US non-financial issuers leverage is currently around cyclical highs (Figure 4).

Based on BofA Merrill Lynch Global Fund Manager Survey, equity investors are now more focused on balance sheet repair that at any other point in this credit cycle (Figure 5).

Investors have grown disenchanted with buyback driven per share growth and are more interested in balance sheet improvement. Almost half (43%) of investors want excess cash used to improve balance sheets, a post-crisis high, compared to just 33% desiring increased capex and a paltry 16% desiring cash return to shareholders. The chart also shows strong cyclicality and previously has reached this level of credit-related concerns only in 2008 and 2002.

A preference for clean balance sheets is evident in valuations, where we find that levered companies within the S&P 500 have de-rated to trade a historical discount to cash-rich peers (Figure 6).

- source Bank of America Merrill Lynch.

If indeed equity investors are getting "Dysphoria" being a profound state of unease or dissatisfaction, and want companies to improve their balance sheets, then indeed it should lead to more "Euphoria" from credit investors we think.

Strong technicals on the back of overseas demand and a 2016 issuance level situation does indeed make us bullish for now on credit markets and in particular for US Investment Grade thanks to a dovish Fed as per our final chart below

• Final chart - In the short term, clearly a dovish Fed marks a return of "Goldilocks" for credit markets

While a strong source of demand for US credit markets comes no doubt from "overseas" in general and Japan in particular, the dovish tilt from the Fed on the back of strong technicals such as issuance make it very supportive for credit markets for now as per our below chart displaying the fall in interest rate risk coming from Bank of America Merrill Lynch in their Credit Market Strategist note from the 18th of April entitled "Party like it's 2016":

"Crucial ingredient for the rally: Re-pricing the FedWe want to end by discussing the key sources of demand driving the present environment of strong technicals in IG – bond funds and ETFs and foreigners. The key development for both is this major shift in monetary policy expectations. The below chart shows that the Fed funds futures market went from pricing in three rate hikes over the coming twelve months to now pricing in about one ease (Figure 11). 

There are two key consequences of this: 1) dramatic decline in interest rates and 2) a much more benign outlook for dollar hedging costs for foreign investors." - source Bank of America Merrill Lynch

So if indeed we have seen a lot of "Euphoria" in the rally so far seen this year particularly in the high beta space  with the start to year for the S&P since 1987 (+17%) , with Oil up 35%, Small Caps by 19% and High Yield up by 9% (HYG) and Investment Grade (LQD) up a cool 7%, given the current "Dysphoria" feeling about the level of leverage for US corporate balance sheet, rest assured that they are more potential for additional AT&T sucker punches being delivered. One would be wise to trade accordingly and rotate towards the credit part of any US issuer at risk but we ramble again...

"Indeed, bull markets are fueled by successive waves of prior skeptics finally capitulating as their fears fade. Eventually, fear turns to euphoria, and that's the stuff of bubbles." - Kenneth Fisher

Stay tuned!

Macro and Credit - Mithridatism

"Many have said of Alchemy, that it is for the making of gold and silver. For me such is not the aim, but to consider only what virtue and power may lie in medicines." - Paracelsus

Watching with interest the tentative rebound in US equities on the back of hope for an agreement between China and the United States on trade, while listening to the "contrition" of French president Macron following the "tax" revolution, promising more spending aka more deficit and more debt, which should no doubt please his technocratic friends in Brussels, when it came to selecting our title analogy given the market gyrations surrounding liquidity withdrawal, we decided to go for "Mithridatism", being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts. 

The word is derived from Mithridates VI, the King of Pontus, who so feared being poisoned that he regularly ingested small doses, aiming to develop immunity. It has been suggested that Russian mystic Rasputin's survival of a poisoning attempt was due to mithridatism, but this has not been proven. It is important to note that mithridatism is not effective against all types of poison (immunity generally is only possible with biologically complex types which the immune system can respond to) and, depending on the toxin, the practice can lead to the lethal accumulation of a poison in the body. 

For example, the Australian Koalas' diet is so much toxic and poisonous that a normal mammal can't survive. It has also come to our attention that finally the long "immune" Australian housing market has come under pressure as of late as indicated by Cameron Kusher on his twitter feed on the 3rd of December:

Sydney dwelling values have been falling for 16 months and are down -9.5%, when Perth started to decline, 16 months in values were -5.3% lower, and in Darwin they were down -4.4% after 16 months. Is this an orderly slowdown?" - Cameron Kusher - Twitter feed 

While thanks to "Mithridatism", Australia's housing market had been spared for such a long time, it looks to us that finally it is coming under tremendous pressure. One of our French friends currently residing in Sydney suggests that the four big Australian banks were displaying classic 2007 US banks characteristics. Our friend Carl Hodson-Thomas Portfolio Manager at Prometheus Asset Management and based in Perth, would probably argue that QBE insurance company should be a prime candidate for a sizable "short" position given it, along with GMA, has the first-loss exposure to the riskiest mortgages in Australia through its lenders mortgage insurance... But, we digress.

In this week's conversation, we would like to look at what 2019 could entail in terms of risk given the most recent bout in widening credit spreads and with the ECB joining the tapering bandwagon on the back of Fed's ongoing QT.

