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 - The Korsakoff syndrome

"A nation that forgets its past can function no better than an individual with amnesia." -  David McCullough, American historian

Watching with interest the continuation of "Mack the Knife" (King Dollar + positive real US interest rates) Emerging Markets bloody rampage with Gold continuing to suffer thanks to Gibson Paradox (negative correlation between gold prices and real interest rates), and also reminding ourselves it has been ten years since the onset of the Great Financial Crisis (GFC), when it came to selecting our title analogy, we decided to go for the Korsakoff syndrome. The "Alcoholic" Korsakoff syndrome is an amenestic disorder caused by thiamine deficiency (Vitamin B) associated with prolonged ingestion of alcohol (or QE...some might argue). This neurologic disorder is caused by lack of thiamine in the brain and is as well exacerbated by the neurotoxic effects of alcohol (or QE...).  The syndrome and psychosis are named after Sergei Korsakoff, a Russian neuropsychiatrist who discovered the syndrome during the late 19th century. There are seven major symptoms of alcoholic Korsakoff syndrome (amnestic-confabulatory syndrome): 

1. anterograde amnesia, memory loss for events after the onset of the syndrome
2. retrograde amnesia, memory loss extends back for some time before the onset of the syndrome
3. amnesia of fixation, also known as fixation amnesia (loss of immediate memory, a person being unable to remember events of the past few minutes)
4. confabulation, that is, invented memories which are then taken by the patient as true due to gaps in memory, with such gaps sometimes associated with blackouts
5. minimal content in conversation
6. lack of insight
7. apathy – the patients lose interest in things quickly, and generally appear indifferent to change.

Back in 2011, in our conversation "Anterograde and Retrograde Amnesia", we commented on the dollar liquidity crisis which was brewing at the time and severely impacted EM as well as the European banking sector as whole which was saved by the ECB's LTROs late that year. The difference of course this time around is thanks to the ECB support, European financials credit spreads have not exploded à la 2011. Yet, with the Fed busy withdrawing liquidity thanks to QT in conjunction with a rising US dollar, as a reminder, a liquidity crisis always lead to a financial crisis. That simple, unfortunately.

We touched on the various form crisis could take in our long February 2016 conversation "The disappearance of MS München". While we won't go again about the various forms a crisis can take, from a currency crisis to a credit crisis, everyone not suffering from the Korsakoff syndrome is rightly asking when this already long cycle will end and what to look for.

In this week's conversation, we would like to look at the potential signs marking the end of the cycle.

Synopsis:

• Macro and Credit - What to look for the Boom moving to Bust?
• Final chart - Boom to Bust? Follow high-yield corporate bond mutual funds flows...

• Macro and Credit - What to look for the Boom moving to Bust?

There is no doubt that liquidity issues always lead to financial crisis. This was the case in 2011 and the ECB prevented the meltdown in the European banking system with its LTROs which was followed by Swap agreements with the Fed. The normalization process followed by the Fed in conjunction with its QT is of course validating our much vaunted global macro reverse osmosis theory discussed on numerous occasions on this very blog hence the continues pressure applied on Emerging Markets thanks to the surge in the US dollar, providing a strong headwind on gold for the time being. 

Given the 10 year anniversary of the GFC, many pundits are questioning how long until the music stops given the flattening of the yield curve as a sign we are reaching the end of the credit cycle. Timing is of course everything, eventually perma bears will be right but the question is when. On this subject we read with interest CITI's latest Global Multi-Asset View entitled "For Whom the Clock Ticks: How Long Till End-Cycle" published on the 4th of September:

"Even a broken clock...

“A man with a watch knows what time it is. A man with two watches isn’t so sure.”
- Segal’s law

Probably the most common question any strategist gets asked is where we are in the investment cycle. Even those who don’t like our debt-equity clock seem to have a triangle or a wave or some equivalent alternative: the notion of the economic cycle, and how markets respond to it, is simply the foundation of how most people think about investing.

But recent months have revealed a problem – even for strategists purportedly using the same framework. While Rob and the equity strategists would put the hands on the clock earlier in “Phase 3” – say 7 o’clock (Figure 1) – Matt and the credit strategists argue markets are closer to Phase 4, or 9 o’clock (Figure 2) – if indeed they recommend using the clock these days at all.

