Macro and Credit - Explosive cyclogenesis

"Invincibility lies in the defence; the possibility of victory in the attack." - Sun Tzu

Looking at the bloodbath occurring in various sectors of the US equity markets during the scary month of October historically for financial markets such as the Black Monday of October 16th 1987, when it came to selecting this week title analogy, we decided to go towards a meteorological analogy, namely "Explosive cyclogenesis".  "Explosive cyclogenesis" is also referred as a weather bomb. The change in pressure needed to classify something as explosive cyclogenesis is latitude dependent. For example, at 60° latitude, explosive cyclogenesis occurs if the central pressure decreases by 24 mbar (hPa) or more in 24 hours. Given the velocity in which US "real rates accelerated upwards at the beginning of the month in conjunction with the surge of the balance sheet reduction of the US Fed to $50 billion per month. The Fed’s QE Unwind Reaches $285 Billion From the 6th of September through the 3rd of October, the Fed’s holdings of Treasury Securities fell by $19 billion to $2,294 billion, the lowest since March 5, 2014. Given an explosive cyclogenesis occurs if the central pressure decreases rapidly, in similar fashion, the acceleration in the Fed's reduction of its balance sheet triggered the "weather bomb" on financial markets. 

Many pundits have been reminding themselves of Black Monday given it occurred during the month of October as well. Many have forgotten the Great Storm of 1987 which was a violent extratropical cyclone that occurred on the night of 15-16th of October. That day's weather reports failed to indicate a storm of such severity, an earlier, correct forecast having been negated by later projections. On the Sunday before the storm struck, the farmers' forecast had predicted bad weather on the following Thursday or Friday, 15–16 October. By midweek, however, guidance from weather prediction models was somewhat equivocal. Instead of stormy weather over a considerable part of the UK, the models suggested that severe weather would reach no farther north than the English Channel and coastal parts of southern England. At 2235 UTC, winds of Force 10 were forecast. By midnight, the depression was over the western English Channel, and its central pressure was 953 mb. At 0140 on 16 October, warnings of Force 11 were issued. The depression now moved rapidly north-east, filling a little as it did, reaching the Humber Estuary at about 0530 UTC, by which time its central pressure was 959 mb. Dramatic increases in temperature were associated with the passage of the storm's warm front. During the evening of 15 October, radio and TV forecasts mentioned strong winds, but indicated that heavy rain would be the main feature, rather than wind. By the time most people went to bed, exceptionally strong winds had not been mentioned in national radio and TV weather broadcasts. The storm cost the insurance industry GBP 2 billion, making it the second most expensive UK weather event on record to insurers after the Burns' Day Storm of 1990. 

Following the storm few dealers made it to their desks and stock market trading was suspended twice and the market closed early at 12.30pm. The disruption meant the City was unable to respond to the late dealings at the beginning of the Wall Street fall-out on Friday 16 October, when the Dow Jones Industrial Average recorded its biggest-ever one-day slide at the time, a fall of 108.36. City traders and investors spent the weekend, 17–18 October, repairing damaged gardens in between trying to guess market reaction and assessing the damage. The 19th of October, Black Monday, was memorable as being the first business day of the London markets after the Great Storm. The trigger for the "weather bomb" in early October which led to a 10% mini-crash was a warning by Fed chairman Jay Powell that the Fed planned to push interest above the "neutral rate" to prevent overheating. So, central pressure fell rapidly, real rates shoot up and the rest is as we say history but, we ramble again.

In this week's conversation, we would like to look at the buildup in recession signs we are seeing adding to the "reflexivity" in the tightening of financial conditions. Are the "weather" forecasts of no recession in sight justified? We wonder.

Synopsis:

• Macro and Credit -  "Reflexivity" and Recessions
• Final charts -  Where is the "credit" weather bomb?

• Macro and Credit -  "Reflexivity" and Recessions

As we concluded our previous post, beware of the velocity in tightening conditions. Both Morgan Stanley and as well Goldman Sachs, indicates that given the large sell-off seen in October, investors perceptions have been changing, and that maybe  we have a case of "reflexivity" one might argue. Goldman Sachs Financial Conditions Index shows the equivalent of a 50-basis-point tightening in the past month, two-thirds of which is due to the selloff in equity markets. Early February this year financial conditions tightened about 80bp over a two week period akin to "Explosive cyclogenesis" aka a "weather bomb".

But, the difference this time around we think, even if many pundits are pointing that forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, making it enticing for some to "buy" the proverbial dip. We think that the Fed's put strike price is much lower than many thinks. As pointed out on Twitter by Tiho Brkan displaying a chart from JP Morgan , almost all asset classes have negative YTD returns (first time in 40 years).:

- graph source JP Morgan, H/T Tiho Brkan

Sure "real rates" have been driving the sell-off but we think many more signs are starting to show up in the big macro picture pointing towards the necessity to start playing "defense".

The rise in “real rates” triggered repricing of forward EPS, and forced investors to mark a lower strike to the Fed “put”.  Real rates grew at the same pace as 12 months Forward EPS until the “repricing”:

- graph source Macrobond

Given financial markets should act for many investorss as a "discounting mechanism", no wonder, with liquidity being removed thanks to QT, markets have had to "reprice" forward EPS accordingly in such a short period of time. The US markets have been defying gravity way too long and their outperformance versus the rest of the world has been significant in 2018.

When it comes to "buying the dip", Merryn Somerset Webb in the Financial Times makes some interesting comments:

"October shouldn’t be seen as the end of the bull market (look at the annualised performance numbers for most markets and you will see that it ended some time ago). But this month can be recognised as the point at which the market shifts from being driven by liquidity to being driven by fundamentals. For those badly positioned going into such a change (less thoughtful growth investors perhaps) this is nasty. For the rest of us it is good news, twice over.

First, some of the things fund managers believed a few months ago could well be true in part. US corporate profits look fine. Around 40 per cent of S&P 500 companies have reported in this earnings season and some 80 per cent of them have managed to produce a positive surprise. Digitalisation may well be about to transform productivity in developed economies. And there is as much scope as ever for conventional industries to be wiped out by canny disrupters. (I still firmly believe, however, that Madrid needs between zero and one provider of e-scooters, instead of between one and three.)

Second, stock markets outside the US really are not that expensive anymore and pockets of them are beginning to look like they offer some value. That should please long-term investors.

It should also be absolutely thrilling to the active investment industry. This sort of shadowy environment is exactly the kind in which they can have another go at proving their special stockpicking skills are worth paying for." - source Financial Times - Merryn Somerset Webb 

In terms of "cheap" market outside the US, and as pointed out in her article as well, apart from the United States, Russia regardless of US sanctions, was left pretty much unscathed relative to other Emerging Markets. Russia, equity market should be priced for a continued rebound. Forget the sanctions, rising oil prices could be very supportive and with a PE of around 5.2, you have very limited downside. The current absurdly low valuation of the Russian market is thus due almost entirely to external political factors; given the extreme volatility of American politics (and thus sanctions). Comparing Eurobond yields with Russian equity yields for the same risks will show you more "arbitrage" opportunities so we suggest you do your homework on this...

But, for sure, with rising dispersion, active management as pointed out by Merryn Somerset Webb  should come back into play, given the growing rotation between value and growth:

- source Thomson Reuters Datastream - H/T Holger Zschaeptiz on Twitter.

The growth trade over value trade is over. That’s your "great rotation" from "growth" to value" in one chart…

Moving back to the "main course" namely "Reflexivity" and Recession, we do believe that we have passed "peak" consumer confidence in the US. For instance the University of Michigan’s consumer sentiment index fell from 100.1 in September to 98.6 in October. This we think was “peak” consumer confidence with cyclicals such as Housing and Autos becoming a headwind for the US consumer.