Synopsis:

• Macro and Credit - 2019: When the central banks are no longer your "friends"...
• Final chart -  Did the Fed already break something?

• Macro and Credit - 2019: When the central banks are no longer your "friends"...

As we pointed out in our previous musing, credit markets and fund flows continue to be "wobbly" to say the least. We continue to monitor credit markets as yet another indication we are in the late stage of this credit cycle. As indicated by Lisa Abramowicz on her twitter feed, the recent credit selloff has been vast and furious in the US:

"The recent credit selloff has hit U.S. debt more than emerging-markets notes. Investors are now demanding the most extra yield to own U.S. junk bonds versus emerging-markets credit since April. (This is a comparison of spreads, as per BBG Barclays data)" - source Bloomberg - Lisa Abramowicz - twitter

Furthermore, more and more pundits are taking the short side of the credit markets and it's not only in the illiquid part of the market such as "leveraged loans" which have come to the attention of central bankers and others, as pointed out by the Wall Street Journal on the 11th of December in their article entitled "Investors Bet $10 Billion Against Popular Bond ETFs":

"Bond investors scrambling to protect themselves from losses are increasingly using bets against the largest junk-bond exchange-traded funds and derivatives that rise in value when corporate bonds lose ground. The popularity of such defensive trades could portend more pain for stock investors as corporate bonds, especially those with sub-investment grade, or junk, ratings, often pick up signs of economic stress before other assets.

The value of bearish bets on shares of the two largest junk-bond ETFs hit a record $10 billion in recent weeks, according to data from IHS Markit . Downbeat wagers on indexes of credit default swaps, or CDS, for junk bonds hit a four-year high in November, according to Citigroup .

Investors are turning to ETFs and derivatives as proxies for actual bonds because debt-trading activity, also called liquidity, has declined over the past decade as new regulations forced investment banks to pare risk-taking. Rising numbers of hedge-fund and mutual-fund managers, for example, are using ETFs to quickly take bearish and bullish positions on bond markets, making them early indicators of investor sentiment." - source WSJ

Over the last 7 days, the US leveraged loans market is down 1.1%. This is the steepest one-week drop since 2011 (per the S&P / LSTA Leveraged Loan Index) according to S&P Global Intelligence.  The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, lost 0.38% on the 11th of December. Loan returns were –0.66% in the month to date and 2.38% in the YTD. You can expect an acceleration in the fall as we pointed out in our November conversation "Zollverein" particularly given their behavior in 2008 and the "illiquidity" premium discussed in our November conversation that needs to be factored in.

Cracks have started to show not only in supposedly "liquid" ETFs but, as well as in the CLO tranches market as pointed out by the Financial Times in their article entitled "Investors signal concerns with leveraged loans" (H/T Lisa Abramowicz):

"The difference between the interest rates on the highest-rated CLO tranches and three-month Libor has hit 121 basis points — the biggest risk premium since February 2017, according to Citigroup. As recently as November 2017, the spread was 90bp.

Lower-rated CLO tranches have also come under pressure. The spread between double-B tranches and three-month Libor rose 70bp in November to 675bp, the biggest monthly increase since early 2016, Citigroup said."

 - source Financial Times

There is more pain to follow we think in 2019. As we pointed out in our November conversation "Zollverein", US High Yield CCC rating bucket is seriously exposed to the Energy sector and to any fall in oil prices. Oil prices and US High Yield are highly connected (15% of US High Yield). As pointed by Lisa Abramowicz on twitter, no wonder some US oil drillers are starting to feel the "heat":

"An offshore driller, Parker Drilling, just filed for bankruptcy because oil prices aren't high enough to sustain its business model. It's bonds:

- source Bloomberg - Lisa Abramowicz - twitter

The big question one might rightly ask if indeed this is a start of a trend. Sure some pundits would like to point out about the current low default rates but that is akin to looking at the rear view mirror. We have indicated in numerous conversations that QT is accelerating the tightening in financial conditions, akin to some stealth rate hikes given the support provided by massive liquidity over the years. With credit spreads widening, so are financial conditions impacted for the leveraged weaker players.

In their most recent blog post on the 12th of December, DataGrapple is asking if indeed PKD is only the first shoe to drop in the Energy sector:

"SRAC (Sears) has been the first name to default in series 31 of CDX HY on October 15th, even though the auction that will help determine the payout of CDS contracts has still not been held. The second default happened overnight, as PKD ( Parker Drilling Company ) voluntarily filed for Chapter 11 protection under an agreement with a group of debtors that will allow it to quickly restructure. Drilling contractors have struggled to recover from a steep drop in oil prices which reached a trough in 2016. The recent step-down in crude levels – Brent lost roughly 30% since early October to close at $60/barrel tonight – threatens to derail a long-predicted recovery for off-shore companies, which typically handle more expensive projects that require higher energy prices to turn a profit. As recently as November, PKD warned its investors it might not be able to repay certain debts. Since then, its obligations have been trading at levels implying a near certain default and today’s announcement did not come as a big surprise to investors. The question is rather whether PKD is only the first shoe to drop and whether they should expect more decompression between the energy heavy CDX HY and other credit indices." - source DataGrapple

In true "Mithridatism" fashion one should indeed start to seriously reduce their credit "high beta" exposure while they can. It's not only a question of what is "illiquid" versus what is "liquid" given than contrary to 2007, dealers inventories are nowhere near to what they used to be.