Our debate mirrors parallel discussions on the shape of the US yield curve. Many economists are dismissive of its current flatness, arguing that it has been distorted by QE, and that rising inflation should soon lead to higher yields and steeper curves. But others, including the San Francisco Fed, our rates strategists and our credit strategists, argue that its steady flattening poses a genuine and immediate problem for risk assets.

Settling these questions is of critical importance. This is especially true for equity investors, who face the dangerous challenge of riding a late-cycle bull market but avoiding the end-cycle carnage when it breaks. Credit investors lose out in both stages, but somehow they seem resigned to that.

While we always receive a steady stream of such questions, recent weeks have seen the trickle turn into a torrent – perhaps fuelled both by the yield curve and this year’s fading returns in most assets outside the S&P. These enquiries are coming not only from traditional asset managers but also from corporates, private equity,  infrastructure and other “alternatives” investors – counterparties whom we do not speak to regularly, and who may well change their positions only once or twice a cycle.

This note is designed at least to air our differences, if not necessarily to resolve them. First, we lay out how the cycle has worked traditionally, and explain why markets seem to follow a global cycle even in the face of regional and sectoral differences in growth and in earnings. Second, we examine the many ways in which this cycle has bucked the traditional pattern. Finally, we look for guidance in history as to what really triggers the transition to Phase 4, and hence what happens next. Unfortunately it is hard to provide definitive answers: we argue that much depends on whether you think the cycle is driven by fundamentals or by market movements, and on whether this cycle’s distortions have merely slowed down the clock’s alarm function, or broken it entirely.

How the cycle works

Our thoughts on how the cycle is supposed to work haven’t really changed over the decades. Companies go through regular phases of leveraging and deleveraging, and you can normally tell where you are in the cycle both from what they’re doing with their balance sheets and from the response in credit and equity markets. Here’s how we put it back in 2005:

Starting at 12 o’clock, in the depths of recessions companies go through intense periods of restructuring in order to reduce their debt burdens. Assets are spun off, dividends skipped and equity raised in order to generate cash and reduce the risk of bankruptcy by paying down debt. Once this activity gets underway, credit spreads rally sharply — the risk of default is perceived to be past its peak — even though equity markets remain in the doldrums because issuance is dilutive and earnings continue to fall.

Eventually, cost cutting and aggressive restructuring, accompanied by economic recovery, yields a rebound in profits (after 3 o’clock). In this next phase, both earnings growth and debt/EBITDA are improving, causing credit and equity to rally together. However, as the cycle matures, this progressively gives way to a period of lower quality earnings growth, in which share gains are often achieved at the expense of corporate leverage, for example through acquisitions or share buybacks (after 6 o’clock). This keeps equities rallying, but deteriorating balance sheets start to drive credit spreads higher.

Finally, the resultant balance sheet deterioration comes to a head, creating a crisis in which profits cannot be sustained, and both equities and credit sell off (after 9 o’clock). It’s time to take all risk trades off. This is usually associated with a recession which induces the retrenchment which eventually allows the cycle to start all over again.

By and large, we think this framework has held up pretty well, and it is not too difficult to discern its workings in the US over multiple decades. Equities and credit are sometimes positively correlated (Phase 2 and 4) but they can also be negatively correlated (Phase 1 and 3). This is visible in terms of the alternation between credit and equity market returns (Figure 3), and in terms of the cyclical leveraging and deleveraging of nonfinancial corporates’ balance sheets (Figure 4).

To be sure, not every cycle is driven by corporates, and the credit and equity market movements are not quite as regular as, well, clockwork. In the 1970s, movements in oil prices were larger drivers of the economy than corporate leverage per se, and emerging from the 1982-3 recession in particular, we cannot see a “Phase 1” in which credit rallied before equities.

But even when recessions were not actually caused by the non-financial corporate sector – as in 2008 – the broad patterns have still seemed to hold. The recession was preceded by a long period of leveraging up, in corporates as well as in households, and credit market returns turned south months (if not years) before equity market returns did. Understanding the workings of the cycle is a useful way to think about how you should invest.