Sure US Q3 GDP came at an annualized 3.5% but, it is because Americans save less to sustain spending as income gains cool. Americans saved 6.2% of their disposable income matching the lowest level since 2013:

- graph source Bloomberg

On top of that we can list the following "headwinds":

• Investors are selling the shares that hit quarterly earnings expectations at the highest rate since 2011. Good times are behind us…
• Early indicators show that economic conditions continue to weaken in China
• Residential investment fell 4% marking the third straight quarterly decline. That hasn’t happened since late 2008 and early 2009.
• Breaking bad? Even equity-long short hedge funds could see their worst month since the Great Financial Crisis (GFC). August 2011 level reached so far.
• U.S. investment-grade bond funds reported $1.6 billion in outflows in the past week, the fourth consecutive withdrawal for total redemptions of $7.2 billion; HY funds reported $2.1 billion of outflows according to Wells Fargo Securities.

We could also add David P Goldman's recent comments in Asia Times that US consumer discretionary stocks have been propped up by credit card binge:

"Consumer discretionary stocks have outperformed the S&P 500 by about 10% during the past year. That may be about to change.

Consumer spending remains robust in the United States according to this morning’s US data release. Personal spending was up 0.4% in September, or a 5% annual rate. The problem is that personal income rose only 0.2%, or a 2.4% annual rate.

Consumers are spending more than they earn. The past year’s pop in consumer spending depended on credit cards. That’s not a sustainable situation.

The chart below shows three-month changes in US retail sales vs. three-month changes in credit card debt outstanding. During the past year, the two lines look nearly identical.

Here’s another way to measure the dependence of retail sales on credit cards: The six-month rolling correlation between monthly changes in retail sales and monthly changes in credit card balances outstanding has risen to about 70%.

- source David P Goldman - Asia Times

US consumers might not be “buying the dip” but, are dipping into their savings to “sustain” their consumption and that's something to worry about. We haven't even much growth deceleration in Europe at this stage. We recently mused around shipping indicative of a slowdown in global trade in our latest conversation "Ballyhoo" and the Harpex index as an indicator.

Apart from the clear underperformance of the exported oriented German Dax Index or the Korean Index, Anastasios Avgeriou, Chief Equity Strategist at BCA Research pointed out on Linkedin today a very interesting chart:

"Who would have thought that the DAX and chip stocks are more or less the same trade... Both are very sensitive to global growth and thus interest rates. In other words, rising interest rates hurts them, and vice versa..." - source Anastasios Avgeriou, Chief Equity Strategist at BCA Research 

Misery do loves company one would argue. Cyclicals such as housing, autos and even chips have been impacted by the deceleration in global trade hence the latest weakness seen in Europe from slower GDP growth. 

As well there are some other signs pointing towards trouble at a later stage, which will follow the "relief" rally we are seeing. 

For instance, as pointed by the IIF, despite stronger earnings growth this year, many US companies struggle with debt service:

"Many companies are not generating enough earnings to cover interest expenses - despite still strong earnings growth. With growth expected to slow in 2019 and rates still rising, the problem could get worse" - source IIF

In our book credit leads equity and we are closely watching credit drifting wider thanks to the Fed tightening slowly but surely the credit noose as can be seen in the below Bloomberg chart posted by Lisa Abramowicz on her Twitter feed:

"Yields on US High Yield bonds with CCC ratings just climbed above 10%, the highest level since the end of 2016" - source Bloomberg - Lisa Abramowicz on Twitter

Watch closely the energy sector in general and oil prices in particular because any additional weakness in oil prices would cause even more credit spread widening given the exposure to the sector of the CCC High Yield ratings bucket.

And of course the problem is getting worse given rates have been rising in-line with improving growth estimates as per the below chart from Bank of America Merrill Lynch:

- source Bank of America Merrill Lynch

If indeed growth is slowing, then again the US Treasury Notes yield should be falling as well. It is difficult to play it at the moment given the rise in issuance by the US Treasury.

When it comes to "Smart Money" some have already been heading towards the exit as pointed out by Eric Pomboy on Twitter with the below Bloomberg chart:

- graph source Bloomberg - Eric Pomboy on Twitter

Someone is clearly not waiting for the explosion of the "weather bomb" it seems...

One thing for sure, the October "Explosive cyclogenesis" aka weather bomb was another warning shot by the Fed but it seems no one was really listening. This effectively means that the Fed’s strike price for US stocks is much lower as it has removed the reference to monetary policy being accommodative. This is pointed out by Morgan Stanley in their Global Interest Rate Strategist note from the 26th of October entitled "The Financial Conditions Jackpot":

"FOMC participants have been clear that the outlook for the hiking cycle is unlikely to shift simply because of equity market volatility. This sort of guidance led to interest rate vol lagging the sharp rise in equity vol. We think this is justified by fundamentals and do not yet recommend buying shorter expiry interest rate options outright. Only when the narrative of FOMC participants starts to shift will we consider paying theta. And when that occurs, we expect short-tail vol to outperform long-tail vol.

A long way to neutral?

Exhibit 47 illustrates how 1m10y vol has been lagging the spike in the VIX.

This is true of rates vol in general, which has underperformed equity vol in both realized and implied terms. We believe the main driver of this dissociation has been the general dismissal by most FOMC participants of the volatility seen in the stock market. This is an excerpt from the Q&A that followed the September FOMC press conference (our emphasis):

CHAIRMAN POWELL. So I don’t comment on the appropriateness of the level of stock prices. I can say that by some valuation measures, they’re in the upper range of their historical value ranges. But, you know, I wouldn’t want to—I wouldn’t want to speculate about what the consequences of a market correction should be. You know, we would—we would look very carefully at the nature of it, and I mean, it—really— really what hurts is if consumers are borrowing heavily and doing so against, for example, an asset that can fall in value. So that’s a really serious matter when you have a housing bubble and highly levered consumers and housing values fall. And we know that that’s a really bad situation. A simple drop in equity prices is— all by itself, doesn’t really have those features. It could certainly feature—it could certainly affect consumption and have a negative effect on the economy, though.

More recent comments from FOMC participants echoed that sentiment, despite the S&P 500 index being 10% off the highs. In effect, this implied that the Fed is not close to stepping in to support the stock market by altering the path for monetary policy. In other words, the so-called "Fed Put" is still out of the money. This is likely to maintain some certainty in the rates market as to the path for rates in the near term as the Fed seems set to at least reach its estimate of neutral.

Less uncertainty about rates begets lower vol. Of course, rates are still going to see higher vol in a risk-off move as a result of investment flows as well as shifting probabilities surrounding the outlook for the Fed. But our view is that this volatility will not be both sustainable and notable until the Fed Put is in the money." - source Morgan Stanley

Until the Fed Put is in the money, that is until the weather bomb has been digested by the market in similar fashion to the rapid storm experienced back in October 1987.

While many pundits are still reeling from the "bloody" October, and many are asking themselves where trouble is brewing, we do believe that some parts of US credit markets do contain some potential "weather" bombs as per our final charts below

• Final charts -  Where is the "credit" weather bomb?

Credit always leads equities in our book when eventually we will have a definitive turn of the credit cycle. For storm chasers out there, we believe that some parts of US Credit Markets are showing signs of fragility, and it's not only the fall in quality of Investment Grade Credit. Our final charts comes from Wells Fargo Economics Group note from the 29th of October entitled "Which Sectors Have Driven Business Sector Debt Growth" and shows that the increase in debt has been most pronounced in the non-cyclical consumer goods sector, the energy sector and the tech sector:

"Business Sector Debt Is Up By Nearly $5 Trillion

In a recent report, we noted that the financial health of the U.S. non-financial corporate (NFC) sector has deteriorated, at least at the margin, in recent quarters. For example, the debt-to-GDP ratio of the NFC sector has trended up to its highest level in decades (below chart).