The story of fund flows is clearly indicative of "crowding out" happening with appetite switching from credit markets towards US Treasury bills and the safety of the US front-end. As shown by Bank of America Merrill Lynch Follow The Flow note from the 9th of December entitled Back to pre-Qe levels, credit markets are under pressure:

"Outflows have now erased the QE flow

Outflows continued for another week in Europe. Cumulative outflows from IG and HY funds have now erased the inflow seen post QE.

The lack of yield and the lack of growth in Europe are pushing assets away. Risks remain to the downside as the buyer of last resort is stepping away and liquidity remains challenging. Spreads are prone of further widening, not due to weak fundamentals, but due to challenging liquidity and weakening macro backdrop.

Over the past week…

High grade funds recorded another large outflow this week. This has been the 17th week of outflows over the past 18 weeks. High yield funds also recorded another sizable outflow this week, the 10th in a row. Looking into the domicile breakdown, outflows were almost equally split between the three buckets we have: US-focused, Euro-focused and Global-focused funds have all lost similar amount of AUM. 

Government bond funds recorded a marginal inflow this week, putting an end to two consecutive weeks of outflows. Meanwhile, Money Market funds suffered again a large outflow, though half the size of last week’s.

European equity funds continued to suffer outflows for the 13th consecutive week, though this week’s outflow is meaningfully smaller than the ones observed in the 5 previous weeks. Still, during the past 39 weeks, European equity funds experienced 38 weeks of outflows.

Global EM debt recorded a large outflow this week, the 9th in a row, in sharp contrast
with the improving trend we saw during the past 7 weeks. Commodity funds recorded a
marginal outflow.
On the duration front, we saw outflows across the entire curve, though mid-term IG
funds led the trend by far." - source Bank of America Merrill Lynch

So yes, there is a "Great Rotation" from "growth" to "value" stocks in US equities, but, in credit land, there is as well a more defensive stance taking place and this doesn't bode well we think for 2019, particularly it could mean even more bad news for equities if one continues to believe that credit leads equities.

When it comes to the year ahead we read with interest Bank of America Merrill Lynch's take in their "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" that ties up nicely with our "Mithridatism" title:

"The Toxic Brew that threatens near term…

Three market drivers have turned hostile simultaneously. 1) The inflation-adjusted global monetary base was growing 10% YoY at the start of the year, and is now contracting 1%. Based on current Fed balance sheet contraction targets of USD472bn in 2019, and a flat ECB and BoJ balance sheet, it is projected to contract 4.6% by December 2019.

2) The breadth of global economic growth has collapsed – in January 2018, 26 of 38 i.e. 70% countries saw rising leading economic indicators, now only 6, or 16% are. This is close to the lowest decile of global economic breadth in the past 35 years.

3) Global equity market breadth has also collapsed. In January, 46 of 47 equity markets were above their 200-day moving averages, now only 6, or 13% are. Again, this is near the bottom decile. This triple toxic brew has percolated only three times in the past 35 years – in 1990, 1998 and 2001.

Each period was rough for risk assets, followed by central banks capitulating and easing monetary policy. Once the monetary elixir arrived, markets rallied hard, except in 2001, when it took longer to work off the TMT bubble valuations. We expect this time will be no different. While global monetary authorities currently plan to tighten, they are most likely to panic next year, and reverse themselves. Asia/EMs are poised to lift-off when that capitulation occurs." - source Bank of America Merrill Lynch

So global growth is indeed decelerating, credit markets are widening, the Fed blinked and it looks like many are hoping for China to come once again to the rescue and provide more Mithridatism it seems.


While Mithridatism being the practice of protecting oneself against a poison by gradually self-administering non-lethal amounts, it seems to us that ng the Fed with its QT is trying to gradually impose to markets more "price discovery" by administering non-lethal amount of rates hike and gradual liquidity withdrawal, a very difficult exercise indeed after years of repressed volatiliy. Our final chart below is asking if indeed the Fed already broke something or not.

• Final chart -  Did the Fed already break something?

Did the Fed recently blinked and December hike will need to a more data dependent Fed? This is the ongoing raging question everyone is wondering about. Clearly liquidity withdrawal has already blown in 2018 the house of straw of the short-vol pigs, the house of sticks of the Emerging Markets carry tourists, and it seems that as of late the house of bricks of the credit pigs have lost a few. The question that remains is if indeed in this cycle the Fed will break something else in 2019. The below chart comes from Bank of America Merrill Lynch "The Inquirer" note from the 13th of December entitled "2019 - the year ahead: A Toxic Brew First, Monetary Elixir Later" and displays the Fed's tightening in this cycle at 5.2% in total:

- source Bank of America Merrill Lynch

Given the above no wonder US based money market funds attracted $81 billion over the weekly period, the largest inflows on records dating to 1992 according to Lipper. It seems to us that some pundits don't believe that much in "Mithrandism" and its potential to protect from the "poison" of liquidity withdrawal but, we ramble again...

