Macro and Credit - The Lindemann criterion

"We're just a bubble in a boiling pot." - Jack Johnson

Looking at the acceleration of inflows, with record flows piling into Investment Grade, Emerging Markets (EM) and equities, when it came to selecting this week's title analogy, we reacquainted ourselves with the "Lindemann criterion", being the first theory explaining the mechanism of melting in the bulk. An attempt to predict the bulk melting point of crystalline materials was first made in 1910 by Frederick Lindemann. The idea behind the theory was the observation that the average amplitude of thermal vibrations increases with increasing temperature. Melting initiates when the amplitude of vibration becomes large enough for adjacent atoms to partly occupy the same space. The Lindemann criterion stated that melting is expected when the vibration root mean square amplitude exceeds a threshold value. Quantitative calculations based on the model are not easy, hence Lindemann offered a simple criterion: melting might be expected when the root mean vibration amplitude exceeds a certain threshold value (namely when the amplitude reaches at least 10% of the nearest neighbor distance). In similar fashion, melting up might be expected with such strong inflows into various asset classes. As we have repeated in numerous conversations, you can expect the credit amplifier to reach 11 in true Spinal Tap fashion.  On a side note Lindemann model is based on harmonic forces, which never give way, whereas melting must involve "bond breaking". This is another serious defect of the model. Furthermore numerous experiments carried out at high pressures indicate that the Lindemann model does not estimate adequately the pressure dependence of the melting temperature, but,  the predictive success of the Lindemann melting criterion lent support to the belief that melting could be a gradual process, beginning within the solid at temperatures below the melting point. 

In this week's conversation, we would like to look at cycles in credit in conjunction with what is happening in US Consumer Credit as well as boiling markets and bubbles.

Synopsis:

• Macro and Credit - The credit boiling frog
• Final charts - Fund flows have a tendency to follow total returns

• Macro and Credit - The credit boiling frog

Whereas the heat continues to be "on" when it comes to fund inflows and in particular for Investment Grade credit, one might wonder from a "Lindemann criterion" approach, when could we reach the boiling point in this on-going "melt-up" phase. Some pundits have even called this phase "euphoria" given the strength of the start of the year performance wise in various asset classes including equities. 

As pointed out recently on Twitter by our good friend Tiho Brkan when it comes to the credit boiling frog bullet point analogy, for us there is no real value left in European High Yield to say the least:

"For the first time (possibly ever?) we have European Junk Bonds yielding less than European equities.

You have to hand it to the ECB. They really a did a terrific job bailing out the whole continent. Not a single bankruptcy was allowed!" - source Tiho Brkan - Twitter feed

No wonder flows have been very strong into equities in Europe as pointed out by Bank of America Merrill Lynch in their Follow The Flow note from the 19th of January 2018 entitled "Turbo-boosted flows":

"Inflows into IG, EM and equities continue stronger

The reach for yield continues for another week. IG, equity and EM debt funds have had a great start of the year. IG fund flows have tripled (3wks YoY); flows into equities have moved from marginally flat to $6.4bn, and flows into EM debt have more than doubled. Nonetheless, flows into HY funds have flipped to negative, on the back of rising idiosyncratic risk. With spreads continuing tighter in the IG space and rates vol remaining close to the lows we see no reason for flows to stop in the IG space.

Over the past week…

High grade funds, continued to record inflows their fourth consecutive week. The monthly December data also reflected the calm of the holiday season with the second smallest inflow of 2017 – second to January. High yield fund flows remained on negative territory recording their 10th consecutive week of outflow. Looking into the domicile breakdown for last week, as chart 13 shows, European-focused HY funds were the main source of outflows, but the US-focused and globally-focused funds also recorded withdrawals. Monthly data for December showed a 2nd month of outflows.

Government bond funds recorded an inflow erasing last week’s outflow and a strong inflow during the month of December as well. Overall, Fixed Income funds flows remained sizable – and positive – for the fourth week in a row. As for the month of December, inflows –despite being the smallest in 2017 due to seasonality - confirmed the overall inflow trend that was seen throughout the year.

European equity funds continued on their positive streak for a third week, with inflows accelerating. Last week inflow was the largest in 36 weeks. However, in December the asset class recorded a large outflow – the largest in 14 months." - source Bank of America Merrill Lynch

As long as rates volatility remains muted, there is no end in sight for the "goldilocks environment" and the Investment Grade TINA (There Is No Alternative) trade supported by the Japanese investment crowd at least when it comes to US credit markets. As we pointed out last week when it comes to US TIPS being enticing and rising risks of inflation surprises, back in October 2017 in our conversation "Who's Afraid of the Big Bad Wolf?" we asked ourselves if indeed the game was turning and if we should switch camp from the "deflationista" towards the "inflationista" camp. Flow wise, what we are seeing is large swath of investors piling into the "inflationista" camp and investors as pointed out by Reuters in their article from the 18th of January entitled "Investors scoop up U.S. inflation-protection bonds":

"Investors on Thursday pounced on $13 billion worth of U.S. bonds that offer them protection from faster wage growth and costlier goods and services as their longer-term inflation outlook rose to their highest in almost a year.

Overall bidding for these 10-year Treasury Inflation Protected Securities was the strongest at an auction in over 3-1/2 years with investors buying nearly 90 percent of the supply.

"The allocation into the (TIPS) asset class has been strong," said Michael Pond, head of global inflation-linked research at Barclays in New York. "It's all related to the pickup in global growth."

Barclays' Pond said the run-up in TIPS may be overdone in the short term. "Evaluation is getting a bit stretched," he said." - source Reuters

TIPS focused funds have reached "boiling point" to the tune of $68.01 billion of inflows in the asset class in the week ending the 10th of January according to Lipper. As the Lindemann melting criterion has shown us, melting is indeed a gradual process. Have we reached the boiling point yet? Could we be on the cusp of a vicious bear market as anticipated daily by the perma bear crowd? One thing for certain, as we pointed out again last week, you need core US CPI to tick up significantly for a bear market to materialize for our equities friends. We do not think we have reached that point yet. Financial conditions continue to remain loose which makes this credit cycle particularly long and extended.

Not all credit cycles are the same and business cycles as well tend to be different across sectors over time. On that subject we read with interest Wells Fargo Interest Rate Weekly note from the 17th of January entitled "Cycles in Credit, Economics and National Finance":

"Business cycle trends differ across major sectors; while some series are mean-reverting, others are shifting over time. Careful analysis leads to a better understanding of ‘normalcy.’

The Bank Credit Cycle: Mean-Reverting

The Federal Reserve reports a bank’s willingness to make loans on a quarterly basis as part of the Senior Loan Officer Opinion Survey. Such a qualitative measure is telling of lender expectations and is often consulted to predict the coming credit conditions in the market. A bank’s willingness to make loans is a stationary series, which contains no structural breaks. That is, the series acts in a predictable nature, allowing one to refer to it as a benchmark to assess lending practices over a business cycle (below chart).

At the beginning of an expansionary period, as banks are very willing to extend credit, the series rises. Once reaching its peak, a bank’s willingness gradually decreases until turning negative during a recessionary period. That said, it would appear that willingness has peaked in the current expansion, which is in line with our assessment of the business cycle being in the late stage.

Elevated Household Debt: Not Back to “Normal” Ratio

Debt as a percentage of GDP serves as a good measurement of indebted households relative to the size of the economy.