Not only do non-financial corporations borrow from financial institutions such as banks, but they also issue bonds in the corporate debt market. In that regard, the market value of investment grade (IG) corporate bonds has shot up from less than $2 trillion during the depths of the financial crisis to more than $5 trillion today. The value of high yield (HY) corporate bonds has mushroomed from about $400 billion in late 2008 to nearly $1.3 trillion today.
The value of corporate bonds outstanding—IG and HY—has plateaued in recent months. But, lending by commercial banks to the NFC sector continues to trend higher. Indeed, the amount of leveraged loans outstanding has grown to almost $1.1 trillion at present from about $800 in early 2016 (below chart).

In total, the value of corporate bonds (IG and HY) and leveraged loans outstanding has risen by nearly $5 trillion, which is an increase of roughly 180%, since late 2008. Is this growth in corporate debt a widespread phenomenon or does it reflect higher debt loads in just a few sectors?
We disaggregated the business sector into 11 broad subsectors, and we find that debt has increased in each of these subsectors over the past 10 years (bottom chart). So the increase in business sector debt has been generally widespread. But, not every subsector has had the same experience in terms of debt growth. The financial sector leads the pack with an absolute increase in debt outstanding in excess of $1 trillion over the past ten years (horizontal axis in bottom chart).

Although the financial sector is the largest sector in terms of total debt outstanding ($1.8 trillion in Q3-2018, which is denoted by the size of the bubble), its 132% rise in outstanding debt places it below the average in terms of debt growth over the past 10 years (vertical axis). Other subsectors with slower-than-average debt growth since Q4-2008 include utilities, transportation, basic industries, consumer cyclicals and communications.
There are three subsectors that stand out in terms of debt growth over the past 10 years. The debt in the non-cyclical consumer goods industry, which includes food & beverage, healthcare and pharmaceuticals, has experienced a 275% increase in debt outstanding to $1.2 trillion at present. Energy (400% increase to nearly $700 billion) and technology (almost 600% to roughly $650 billion) are also notable for the debt growth they have experienced. In sum, most business sectors have experienced rising levels of debt over the past 10 years, but the increase in debt has been most pronounced in the non-cyclical consumer goods sector, the energy sector and the tech sector." - source Wells Fargo

So there you have it, given Tech is under pressure, the energy sector is depending on the trajectory of oil prices to stay afloat (see our above point relating to interest expenses coverage) and consumer goods are depending on a more and more fragile US consumer, you can probably think that there is indeed an Explosive cyclogenesis in the making...Happy Halloween!

"The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore." - Vincent Van Gogh

Stay tuned !

Macro and Credit - Ballyhoo

"Chaos is inherent in all compounded things. Strive on with diligence." - Buddha

Watching with interest recent market gyrations, with the intervention of China in the mix to calm down the turmoil in its equities market, when it came to selecting this week's title analogy, we decided to go for the word "Ballyhoo":

1. : a noisy attention-getting demonstration or talk
2. : flamboyant, exaggerated, or sensational promotion or publicity
3. : excited commotion

A "Ballyhoo" is as well a "publicity, hype" from circus slang, "a short sample of a sideshow" used to lure customers (1901), which is of unknown origin. The word seems to have been in use in various colloquial senses in the 1890s.  In nautical lingo, ballahou or ballahoo (1867, perhaps 1836) was a sailor's contemptuous word for any vessel they disliked. There is as well a 2009 book entitled "Heroes and Ballyhoo" by Michael K. Bohn about sports stars during the period 1919-30s an "era of wonderful nonsense", when sport-crazed public demanded spectacles instead of just matches. Given this golden crazy age lasted 12 years long and many pundits are indicating that a recession in the United States could happen in the next two years, we are indeed wondering when this period of "irrational exuberance" to paraphrase former Fed supremo Alan Greenspan will end. On a side note, for sports fanatics out there, baseball legend Babe Ruth personified the Golden Age of the roaring "Ballyhoo" twenties, a close second was the boxer Jack Dempsey. 

In this week's conversation, we would like to look at housing as yet another sign that we think we have reached "peak" US economic activity.

Synopsis:

• Macro and Credit -  The real state of Real Estate in the US and the consequences
• Final chart - Beware of the velocity in tightening conditions

• Macro and Credit -  The real state of Real Estate in the US and consequences

Back in April 2012 we indicated the following relationship with the housing bubble: 

"The surge in the Baltic Dry Index before the start of the financial crisis was a clear indicator of cheap credit fueling a bubble, which, like housing, eventually burst. In the chart below, you can notice the parabolic surge of the index in 2006 leading to the index peaking in May 2008 at 11,440; with the index touching a low point of 680 in January 2012"  - source Macronomics, April 2012

- source Macrobond

The Baltic Dry Index, a gauge of rates to transport dry-bulk commodities including grains and coal by sea. Dry bulk cargo represents the largest part of the $380 billion shipping industry. Container shipping traffic is driven by consumer spending as it is dominated by consumer products. Container volumes to the United States are dependent on the housing market. Furniture and appliances are some of the top freight categories imported in both the United States but, in Europe as well from Asia. 

Any changes in consumer spending trends are depending on the health of the housing market:

- source Macrobond

With the Fed on its hiking mission, house affordability is being impacted through rising mortgage rates. Housing is getting more expensive in conjunction with labor shortages and rising costs linked to some extent to tariffs such as those on imported steel.

Basically it seems that the housing market in the United States seems to be stalling as affordability is becoming an issue:

- source Macrobond

Making a quick detour to shipping, there are as well signs that global trade is indeed cooling off. 

Another indicator other than the BDY is the Harpex Shipping Index. It is considered a good indicator of global economic fleet shipping activity since it tracks changes in freight rates for container ships over broad categories. It is slightly different than the BDY. Harpex weights average daily charter rates across eight size classes of vessels to formulate its index. A vessel containing dry bulk generally transports a single load type. Containers ship, by comparison, usually transport a wider variety of finished goods, which makers therefore the Harpex Shipping index a more accurate indicator for measuring global trade:

- source Macrobond

We can clearly see a deceleration in global trade happening at the moment thanks to this index.

But, let's return to US Housing. 

The housing market has clearly been the weak spot in the “strong economy” narrative. The Fed’s hiking path is leading to rising 30 year fixed mortgage rate towards 4.90%, the highest level touched since April 2011:

- graph source Macrobond

Single-family homebuilding is the largest share of the US housing market and fell by 0.9%. Housing affordability is becoming a challenge. 

At the same time, US housing prices are now 6.3% higher than their peak in July 2006 and 46% above their trough in February 2012:

- graph source Macrobond

On the subject of housing being a cause for concern, we read with interest Bank of America Merrill Lynch's US Economic Weekly note from the 19th of October entitled "Will housing hurt?":

"Will housing hurt?

• We have made a number of changes to our housing forecasts to reveal a weaker trajectory of sales, starts and home prices amid rising rates.
• We think home price appreciation is set to slow but not fall negative absent a recession in the overall economy.
• Housing is no longer a tailwind for the economy, but the headwinds are blowing very gently.

Home prices: from boom to bust

Home prices nationally, as measured by the S&P CoreLogic Case-Shiller index are running at 6.0% yoy as of the latest data in July. Assuming some modest slowing into the end of the year, we believe we are on track for home prices to end up 5.0% this year, as measured by 4Q/4Q change. As we look ahead into next year, we expect the slowing in home prices to persist, leaving home price appreciation (HPA) of 3% at the end of 2019 (Chart 1).

Thereafter we expect home price appreciation to hold at that 3.0% pace in 2020.

Back to econ 101, home prices should be a function of housing supply and demand. As we argued in Home sales: the peak has been reached, we think existing home sales peaked at the very end of last year and have since been moving sideways in a choppy fashion. This is a function of affordability which has been challenged from rising mortgage rates and elevated home prices. Inventory levels have remained extremely low, but since we look for some continued growth in single family housing starts but little change in home sales, we could start to see the supply of homes increase. The modest shift in the demand curve and out of the supply curve naturally implies slower  home price appreciation. As Chart 2 shows home price appreciation typically peaks along with the peak in home sales.

