Macro and Credit - Stalemate

"In life, as in chess, forethought wins." - Charles Buxton, English public servant

Watching with interest the outcome of the US midterm elections in conjunction with a divided congress leading somewhat to a gridlock, as well as the tentative rebound in Emerging Market equities, when it came to selecting our title analogy, we decided to go again for a chess analogy on this very post (see previous chess analogies: "Zugzwang", "The Game of The Century"). "Stalemate" is a situation in the game of chess where a player whose turn it is to move is not in check but has no legal move. The rules of chess provide that when stalemate occurs, the game ends as a draw. During the endgame, stalemate is a resource that can enable the player with the inferior position to draw the game rather than lose. In more complex positions, stalemate is much rarer, usually taking the form of a swindle, a ruse by which a player in a losing position tricks his opponent, and thereby achieves a win or draw instead of the expected loss. A swindle in chess only succeeds if the superior side is inattentive. Stalemate is also a common theme in endgame studies and other chess problems. The outcome of the US midterm elections gridlock could create short term what we would call "Goldigridlock", namely a potential end to the bear steepening experienced during the jittery month of October and some restrain on the US dollar. In conjunction with the return of buybacks following the blackout period of earnings, then, this obviously could be bullish equities wise we think, with high beta pulling ahead until the end of the year. For credit, we are not too sure, given a fall in oil prices with definitely put pressure on the high beta CCC bracket of US High Yield and its well documented exposure to the energy sector but, we ramble again...

In this week's conversation, we would like to look at what the US midterm election stalemate entails of asset prices in general following a very much "red October".

Synopsis:

• Macro and Credit - Goldigridlock for asset prices? 
• Final charts -  The invisible hand is fading...

• Macro and Credit - Goldigridlock for asset prices? 

The month of October was clearly a bloodbath for many asset classes and diversification didn't offer protection. While the velocity in real rates as we pointed out in our previous conversation forced a serious repricing of the Fed "put" at a much lower strike, the fact that it was a blackout period thanks to earnings reporting season and lack of buybacks, being another strong pillar in US equities rally seen in recent years was enough to wreak havoc on global markets on the back of weaker US equities. Looking at the below performance chart from Bank of America Merrill Lynch for the month of October can clearly see that, indeed, “misery loves company”:

- source Bank of America Merrill Lynch

As we pointed out in our final chart in our mid-October conversation "Under the Volcano", 2018 has marked the return of large standard deviations move, typical of late cycle behavior in conjunction with rising dispersion. 

What we also find interesting (H/T Driehaus on Twitter) is that 89% of asset classes tracked by Deutsche Bank have a negative total return YTD in USD terms. This is the highest percentage on record since 1901. Last year just 1% finished without negative total return:

- source Deutsche Bank - Driehaus Twitter feed

2018 is indeed a year where volatility and large standard deviations move have staged a comeback as the US Federal Reserve is trying to exit the stage with its Quantitative Tightening policy (QT) and its continuing hiking process. US Employment and wage growth likely to trigger another hike in December from the Fed. That’s a given. Total nonfarm payroll employment increased by 250,000 in October vs. 190,000 expected. Over the year, average hourly earnings have increased by 83 cents, or 3.1 %. Fed will remain hawkish.

With the "Stalemate" with the latest US midterm elections, what are the implications for asset prices, one might rightly ask?

First thing we would like to look at given the recent bounce from Emerging Market equities with Brazil leading ahead the bounce thanks to the hope brought by the presidential elections is the trajectory for the US dollar and what it means for "high beta". On that subject we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 7th of November entitled "Midterm outcome":

"FX: a split Congress is bearish USD, but downside could prove limited

As we have argued, tonight’s split Congress outcome should result in dollar weakening. We think this could continue for a while yet as the first order effects of US growth deceleration and increasingly-limited monetary policy support cause a reevaluation of long USD exposure. Ultimately, second order effects could limit USD downside; however, we think that markets are likely to focus on first order effects for now.

Initially, we expect a weaker USD predicated on a further softening in US growth leading to reduced monetary policy support. US growth deceleration from the 2Q high water mark should continue as intense political gridlock precludes new stimulus measures, putting the prospect of a Fed move beyond neutral in doubt for now absent convincing evidence of inflationary pressure. Indeed, our US economics team is forecasting a gradual US growth deceleration toward 2% (around potential) by the end of next year, alongside a largely-benign inflation profile. While a Fed move beyond neutral was never in the market (the Fed is still priced to end the cycle at around the long-term median dot of 3%), a move above neutral looks increasingly less likely given the new information set. Thus, interest rate support for USD looks asymmetrically skewed to the downside, and the market’s expectation for Fed hikes next year (currently about +50bp) is at risk of compression, in our view. Positioning is net long USD – particularly in the riskier parts of the FX spectrum (Exhibit 1).