However, analyzing averages can be significantly misleading. As seen in the middle chart, after rising exponentially in the prior expansion, household debt as a percent of GDP never returns to its “average” trend, as portrayed in the 1991-2000 expansionary period. Despite decreasing significantly from its peak prior to the Great Recession, household debt still remains quite elevated, stabilizing around 77 percent. As this series is not mean-reverting, it does not follow a cyclical trend, and the behavior of the series in this cycle is distinct compared to prior expansions. The recent deleveraging is likely attributable to increased caution as households acquired large amounts of debt during the previous expansion, which led to a sharp increase in the debt burden.

Unusual Behavior of Profits

Corporate profits as a share of GDP appear to follow a cyclical pattern in which they gradually increase, peaking late in an expansionary period, before steadily declining during a recession. However, pre-tax corporate profits are non-stationary, and thereby are a less predictable series. Although profit growth as a percent of GDP appears to follow a traditional peak to trough trend, there have also been various structural breaks within the series leading to highly irregular and quite misleading judgements based on prior trends. Although this might not be very surprising, the larger decline being in the 2001 recessionary period seems unusual (bottom chart).

The greatest decline in corporate profits would be assumed to have occurred during the Great Recession, as we saw dramatic movements in a bank’s willingness to lend as well as households acquiring record amounts of debt. That is, one might suspect a similar case of dramatics in the decline of profits during the Great Recession; however, the drop was more significant in 2001." - source Wells Fargo

When it comes to the US economy, US consumer credit matters a lot. We continue to monitor that space given any weakness in US consumer credit could be an additional sign the US economy is reaching a turning point. Also in our October 2017 conversation "Who's Afraid of the Big Bad Wolf?" we asked ourselves what could make the credit cycle turn once we have reached boiling point:

"When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer. But for now financial conditions are pretty loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion. " - source Macronomics, October 2017

From a Lindermann criterion perspective, measuring the level of indebted households matters and in particular the use of Consumer Credit and in particular non-revolving credit we think. In regards to the results from big US banks we read with interest the Financial Times article from the 21st of January indicating a surge in credit card losses:

"US banks suffer 20% jump in credit card losses

Rising soured debts raise concerns about the financial health of middle America

The big four US retail banks sustained a near 20 per cent jump in losses from credit cards in 2017, raising doubts about the ability of consumers to fuel economic expansion.

“People are using their cards to get from pay cheque to pay cheque,” said Charles Peabody, managing director at the Washington-based investment group Compass Point. “There’s an underlying deterioration in the ability of the consumer to keep up with their debt service burden.”

Recently disclosed results showed Citigroup, JPMorgan Chase, Bank of America and Wells Fargo took a combined $12.5bn hit from soured card loans last year, about $2bn more than a year ago.

Banks have ramped up lending, wooing customers with air miles, cashback deals and other offers. The number of open credit card accounts in the US is forecast to reach 488m this year, according to Mercator Advisory Group, a rise of 108m from post-crisis lows in 2010.

Yet borrower delinquencies are outpacing rising balances. While still less than half crisis-era levels, the consultancy forecasts soured credit card loans will reach almost 4.5 per cent of receivables this year, up from 2.92 per cent in 2015."  - source Financial Times

Low inflation and loose central bank policies have indeed played a critical role in moving asset prices towards the boiling point and the ongoing "melt-up" but the narrative is slowly but surely changing as we pointed out on numerous occasions. 

Nonetheless, the most predictive variable for default rates remains credit availability. Senior officer loan survey leads default rates (SLOOs) so it is important to track them. When it comes to consumer credit, as the credit cycle matures, it is becoming essential to monitor what is happening for Credit card ABS we think.  As displayed by Wells Fargo in the below chart in their Credit Card Surveillance Report from the 19th of January, credit card ABS issuance has been increasing in 2017 but it is still relatively tame compared to the years prior to the Great Financial Crisis (GFC):

- source Wells Fargo

While securitization of US consumer credit is comparatively tame compared to what happened before the GFC, US consumer debt surged by the most in over 2 years to $3.8 trillion and jumped by 8.8% in November, the most in two years, to $3.83 trillion, according to the Federal Reserve. Clearly in the coming months US Consumer Credit should be on everyone's radar in conjunction with SLOOs we think.

As per our bullet point the credit frog is slowly but surely heating up for sure as per the Lindemann criterion but, we do not think yet we have reached the boiling point yet in credit we think.

For our final charts we have always thought tracking flows matter, particularly this year the ones coming from Japan given their support for US Credit as a whole. 

• Final charts - Fund flows have a tendency to follow total returns

When it comes to flows the most cited linkage according to CITI is trailing returns. Our final charts come from CITI's European Credit Weekly note from the 19th of January entitled "How durable is the fund flow frenzy" and display fund inflows as a percentage of AUM (Assets Under Management) versus total returns for both US Investment Grade and US High Yield:

"Fund flows have a tendency to follow total returns, both on the way up and on the way down. The relationship holds in IG (Figure 7), in HY (Figure 8) and in equities, and while sometimes coincident, the return series quite often seem to lead at turning points.

This relationship is clearly sending a positive signal at the moment. While it left us very worried in early 2016 (after investors had lost money on almost every asset class in 2015), 2017 returns were almost universally positive. If investors simply chase trailing returns, there is very little reason for them to withdraw their money at present.

Admittedly there are a few wrinkles. In such a risk-on environment seems odd that investors are quite so keen on IG (both outright and relative to trailing returns), and quite so cautious on HY (likewise). It might just be an overhang from the losses of 2015, when investors clearly ended up regretting their enthusiasm for HY in 2010-14.

Something similar is apparent in equities: last year’s $200bn inflow to mutual funds and ETFs – a mere 1% of total holdings – seems relatively paltry when markets are returning 15+ percent. Again, it may just be that investors have been unable to regain the love of the asset class they displayed during the 1990s (Figure 9).

But we would be much more convinced of private investors’ ability to take over from central banks as the main driver of risk assets this year if we saw more elevated and sustained inflows to both HY and equities. Perhaps those are on the verge of showing up, but there is an alternative interpretation which points in the opposite direction.

Cash is king

Just as last year’s outflows from HY funds did not seem to have much negative impact on their performance – perhaps because IG or other investors were crossing over into HY – so we find we get the best understanding of fund flows when we consider the big picture, rather than looking at each asset class individually.

Specifically, we like to look at inflows to all risky (or “long-term”) assets together – IG, HY, govies, EM, equities and alternatives, in mutual funds and ETFs – relative to total inflows into money market funds and deposits. How much of people’s saving is going into risk assets relative to what they a simply trying to keep safely in cash?

This combined flow also exhibits a strong relationship with equity returns, with recent strong inflows at first sight almost exactly where they “should be” (Figure 10).

When risk assets are performing well, investors do most of their saving in risky assets, and keep relatively little in cash.

But look more closely, and another pattern is visible. In each cycle, as the economy emerges from recession, with risk assets priced cheaply and deposit rates low, investors start by doing the vast majority of their saving in risk assets (1992-3, 2003-4, 2009-10). Then as the cycle matures, risk assets become more expensive and deposit rates rise, they do steadily more of their saving in safe assets. Finally as risk assets start to wobble they try and withdraw some money and do all of their saving in cash, precipitating a sell-off, before the cycle starts again (Figure 11).

In addition, both the red and blue lines have exhibited a long-term downward trend. The move in the blue line could just be the relative growth in deposits across cycles. But an alternative interpretation – consistent with investors’ relative reluctance to buy both HY and equities – is that as markets have become more obviously expensive, it has taken steadily lower deposit rates just to prevent them from hoarding cash.

One way or another, the past year’s shift into risk assets, so late in the cycle, is extremely unusual. Even the late 1990s sees nothing like it. It is the exact opposite of what one would normally expect as deposit rates rise. And yet this year needs to see an even bigger such shift if private investors are to absorb the $1tn global hole left as central banks reduce their purchases.