With mortgage rates heading higher, the challenges with affordability will continue. As a simple rule of thumb based on the NAR’s affordability index, we find that a 50bp increase in mortgage rates would need about a 5.5% offsetting drop in home prices in order to keep affordability unchanged. Of course, this does not account for the rise in income which provides an additional modest offset. Plugging in forecasts for mortgage rates based on our rates strategy call for the 10 year to end this year at 3.25% and 3Q 2019 at 3.35% – which implies close to 5.15% and 5.25%, respectively, for the 30-year fixed-rate mortgage – we would see affordability continue to slip lower (Chart 3). 

While affordability would still be above the historical average, it would still be more challenging than the past several years.

Another important aspect when thinking about the trajectory of home prices is an idea called “mean reversion”. Home prices are ultimately anchored to a fair value which is a function of income growth. Based on the OECD’s methodology, we compare nominal Case-Shiller home prices with disposable income per capita, indexed to 100 in 1Q 2000 (Chart 4) which shows the overvaluation during the housing bubble given the irrational exuberance in the market and easy credit conditions.

The housing bust left prices to tumble back below fair value. Based on our calculation, prices are once again overvalued on a national level, albeit not nearly as much as during the bubble period. Over time the overvaluation can be solved in two ways: 1) home prices grow at a rate below income for a period of time to close the gap; 2) home prices decline to correct the valuation difference. The pull to fair value can be quite strong.

Regional realities

We have been discussing the national outlook for the housing market but the dynamics will vary on a regional basis. Focusing on the top 20 metropolitan statistical areas (MSAs), we find that all 20 are still witnessing positive YOY home price appreciation, ranging from a low of 2.8% in Washington DC to a high of 13.7% in Las Vegas.

Generally speaking the West Coast has seen stronger home price appreciation relative to other regions. This reflects the fact that the West has enjoyed robust economic growth, supported by the thriving tech sector, which has led to greater income and wealth creation. This subsequently feeds into housing demand and a bid on prices (Chart 5).

At the same time, the West has also suffered from greater building constraints and a more severe housing shortage, owing to restrictive land-use regulations and zoning laws. This has contributed to home prices well outpacing income growth. Unsurprisingly, a regional analysis of price/income ratios finds the greatest levels of overvaluation in  Western MSAs (Chart 6).

Conversely, the Midwest cities were generally undervalued.

The higher prices rise in overvalued regions, the harder they may fall. So outright price declines could be seen as demand pulls back, though as discussed earlier we think this is less likely for aggregate national prices. Meanwhile, more affordable areas should continue to see price gains assuming healthy regional economic growth.

Sales and starts are a bit weaker

While existing home sales have peaked and will continue to hold around 5.5 million through next year, we see further upside for new home sales, albeit only modest. We forecast new home sales to edge up to 665K next year from our forecast of 640K this year, which is up from 612K last year. Why would new home sales increase while existing home sales move sideways? The recovery in new home sales was much slower since builders were hesitant to add supply to a challenged market, particularly in the early stages of the recovery.

We have revised down our forecast for starts this year and next. We expect 1.260 million starts this year and 1.30 million next year. The gain will be entirely in single family construction as multifamily has little upside.

- source Bank of America Merrill Lynch 

While we expect single family starts to edge higher – consistent with continued elevated levels of NAHB homebuilder sentiment and low levels of inventory – we think builders will be cautious in the face of rising mortgage rates." - source Bank of America Merrill Lynch

Unfortunately we do not share Bank of America Merrill Lynch's optimistic view. That would not make us "perma-bears" but we do not fall easily prey to "Ballyhoo" games namely sensational promotion.

No offense to Bank of America Merrill Lynch but, Main Street has had a much better record when it comes to calling a housing market top in the US than Wall Street. 

If you want a good indicator of the deterioration of the credit cycle, we encourage you to track the University of Michigan Consumer Sentiment Index given the proportion of consumers stating that now is a good time to sell a house has been steadily rising:

- graph source Macrobond

Maybe after all, they are spot on and now is a good time to sell houses in the US? Just a thought. Main Street was 2 years ahead of the 2008 Great Financial Crisis (GFC) as a reminder. Many pundits are predicting a recession in the US economy in the next two years.

As we have stated before, the Fed will continue its hiking path, until something breaks, and we have already seen some small leveraged fish coming belly up when the house of straw build up by the short-vol pigs blew up and when during the summer the house of sticks of the macro tourist carry pigs blew up (Turkey, Argentina, etc.). We keep pounding this but, Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount to track going forward as the credit noose tightens.

Furthermore, it’s isn’t only residential housing which is a concern, in recent years Commercial Real Estate prices have gone through the proverbial “roof”:

- graph source Macrobond 

We think that "housing is no longer a tailwind for the economy" and that "headwinds are blowing very gently" is in this case a "Ballyhoo".

If one looks at US Homebuilders index versus the S&P500 that cyclicals matter when it comes to assessing the rising probabilities of a US recession:

- graph source Macrobond

This is telling you that housing activity is leading overall economic activity, housing being a sensitive cyclical sector. We have reached "peak" everything when it comes to US economic activity. It might be very well all downhill from there. We are already seeing signs in Europe with the latest PMIs of global trade deceleration, and not only from shipping mentioned above.

Also, if one looks at the S&P500 versus US Regional banks, one could conclude that "misery loves company":

- graph source Macrobond

The Regional Banks index has fallen 16.58% from its high back in early June and has fallen 7.05% since the start of October. Bank OZK’s stock dropped nearly 24% on the 19th of October after Commercial Real Estate (CRE) write-offs. The Arkansas-based bank is one of the largest condo construction lenders in Miami, NYC and LA. You would be wise thinking about selling your condo in Miami according to Main Street's predictive history.

As indicated by Bank of America Merrill Lynch in their weekly Securitized Products Strategy weekly note from the 22nd of October, bank stocks and MBS basis have a strong relationship since 2015:

"How Q3 bank earnings inform us

Domestic bank demand is key to agency MBS valuations; one simple relationship we have ascribed to is the strong relationship between bank equity valuations and the current coupon mortgage basis. Even recently, lower bank stock valuations have coincided with the basis widening. The underlying logic tying these two together is the outlook for bank balance sheets, reflected in stock prices, suggesting a technical backdrop for bank demand for agency MBS.

Many individual moving parts, however, come into play on the various pieces of bank balance sheets. For example, theory suggests deposits are impacted by the Fed’s balance sheet runoff. Appetite for securities relies on tolerance for capital volatility related to AOCI (all other comprehensive income), which changes with rate views and duration appetite. Finally, loans funded vary based on credit risk appetite and industry competitiveness, such as non-bank participation and accessibility to the high grade, high yield markets. These moving parts change, dampening or expanding bank demand for securities. We leverage the 3Q18 earnings call transcripts of the largest banks to extract takeaways on driving factors influencing these trends.

Lower tolerance for incurring AOCI risks – Tax reform, lower tax rates specifically, has reduced bank tolerance for incurring AOCI risks. AOCI losses have led to a larger tax deductible historically than what the current lower tax regime offers. The outlook for higher rates this year, and the potential for even higher rates ahead, has dampened enthusiasm for banks to take duration risk.

Cash is king, a compelling alternative, only getting better– Cash yielding 2+% compared to a post-crisis era of offering nothing raises the bar for investing in securities and taking on duration risk. Projecting returns on cash, along the forward path, only further stands to enhance the appeal of this strategy. Indeed, this is how the Fed’s tightening of policy works its way through banking channels, essentially raising the risk-free rate!