Time waits for no man (but seemingly for a few corporates)

Note that we have never claimed that it has to be the same “time” for different regions, or even for different sectors. Indeed, while similar principles hold at the individual company level, with credit and equity prices responding to changes in  balance sheets, different companies can employ very different strategies. For example, while US-based Apple is reducing its cash pile with the primary intention of rewarding shareholders, China’s Anbang – after a previous spree of debt-fuelled acquisitions – is now making bond-friendly disposals and trying to shore up its balance sheet.

Aggregating leverage statistics across companies and sectors is as much an art as a science; we often joke that you can demonstrate that aggregate leverage is doing almost anything if only you try hard enough. To what extent when calculating net debt/EBITDA should the tech sector cash pile be allowed to offset the debt burdens shouldered elsewhere? Should you calculate median (net debt/EBITDA), median (net debt)/median(EBITDA), or use means? How as an investor in public equities should you treat the hundreds of billions in debt from private-equity-owned names?

Nevertheless, even given substantial variation at the company and sector level, it is possible to calculate overall averages (Figure 5).

It is almost remarkable how similar are the patterns those averages follow across regions and different data sources (Figure 6).

From the noise of individual companies’ balance sheet decisions, there emerges a global cycle.

We can see different levels of global correlation when we look at other important variables. While GDP growth is imperfectly correlated, with the US generally considered to be ahead of other countries, EPS growth by region is more closely related, especially recently. And, despite being more volatile, actual stock price returns (Figure 9) or credit spread changes (Figure 10) are all but indistinguishable across regions. Markets are highly correlated, even if fundamentals aren’t.

Beyond this, it seems to us that there is a strong element of reflexivity to the process. Company balance sheet decisions, and investor calls on what to buy and sell in credit and equities, are not taken in a vacuum: they influence one another. When Vodafone bought Mannesmann in 1999 in what was then the largest ever M&A deal, its stock continued to rally. This increased the likelihood that AOL would end up buying Time Warner. When Enron filed for bankruptcy in 2001, the environment of increased investor nervousness added to the risk that WorldCom would subsequently do so in 2002. Market movements – and investors’ and corporates’ responses to them – are themselves significant drivers of the cycle.

But how have markets been moving this time round, and what does that tell us about the all-important transition to Phase 4?

Who stopped the clock?

In fundamental terms, this cycle things seem to have proceeded pretty much as usual. A period in which profits were growing faster than debt, from 2009 to 2012, has been followed by one in which debt has been growing faster than profits. As a result, overall corporate leverage has risen well beyond that reached in 2008, to the highest level ever recorded outside of an actual recession (Figure 4, Figure 5, Figure 6). Presumably one reason this has been possible is that record-low levels of interest rates have made interest payments look manageable, even with record-high levels of debt (Figure 11).

When broken down by sector, the pattern is more varied, but probably no more so than normal.

The sectors seemingly most intent on leveraging up are those which it might be reasonably argued ought to be most able to bear it: Utilities, Healthcare, Consumer Staples and Telecoms. That said, in many cases they are now running with substantially more leverage than ever previously (Figure 12).

A second group of sectors – traditional cyclicals – have likewise spent most of the past few years leveraging up. But they are not running with significantly more debt than in previous cycles (Figure 13).

Energy and Materials seem almost to have come out the other side, and are now engaged in deleveraging following a leverage peak in 2015 (eg Glencore making disposals and Anglo American buying back bonds). These are also the sectors which have led to the recent deleveraging visible in the overall statistics for US HY and Emerging Markets (Figure 6).

Finally, Industrials and IT have bucked the broader trend entirely, and have largely been reducing indebtedness since the early 1990s (Figure 14).

A second group of sectors – traditional cyclicals – have likewise spent most of the past few years leveraging up. But they are not running with significantly more debt than in previous cycles (Figure 13). Energy and Materials seem almost to have come out the other side, and are now engaged in deleveraging following a leverage peak in 2015 (eg Glencore making disposals and Anglo American buying back bonds). These are also the sectors which have led to the recent deleveraging visible in the overall statistics for US HY and Emerging Markets (Figure 6). Finally, Industrials and IT have bucked the broader trend entirely, and have largely been reducing indebtedness since the early 1990s (Figure 14).