Perhaps the strong start to the year will encourage just such buying on the part of investors. And in €, at least, negative deposit rates will continue to be an incentive for a good while yet. But despite the recent drop in correlations, our instinct remains that markets remain deeply interlinked across both assets and across geographies – meaning that the Fed’s rate rises have significance even in €, and the ECB’s and BoJ’s reductions in purchases have relevance for $ investors alongside the Fed. So while the signal from recent fund flows is undeniably positive, it will take more than just a good few weeks at the start of the year to convince us that 2018 as a whole will see a continuation of this raging bull market." - source CITI

As we posited at the start of our conversation, from a Lindemann criterion perspective, melting up might be expected with such strong inflows into various asset classes, particularly in credit. That simple. Melting is indeed a gradual process, particularly for our credit frog but it seems our central banker are using a pressure cooker, which is interesting because by pressurizing the vessel, they are able to produce much more heat than the boiling point of water, and still have water (inflows) present but we ramble again...

"When the water starts boiling it is foolish to turn off the heat." - Nelson Mandela

Stay tuned ! 

Macro and Credit - Narrative paradigm

"The first step towards philosophy is incredulity." - Denis Diderot, French philosopher

Watching with interest hard data becoming softer with the latest weak US CPI (-0.3%) and disappointing retail sales falling by 0.2% (0.1% fall expected), when it came to choosing our title analogy we reminded ourselves of the Narrative paradigm, a theory proposed by 20th century scholar Walter Fisher. It stipulates that all meaningful communication is a form of storytelling or reporting of events. It promotes the belief that humans are story tellers and listeners and are more persuaded by a good story than by good argument. Because of this, human beings experience and comprehend life and financial markets as a series of ongoing narratives, each with its own conflicts, characters, beginning, middle, and end. In his theory Walter Fisher believed that all forms of communication that appears to our reason are best viewed as stories shaped by history, culture, and character. The ways in which financial pundits and the Fed have been selling us the "Trumpflation" and "recovery" story justifying the hikes in interest rates have more to do with telling a credible story than it does in producing evidence or constructing a logical argument we would argue, hence our chosen title. These pundits, like the Fed are essentially storytellers and each individual chooses the ones that match his or her values and beliefs. Obviously, the test of the narrative rationality is based on the probability, coherence, and fidelity of the stories that underpin the immediate investment decisions to be made. Unfortunately, these "Jedi tricks" do not function well with us. We must confess that we never bought the strong dollar narrative story that everyone piled into. As of late, the latest raft of hard US macro data has pushed us to revisit a US long duration exposure. It seems to us that US GDP for Q1 2017 is going to be most likely more disappointing than Q1 2016, therefore we have gone with the narrative rationality of MDGA (Make Duration Great Again) from a tactical perspective but we ramble again...

In this week's conversation we would like to look at 

Synopsis:

• Macro and Credit - Foreign bonds allocation - Are the Japanese back in town?
• Final charts - Credit, the only easy day was yesterday...

• Macro and Credit - Foreign bonds allocation - Are the Japanese back in town?

At the end of March in our conversation "Outflow boundary", we argued that it was important to focus on what our Japanese friends such as GPIF, Lifers and Mrs Watanabe were doing in terms of foreign bonds allocations.  At the time we also added:

"The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment" - source Macronomics, March 2017

We also note that our tactical bullish US long bonds allocation since our recent post was validated:

"Now, if US long bonds yields such as 30 years continue receding, then indeed our contrarian stance of once again dipping our toes in long duration exposure (ETF ZROZ - TLT) and adding to Investment Grade credit with higher duration as well could be tactically enticing. We are watching closely the 3% level on the 30 year." - source Macronomics, March 2017

With the 30 year US bonds now at a yield of 2.89% supported mostly by geopolitical woes in conjunction with recent weaknesses in hard data such as CPI and retail sales. As we pointed out in our recent musings including our most recent one, we were eagerly anticipating a return of the Japanese investment crowd in US Treasuries and US credit thanks to an improving cross-currency basis. We also highlighted last week that European domiciled accounts had been front-running the Japanese investment crowd, which has now entered its new fiscal year. The big question one might ask in the current "Narrative paradigm" is as follows: are the Japanese back in town when it comes to their foreign bonds purchases?

One clear trend seen in recent years has been Bank of Japan's QE programme between December 2012 and June 2016 which has enticed large inflows into the US bond markets as displayed in Nomura FX Insights note from the 10th of April entitled "Where has the ECB QE Money gone":

- source Nomura

Is this time going to be different? We wonder. There is currently a clear avoidance in terms of allocation by the Japanese investment crowd for French Government bonds given the looming French elections. There is as well prevailing uncertainties from the new US administration when it comes to fiscal policies. What appears to be the case is that the current level of uncertainties is clearly slowing the return of the Japanese crowd this time around.

Also, the recent bout or "risk-off" with USD/JPY trading through the significant 110 level is somewhat probably dampening the velocity in the return of this specific investment crowd. On this subject we read with interest Bank of America Merrill Lynch Liquid Insight note from the 13th of April entitled "New fiscal year, new flow":

"New fiscal year, new flow

Japan entered the new fiscal year this month. Last week, we argued JPY strength may be overdone and that the USD/JPY’s medium-term uptrend has not ended despite a near-term possibility of further technical sell off through 110 where we stop out (Is JPY strength justified? 105 first or 117? 07 April 2017). In our view, global risk events may not fully explain the extent of JPY strength, and flow dynamics could have been behind the JPY strength. With new data from the balance of payment statistics, we argue the demand/supply balance of USD/JPY should be improving especially after an eventful April.

Japanese money in the new fiscal year

We have seen a notable slowdown in foreign securities purchases by Japanese investors since the US election in November (Chart of the day).

The slowdown probably reflects position unwinding among bank accounts and a wait-and-see stance among the Japanese real money community amid a volatile Treasury market in the final months of the Japanese fiscal year (Chart 1-Chart 2).

Banks could continue to unwind Treasuries, but it would involve little FX impact as they usually fund these investments in the USD, unlike real money accounts we discuss below.

Lifers – more USD buying

There is a seasonality of increased foreign bond purchases by insurance accounts during the early part of Japanese fiscal year. This year, we observe (1) rising yields in the JGB’s super long sector, but still at a relatively low level; (2) lower FX hedge cost; and (3) higher US yields, and (4) a lower USD/JPY (Chart 4).

True, it is unlikely they would be very aggressive in unhedged foreign bond investments as investors would balance across JGBs, hedged foreign bonds, and unhedged foreign bonds. For now, the USD/JPY at 110 may not attract strong demand, but we believe the USD demand will increase in the next few months once we go through April full of risk events or if we get renewed optimism for the US tax reform.

Trust accounts – market stabilizer

Trust accounts continued to sell rising assets and buy falling assets last quarter as the GPIF portfolio has presumably been close to its target for some time (Chart 5).

Going forward, a traditional risk-off market, as we currently observe, would likely be met by selling of domestic bonds (and potentially foreign bonds) and buying of domestic and foreign equities by pension funds. Reflation trade would be met by selling of foreign and domestic equities and buying of foreign bonds (and potentially domestic bonds) by pension funds.

Exporters’ hedging

Another source of the earlier USD/JPY weakness may have to do with Japanese exporters’ hedging activity into the fiscal year-end. Japan’s trade balance has been rising in light of stable oil prices and rising real exports (Chart 7).

There is a possibility the final months of the fiscal year generated additional USD selling.