Yes, higher base case NIMs, but a few IF’s echoed – The selloff in rates highlights better NIM opportunities presented today, as deposit rates undershoot model forecasts. However, it is far from being just this simple. Convexity concerns and volatility ahead pose risks, along various forward paths. The outlook for loan growth, hinging on whether the economy keeps expanding, dictates securities demand, be it for HQLA/LCR reasons or for NIM/earnings.

The big question is can the US economy continue to expand as such a pace when housing is already struggling and even if FICO scores get lowered to facilitate credit card use by a pressurized US consumer?

There are indeed some implications down the line as highlighted by Bryce Coward from Knowledge Leaders Capital in his blog post from the 19th of October entitled "More evidence of a slowing housing market, and its implications":

"The slowdown housing activity leads overall economic activity by eighteen months. Housing, being one the most cyclically sensitive sectors of the economy, often feels the impact of higher rates well before other areas. This alone implies a peaking of economic activity right about now, leading to persistently slower growth rates through Q1 2020. 

Not coincidentally, a peaking of economic activity about now is also consistent with the 1.2% fiscal stimulus boost we’re getting in 2018. Incremental stimulus for 2019 drops to .4%, with the potential of that entire stimulus being negated by dead weight losses from tariffs, but that is a topic for another day." - source Knowledge Leaders Capital

This ties up nicely we think with Main Street sanguine view of the housing market, namely that it's less and less the time to buy a house and more and more the case of selling a house as per the previous credit cycle call Main Street made. The credit cycle is no doubt turning regardless of the "Ballyhoo" put forward by some pundits.

Sure overall, the latest quarterly Fed Senior Loan Officer Opinion Survey (SLOOs) points towards gradual tightening of financial conditions overall, yet the recent move based on the sensitivities of major market variables points towards an accelerating trend as per our final chart.

• Final chart - Beware of the velocity in tightening conditions

Our final chart comes from Morgan Stanley US Economics note from the 11th of October and indicates how using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions:

"An updated view on financial conditions indices shows a mixed picture, with the
Chicago Fed’s FCI actually easing further in the week ending October 5, while other alternative financial conditions metrics show a more considerable tightening in recent days.

The Chicago Fed updated its weekly FCI this morning. The latest update covers through last Friday, October 5, so it’s quite lagged. Somewhat surprisingly, the index eased 0.026 points – the largest one-week easing since the week ending August 10 and the 13th consecutive week of easing for the index.

The index now stands at a level of -0.76, a low since July 2015, driven by lower readings on the risk, credit, and leverage subcomponents. 49 underlying indicators tightened in the last week and 56 loosened – some of the biggest contributions to easier conditions were the Markit IG 5-yr senior CDS index, HY 5-year senior CDS index, and the 3-month TED spread.

An alternative metric that we look at for a more real-time look at financial conditions has shown a greater tightening in financial conditions so far this week. This metric tracks financial conditions based on the sensitivities of major market variables in the Fed’s FRB/US macro model, and we express it in a fed funds rate equivalent.

By this approach, financial conditions have tightened about 10bp from last Friday and about 50bp from the end of September. That compares with the experience from early February this year when financial conditions tightened about 80bp over a two week period." - source Morgan Stanley

Is this velocity seen in greater tightening of financial conditions a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions, or is it simply a case of "Ballyhoo" at play? We wonder...

"Civilization begins with order, grows with liberty and dies with chaos." - Will Durant, American historian

Stay tuned!

Macro and Credit - Thermidor

"The seed of revolution is repression." - Woodrow Wilson, American president

Watching with interest the disappointment unfold thanks to Bank of Japan's holding pattern, pushing us to quickly take our loss and cut our small short yen exposure, while looking at the news that France was about to harvest the least wheat in 28 Years, it reminded us for our title analogy, the French Republican Calendar implemented during the French revolution and used by the French government for about 12 years from late 1793 until 1805, with Thermidor (or Fervidor) starting the 19th or 20th of July and coming from the Greek "thermon" meaning "summer heat". On many printed calendars of Year II (1793–94), the month of Thermidor was named Fervidor (from Latin fervens, "hot"). Looking at the performance of European banks stocks since the beginning of the year and following the publication of the "stress tests", we do think indeed that our title is indicative of a build up in "summer heat", at the same time it is as well indicative of the significant performance in credit which was yet given another boost thanks to the latest Bank of England raft of decisions. 

What is of interest in the Republican calendar was the tentative in the alteration of time measurement we think:

"Each day in the Republican Calendar was divided into ten hours, each hour into 100 decimal minutes, and each decimal minute into 100 decimal seconds. Thus an hour was 144 conventional minutes (more than twice as long as a conventional hour), a minute was 86.4 conventional seconds (44% longer than a conventional minute), and a second was 0.864 conventional seconds (13.6% shorter than a conventional second).
Clocks were manufactured to display this decimal time, but it did not catch on. Mandatory use of decimal time was officially suspended 7 April 1795, although some cities continued to use decimal time as late as 1801." - source Wikipedia

This was part of a larger attempt at decimalisation in France (which also included decimal time of day, decimalisation of currency, and metrication). When we look at the effects of Negative Interest Rate Policy aka NIRP, we can only think about the attempt of central bankers towards "decimation" of European bank stocks, decimation meaning to destroy a great number or proportion of. On a side note France introduced "decimilisation" of the franc in 1795 to replace the "livre tournois", abolished during the French Revolution whereas the United States introduced decimal denomination from the outset of home minted currency in 1792 with the dollar being equal to 100 cents.

Of course our use of a French revolutionary calendar term is as well a reference to our previous conversation from September 2012 "Pareto Efficiency" where we indicated the following when it comes to "wheat prices" and "revolutions":

"Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for  a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops.

Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.

The proper French revolutionary period (1789-1794) was characterized by poor harvests and very similar meteorological factors witnessed in 1788 and 1789, namely very hot spring-summer periods with very bad weather followed by very cold winters (-21 degrees Celsius in Paris during the winter of 1788), of course any similarities with this year's meteorological events are purely fortuitous given we are rambling again...Are we?" - source Macronomics, September 2012

Now, going towards 2017 with first the Italian referendum in October, then with some important elections taking place next year in both France and Germany, we are wondering if indeed "Thermidor" will not lead to yet another summer of discontent in 2017 given the the significant rise of populism tied to the "War on Inequality" mentioned recently by Michael Hartnett's team in the latest Bank of America Merrill Lynch Thundering Word note from the 29th of July entitled "Fiscal Flip...Get Real":

"Long View

The policy baton is passing from Monetary to Fiscal stimulus in 2016/17. Central bank
rate cuts ending. New policies to address populist desire for "War on Inequality"
emerging. Policy response will be combination of:
1. Redistribution…stagflationary: winners…TIPS, munis, low-end consumption (retail,
payments, tax services); losers…brokers, luxury, growth stocks; yield curve bear
flattens.
2. Protectionism…deflationary: winners…government bonds, gold, volatility, high
quality defensive stocks; losers…banks, multinational companies; yield curve bull
flattens.
3. Keynesianism…reflationary (with “helicopter money): winners TIPS, commodities,
banks, value; losers…bond substitutes; yield curve bear steepens.

Fiscal flip reflects policy intent to reduce deflation, wealth inequality and wage
insecurity. Success means rotation from “deflation” to “inflation” assets; note real
assets (commodities, collectables & real estate) now at all-time lows relative to financial
assets (stocks & bonds) – Chart 1.

- source Bank of America Merrill Lynch

Could this rotation from "deflation" to "inflation" trigger indeed a surge in commodities? We wonder...

The only issue is once the "Inflation Genie" is "Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:

“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it”

As we have repeatedly pointed out, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy" as shown by the latest yet unsurprisingly dismal US GDP print. This of course leading to a "pre-revolutionary" mindset setting in, leading to the rise of "populism" and the deafening sound of "helicopter money" and fiscal profligacy as the "elites" and their central bankers are starting in earnest to "panic" somewhat. We will touch more on this in our conversation.