 "The true alchemists do not change lead into gold; they change the world into words."- William H. Gass

Stay tuned !

Macro and Credit - White Tiger

"Earnings don't move the overall market; it's the Federal Reserve Board... focus on the central banks, and focus on the movement of liquidity... most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets." - Stanley Druckenmiller

Watching with interest the trade war between the United States and China ratcheting up with Beijing cancelling its plans to send two delegations to Washington, given the season of fall is upon us, when it came to selecting our title analogy, we decided to go for "White Tiger". The White Tiger is one of the four symbols of the Chines constellations. It is sometimes called the White Tiger of the West and represents the West in terms of direction as well as the autumn season.  It has been said that the white tiger only appeared when the emperor ruled with absolute virtue, or if there was peace throughout the world. Obviously for those who remember our June conversation "Prometheus Unbound", we argued the following:

"It seems more and more probable that the United States and China cannot escape the Thucydides Trap being the theory proposed by Graham Allison former director of the Harvard Kennedy School’s Belfer Center for Science and International Affairs and a former U.S. assistant secretary of defense for policy and plans in 2015 who postulates that war between a rising power and an established power is inevitable:
- source Macronomics June 2016 

"It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable." Thucydides from "The History of the Peloponnesian War" -

In similar fashion, more recently maverick hedge fund manager Ray Dalio came to a similar prognosis in his recent musing entitled "A Path to War" on the 19th of September:

"The economic/geopolitical cycle of economic conflicts leading to military conflicts both within and between emerging powerful countries and established powerful countries is obvious to anyone who studies history.  It’s been well-described by historians, though those historians typically have more of a geopolitical perspective and less of an economic/market perspective than I do.  In either case, it is well-recognized as classic by historians.  The following sentence describes it as I see it in a nutshell:

When 1) within countries there are economic conflicts between the rich/capitalist/political right and the poor/proletariat/political left that lead to conflicts that result in populist, autocratic, nationalistic, and militaristic leaders coming to power, while at the same time, 2) between countries there are conflicts arising among comparably strong economic and military powers, the relationships between economics and politics become especially intertwined—and the probabilities of disruptive conflicts (e.g., wars) become much higher than normal.

In other words economic rivalries within and between countries often lead to fighting in order to establish which entities are most powerful.  In these periods, we have war economies, and after them, markets, economies, and geopolitics all experience the hang-over effects.  What happens during wars and as a result of wars have huge effects on which currencies, which debts, which equities, and which economies are worth what, and more profoundly, on the whole social-political fabric.  At the most big-picture level, the periods of war are followed by periods of peace in which the dominant power/powers get to set the rules because no one can fight them.  That continues until the cycle begins again (because of a rival power emerging).

Appreciating this big economic/geopolitical cycle that drives the ascendancies and declines of empires and their reserve currencies requires taking a much longer (250-year) time frame, which I will touch on briefly here and in more detail in a future report.
Typically, though not always, at times of economic rivalry, emotions run high, firebrand populist leaders who prefer antagonistic paths are elected or come to power, and wars occur.  However, that is not always the case.  History has shown that through time, there are two broad types of relationships, and that what occurs depends on which type of relationship exists.  The two types of relationships are:

a) Cooperative-competitive relationships in which the parties take into consideration what’s really important to the other and try to give it to them in exchange for what they most want.  In this type of win-win relationship, there are often tough negotiations that are done with respect and consideration, like two friendly merchants in a bazaar or two friendly teams on the field.

b) Mutually threatening relationships in which the parties think about how they can harm the other and exchange painful acts in the hope of forcing the other into a position of fear so that they will give in.  In this type of lose-lose relationship, they interact through “war” rather than through “negotiation.”

Either side can force the second path (threatening war, lose-lose) onto the other side, but it takes both sides to go down the cooperative, win-win path.  Both sides will inevitably follow the same approach.

In the back of the minds of all parties, regardless of which path they choose, should be their relative powers.  In the first case, each party should realize what the other could force on them and appreciate the quality of the exchange without getting too pushy, while in the second case, the parties should realize that power will be defined by the relative abilities of the parties to endure pain as much as their relative abilities to inflict it.  When it isn’t clear exactly how much power either side has to reward and punish the other side because there are many untested ways, the first path is the safer way.  On the other hand, the second way will certainly make clear—through the hell of war—which party is dominant and which one will have to be submissive.  That is why, after wars, there are typically extended periods of peace with the dominant country setting the rules and other countries following them for the time it takes for the cycle to happen all over again." - source Ray Dalio

Because the color white of the Wu Xing theory also represents the west, the white tiger became a mythological guardian of the West on the mythological compass. The White Tiger is as well considered in China as the ruler of the Autumn and the governor of the metallic elementals (hint for you gold bugs out there...) but we ramble again. Will the age of reason disappear with the White Tiger? We wonder.

In this week's conversation, we would like to look at the gradual path towards recession in the US and how does the credit cycle will end.

Synopsis:

• Macro and Credit - Credit cycles die of "old age". 
• Final chart - Hey Fed, NAIRU this!

• Macro and Credit - Credit cycles die of "old age". 