As FY17 starts, we think corporate hedging should be more orderly, unlike last year. According to the BoJ’s tankan survey, large manufacturers had assumed an average USD/JPY rate of 117.5 heading into FY16, while the year actually opened at 112s, which led to a severe USD selling pressure last April, in our view (Revisiting the dollar’s 100 yen scenario 07 April 2016). This year, corporates assume an average USD/JPY rate of 108.4 (Chart 8).

Though this may suggest some near-term pressure, the assumption itself seems conservative, in our view. While the improving trade balance may support the JPY over the medium-term at margin, we believe corporate USD selling will be spread out and less intense this year." - source Bank of America Merrill Lynch

Whereas the Narrative paradigm has been so far seen in renewed optimism for US tax reform, the latest raft of hard data makes us wonder how many weeks before we seen again "Bondzilla" the Japanese NIRP monster's appetite return. Our current stance, given the weaker tone in both geopolitical rising tensions in conjunction with a much softer tone in hard data, has pushed us, was we indicated earlier on in our conversation to play the duration game again, in effect front-running the Japanese investment crowd before they are back in town, yet this time around in 2017 with a delay we think. On that point we agree with Bank of America Merrill Lynch's conclusions:

"Flow in the new fiscal year will likely put widening pressure on JPYUSD basis but the magnitude will be less this time

As highlighted above (and here), lifers are expected to start investing in foreign bond markets after the French election, but in the early part of the Japanese fiscal year. Lifers’ outward flow usually pushes JPYUSD basis wider as they try to hedge FX risk. This will likely be no different this time, but we expect the widening pressure will be less and it would be difficult to see JPYUSD basis go wider to last year’s level. At the current level of USDJPY, lifers will be more open to keep their foreign bonds unhedged and some of the contributing factors to the tightening of USDJPY basis since the start of the year are structural." - source Bank of America Merrill Lynch

No doubt the Lifers will come into play in terms of their foreign bonds allocations, and this will also have some impact in the already volatile USDJPY currency pair. What is of interest of course, when it comes to the "Narrative paradigm" is that there are already early signs of the Japanese investment crowd dipping their toes back into foreign bonds as indicated by UBS in the Global Rates Strategy note from the 10th of April entitled "What Japanese Investors Are Buying":

"French bonds overtake US Treasuries as main force behind Japanese selling Japanese investors' post-US presidential election trend of considerable net selling of overseas bonds continues. Weekly flow data underscores how Japanese investors sold ~¥5.4 trillion of foreign bonds from the time of the election to the end of Mar-17.
Today's more granular data release of which individual sovereign bond markets were bought and sold in Feb-17 highlights that French bonds have overtaken US Treasuries as the main force behind the overall selling pressure. This suggests that political risks as of February overshadowed the increasingly attractive currency-hedged pick-up over JGBs offered by French bonds. Separately, we note that the last week of Mar-17 saw the largest net purchases of overseas bonds in six months. However, as this follows the typical pattern around Japan fiscal year-end (.Figure 4), we would caution interpreting this as a sign of a sustainable rebound in Japanese demand for overseas bonds.

 - source UBS

While, yes it might be seen as too early to embrace yet the "Narrative paradigm", in the light of the recent weakness in both the US dollar and hard macro data, we would rather be a little bit early and start tactically adding at least on the long end of US Treasuries, rather than wait for additional signs from the Japanese investor crowd. Some says fortune favors the brave, we would posit that in most occasions it favors the bold contrarian but we ramble again here.

Finally, for our final charts below, as we posited in previous conversations, when it comes to the situation in credit and in particular in 2017, we would rather go for US credit, given it seems to us that Euro High Yield is "priced to perfection" and when it comes to US High Yield we closely follow what oil prices are doing and much less sanguine than we were back at the end of 2015. Yes, the credit cycle seems to be turning, but, it is slowly turning.

• Final charts - Credit, the only easy day was yesterday...

Whereas the second part of 2016 saw a very significant rally in general for US High Yield and in particular for the US energy sector, the rally so far this year has been significant as well, making us wonder if there is any "juice" left given the performance so far. Yet something we would agree with Barclays from their Global Strategy Chart book from the 10th of April is that when it comes to credit we would favor US Investment Grade over Euro Investment Grade. On top of that agreement we also think that, when it comes to credit overall, the only easy day was yesterday:

"Credit was strong in 2016n but easy gains likely behind us" - source Barclays

As we pointed out, foreign demand remains key to not only US credit but as well for US Treasuries, so overall, let's see if indeed the Japanese Investment crowd and Bondzilla the NIRP monster find again their appetite while the "Narrative paradigm" surrounding the "Trumpflation" story fades away.

"Skepticism is a virtue in history as well as in philosophy." -  Napoleon Bonaparte

Stay tuned!

Macro and Credit - Mexican divorce

"Friendship is the marriage of the soul, and this marriage is liable to divorce." - Voltaire

Watching with interest Theresa May the Prime Minister of the United Kingdom triggering the article 50, therefore putting in motion BREXIT, when it comes to our title analogy we reminded ourselves of the Mexican divorce. In the 1960s, some New-Yorkers used to travel to Mexico to obtain a "Mexican divorce". At the time, a divorce in Mexico was easier, quicker, and less expensive than a divorce in much US States. It is also mentioned in Jack Kerouac's famous book "On the Road" and often referred to as a "quickie Mexican divorce". Mexico doesn't require spouses to be present at a divorce hearing as they can send a lawyer to represent them. This "fast-track" process differed very much with the American divorce procedure which can be cumbersome to say the least. In the 1970s though, in accordance to Mexican Federal law recommendation, many courts stopped accepting divorce petitions from non-residents. With the advent of no-fault divorce in the United States, obviously Mexican divorces became much less popular as a result. On a side note, "No-fault divorce" is a divorce in which the dissolution of a marriage does not require a showing of wrongdoing by either party and without requiring the petitioner to provide evidence that the defendant has committed a breach of their marital contract. What is of historical intellectual curiosity to us is that the first modern no-fault divorce law was enacted in December 1917 during the Bolshevik Revolution given marriage was perceived as a "bourgeois institution". Also, the state of New-York in August 2010 was the last state to pass no-fault divorce law. It remains to be seen if BREXIT will entail down the line the implementation of additional "no-fault divorce" for additional European countries seeking their exit from a much flawed currency union but we ramble again...

In this week's conversation we would like to look at the prospects and risks for credit in Q2 2017. 

Synopsis:

• Macro and Credit - That late 2006 feeling for credit
• Final charts - Get ready for the Boomer slowdown

• Macro and Credit - That late 2006 feeling for credit

Q1 was clearly a continuation of "risk-on" thanks to the Trumpflation trade initiated in November, with Emerging Markets (EM) racing ahead when it comes to equities. Clearly the big loser was the long US dollar crowded traded and we saw gold making a comeback as of late. In the credit space, EM and High Yield continued their race ahead, moving closer to being priced to perfection. Yet, it feels that we are indeed moving closer towards the highs in the current tight spread environment from a credit perspective, hence our late 2006 feeling towards the asset class as a whole. As we posited in a previous conversation we continue to feel that 2017 could play out as a reverse of 2016, namely that the disappointment could come in the second part of the year, contrary to what played out in 2016 with a spectacular rally in US High Yield in the second part of the year. One thing for certain, is although this credit cycle appears to be somewhat longer than usual, technically, credit continues to be well bid thanks to a strong demand for yield products in conjunction with plentiful of supply. For instance, inflows, in Investment Grade credit continue to be strong, while in High Yield, the recent weakness manifesting itself with outflows has somewhat waned, As we argued in our conversation last week, given April is the new fiscal year in Japan, thanks to a better cross-currency basis, we could see a return of the Japanese Lifers in the foreign bonds market, at the time where core inflation is receding, making yet another compelling support argument for US Investment Grade credit, providing higher yields relative to Europe. While there might be hopes for a Mexican divorce when it comes with European politicians' woes relating to BREXIT and much uncertainties building up in the face of upcoming French elections, there is still room for some additional compression à la 2006, but not much left for the global yield hunters. On the subject of the on-going bull market for credit we read with interest Bank of America Merrill Lynch's take in their Credit Market Strategist note from the 31st of March entitled "Lower foreign core inflation=better sleep":

"Lower foreign core inflation=better sleep.