Putting these numbers together, Matt thinks aggregate leverage is higher than might be expected outside of a recession, and hence more reminiscent of late Phase 3 than early Phase 3. But low interest rates and the predominance of increased leverage amongst the more defensive sectors help explain why this has not yet been seen as a problem for markets as a whole. Moreover, there are even signs that aggregate leverage is beginning to decline given recent strong profit growth and helpful US tax cuts.

But Rob’s primary reason for thinking this is Phase 3 is not based on fundamentals but more on market movements – in particular, the current outperformance of equities relative to credit is classic Phase 3. Other Phase 3 characteristics, such as narrowing market leadership, are also evident (Global Equity Quarterly: Narrowing Bull Market)." - source CITI

The reason the credit clock has been much slower than usual is of course due to the Korsakoff syndrome, namely that central banks intervention have been very supportive of credit spreads in many instances, providing as well some support to many "zombie" companies which should have been eliminated but managed to survive thanks to the low interest rates environment. Record low levels of interest rates have made interest payments manageable even with higher leverage creeping up thanks to the distortion created by our central banking deities.

While EM have been on the receiving end of the latest summer heat thanks to the strong dollar, the S&P 500 and US stocks have been racing ahead while the rest of the world has been languishing. Credit wise both US High Yield and US Investment Grade have had a less torrid time than EM High Yield or EM equities. Indicators of aggressive issuance such as the percentage of the CCC credit bucket accessing the primary market has remained fairly stable still and revenues even for US High Yield remain overall solid as per the below Bank of America Merrill Lynch chart:

- source Bank of America Merrill Lynch

The most recent quarterly Fed Senior Loan Officer Opinion Survey (SLOOs) points that financial conditions still remain favorable. Overall credit remains fairly stable for now at least in the US as pointed out by CITI's comprehensive report:

"A central banker in the works

Most importantly, the steady leveraging-up by companies since 2012 has simply not been accompanied by spread widening on anything like the same scale as in previous cycles. Indeed, even with non-financial corporate leverage higher than the levels seen in 2008 and (on some universes) 2001-2, credit spreads are not far off traditional cyclical tights, especially in US HY (Figure 15).

The pattern in € HY and $ and € investment-grade is similar, if slightly less extreme. Even long-term charts – over which period it becomes difficult to difficult to obtain consistent universes for both spreads and leverage – suggest that something is awry (Figure 16).

If it were just credit spreads which were behaving in this fashion, the signal could perhaps be ignored, or dismissed as an excessive focus on headline debt levels rather than interest coverage and debt sustainability. Indeed, the rating agencies invoke just such an argument when asked why such high debt levels have not led to an increase in downgrades.

But the same time period – since 2012 – which has seen leverage rising and spreads tightening also reflects a breakdown in other market relationships. Equity volatility traditionally correlates with metrics designed to capture policy uncertainty (the number of references to uncertainty in the news, for example). But since 2012 uncertainty has been high, and yet volatility across markets has been setting new record lows (Figure 17). 

Changes in consensus earnings expectations used to correlate with equity market moves in every region, yet since 2012 that relationship has broken down too, even if it is now beginning to re-establish itself (Figure 18, Figure 19).

Matt has argued loudly for several years that all these breakdowns are due to QE, and “too much money chasing too few assets”. He thinks that as central banks pull back, both credit and equities are vulnerable, and cites in his support continuing strong correlations between global central bank purchases and market movements. As was visible in February this year, the central banks have effectively “broken” the normal clock functioning, and credit can no longer be relied upon to lead equities in the way it has done historically.

Rob sees it slightly differently. QE intentionally decoupled credit spreads (kept falling) from corporate leverage (kept rising). Even as balance sheets moved through 6 o’clock, so central bankers kept risk asset pricing back at 5 o’clock. The reason that equity volatility fell is that it is highly correlated to credit spreads (Figure 20), and QE kept spreads falling.