While many pundits have been focusing on the continuation of the flattening of the yield curve, as we pointed out in our most recent conversation again, credit cycles die because too much debt has been raised. What the most recent Fed quarterly survey Senior Loan Officers Opinion Survey (SLOOs) tells us is that financial conditions remain very benign still. Yet, no one can ignore the hiking path followed by the Fed and that already some part of the economy such as housing are already feeling the heat and the gradual tightening noose of financial conditions. 

From a "White Tiger" perspective, a full-blown trade war between China and the United States would push US companies to pass on prices increases onto the US consumer. Any acceleration in inflation would lead to the Fed to be more aggressive with its hiking stance. The rhetoric of Fed members in recent week has become decisively more “hawkish”.

First question we are asking ourselves is when does the US consumer gets "maxed out"? We are already seeing credit card usage surging as well as the return of housing equity extraction thanks to the return of HELOC. On this subject we read with interest Wells Fargo Economics Group note from the 18th of September entitled "Consumer outlook in a rising rate environment":

"Executive Summary

Conventional wisdom has it that rising interest rates are bad for consumer spending because swelling financing costs put a squeeze on a household’s capacity for other outlays. What if conventional wisdom is wrong? Our analysis finds that a rising interest rate environment does not immediately snuff out consumer spending growth.

As the current expansion stretches further into its tenth year, the economy is on track to eclipse the expansion of the 1990s as the longest on record. In this report we consider the outlook for consumer spending against this backdrop of a record-setting expansion and consider how long the good times will last. Our base-case scenario, spelled out in this special report, anticipates a modest pick-up in consumer spending, at least in the near term. Eventually, like all good things, the longest economic expansion on record will come to an end and consumer spending will come back down with it. That will likely occur alongside financial conditions that warrant rate cuts by the Fed. The precise timing of these events is tough to get right, but by signaling this drop-off in activity in late 2020, we are essentially saying that while the end of the party is not imminent, no cycle lasts forever.

- Source Bloomberg LP, The Conference Board, University of Michigan and Wells Fargo Securities

As per the below Macrobond chart, the University of Michigan Consumer Confidence turning points tend to coincide with significant S&P 500 12 months return:

- source Macrobond (click to enlarge).

Before we go into more details of Wells Fargo's note, there are a couple of points we would like to make. Despite decreasing significantly from its peak prior to the Great Recession, household debt still remains quite elevated, stabilizing around 77%. Also back in March in our long conversation "Intermezzo", when it comes to consumer credit, as pointed out by famous French economist Frédéric Bastiat, there is always what you see and what you don't see. We pointed out the following from Deutsche Bank's State of the US Consumer report from the 26th of February entitled "Robust Consumer with Pro-cyclical and Seasonal Tailwinds on the Horizon":

"Items to watch

Lower income consumers are more levered than they appear: The aggregate deleveraging post-crisis has largely benefited from mortgage leverage sitting at its lowest level since 2001. However, other consumer leverage (card, student, auto, and personal) continues to grind higher into 2018 and is now at all time highs (~26%). Excluding disposable income for the Top 5% income bracket of US consumers, consumer debt levels are closer to 43% of adjusted disposable income—almost double the reported measure of ~26%. The latest triennial Fed Survey of Consumer Finances highlights this dynamic, with the bottom 40% income households running at ~50% non-mortgage DTI, which is ~10% more than LT averages.

The subprime/low income consumer is stretched: Sluggish wage growth and rising healthcare and rent expenses as a percentage of income (non-debt obligations near 25 year highs) among lower income households have stretched subprime consumers as they look to augment rising expenses with debt. 

Banks have met this increased demand by providing deeper credit access to subprime (increased participation, especially for cards), leading to higher leverage and an increased severity risk of loss as delinquencies start to diverge for lower quality consumers. Like DTI, adjusting debt payment burdens to exclude the top 10% income brackets almost doubles the reported Fed figure (9.6% PTI vs. 5.8% reported PTI by the Fed).

Socio-economic divide driving credit cycle: While aggregate consumer fundamentals remain robust, subprime consumers are seeing rising delinquencies and losses starting to normalize much faster than other credit tiers: +90-day DQs within subprime cards have rose+300bps Y/Y in 3Q17 vs. only~30bps on average for near prime/prime borrowers. ~45% of Americans would have difficulty paying a surprise medical bill of ~$500 (Kaiser Foundation), while ~50% of US consumers live paycheck to paycheck (FITB). Taken all together, a disconnect between the lower credit tier borrowers and the economic cycle is starting to emerge." - source Deutsche Bank

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

But let's return to Wells Fargo's take:

"A Consumer Spending Framework in the Context of Rates

As we would at any time in the business cycle, we consider the macro drivers of consumer behavior. Consumer sentiment and confidence, by about any measure, are at or near high levels last seen around 2001; which, not coincidentally, was in the late stages of that prior long-lasting expansion (Figures 1 & 2). We also look at the purchasing power in consumers’ wallets, be it in the form of personal income, which is at last picking up (albeit in only a modest way) or in access to capital through borrowing, where measures of revolving consumer credit growth indicate a levelling off more recently. Finally, we tally the actual spending numbers reflected in the personal income and spending report and the monthly retail sales numbers, both of which have been on a roll in recent months.