Our view continues to be that the biggest longer term risk for the bull market in high grade credit spreads is upside to foreign core inflation as that would re-price foreign central bank accommodation – particularly the ECB and BOJ. Such scenario could lead to significant compression between US and foreign yields, which would threaten the foreign inflows - that buy close to 100% of net supply in our market - and lead to a rates shock domestically and large outflows. However, this risk no longer keeps us up at night as there is not a trace of acceleration in core inflation to be found in Europe or Japan.

Quite the contrary was today’s disappointing 0.7% YoY reading on Eurozone core CPI inflation for March, down from 0.9% the prior month. For context the all-time low was 0.6% in 2015, a reading eerily similar to where we are today.

Happy New (fiscal) Year.

April is the start of the new fiscal year in Japan. It is also the time of the year where Japanese insurance companies significantly increase their purchases of foreign bonds, including corporate bonds. Most Japanese investors hedge FX risk using rolling 3-month forwards. Adjusted for these hedging costs, USD credit continues to offer higher yields relative to their EUR denominated counterparts - although less so than a year ago. Combined with bigger size, stronger liquidity and less political risk this suggests that the USD corporate bond market should continue to attract the majority of the Japanese demand for foreign bonds.

1Q=Excess demand.

Much focus this year has been on the record high grade new issue supply volumes –$401bn in 1Q, or $38bn (10%) higher than in the same quarter last year. However, arguably the bigger story is the surge in demand, as we forecast a record $80bn inflow to high grade bond/ETFs in 1Q, or an even bigger $66bn increase over the same period last year.

Excess demand for corporate bonds is the main reason why credit spreads have tightened 8bps this year to 122bps. Going forward we expect strong demand and a slowdown in supply – i.e. continued excess demand – and another 17bps of spread tightening to 105bps by year-end.

See it twice and it’s a pattern.

Much attention this week was devoted to the lack of buying and even selling of 30-year corporate bonds in the overnight market. However, since we saw the exact same pattern during the same week last year this could be a repatriation-related seasonal associated with the March 31st end of the Japanese fiscal year. That is our best guess. It could also be exhaustion in Taiwan after the insurance companies have bought $19.7bn of mostly 30-year paper in the in USD Formosa market - a 54% increase over the same period last year. If overnight buying of the back-end does not resume on Monday it was probably the latter story as Taiwanese markets are closed Monday and Tuesday next week." - source Bank of America Merrill Lynch

Overall in the credit space it's difficult to be "bearish" in an environment very similar to what we experienced first end in late 2006. There is continuous pressure on yields, thanks largely to strong demand and inflows. While we do remain for the time being "Keynesian" as the "animal spirits" continue to chase yield, we remain over the medium term more "Austrian" and very wary of the slowly but surely turning credit cycle as the Fed turns up the pressure to financial conditions with its on-going tightening bias. Relating to our reminiscence of 2006, we read with interest JP Morgan's Global Strategy note from the 30th of March:

"A look back at 1Q17 - what were the biggest surprises; a look forward to 2Q17 - what are the risks

Back in 4Q16 when thoughts first turned toward the outlook for the coming year, the mental playbook for 2017 was for something like 2005 through 2006. That is, a relatively low volatility environment where credit spreads mostly moved sideways-to-ground-tighter; where there was some compression; and where the synthetic structured credit bid of the 2005-06 period substituted for today’s central bank purchases.

To-date, this thesis seems to have been largely well-founded. Even when stocks recently traded lower and there was much talk of a more meaningful correction and the end of the reflation trade, credit spreads proved to be relatively resilient, with the possible exception of North American High Yield. Perhaps this reflects that calling the end of the reflation trade has been relatively consensual ever since the election of the New Administration in the US, such that positioning in global credit markets has never really been over-extended. Everyone’s been looking for the proverbial bogeyman for some time.

Back to our original 2017 investment thesis: if we really think 2005-2006 is the parallel period for today’s credit market environment, then it matters whether we think we're in 2005 or have migrated into 2006. 2005 was followed by 2006, i.e. more of the same. 2006 was, of course, followed by 2007 and we all remember what happened then!

Indeed, there are some interesting parallels, explicit and implicit, which can be drawn between the credit market environment today and the run-in to 2007. Firstly, in High Yield: Attack of the Loans, 22 March, Daniel Lamy highlighted how first-lien leverage in the loan market has risen to new highs, though a differentiating factor between today and late 2006 through early 2007 is a much lower level of end-investor leverage.

Secondly, how should we assess the market impact of any tapering by the ECB (and possibly the BoJ) if we regard this as the current day analogue of the structured credit bid going into reverse? J.P. Morgan's European Economics team expects the ECB to start tapering its asset purchases in 1Q18, with the likelihood that this is flagged at some point through 2H17. To the extent the announcement of CSPP last March impacted credit spreads globally, this could be significant." - source JP Morgan

From our perspective, we think, the current period is more akin to 2006, given how fast credit has tightened under the "Trumpflation" trade. While the recent weakness we have seen when it comes to US High Yield has been coming from the renewed pressure on oil prices since the beginning of the year. On this very subject we agree with JP Morgan's take when it comes to US High Yield:

"US High Yield

One of the key risks for high-yield investors in 2Q17 is the uncertainty surrounding Oil prices amid abundant supply and uncertainty ahead of a 5/25 OPEC decision to extend production cuts. Oil prices are off more than 10% versus the February high, and a key component for the high-yield outlook going forward is the forecast for tighter balances and higher prices into the summer months. While we are not worried about mid-$40 Oil prices, something much lower would likely prove disruptive. WTI Oil prices of $40 or below would likely not only disrupt the elevated level of complacency around credit risk, but probably more so, would translate into higher equity volatility and disrupt capital market activity.

The second risk for high-yield investors as we embark on 2Q17 is the current level of complacency around interest rates. At the March meeting, the Fed delivered a dovish hike when the Committee left its interest rate “dots” unchanged for 2017. 10-year US Treasury yields are now down 25bp since, which is providing a demand boost for higher quality credits. Should Treasury yields resume a climb above the prior recent high (10yr 2.65%) in response to a more hawkish central bank narrative, demand for high-yield credit would suffer. Recall, the bulk of the $7.1bn of retail outflows in March occurred alongside the rise in Treasury yields ahead of the Fed

Biggest surprise of 1Q17

The biggest surprise for us in 1Q17 was simply how well the market performed in January (+1.29%) and February (+1.42%) following a solid December (+2.20%). For context, the high-yield market had provided investors with gains in 12 of the past 13 months before March’s correction. And high-yield bonds yields had declined comfortably beyond our target by early March (5.95% actual versus 6.50% target) after residing above 7.00% in mid-November. Of course, driving these benign conditions were a number of factors. For one, Oil prices rose to a multi-year high by the end of February before sliding throughout March. Second, US Treasury yields defied consensus and declined throughout much of the quarter, despite optimism surrounding Trump’s pro-growth agenda. Third, stocks rose to a record high and volatility approached a record low. And lastly, overseas demand for $-based credit assets exceeded our expectation amid a continued dearth of alternatives. The byproduct of all of this: HY new-issue volume has positively surprised us, driven predominantly by a wave of refinancing activity." - source JP Morgan