In this week's conversation we would like to reiterate, like many others our concern relating to the continuation of tightening financial conditions as per the US Senior Loan Officia Survey relative to the rally seen so far in US High Yield thanks to massive inflows from the retail crowd. While we remain tactically short term bullish, or "Keynesian", we do feel fundamentally "medium term" bearish" or "Austrian" given current "credit valuations" do not reflect the deterioration in economic fundamentals. On that note we were not surprised at all by the latest US GDP print, given in January 2016 in our conversation the "Ninth Wave" we indicated:

"Whereas we disagree with Bank of America Merrill Lynch is with their US economy views, we believe that the US economy is weaker than what meet the eyes and that their economists suffer from "optimism bias" we think (more on this in our third bullet point), but nonetheless high quality domestic issuers are definitely credit wise a more "defensive" play.
We think that for "credibility" reasons, the Fed had no choice but to hike in December given the amount spent in its "Forward Guidance" strategy and in doing so has painted itself in a corner. We ended up 2015 stating that 2016 would provide ample opportunities in "risk-reversal" trades. The latest move by the Bank of Japan delivered yet another "sucker punch" to the long JPY crowd. Obviously, should "risk" decide to reverse course in 2016, there will be no doubt potential for significant rallies in "underloved" asset classes such as Emerging Market equities. But, for the time being, the macro picture is telling us, we think that regardless of how some pundits would like to spin it, not only is the credit cycle past "overtime" and getting weaker (hence our earlier recommendations in our conversation) but, don't forget that there is no shame in being long "cash". It is a valid strategy." - source Macronomics, January 2016

When it comes to our positioning relative to the US recessionary crowd, we believe that a flattening of the US yield curve is never a good sign, particularly for the financial sector which has been vaunted by some as a "compelling" buy.

Why is so?

Underperformance by the banking sector always is a bad sign for markets and the economy; it suggests that the credit mechanism is clogged, with knock-on effects for the rest of the economy, that simple.

Synopsis:

• Macro and Credit - Is it High Noon for US High Yield tourists?
• Macro and Credit  - Investing Greed leaning towards Investment Grade
• Final chart: Bank stocks under pressure? Blame central banks

• Macro and Credit - Is it High Noon for US High Yield tourists?

For tracking credit availability, you need to use the central banks’ credit surveys. The most predictive variable for default rates remains credit availability. 

For the US you need to follow the Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans.

As we pointed out in our November conversation "Ship of Fools", credit investors are often too complacent when it comes to assessing the stage of the credit cycle and when it comes from the retail crowd aka the US High Yield tourists, they have been pouring "inflows" at a very late stage of the "game":

"Furthermore, despite their alleged high degree of sophistication, credit investors have a very weak predictive power on future default rates. This was largely discussed by our Rcube friends in their long March 2013 guest post entitled "Long-Term Corporate Credit Returns":
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)." - source Rcube
From a medium term perspective and assessing the "credit cycle" we believe the latest US Senior Loan Officer Survey points to yet another "warning" sign in the deterioration of the on-going credit cycle which has been so far pushed into "overtime" by central banks with ZIRP and their various iterations of QEs.

"When default rates are low, credit investors believe that stability is the norm, and start piling up on leverage, inventing new instruments to do so (CLOs, CDOs, CPDOs etc.). This recklessness leads to mal-investment, and sows the seeds of the next credit crisis." - Macronomics, November 2015

Lather, rinse, repeat. 

While it isn't yet "high noon" per se for the US High Yield tourists, the latest publication of the US Senior Loan Officer Survey confirms clearly a deteriorating trend in financial conditions which is indeed down the line (most likely in 2017) a recipe for a serious "repricing" of the asset class as a whole. To re-iterate our November call, we remain short-term "Keynesian" bullish / long term "Austrian" bearish when it comes to assessing the current stage of this credit cycle. This should provide sufficient proof for us not being labelled "perma-bears" or having a "pessimism bias" but, rather a "realistic bias" we think.

When it comes to assessing global credit conditions, we share our concerns with UBS and read with interest their latest Global Credit Strategy note from the 2nd of August entitled "Q2 Lending Conditions: Why did lenders tighten?":

"Q2 Lending Conditions: Why did lenders tighten?

A critical linchpin in our frameworks for assessing credit spreads, defaults and the read-through to macro implications is the state of lending conditions. And, to cut to the chase, recent releases could aptly characterize current conditions as increasingly uncomfortable, albeit not alarming. The improvement in our non-bank liquidity indicator since March has stalled, with the latest reading rising from 7 to 9.1 – principally due to less robust issuance of lower-quality high yield debt since April. In our view, this gauge is superior to the Fed's SLOS survey tracking bank liquidity conditions given nearly 80% of corporate funding is done via non-banks. That said, our non-bank indicators have now largely converged with the Fed's bank liquidity gauge, with net tightening of credit standards on C&I loans to SMEs increasing from 5.8 to 7.1 in the latest survey (Figure 1).

Notably, we do not believe the latest SLOS survey results were significantly affected by the UK's Leave vote (as banks received the survey on June 28, and responses were due by July 12). For C&I lending conditions, the rationales given from bank loan officers for shifts in lending standards continued to be dominated by net tightening attributed to a weaker economic outlook and industry problems versus net easing due to competition; however, in terms of shifts there were fewer officers reporting industry specific problems (e.g., energy, but prior to the latest decline in oil prices) as a reason for tightening, more respondents citing lower risk tolerance and higher regulatory concerns as rationale for tightening, and more noting increased competition as a driver of easing (Figure 2).

And lower risk tolerance and greater regulatory pressures would be consistent with sentiment from the latest Shared National Credits (SNC) review, which continues to highlight concerns related to an elevated level of special mention and classified (i.e., higher risk) loans which may increase defaults this cycle and the prevalence of incremental facilities allowing greater sharing of priority claims which may lower recovery rates1 . In terms of our key forecasts, our HY spread forecast increases from 660bp to 666bp (vs 566bp current), our HY default forecast is unchanged at 5 – 5.5% by mid-2017, and our credit-based probability of recession rises to 33% from 31% (over the next 12mos).

Why the discomfort? First, the persistent albeit moderate tightening trend in C&I liquidity conditions bears watching as the relationship is not linear; i.e., further increases in net tightening from current readings will disproportionately increase spreads, defaults and recession risks in our models, respectively, when compared with commensurate decreases in net tightening (e.g., see recession gauge sensitivities on net tightening – Figure 4). 

Second, our prior concerns related to significant easing of lending standards and rising credit risks in other sectors seem to be trending in the wrong direction2. In particular, lending standards for commercial real estate (CRE) loans contracted further, with aggregate (debt-weighted) net tightening of 27% from 20% the prior quarter (CLD to 31% from 25%, nonfarm nonresi to 18% from 12%, and multifamily to 44% from 36%). While not cited, we believe the tightening reflects increased regulatory scrutiny (e.g., 2006 CRE guidance, risk retention requirements) as well as concerns around lax lending standards and lofty valuations. 

At current levels, the significant tightening observed in CRE standards, which is historically reasonably well correlated with C&I standards (as we have detailed previously), is near historical extremes (as per Figure 4).

Aside from commercial lending, the mosaic from consumer and residential sectors has been more benign in prior surveys. However, there were some signs of less easing in consumer loans – with net tightening in auto loan standards moving from -6.3 to 0 (while in credit cards net tightening was -5.6 vs -5.7 the prior quarter). Banks reported higher spreads on auto loans, and higher spreads and lower credit scores for credit card loans. For residential loans, the SLOS survey overall signaled marginally less easing – i.e., the second derivative is negative. However, like C&I loans, residential lending is primarily driven by non-bank lending (Figure 5).