In an effort to better inform a consumer outlook, it is essential to have a framework for thinking about these fundamentals and how households will manage finances at this late stage of the cycle. The trouble with considering this period in the context of what has happened in prior cycles is that for a long stretch in the current cycle, from December 2008 until December 2015, the Federal Reserve maintained a near zero interest rate policy (ZIRP), and at various points during those years was engaged in a broad expansion of the balance sheet through quantitative easing (QE), (Figures 3 & 4).

- source Federal Reserve System and Wells Fargo Securities

The Fed has historically purchased Treasury securities to expand the monetary base, although the monetary policy “medicine” applied during that era, including the purchases of mortgage-backed securities and other assets, had not been tried before, at least not in the United States.

Central bank actions, no doubt, are a factor in the remarkable duration of the current cycle, and on that basis any informed outlook for consumer spending ought to not only consider these macro drivers (like confidence, access to capital and willingness to spend) but to consider them in the context of Fed policy.

To that end, we went back to just before the 1990s expansion began in 1989 and divided the years since into four broad categories based on what the Federal Reserve was doing with monetary policy at the time: (1) lowering the fed funds rate, (2) a “stable” rate environment, (3) raising the fed funds rate and (4) ZIRP with QE.

The date ranges for each of these periods is spelled out in Table 1 below.

Most of the time periods are straightforward, although the one period that might invite critique is that we have characterized the time period from March of 1995 through January 2001 as “stable” (revisit Figure 3).

One could reasonably observe that the fed funds rate actually moved up and down during that nearly six-year stretch. Our argument for calling it “stable” is that this period was essentially from the “mid-cycle” slowdown until the end of that expansion. Admittedly, there were adjustments up and down throughout the period, but from the start of the period to the end, the funds rate finished just 50 basis points higher. Reasonable minds could disagree, but in our view, the idea of thinking of that period as four unique rate cycles would unnecessarily complicate our analysis.

With our various Fed cycle dates established, we looked at our macro drivers for consumer spending through the lens of the Fed policy that was in place at the time. For each interest rate backdrop, we calculated the average levels for various measures of consumer confidence, the average annualized growth rate of personal income, the average net monthly expansion in consumer credit and finally the average annual growth rates of both real personal consumption expenditures and of nominal retail sales.

A key takeaway from our exercise, depicted in Table 2 below, is that measures of consumer fundamentals tend to do best in periods of stable interest rates. Interestingly though, a rising rate environment is almost as good for these same consumer fundamentals.

Perhaps that is not altogether surprising, considering that the Fed is apt to raise rates when the economy is at full employment and inflation is heating up beyond the Fed’s comfort zone. Those factors tend to exist when the economy is doing particularly well or even overheating.

The inverse of that dynamic may explain why the worst rate theme for consumer spending is during periods when the Fed is lowering rates. Personal income and spending as well as nominal retail sales all performed worst during periods when the Fed was cutting rates. Interestingly, the lowering of interest rates does not compel consumers to increase their appetite for credit, at least not immediately. The average net monthly increase in consumer credit came in a distant last during periods when the Fed was actively lowering rates.

2020 Vision

So what sort of Fed policy theme should we consider looking forward? To judge from the Fed’s dot plot, a visual rendering of policymakers’ own forecasts for the fed funds rate, the FOMC is closing in on its neutral rate for fed funds. With most dots clustered around 3.00 to 3.25% and the current fed funds rate at 2.00%, there are only four or five quarter-point rate hikes left to go in the current cycle, barring some change in forward guidance from the Fed (Figure 5).

Our forecast anticipates two more hikes this year and another three next year. After that it stands to reason we would be in a stable rate environment slightly above the neutral rate until the Fed’s understanding of r* changes (favoring another hike) or until conditions warrant a cut. In a separate special report1, we explained our use of an analytical framework we recently developed to inform our view of Fed policy going forward and why we look for the FOMC to raise rates another 125 bps before it cuts rates at the end of 2020.

In forming our outlook for the consumer, we take the findings of our rate-environment study and overlay them with our expectations for Fed policy over the next couple of years. If things play out the way we anticipate, monetary policy is entering an era of transition unlike anything the economy has seen in more than a decade. For a number of factors including the longevity of the cycle, growing fiscal budget imbalances and a potential fallout from the global economy, we indicated in our initial 2020 forecast that by the end of our forecast horizon the Fed would likely begin cutting the fed funds rate.2 A rate-tightening environment is expected to prevail at least through the first part of 2019, which will be followed by a stable rate for another year or so before the Fed begins to signal eventual rate cuts.

For the consumer, this Fed forecast implies a pick-up in the pace of consumer spending in the near term before an eventual slowing the further out we go in the forecast period. Full year PCE growth was 2.5% in 2017. By the time we close the books on the current year, we expect the comparable number for 2018 to pick up to 2.6%, prior to quickening to 2.7% in 2019 and slowing to just 2.2% in 2020 (Figure 6).