Currently the aggregate signal we are getting from the tool DecisionScreen remains bullish US High Yield with a Sharpe Ratio of 2.11 since inception. This aggregate rule comprises the following input, BB Financial Conditions Index US (3M Z-Score), US Budget balance (Level), G10 Economic Surprise (5Y Z-Score) and finally US Government Bond 10 year yield (1Y Z-Score):

- source DecisionScreen

It remains to be seen how long US High Yield maintains its elevated valuation level. This of course, is depending on the trajectory that will be taken by oil prices in the second quarter. As far as US High Yield and the S&P 500 are concerned, correlation between both asset classes remain very strong as per the below chart from MacroCharts.pro we also used in our last conversation:

- source MacroChart

Correlation 0.987, R2 0.974 on both asset classes. We shall see how the relationships evolve during the second quarter of this year. We do feel valuations for both US equities and European High Yield are stretched though. Probably from an allocation perspective, European equities versus US equities remain more favorable while US credit is still more enticing than European credit from a valuation perspective we think.

From a yield perspective, given the on-going financial repression still going on in both Europe and Japan, US Investment Grade remains still enticing thanks to strong technicals yet, it remains to be seen how the scenario for risky assets is going to play out during in the second quarter. For US High Grade, we read with interest JP Morgan's case given we expect Japanese to be attracted again to the asset class in the near future:

"US High Grade

Our current YE forecast is 140bp, just a few basis points tighter than the current level. When the forecast was developed in November 2016 spreads were at 160bps; the post-election rally brought them most of the way towards our YE17 target. While we are comfortable that the current level of UST yields, US growth and bond supply is consistent with our YE spread target, if growth accelerates and/or UST yields rise meaningfully, this is likely to support lower spreads.

A more bullish scenario of strong growth and higher UST and European yields would be positive for spreads for both Technical and Fundamental reasons. Note that JPM’s US 10yr YE17 yield forecast is 3.00% and Bund forecast is 0.90%. Higher UST yields would be bullish for both US and European Financial issuers as it would improve interest earnings. Financial issuers represent 30% of the USD HG credit market and a rally in this sector would be supportive of the index. It would also be supportive for technicals, as there is a strong negative correlation between UST yields and bond spreads in the long end of the curve. This is because higher 10yr and 30yr UST yields tend to attract more buying from pension funds, insurance companies and sovereign wealth funds. Under the bullish macro case described above, we see HG bond spreads reaching 125bp, close to the post crisis peak of 122bp reached in June 2014.

A more bearish economic outlook would have the opposite effect. A mildly bearish scenario with lower growth, lower UST yields and presumably lower oil prices as well (JPM’s YE Brent forecast is $48/bbl) would lead to wider spreads. Energy issuers represent 10% of the HG bond market and they would contribute to wider spreads. Also, Financial issuers and long end bonds would likely widen with lower UST yields. We would expect spreads to reach 160bp under the mildly bearish scenario. A recession scenario would lead to much wider spreads. Given the rise in leverage over the past few years for HG issuers, a recession would likely lead to more downgrades to HY. UST yields would fall further, contributing to wider spreads as well. In February 2016, when recession fears were high, the US HG bond market spread peaked near 250bp, and we would forecast a similar result when/if the next recession occurs." - source JP Morgan

No doubt those exogenous factors such as a different expected outcome at the end of April for the French presidential elections could put a spanner to the continuous grind tighter in credit spreads. Oil as well remains a dominating factor when it comes to assessing the potential for further weakness in US High Yield.

On a side note and in relation to the dangers of "exogenous" factors, back in February 2016 in our conversation "The disappearance of MS München", we mentioned "rogue waves" akin to exogenous factors, that sunk the MS München, a 261.4 m German LASH carrier in December 1978.

Last Friday a 266,000 ton South Korean bulk carrier called Stellar Daisy, a Very Large Ore Carrier (VLOC)  disappeared off the coast of Uruguay en route from Brazil to China, hours after issuing a distress signal. The Marshall Islands-flagged vessel measured 323.86 in length and had a beam of 58 meter. In this case we are talking about a huge ship. While in that specific case, it doesn't look a "Rogue Wave" was involved, it seems probably, the very large vessel had some structural damage with cracks in hull. Though when did those cracks or crack appear, is unknown, in similar fashion we do not know, what exogenous factors will trigger, cracks in the credit cycle, yet, normalization in the Fed's monetary policy is akin to tightening financial conditions.

In the case of Stellar Daisy, ensuing water ingress during voyage, which in itself, wasn’t deadly, most likely caused liquefying, cargo shift, developing 15 degrees list and finally, fatal disaster.  There are reports of iron ore sinter feed (or sinter feed) shipments from Brazilian ports, including Ponta da Madeira, Tubarao and Itaguai, liquefying en route. Liquefaction of mineral ores, resulting in cargo shift and loss of stability, has been a major cause of marine casualties for many decades. In cargoes loaded with a moisture content in excess of the Flow Moisture Point (FMP), liquefaction may occur unpredictably at any time during the voyage. Some cargoes have liquefied and caused catastrophic cargo shift almost immediately on departure from the load port. some only after several weeks of apparently uneventful sailing. While the risk of liquefaction is greater during heavy weather, in high seas, and while under full power, there are no safe sailing conditions for a cargo with unsafe moisture content. Liquefaction can occur unpredictably even in relatively calm conditions on a vessel at anchorage or proceeding at low speed.

To end our side note, we believe that liquefaction and "liquidation" in financial markets can occur unpredictably in relatively calm market conditions and during low economic growth periods like ours, particularly with the rising appetite in the retail space for passive investments such as ETFs.

Whereas "Trumpflation" and "reflation" have so far been the "trade du jour", there is we think still considerable deflationary forces at play is this low yield, low growth environment. One of these forces, is clearly the growing cohort of Boomers in the United States which in many ways represent additional headwinds as per our final chart below for US consumption, still a hefty part of US GDP.

• Final charts - Get ready for the Boomer slowdown

The deflationary headwinds facing Developed Markets, while at bay thanks to the current "reflationary" trend have not disappeared. For instance, US GDP and its heavy reliance on consumption. Our final chart comes from Wells Fargo Economics Group note from the 24th of March entitled "Boomer Spending: Bracing for the Slowdown". This chart displays the spending by age bracket and illustrate the predictable pattern in consumption in again population over time, hence the deflationary headwinds it represents over time:

"Consumer Spending: Boomers Shift from Tailwind to Headwind

Spending follows a predictable pattern as consumers age. As earnings rise and families grow, household spending increases through middle-age before falling as the kids move out and the house (ideally) gets paid off. Over the past few decades, falling outlays among older households were
masked by the rising earning and spending power of the Boomers as they entered their prime working years. With adults age 65+ expected to rise from 20 percent of the adult population to 25 percent over the next 10 years, there is no offset to the slowdown in senior spending this time around.
More than three quarters of the Boomers are already over the age of 55, when household spending begins to decline (below chart).

With retirement age households spending 25 percent less than younger households, the aging of the Boomers stands to weigh on consumer spending, the powerhouse of the U.S. economy, in the years ahead. Spending could be hampered further in the near term if Boomer households try to shore up their retirement savings by putting more money away now, although this at least would limit the drag on spending further down the road.

What Areas of Spending Will Be Hit Hardest?