But now that has changed. As central banks step back, so the credit and equity markets will catch up with fundamentals. This year’s rise in spreads and volatility finally marks the move into Phase 3 that, without QE, would have started in 2012. Rob thinks that QE has held the clock back, not broken it." - source CITI

One could indeed agree somewhat with Rob from CITI that, indeed the Korsakoff syndrome associated with prolonged ingestion of QE has clearly distorted the "credit clock" and slow down the normal aging process thanks to financial repression and low interest rates. Now with QT in full swing, the tide is slowly but surely turning, with the over-leveraged players being the first one taken to the cleaners such as the house of straw of short-vol yield pigs and now the house of sticks of macro EM tourists carry pigs.

What about record high corporate margins? Surely trade war and surging PPI will eventually put a dent in corporate margins one might argue as corporations pass on price increases onto their customers. CITI discusses as well this issue in their note:

"Time is an illusion. Lunchtime doubly so.

Unfortunately a closer examination of both market and fundamental data in this cycle does relatively little to shed light on this debate, or at a minimum can be construed as arguing in both directions.

One potential end-cycle sign is compression of corporate margins, at least as proxied by companies’ unit labour costs (usually the major driver of their cost base) relative to output prices (tracked by the broad GDP deflator). In the US in 1979, 1989,1999 and 2007, labour costs rose more rapidly than output prices as the cycle matured, labour gained in pricing power and corporate profit margins were  squeezed (Figure 21).

Something similar happened for the Euro area in 1999, 2007- 8 and in 2012 (Figure 22).

Each time, this was a useful warning that companies were resorting to leverage in order to support earnings growth, and of the consequent vulnerability of the equity market.

Rob agrees that you may get a rolling over in “per unit” margins in the macro data, even as overall profit margins of listed corporates keep rising. But a combination of strong volumes and high margins are enough to keep profits rising and the bull market rattling along (Figure 23).

Overall profit margins don’t collapse until the recession begins, volumes fall and companies are left with excess fixed cost bases. As such profit margins are a coincident indicator with the stock market, which is why Matt doesn’t like them. They don’t give any prior warning; they always look great right up to the last minute.

The trouble is, this time round, while there is some evidence of margin compression in the Euro area, US unit labour costs have been oscillating without any clear trend. However you look at it, the sort of earnings growth and especially revenue growth we have seen in 2017-18 simply defies traditional models for what is “supposed” to happen at this stage of the cycle." - source CITI

There is indeed a "Dissymmetry of lift" between the US and Europe, leading to the current growth differential outcome with Europe slowing at the moment while the US showing signs of expansion with the latest ISM. Some would argue it could be a peaking sign in this credit cycle. Also as we have argued various times, a sudden acceleration and surge in oil prices would obviously ignite more inflationary expectations (or scare) and lead to a more hawkish Fed. This would of course be much more negative for asset prices overall and lead to the famous bust after the boom.

Another interesting discussion within CITI's note has been around mutual fund flows. Those who read us on a regular basis know that we look at mutual fund flows as an indicator of investors mood and confidence. This we think is quite interesting:

Yet another potentially useful late-cycle indicator is mutual fund flows. You might reasonably have expected Phase 3 to be associated with strong flows into equities. A strong rotation from bonds into equities is very visible in 1997-2000, and is notable by its absence this time round, perhaps suggesting Phase 3 has much further to run (Figure 24).

But both 1985-87 and 2005-2007 were associated with exuberance in fund flows in general – an exuberance which now seems to be running out of steam. Another way to think of fund flows is in terms of total inflows to all risky assets (bonds, equities and hybrid funds combined) relative to inflows to money market funds and deposits. This seems to follow a regular cycle with respect to deposit rates (Figure 25).

In Phases 1 & 2, emerging from recession, when deposit rates are low, and valuations are cheap, investors do most of their saving in risk assets. As the cycle matures and as deposit rates rise, they steadily move some of their savings in deposits. Eventually in Phase 4, they sell all risk assets, prices fall, deposit rates are cut and the, eventually, the cycle starts again. This year’s tremors in markets may be a sign that just such a phase is being reached already.

Yet here too, the signals are ambiguous. Fund flows both influence market returns and are influenced by them (Figure 26).