- Source: Bloomberg LP, Federal Reserve Board, U.S. Department of Commerce and Wells Fargo Securities

Outlook

Consumers may be better prepared to endure a slowdown than in the past. The saving rate, currently at 6.7%, is rather elevated given the late stage of expansion, while real median household income surpassed its pre-recession peak in 2017. With the unemployment rate currently matching low levels last seen in the late 1960s, there remains little slack in the economy. The labor market is expected to grow increasingly tight, with the unemployment rate trending to as low as 3.3% by 2020. Similarly, inflationary pressures that continue to gradually build over our forecast horizon will put downward pressure on real income gains.

The length of the current expansion is expected to surpass that of the 1990s, taking the title as the longest expansion on record. While monetary policy changes act as signals to markets about the health of the economy and/or concerns about inflation expectations, we must be sensitive to policy movements and their implication for consumer spending. Our initial 2020 forecast expects the Fed to surpass its neutral rate, prior to beginning to cut policy by the end of 2020. With this signal of a slowdown in activity, we are essentially saying that this expansion will eventually draw to a close. The rate cutting environment will act as a last call announcement – and for the consumer sector it serves as a valuable indication for longevity of this expansion." - source Wells Fargo

Whereas we agree with the timing, we disagree with the perceived health of the US consumer, as per the above points illustrated in a previous Deutsche Bank research note. There is more leverage than what can be seen, not only when it comes to the US consumer but as well when it comes to the distorted balance sheets of many US corporates after years of a buy-back binge and a fall in the quality of the overall rating for the Investment Grade category much closer to "junk" than in the previous cycle.

Overall the timing for the end of the credit cycle could indeed be in the region of 2020. This is as well Ray Dalio's most recent view and also Christopher R. Cole, CFA from Artemis Capital Management as per his July  2018 letter entitled “What is water?”:

“When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents. The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets. Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates.Despite this trend, U.S. equities will very likely escape 2018 without a crisis or volatility regime shift because of the one-time wave of corporate liquidity unleashed by tax reform. Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate.” – Source Christopher R. Cole, CFA from Artemis Capital Management

The whole note written by Christopher R. Cole is worth a read particularly on the subject of passive management and liquidity. His quote from above resonates as well with our opening quote from maverick investor Stanley Druckenmiller.

 As well in his note, Christopher R. Cole indicates when he thinks we will most likely have another crisis on our hands:

“When does this all end? If or when the collective consciousness stops believing growth can be created by money and debt expansion the entire medium will fall apart, otherwise it is totally real… and will continue to be real.

A crisis-level drought in liquidity is coming between 2019 to 2022 marked by a perfect dust storm of unprecedented debt supply, quantitative tightening, and demographic outflows.

Quantitative easing has caused the natural relationship between corporate debt expansion and default rates to break down. U.S. debt is at an all-time high of $14 trillion (45% of GDP) and high yield default rates are near all-time lows at 3.3% (MarketWatch, 13d). This is not sustainable. Years of cheap money has led scores of investors to buy debt at levels that do not reflect credit risk. The poster child is the 2017 issuance of 100-year Argentina bonds (USD denominated) that were oversubscribed 3.6x with a 7.9% yield. It is hard to find a decade where Argentina has not defaulted, much less a century. That medium of bond market demand has already begun to show signs of cracking.” – Source Christopher R. Cole, CFA from Artemis Capital Management

Fiduciary duty anyone? Credit cycles tend to die of old age and too much debt. We have entered the season of the White Tiger we think. Only a few innings left. 

On the current evolution of the credit cycle we read with interest Bank of America Merrill Lynch's take in their High Yield Strategy note from the 21st of September entitled "The Evolution of the Credit Cycle:

"The Evolution of the Credit Cycle

As we continue to study the state of the current credit cycle, the accumulated evidence sides with the argument that it has more room to develop, as long as few more years. Previous cycles have lasted anywhere between 6-8 years, on average, and this observation would make it an unusual development to see the current cycle extend for much longer. However, we also note that more broadly, this economic cycle has been an unusual one in many respects, including how long it took the US GDP to return to trend growth rates, the unemployment to decline, and the inflation to recover. And if those major macroeconomic variables took an unusually long time to return to normal levels, then why should we expect the credit cycle to be an average one?

Away from this argument, we also continue to believe that the commodity episode in 2015-2016 represented a partial cycle in and of itself. Among the most conclusive pieces of evidence in support of this view, we present the charts in Figure 3 for debt growth and Figure 4 for capex.

In both cases, we highlight cyclical turns, as defined by catalyst events as the starting points and subsequent observed peaks in trailing 12mo HY issuer default rates as ending points.

Both graphs suggest that previous cyclical turns have occurred at similar points on each respective line, had similar impact on each measure, and had left them at similar levels after defaults receded. Both graphs also suggest that a cyclical turn at current levels and given their recent trends would be inconsistent with historical experiences going into previous default cycles.

And yet, inconsistent does not imply impossible, particularly in light of trade tariffs that are being threatened and imposed by the Trump Administration. It remains our view that at the end, these policies are unlikely to survive the test of time, however it is difficult to say how much time it would take to prove them wrong and how much damage they could do in the meantime.