In turn, the Fed's SLOS survey results should be taken with a grain of salt. One alternative, which encompasses non-bank lending, is the AEI's change in its National Mortgage Risk Indices (NMRI) 3 . This metric, updated monthly and based on actual loan origination risk metrics, suggests that while banks are reducing risk in residential originations (for FHA/VA/RHS primarily), non-banks are increasing risk in a bigger way – causing a net easing of credit conditions in resi. This point illustrates that non-bank lending standards are increasingly (if not more) important than bank lending conditions in some asset classes and, in particular, in instances when the signals can diverge. And, in this instance, continued easing in residential mortgage credit conditions is one development which is helping offset the more persistent, marginal to moderate tightening in lending standards across other asset classes. In short, for now the prognosis is increasing discomfort, but not alarm." - source UBS

Whereas the SLOS survey doesn't yet point out to "High Noon" for our US High Yield tourist friends from the retail space, we do think that the evolution of tightening financial conditions is a harbinger for things to come in 2017, namely spread widening and a rise in defaults. We do agree with UBS and share their increasing discomfort. 

As well, on the deterioration of the credit cycle, we read with interest Oaktree's insights in their special edition "Navigating cycles":

"Bruce Karsh: How does this credit cycle resemble and differ from past credit cycles?  

Rajath Shourie, Co-Portfolio Manager, Distressed Opportunities: The down-leg of the current cycle feels most like the down-leg we experienced in the early 2000s, when too much capital came into a popular industry; that industry blew up; and the dislocation spread to other industries. In the early 2000s, telecom was the darling industry that went bust. Today it is energy. In the early 2000s, a majority of the high yield bonds issued by telecom companies defaulted, and unless oil prices make a major recovery, today’s exploration and production companies are likely to face a similar fate.

Jordon Kruse, Co-Portfolio Manager, Global Principal: I’ll focus on a comparison of the current downleg to the one we experienced in 2008-09. They are similar in that both followed long periods of significant debt issuance, but different in that there is far less systemic risk today than there was in 2008-09. A major driver of that risk was the substantial amount of bad mortgage securities held by large financial institutions that played a major role in the financial system at large.

Bruce Karsh: What is your expectation for defaults this year?  

Sheldon Stone: The 2016 default rate for U.S. high yield bonds is projected to increase to between 5 and 6%. This compares to the 2015 default rate for U.S. high yield bonds of 2.8% and the 30-year average of 4%. While this 2016 estimate is higher than what we’ve seen since 2009, it is not meaningfully higher than normal observations. As you would likely guess, defaults this year already have been—and will be—heavily impacted by oil prices. I believe that easily two-thirds, or maybe even three-quarters, of the defaults this year will stem from energy-related issuers. 

... 

Bruce Karsh: Outside of China, what factors do you think are exerting the greatest impact on the current market environment?  

Sheldon Stone: The obvious ones are low energy and commodity prices; however, those are linked to China. The other one worth highlighting is liquidity. Current trading markets are significantly less liquid, causing rapid changes from a buyer’s market to a seller’s without large trading volumes. We estimate that today, banks are carrying about 20% of their 2007 peak inventory of senior loans and high yield bonds.  As a result, banks are now looking for trades to cross, rather than putting their capital at risk.  It doesn’t take much selling these days to move bond prices a fair amount. 

Rajath Shourie: I completely agree with Sheldon. Prices have recently been declining dramatically because there’s a buyers’ strike at play, not because there is a lot of supply from forced sellers." - source Oaktree insights, July 2016

When it comes to "liquidity, to that effect we would like to repeat the quote used in the conversation "The Unbearable Lightness of Credit":

Today investors face the same "optimism bias" namely that they overstate their ability to exit.

“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“

Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain such as the gains seen in single A credit in the United Kingdom following's the Bank of England early "Christmas present" for the speculating crowd. Yes indeed, the fun is "uphill", in the bond market.

When it comes to "Thermidor" or "investment heat", when it comes to "investment grade" credit, the summer heat is truly "on". This leads us to our second point below.

• Macro and Credit  - Investing Greed leaning towards Investment Grade

While we have been predicating for the right reasons to stick with quality Investment Grade credit since the beginning of the year (particularly as per our last post on Senior Unsecured bank credit rather than equities...), even recommending a long duration exposure to the asset class, the ECB playing the "corporate credit game" now being followed as of late by the Bank of England points towards even more "fun" running uphill to this particular segment, or, to put it bluntly, "Investment Greed" is leading to "Investment Grade". When it comes to "flows", the "summer heat" is indeed "on" during our "Thermidor" period rest assured as pointed out by Bank of America Merrill Lynch in their latest Follow The Flow note from the 5th of August entitled "Largest inflow into IG funds ever":

"Large outflows from equities; large inflows into IG 

Inflows into high-grade have accelerated. Over the past four weeks inflows have been almost doubling on a w-o-w basis. However, while inflows into credit have been strong, equity funds have been suffering continuous outflows over the past 26 weeks. Should the recent trend continue, the inflows that came into the asset class since 2015 would be erased in the next 10 weeks or so (Chart 1).  

High grade funds recorded their 21st week of inflows and the highest ever since the start of our data set (table 1).

Flows into the asset class have doubled w-o-w, and propelled the year to date cumulative inflow to over $13bn. High yield funds however reported a substantial outflow, the first in five weeks. The outflows were a mix of global, US and European-focused funds. More in chart 13. 

Government bond funds flows switched to positive after two weeks of outflows. Money Market funds flows also turned positive after three weeks of outflows. 

Flows into equity funds remained in negative territory for the 26th consecutive week. Almost $80bn has left the asset class over that period." - source Bank of America Merrill Lynch

So much for the much lauded "Great Rotation" story from "equities" towards "bonds". When it comes to having some "fun" uphill, Fixed Income is still "the place to be" and when it comes to "greed", Investment Grade credit rules the game for now thanks to central banks joining as well the "party".

While equities are making news highs while flows are making new lows, we think that we haven't seen yet the lows of the current credit rally in investment Grade à la 2006. On this particular point we agree with JP Morgan's take in their Credit Market Outlook and Strategy from the 28th of July when it comes to US Investment Grade:

"Credit has not reached a low in spreads while equity indices are at all-time highs 

One of the interesting cross market dynamics recently is that equity markets are reaching new highs while HG bond spreads have been range bound well off of their tightest levels. This month the Dow and S&P reached new peaks and the Nasdaq came close. The JULI spread is at 171bp, 83bp above the pre-crisis low of 89bp (29th July, 2005) and 49bp above post crisis low of 122bp (24th June, 2014). There are several logical explanations for this divergence in performance, but we still believe the trend is for tighter spreads.

The most important explanation is that HG bond yields rather than spreads are the key valuation metric for many now (particularly overseas investors), and they are almost at a record low. The JULI yield is 96bp lower YTD and at 3.32% as of Wednesday it’s just 6bp off its record low of 3.26% reached on July 8th of this year.
The second explanation is the much higher weighting of banks in credit (24.4%) vs in the S&P (5.2%). The banks index of the S&P is not at its post crisis peak – it is 16.4% below the peak reached on 22nd July, 2015.

JULI Financials are at 172bp, 96bp above where they were when JULI spreads were at a pre-crisis low and 54bp above the JULI post-crisis low point. Banks have lagged in both equity and credit markets, but it matters more in credit markets. The third explanation is that 30.5% of the JULI comes from issuers outside the US. Of this 29% is EM and 71% is DM. This subset of the JULI is at a spread of 183bp, which is 93bp and 38bp above where it was vs the pre and post crisis low spread points for the index. Excluding EM these figures are 81bp above and 54bp above for Yankee
issuers." - source JP Morgan.