The degree to which businesses will need to brace for the spending slowdown as more Boomers reach retirement age varies by industry. Not surprisingly, one segment where spending rises with age is healthcare (out-of-pocket and government). In every other major category, however, spending among households over the age of 65 falls. Apparel, dining out and transportation (vehicles purchases, finance charges and gasoline) see the largest drop off, with average annual expenditures for households 65 and over falling by at least than one-third (below chart).

Discretionary Spending Pressured by Healthcare and Housing

But will Boomers spend the same way as older generations after turning 65? Healthcare looks set to account for a greater share of spending among Boomers than previous generations. Rising insurance premiums have more than offset out-of-pocket savings on prescription drugs due to Medicare Part D. Of course, a substantial share of healthcare spending is paid for by the government, and, with the rising number of beneficiaries, total healthcare spending is likely to remain one of the strongest segments of consumer spending in the years ahead.

Housing is also taking up a higher share of senior spending as more households reach age 65 without having paid off their home or are renting, leaving them exposed to future price increases (bottom chart).

In contrast, seniors are saving at grocery and clothing stores, helped by relatively low inflation in these categories the past two decades. This should limit the hit to discretionary spending, but won’t change the fact that Boomers will still be spending less overall, generating a drag on consumer spending." - source Wells Fargo

While the "Trumpflation" / "reflation" trade continues its course in both equities and credit as we enter the second quarter, it is clear to us that, structural issues such as the ability to spend by Boomers overall remains a clear long term headwind for the US economy as a whole but, as well for other similar Developed Markets (DM).

"The older you get the stronger the wind gets - and it's always in your face." - Pablo Picasso

Stay tuned!

Macro and Credit - Just Like Heaven

"The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of "private market value" as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism." -  Seth Klarman

Looking at the sudden jump in the Fed March hike probability concomitant with the "sucker punch" delivered in short order on Monday to the gold mining complex (making us reduce our exposure for the time being), while equities markets continuing their upward trajectory and credit their tightening bias, it made us wander this time around for our title analogy towards 1987 British band The Cure third single released and first American hit song "Just Like Heaven". Given the song is about hyperventilating and taking into account composer Robert Smith's childhood memories of mastering magic tricks, we are feeling impressed by the rapid move in markets from their hypomanic mood towards somewhat state of "euphoria" hence our chosen title. Whereas for the time being both flows and price action point towards a continuation of the rally, if indeed we are short term "Keynesian", we do remain, long term "Austrian" from a valuation perspective and that's just our "realistic bias".

In this week's conversation we would like to look at the sustainability of the rally particularly in credit from a flow perspective given in credit land since the beginning of the year and in particular High Yield, it feels "Just Like Heaven".

Synopsis:

• Macro and Credit - Tactically bullish, politically skittish
• Final chart - Global expansion? This time it's different

• Macro and Credit - Tactically bullish, politically skittish

When it comes to assessing credit, the ongoing rally in credit is supported by strong inflows into the asset class. What is questionable is the sustainable of the rally given its rapid advance. For instance, as displayed by Bank Of America Merrill Lynch from their most recent High Yield chart book for February, the year to date performance in credit and in particular US High Yield has been significant:

Cross-Asset Total Return Performance from 31st of December until 28th of February 2017 - Source Bank of America Merrill Lynch

What is of interest is that many sell-side pundits expect returns for US High Yield to be close to flat for the entire year. Yet, there has been a significant tightening in credit spreads on the back of strong inflows into the asset class as reported by Bank of America Merrill Lynch in their Follow The Flow note from the 3rd of March 2017 entitled "Reaching for yields continues":

"It’s all about rates

Lower front-end rates have been pivotal to support flows into credit to the detriment of flows into equities. Investors continue to favour short-duration high-grade paper to insulate against steepening of curves, while outflows continue from high duration pockets.

Over the past week…

High grade funds continued on a positive trend for the sixth week in a row; and recorded the highest inflow in three weeks. High yield funds inflows remained strong for another week, now counting 13 weeks of positive flows. Looking into the domicile breakdown, as charts 13 &14 show, even though European-focused funds recorded inflows, the majority of the inflow is concentrated in US and globally-focused funds.

Government bond funds flows went back to negative territory after a brief week of inflows. Money market funds weekly flows were negative for the third week in a row. Overall, fixed income funds flows remained strong and positive for the tenth consecutive week; with more than $30bn over that period.

European equity funds flows on the other hand moved back to negative territory after five weeks of inflows. The outflow from the asset class was the biggest in thirteen weeks.

Global EM debt fund flows continued on the positive trend for a fifth week, however we note a weakening of that trend recently. Commodities funds flow remained positive for a seventh week.
On the duration front, strong inflows continued in short-term IG funds for the 11thweek in a row. Mid-term funds’ flows turned slightly positive after three weeks of sizable outflows, while flows into long-term funds remained negative for a second week." - source Bank of America Merrill Lynch

So all in all, the technical support for credit in particular and risky assets in general, in this "risk-on" environment has clearly sounded "Just Like Heaven". But, according to Société Générale in their Credit Market Wrap-up from the 27th of February entitled "Why inflows into credit do not mean spreads will go tighter", they indicate that there is no guarantee this rally could continue and therefore the ongoing tightening of credit spreads is unsustainable:

"Market thoughts

We have been bearish about credit markets this year, and so far (despite a slight widening in spreads last week) we have been wrong. In The big hangover Part II, we outlined the reasons for concern. In The worst is yet to come, we reiterated why we thought rising government yields would eventually put pressure on credit markets. Yet it is clear that most market participants are a lot more bullish than we are.

Chart 1 shows the percentage moves in spreads since the US elections. Euro IG spreads are wider (though the move occurred in mid-November). Spreads are tighter in all other markets, with US high yield leading gains, EM (either high yield or investment grade) in second place, and Euro high yield tied with the US IG market over the whole period. Note that Euro HY gains have mostly taken place this year, while US IG gains principally happened in 2016.

One of the drivers of the good performance has surely been capital inflows. In their latest Mutual Fund & ETF watch, SG’s asset allocation team note a surprising shift in the flow of funds into credit. Between the end of January 2016 and October 2016, there was a startling 40 weeks of successive inflows into US investment grade credit funds, with inflows totaling some $77bn. Then came an equally consistent 11 weeks of outflows totaling more than $12bn. Since mid-January, inflows have returned; the $5bn inflows in early February were the highest since summer 2016 and indeed one of the highest weekly totals since the data began.

Are we back to a lasting period of inflows – and tightening spreads? Perhaps, but be careful, for the flow of funds into credit is not necessarily a good pointer for how credit spreads are going to evolve from here.

Chart 2 shows the three month total of inflows into USD IG credit (in blue) and the subsequent three-month change in spreads (in red). The correlation between the two is slightly negative; what’s more interesting, however, is to concentrate on the periods where flows sharply accelerated (which we have picked out in blue).

We note the following:

• In two of the five periods (4Q14 to 1Q15; 1Q45) rising inflows subsequently led to higher spreads.
• In three of the five periods (late 2013-early 2014; 2Q16; 3Q16) inflows led to tighter spreads but the tightening trend decelerated.

If the inflows into credit persist, then, this is not necessarily a good sign for the market: history would, indeed, tend to suggest the reverse, with inflows met by more supply, worsening credit metrics and eventually a widening in spreads rather than a tightening. Credit investors should be careful what they wish for from here on in."  - source Société Générale.