While we find it quite easy to imagine a scenario in which fund outflows drive markets lower and trigger a growth slowdown, it is by no means a foregone conclusion. We seemed to be embarking on just such a negative path in February 2016, but then an unusual (from the perspective of these charts) rally in markets – admittedly following more central bank intervention – halted the outflows and triggered two years of further inflows. While central bank easing now feels much less likely, positive market returns in equities, driven by earnings growth and share buybacks, may well suffice to spark inflows of their own
accord.

If Matt is right, further central bank withdrawal should mean the inflows fizzle out and turn to outflows, conclusively creating a bear market not just for credit but also for equities. If Rob is right, central bank withdrawal and renewed corporate releveraging should cause credit spreads to widen, but equities may yet have further to rally. They become the only game in town. But equally, it would not be that surprising – especially given the example of the Energy and Materials sectors, and the broad-based deleveraging thanks to earnings growth – for us to skip Phases 4 and 1 entirely, and go straight back to the “organic” deleveraging associated with Phase 2, in which both credit and equities rally. This is, in effect, what markets did during 2017. But was that fundamentals, or the effect of extraordinary central bank policies? Once again, this cycle defies easy categorization." - source CITI

We think, when it comes to Matt King's argument about inflows fizzling out and turning to outflows, creating a bear market is an interesting proposal. In our final chart below we would like to provide additional support to Matt King's view

• Final chart - Boom to Bust? Follow high-yield corporate bond mutual funds flows...

To add more ammunition to this hypothesis we would like to point out towards a Wharton paper written by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein published in September and entitled "Mutual Fund Flows and Fluctuations in Credit and Business Cycles" (h/t Tracy Alloway for pointing this very interesting research paper on Twitter).

This paper points to using flows into junk bond mutual funds as a gauge of an overheated credit market to tell where we are in the credit cycle. Could that be finally a reliable "Boom to Bust" indicator?

"Several measures of credit-market booms are known to precede downturns in real economic activity. We offer an early indicator for all known measures of credit booms. Our measure is based on intra-family flow shifts towards high-yield bond mutual funds. It predicts indicators such as growth in financial intermediary balance sheets, increase in shares of high-yield bond issuers, and downturns of various measures of credit spreads. It also directly predicts the business cycle by positively predicting GDP growth and negatively predicting unemployment. Our results provide support for the investor demand–based narrative of credit cycles and can be useful for policymakers.

A large body of literature in macroeconomics and finance studies the link between credit markets and macroeconomic cycles. A pattern that emerges from the data is that credit booms precede downturns in macroeconomic activity. This pattern attracts considerable attention from academics and policymakers: if credit markets are at the root of macroeconomic fluctuations, then it is important to better understand what drives credit cycles and identify leading indicators to try and design policies that will moderate them.

In this paper we show that investor portfolio choice toward high-yield corporate bond mutual funds is a strong predictor of all previously identified indicators of credit booms. An increase in our measure in year t predicts credit booms marked by the other indicators in the literature in years t+1 and t+2. These other indicators include the proportion of low-quality bond issuers (Greenwood and Hanson, 2013; López-Salido, Stein, and Zakrajšek, 2017), the degree of reaching for yield in the bond market (Becker and Ivashina, 2015), balance sheet growth in financial intermediaries (Schularick and Taylor, 2012; Krishnamurthy and Muir, 2015), and various measures of credit spreads (Gertler and Lown, 1999), in particular the excess bond premium (EBP) recently proposed by Gilchrist and Zakrajšek (2012).

In addition, our measure, as a leading indicator of credit booms, positively predicts GDP growth and negatively predicts unemployment rates in years t+1 and t+2 (before they turn in the reverse direction in year t+3)."  - source Wharton paper, by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein 

Prolonged ingestion of QE surely is a way leading to many credit investors getting the Korsakoff syndrome such as the Macro EM tourists that piled into the 100 years bond issued by Argentina, causing them memory loss of their fiduciary duty but we ramble again...

"We live in a world where amnesia is the most wished-for state. When did history become a bad word?" - John Guare, American playwright.

Stay tuned !