Diminished rationale for USD longs and a potential relief rally in markets post-midterm resolution suggests liquidation flow driving USD lower. Finally, we would expect modestly higher USD risk premium – reflecting a state of political acrimony in DC – to provide an additional headwind to the dollar. That said, because the Senate has remained Republican-controlled, we do not expect a material spike higher in USD risk premium arising from the expectation that House leadership could successfully remove the President through impeachment.

Looking beyond the initial reaction, however, we think that potential second round effects could serve to limit USD downside. Successful resolution of the present state of global trade policy uncertainty has become more challenging, particularly if President Trump’s negotiating position has been weakened as we suspect may well be the case. To be sure, the evolution of global trade policy uncertainty is critical to the global economic cycle. Reduced prospects for a speedy end to this uncertainty, and indeed increased risks of further deterioration, add to downside global growth risk in our view. Although hardly a recession story, US deceleration represents a potential negative impulse to the already-sagging global economy. An increase in risk aversion as markets anticipate a global downturn could thus broadly support the dollar. Finally, on a brighter note, compromise on US economic stimulus later next year is possible due to potentially overlapping interests. Democrats seem to be advocating an increase in infrastructure spending, and the President may well seek to prime the economy in advance of his 2020 reelection bid. If ultimately successful, this should support USD as it could lead to a renewed bout of US cyclical and monetary policy divergence.

Historical parallels suggest gridlock is not always so benign

The consensus among investors is that a gridlock is a benign outcome for markets. We think this may be overly optimistic. In our view, the most relevant historical precedent for the next half year may be the months following the mid-term elections of 2010 that resulted in the same configuration in Washington as the latest elections (with the President’s party controlling the Senate but the other party controlling the House). In 2011, the Republicans, upon regaining control of the House, used the debt ceiling as a lever to demand budget reduction by the Obama administration. The brinksmanship that ensued raised concerns in the market of a possible default by the US government which led to a sharp sell-off in risky assets as well as a major rally in rates (10y Trsy yields falling from 3.7% in March 2011 to 1.8% by September). The USD came under considerable selling pressure during the same period as foreign investors avoided US assets (EUR/USD rose from 1.30 in January to 1.48 by July that year). The market turmoil around the US debt ceiling crisis probably exacerbated the Eurozone sovereign crisis that occurred later that year (which saw the euro surrendering all of its earlier gains).

With the House Democrats having stated their intention to open new investigations against President Trump and with the 2020 presidential election campaign kicking off very soon, we see greater chances of brinksmanship than cooperation. History suggests that brinksmanship could mean lower rates and lower USD." - source Bank of America Merrill Lynch

With growing downside risk for growth with a notable deceleration in Europe and in global trade, there is indeed potential scope for the US yield curve to start flattening again. A conjunction of a flatter yield curve would be positive for the long end of the US yield curve and a falling US dollar would enable Emerging Market equities to continue to rally in the near term we think.

Second point, the recent fall in oil prices is as well putting some pressure on US breakevens as of late, meaning that for now a scary inflation spike has been avoided but, nonetheless, healthcare inflation, namely acyclical inflation is something to monitor closely as indicated by Bank of America Merrill Lynch in their US Economic Viewpoint note from the 5th of November entitled "Inflation in pictures":

"No scary inflation monsters

• Procyclical inflation has moved sideways over the past year, despite the unemployment rate improving by half a percent to 3.7%. The muted inflation response highlights the flattening in the Phillips curve.
• In No fear of an inflation curveball, we evaluated whether there was a kink in the Phillips curve at full employment. We find some, but not strong evidence, and therefore believe a strong cyclically-driven breakout in inflation is unlikely.
• While procyclical inflation has been flat, acyclical inflation has picked up, healthcare in particular. We expect healthcare inflation to continue to accelerate, driven by hospital services.

• In No inflation monsters under the bed, we looked at the disaggregated PCE components and found that there was an increasing share of PCE that has moved into a “low inflation” (0-2%) bucket, and a dwindling share in the “high inflation” (5-10% bucket).
• This shift in inflation dispersion is illustrative of a structural move lower in inflation. A lower trend decreases the probability of an inflation breakout.
• Digging into the components, we found that healthcare services accounts for much of the shift. As healthcare inflation picks up going forward, we may see some reversal of the shift, albeit into the more moderate 2-5% inflation range.

• Another reason to expect only a gradual pickup in inflation is because of inflation expectations, which have drifted lower over the cycle and serve as an anchoring point.
• In particular, University of Michigan 5-10yr inflation expectations have descended to a trend of 2.5%. The central tendency has also consolidated closer to the median, mostly from the 75th percentile. This indicates a greater decline in those expecting high inflation.
• Given core inflation is likely to run above target by next year, inflation expectations could improve, presenting upside to the outlook. But even with some improvement in expectations, inflation upside would likely remain contained." - source Bank of America Merrill Lynch

In our recent conversation we hinted that housing was in earnest starting to turn "South" in the US and that housing affordability was becoming a headwind on top of US consumers using their savings and increasing their use of the credit card to maintain their consumption level. Both auto and housing, which are very cyclical in nature are clearly showing the late stage of the credit cycle in our book.  