Whereas we think equities have much more less room to rise in the US, we do think we are going to see additional melt-up in and records been broken in the US. When it comes to "valuation" and "rotation", we do think that in this "japanification" and "Thermidor" period, the trend is indeed, your friend and there is more "fun" to come given "greed" is still running high in the context of "financial repression". 

While we keep noticing the deterioration in "financial conditions" as pointed out by the US Senior Loan Officers Surveys (SLOS), we still recommend a "rotation" towards "quality". This recommendation was made again in our previous conversation when it comes to bank exposure and "senior unsecured credit" was less volatile than merely chasing "beta".

When it comes to "greed" and "Investment Grade" credit, we continue to favor US Investment Grade credit and we do think that having the ECB, the Bank of England and the Bank of Japan, competing with their local investment base when it comes to chasing assets, we do think that once more US credit will strongly benefit from investors in September after the summer lull or "Thermidor" period. 

We therefore agree with Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 29th of July entitled "Kuroda and Draghi and Yellen":

"Fed+ECB+BOJ>0 

On balance we view recent developments in global monetary policies from the major central banks as positive for the US HG corporate bond market. At this week’s FOMC meeting the Fed was not as hawkish as investors had feared – specifically they did not prepare investors for a September rate hike. Recall that last year - prior to starting the rate hiking cycle at their December meeting - the Fed had warned the market of that possibility explicitly in the statement from their previous (October) meeting.
In Europe, as our European credit strategist, Barnaby Martin, highlights (see: Resistance is futile), the ECB appears on a mission to deflate credit spreads in the European corporate bond market. This has to drive even more European investors into the US corporate bond market – probably when they come back from vacations in September (Figure 3). 

Furthermore, unlike the BOJ the ECB has plenty of ammunition left that – if deployed – would help drive US credit spreads tighter. This includes changes to its capital key (Figure 4) that would direct QE purchases away from bunds toward assets that have more credit risk (see: Brexit pushing Draghi out the curve?).

So we continue to expect accelerating foreign purchases of US corporate bonds during the last part of the year driven by Europe, while Asian buying remains steady – which means strong.

(Reverse) Yankees are coming 

In additional to accelerating European demand for US corporate bonds starting in September, we should we expect accelerating reverse Yankee issuance (i.e. US companies coming abroad in non USD currencies). Given what the ECB is doing this is certainly the case for the EUR market (Figure 5), but with global yield starvation we expect increasing reverse Yankee issuance in other currencies too (Figure 6). 

That should further support USD credit spreads just like we saw for the banking sector this month post-earnings." - source Bank of America Merrill Lynch

If indeed "greed" is "good" then obviously there is more room when it comes to spread tightening in US Investment Grade thanks to somewhat to some "crowding out" due to to central bankers competing with investors in this "unhealthy" yield chasing game. We can as well anticipate a significant return of the Japanese investor crowd to foreign bond markets while the Bank of Japan, while on hold, is preparing for some more "unconventional" bazooka in September when we will eventually revisit our short yen exposure.

When it comes to "crowding out" and the ECB, we read with interest Bank of America Merrill Lynch's European credit strategist Barnaby Martin note "Resistance is futile" from the 28th of July highlighting how central banks are pushing outside of their comfort zone "yield hogs" towards more credit risk and/or higher duration exposure:

"Honesty doesn’t pay 

Spreads took another leg tighter last Monday as CSPP ISINs were disclosed. We sense “doubters” threw in the towel. But we think disclosure rubs both ways. While the aim is to facilitate securities lending – and aid credit market liquidity – we fear the sheer size of CSPP buying has heightened investors’ nervousness over credit market liquidity.

As chart 1 shows, investors are already starting to have concerns over the growth of negative yielding corporate debt across the globe. Note the weakness in European corporate bond spreads over the last 2 days despite equities being up…

How has credit market liquidity fared through CSPP life?  

Chart 2 shows the average bid-offer spread (in bp) for investment-grade corporate bonds. We split the universe up into  CSPP eligible,  non-eligible (non-banks) and  CSPP purchased bonds. 

We think that the picture shows some encouraging but also some concerning developments: 

• What’s clear is that the announcement of CSPP on March 10th initially caused mass confusion in the market. Bid-offers surged and liquidity deteriorated meaningfully in non-financial bonds. Yet, bid-offers remained steady in parts of the market that were expected to be untouched by Draghi (note the calm in  non-eligible bid-offers).
• From March 10th until CSPP buying began (June 8th), credit market liquidity improved noticeably. Bid-offers tightened for all parts of the market as CSPP was deemed to be the policy that would rejuvenate the corporate bond market.
• But since June 8th, bid-offers have widened and liquidity has deteriorated again. True, Brexit took place on June 23rd, but nonetheless there has been a drift higher in bid-offers since Draghi started buying credit. And if anything, liquidity seems to have deteriorated further for  eligible and  purchased names, post the ISIN publication last week.
So while the aim of CSPP disclosure was to preserve credit market liquidity, the initial signs seem to point to something more worrying: that the ECB’s dominance in corporate bond buying is in fact becoming counterproductive for market health.
We think that this will be another reason why investors will want to accelerate their movement into non-eligible parts of the credit market post the summer break. Not only are non-eligible sectors relatively attractive spread-wise now, but they also offer an attractive combination of yield and volatility, we think, compared to CSPP purchased sectors" - source Bank of America Merrill Lynch

In similar fashion than the Bank of Japan has completely destroyed the liquidity in its Government Bond Market (JGBs), the ECB is as well in the process of wreaking havoc in the liquidity of the Corporate bond market and has now been joined in a similar process by its neighbor the Bank of England. 

When it comes to the "Thermidor" period, we do live in pre-revolutionary times we think and wonder how long markets are going to cope with this financial repression.

On a final note and in our final chart and in continuation to last week's conversation surrounding bank "valuations", we would like to point out how interest policies of our "omnipotent" central bankers and now with NIRP are destroying slowly but surely "bank capital".

• Final chart: Bank stocks under pressure? Blame central banks

We will not re-iterate why we dislike banks stocks and in particular European banks stocks given the "japanification" process and the significant on-going deleveraging. If there is indeed some clear culprits when it comes to "capital destruction" thanks to Zero Interest Rate Policies (ZIRP) and now with Negative Interest Rate Policies (NIRP), the blame is entirely on the shoulders of our "generous gamblers" aka central bankers and their experiments. 

This is clearly illustrated in our final chart displaying the correlation between interest rate policies and bank stocks as pointed out by this chart from Bank of America Merrill Lynch from their Credit Derivatives Strategist note from the 5th of August entitled "Corporate ‘QE²’ - When CBPS met CSPP":

- source Bank of America Merrill Lynch

As a "bonus chart" we will point out to yet another chart from Bank of America Merrill Lynch's European credit strategist Barnaby Martin note "Resistance is futile" from the 28th of July chart displaying that the "fun" has been going "uphill", namely to the bond market and in particular German Bunds:

- source Bank of America Merrill Lynch

For the "real economy", downhill that is, we are not too sure they are getting their share of the "fun", which does indeed explain the rise in inequalities, populism and the rising prevailing "pre-revolutionary" mood in many parts of the world.

Back in November 2014 in our conversation "Chekhov's gun" we argued the following:

"Our take on QE in Europe can be summarized as follows: 

Current European equation:  

QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 

“Hopeful” equation:  

QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend." - source Macronomics, November 2014

Obviously our "Hopeful equation" suffered from "Optimism bias" and we argued at the time:

"Our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015) " - source Macronomics, November 2014

Increasingly it looks to us that we are moving towards the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). That's our take and our "realist bias" for now unless of course we finally get a wake-up call from the political class leading to the realization of our "Hopeful" equation but we would not bet on it for the time being.

"Those who make peaceful revolution impossible will make violent revolution inevitable." - John F. Kennedy

Stay tuned!