Yet, while credit is behaving "Just Like Heaven" thanks to the supportive background of strong technicals, as we mused out recently, early 2016 was very different in the sense that the first part of the year was plagued by "bad news" from the energy sector that spilled-over to other risky asset classes and ended up "good news" performance wise during the second part of the year. We believe that 2017 could be the reverse where "good news" (technicals and fundamentals), get impacted in the second part of the year by "bad news" (additional tightening financial conditions, credit cycle turning, rise of political risk, etc.). When it comes to US High Yield and "fundamentals", the picture in 2017 is completely different from 2016 as pointed out by Bank of America Merrill Lynch in their High Yield Strategy note entitled "Let's do the limbo" from the 2nd of March 2017:

"The HY rally continues

High yield spreads tightened another 26bps for a 1.21% excess return in February, the 8th consecutive month of spread tightening. Although all 18 sectors finished in the green, performance across industries varied with Health Care (+3.40%) and Telecom (+2.97%) leading all others. The former outperformed due to alleviated concerns surrounding changes to the ACA, while the latter delivered strong returns because of M&A speculation amongst two of the largest capital structures in the index (S and INTEL). On the opposite end of the spectrum, Energy was the worst performing industry with a +0.36% gain, just the 2nd time the sector has underperformed the overall index in the last year (Note: we lowered over view on Energy from overweight to market weight back in January). Although valuations have certainly become stretched across high yield as we are now just 39bps away from the post-crisis tights, we think this trend can continue (albeit more slowly) as it has come against a backdrop of improving fundamentals and a declining default rate, which we discuss below.

 Q4 fundamentals first take: sustained improvement

With roughly 70% of our HY universe having reported Q4 earnings, so far top and bottom line growth have continued to trend higher. Notably, HY revenue continued to improve for the 4th consecutive quarter; in fact, the current +5.0% growth represents the first YoY increase since Q4 2014. The same story holds true ex-Commodities, where revenue growth increased from +3.3% in Q3 2016 to +5.7% last quarter. And because EBITDA growth outpaced modestly higher debt levels, leverage continued to decline while coverage ratios increased.

Although these figures remain better than their historical averages during ‘normal’ times, the recent trends should act as a token of optimism for investors. Within sectors, these preliminary earnings results show the strongest YoY gains in Gaming, Capital Goods, and Retail. On the other hand, Food and Health Care have experienced the largest deterioration in EBITDA on a year over year basis.

Default rate sees largest 1 month decline since 2010 

The US HY default rate fell from 7.06% last month to 6.11% today; this 95bp reduction is the largest 1 month change since August 2010, when the rate fell from 4.25% to 2.97%. There was a noticeable lack of filings last month, where for the first time in over 2 years there were 0 first time defaulted issuers1. However, also driving the default rate lower was the removal of February 2016 from the trailing 12 month rate, where we saw 10 unique issuers default. Although the reduction in Energy defaults is responsible for most of the decline, on an ex-Commodity basis the default rate still ticked lower, from 3.3% to 2.9%. These drops are consistent with our view for a lower default rate in 2017, where we expect the rate to decline to just 4.0% for US HY issuers and remain at 2.9% ex-Commodities. With just 5 defaults YTD, this would imply an additional 31 defaults in 2017 (20 ex-Commodities)." - source Bank of America Merrill Lynch

While looking at the High Yield default rate is like looking at the rear view mirror, the most noticeable change in terms of fundamentals between 2016 and 2017 has been EBITDA YoY percentage change as per the below chart from Bank of America Merrill Lynch High Yield chart book:

- source Bank of America Merrill Lynch

Some would rightly ask if this "Just Like Heaven" picture would be distorted by the Energy sector, it isn't as per the chart below:

- source Bank of America Merrill Lynch

What matters for default rate going forward is the evolution of lending conditions. As we have mentioned recently the noose is already tightening for Commercial Real Estate (CRE), but we have to see a meaningful deterioration overall, spilling over to the default rate as per the chart below from Bank of America Merrill Lynch:

- source Bank of America Merrill Lynch

Yet, while the picture seems rosy, in fact "Just Like Heaven", given our fondness for monitoring credit conditions to assess the credit cycle, we have noticed that since the beginning of the year in the US Commercial and Industrial Loans (C&I) have turned "South". The chart below from Bank of America Merrill Lynch illustrates the latest trend:

- source Bank of America Merrill Lynch

Given C&I loans are strongly related to what the "real" economy does, this warrants we think close monitoring in the coming months, to assess if it is only a short blip or if there is indeed something more sinister going on (slowing credit growth).

While markets so far seems oblivious to political uncertainties building up and remain tactically bullish, political uncertainties particularly the mess in France could throw in short order a spanner in the works, hence our cautious "optimism" or short term "Keynesian" bias. In relation to French elections and us being French we would like to give you our opinion on the matter. After all, we got Trump and Brexit right in 2016, but, when it comes to having a clear view on the outcome, we must confess we do not have one. It is probably the first time since 1958, that French elections represent such a "known unknown". One would think pundits would have learned from making inaccurate predictions after an eventful 2016 which saw BREXIT, Trump's elections and the Italian referendum. The odds of Marine Le Pen upset in the second round has to be taken into account, particularly given that the second round occurs on Sunday 7th of May and the Monday is a holiday. People might decide they have other things to do than show up at the poll stations. Bear that in mind. Whoever gets elected on the 7th of May doesn't resolve the uncertainty for France given that a month later you get the parliamentary elections for the national assembly. All in all, France is a very big mess. 

As things stand, global expansion in this particular credit cycle has seen volatility subdued, but, given the gradual pull back from accommodation from central bankers, one would think there is a heightened probability in seeing a regime change in terms of volatility regime. We think the second part of the year could mark this change. In our final chart below, we will briefly discuss the relation between global expansion and lower volatilities.

• Final chart - Global expansion? This time it's different

Though the macro data seems to be pointing towards an acceleration in global expansion, volatility continued to be subdued, yet political uncertainties keep rising on a daily basis. Our final charts comes from Nomura FX Insights note from the 3rd of March entitled Le Pen and the lessons learnt for FX Vol" and shows that global expansion has led to lower volatilities, yet this expansion, in the ongoing credit cycle has been very different from the past:

A global expansion has historically meant lower FX vols overall, but ending unconventional monetary policy could be the exception to the rule
Historically, when we have entered into a global expansion phase as we expect (see Catch-up expectations and Back to boom/bust?), we tend to see FX vols head below their long-term averages (see The Great Moderation of 2014).
While this is perhaps true for equity vols, it could be different this time for rates and therefore FX vols. The US expansion is entering its seventh year of growth, which is already the fourth-longest expansion we have seen since the late 1940s (Figure 1) and on some metrics is looking rather mature already.

Big questions remain on the outcome of the geopolitical risks, but also what impact on markets the years of unconventional monetary policy will have when it comes to an end. We studied the impact of the zero lower bound (ZLB) on fixed income and what happens at times of lift-off, where we found term premia in fixed income markets can increase in a non-linear fashion (see Lift-off, term premia and exchange rates). With the risk of a sudden non-linear increase in interest rates as the ECB and other central banks look to exit unconventional monetary policy the “post Trump” sell VIX / Buy MOVE trade still looks like it will remain at high levels (even though we already hit our target, see Top Trump Trades).
So while equity markets continue to exhibit strong optimism for global growth, in fixed income it may not be such a smooth ride, given the removal of monetary policy stimulus, which could also have a feed-through impact on FX vols on a general basis." - source Nomura

When it comes to changes in the volatility regime, for now it's "Just Like Heaven", but, maybe the road to hell is paved with European elections? Who knows...

"Fragility is the quality of things that are vulnerable to volatility." -  Nassim Nicholas Taleb

Stay tuned!