The exact timing of cyclical turns is an inherently uncertain exercise and we do not claim to possess superior skills to do so. Instead, our approach relies on using all available data and analytical tools to help us make a judgment on a relatively short next-12mo time horizon, and continue doing so as time progresses and new data becomes available. As such, we made a call that this cycle was unlikely to turn at this point last year. With all the evidence we accumulated since then, we believe this view still holds today.

Our default model continues to suggest low likelihood of a meaningful spike in defaults over the next year, based on its latest inputs. It currently projects a 3.25% issuer weighted rate during this time period, marginally lower than the actual realized 3.41% rate as calculated by Moody’s (Figure 5). A 3.25% issuer default rate would be consistent with 2.0% par-weighted rate. 

How it ends?

In our last year’s outlook on the prospects of this credit cycle, we listed three key risks to its longevity: (1) inflation spike; (2) trade contraction; and (3) sector distress. We think all three remain valid and potent sources of known risks going forward as well. In our judgment, the spike in inflation remains a lower probability risk, followed by trade contraction, somewhat higher on our scale of likely developments, and still inside of a tail risk zone.

A contraction in one of the key industry sectors is a higher probability outcome, in our opinion, albeit not an imminent one. Previously, we published our thoughts on capital allocation trends across various sectors, and identified healthcare as the most overextended sector in terms of the amount of capital raised in recent years.

A higher capital formation could lead to higher capex, higher production capacity, higher supply, lower prices, and an eventual need to remove excess capacity. The latter stage often goes hand in hand with a need to eliminate excess debt that was used to finance excess capex.

Other sectors that we found to be overextended on this scale include autos, utilities, and food producers, although these three are relatively small compared to healthcare.

And at the end of this conversation on risks, we think it is also important to remind ourselves that previous cycles have ended with a surprise event, a “black swan” of sorts, which, by definition, was unexpected by the consensus and meaningful in its impact. We do not see any particular reasons as to why the next one would break out of this mold." - source Bank of America Merrill Lynch

From our "White Tiger" perspective, an inflation spike is something very much on our radar, hence our close attention to market gyrations in oil prices and geopolitical risk, the famous known unknowns which have been building up recently in world which has decisively moved from cooperation to noncooperation.

As we have stated above, many pundits are focusing on the flattening of the yield curve, from an employment and non-accelerating inflation rate of unemployment (NAIRU), Monetary policy conducted typically involves allowing just enough unemployment in the economy to prevent inflation rising above a given target figure, we think the Fed will once again be behind the curve as per our final chart.

• Final chart - Hey Fed, NAIRU this!

In our previous conversation we discussed the great work of American economist Irving Fisher, in relation to NAIRU,  the concept arose in the wake of the popularity of the Phillips curve which summarized the observed negative correlation between the rate of unemployment and the rate of inflation (measured as annual nominal wage growth of employees) for number of industrialised countries with more or less mixed economies. This correlation (previously seen for the U.S. by Irving Fisher) persuaded some analysts that it was impossible for governments simultaneously to target both arbitrarily low unemployment and price stability, and that, therefore, it was government's role to seek a point on the trade-off between unemployment and inflation which matched a domestic social consensus, the famous dual mandate of the Fed. We won't go into more details about our fondness of the Phillips curve, it's a subject we have discussed on this very blog on many occasions. Our final chart comes from Deutsche Bank's US Economic Perspectives note from the 20th of September entitled "How the Powell Fed can make history" and shows that the Fed has never succeeded in returning unemployment to NAIRU from below without a recession ensuing:

"With unemployment now noticeably below standard measures of its natural level of full employment and likely to tighten further and with wage and price inflation returning to desired levels and likely to continue upward, the Fed has a delicate task on its hands. It needs to begin to close the gap between growth of aggregate demand and aggregate supply in the economy — in other words, to slow and eventually reverse the tightening of the labor market before it risks pushing up inflation and inflation expectations excessively. The question is whether it can do so without pushing the economy into recession and causing unemployment to surge upward, overshooting its natural rate.

Many in the market already see the storm clouds of recession gathering in the distance, a narrative that has found an ally in the flattening yield curve. Talk of a downturn by 2020 is increasingly in vogue and for good reason: a soft landing in unemployment from below NAIRU has never been achieved before. In the modern history of US national economic statistics since the late 1940s, every time the unemployment rate has overshot to the downside, policy firming by the Fed has helped drive the economy into recession (Figure 1).

We think the Powell Fed can make history by achieving the unprecedented outcome of a soft landing from below sans recession." - source Deutsche Bank

Contrary to the elements put forward in this very interesting note, we think that once again this time isn't different. On a final note we thought we had run out of arguments against the cult of the Philipps curve as per our conversation "The Dead Parrot Sketch" back in August 2017, we did read additional arguments against the Phillips curve cult in Saad Filali's take on Seeking Alpha in his article "There Is No Inflation: Too Much Supply, Not Enough Unions", which we found of great interest.  It has been said that the white tiger only appeared when the emperor ruled with absolute virtue, it could be said that the white tiger only appeared when the BIS ruled with absolute virtue as per their very interesting most recent quarterly survey, but we digress...

"Liquidity is oxygen for a financial system." -  Ruth Porat

Stay tuned!