One segment where spending rises with age is healthcare (out-of-pocket and government). Healthcare will 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. 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.  This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further:

- graph source Macrobond

Sure falling oil prices bring some relief to the US consumers but rising healthcare costs as well as housing costs will not be sufficient to offset the risk of "stagflation". We could see lower growth ahead and even looming recession risk.

As we pointed out in our recent conversation "Ballyhoo", 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.

As pointed out by Lisa Abramowicz on her Twitter feed, you need going forward to monitor closely in the months ahead the rise in inventory of new unsold homes:

"The inventory of new unsold homes in the U.S. has reached the highest level since 2011, as measured in months of supply. https://blogs.wsj.com/dailyshot/2018/11/07/the-daily-shot-the-inventory-of-unsold" - source Lisa Abramowicz, Twitter

In a response to Lisa's Tweet, M&G Bond Vigilantes made the following important point on Twitter:

"If you saw the Lisa Abramowicz tweet about inventory of new unsold homes reaching 7 months, you should worry. Historically that level is consistent with GDP growth of zero. This chart is from our 2007 blog."

- graph source M&G Bond Vigilantes - Twitter

Housing has always been a leading indicator in the United States when it comes to forecasting GDP growth.

To illustrate further the rift between Main Street's much more sanguine view of housing than Wall Street we would like to point towards Wells Fargo's take on the weakness in home sales from their Economics Group note from the 7th of November entitled "Home Sales Remain Soft":

"The Softening For-Sale Market Has Been Good for Apartment Owners

The magnitude and speed at which home sales have weakened is surprising, following just a three-quarter of a percentage point rise in mortgage rates. We suspect the problem is a lack of affordable product in the markets where potential home buyers would like to live. This helps explain why sales turned down well ahead of this fall’s rise in mortgage rates. The lack of inventory in desirable markets is a function of how highly concentrated economic growth has been in this cycle. Two industries, technology and energy, have accounted for a disproportionate share of job growth. While job gains have broadened more recently, a larger proportion of the high-paying, creative industry jobs are being added in submarkets closer to the central business district. By contrast, job growth in suburban markets has been slower to recover and wage gains have lagged for many occupations that are at greater risk of automation and outsourcing.

The rapid growth in higher value-added positions closer in to many major cities has fueled a housing crunch that has sent home values and rents soaring in many rapidly growing markets. The lack of developable lots closer in to the city has fueled growth of in-fill developments and teardowns, which have often removed more affordable homes from the market. The resulting battles over gentrification have also led to some political blowback, which has stymied development in some areas. Growth is also creeping back out toward the suburbs, particularly those that are developing their own urban cores. What has largely been missing, however, has been the push to develop exurban areas, where land has historically been less expensive. Such development has remained elusive, as higher development costs have largely offset any savings in raw land costs.

The same trends impacting home sales are evident in the rental market. Demand remains strong for amenity-rich apartments located near the city center or in the metro area’s second or third largest employment centers. Demand for apartments further out in the suburbs has taken longer to recover but has been doing better more recently, reflecting stronger job growth and an acceleration in wage gains. The suburbs have generally seen less development, so the improvement in demand has pulled vacancy rates lower and pushed rents higher. New suburban development remains elusive, however, and most new projects continue to cluster around pricier submarkets closer to the central business district.

We have further reduced our forecasts for home sales and new home construction following the recent string of weaker housing reports and downward revisions to previous data. We still see new home sales increasing over the forecast period but now look for just 5.6% growth in 2019 and 5.3% growth in 2020.

Much of that increase will come from more affordable homes in the South and West, which will restrain new home price appreciation. With little inventory, new home construction will continue to gradually edge higher. Apartment development is now expected to remain stronger for a little longer. There are a great deal of projects in the pipeline and a large number of proposed projects that have not yet moved forward. Demand for well located projects should remain strong, but vacancy rates will likely rise as job growth moderates in 2019 and 2020."  - source Wells Fargo

We do not share the optimism above relating to new home construction due to affordability issues coming from rising mortgage rates due to the Fed continuing its hiking path, their views being supported by the most recent employment report. Housing affordability has become a headwind, no wonder in some parts of the US prices are starting to cool down as indicated by Bloomberg on the 30th of October in their article entitled "Mortgage Rates Are Pushing U.S. Homes Out of Reach":

"While U.S. home prices have gained almost 60 percent since March 31, 2012, according to the S&P Corelogic Case-Shiller 20-City Composite Index, household income is up a little less than 30 percent in the same period, Bureau of Economic Analysis data shows. The average rate for a 30-year fixed mortgage rose from about 3.85 percent at the start of 2018 to about 4.74 percent now, Bankrate.com reports. Next year, it’s expected to rise further.

A buyer with a $2,500 monthly housing budget has lost almost $30,000 in purchasing power this year, according to Redfin Inc., a national brokerage.

In Orange County, California, more than 30 percent of homes for sale in the metro area would become unaffordable to buyers with a $3,500 monthly budget, Redfin estimates. In San Jose, that number would be almost 40 percent." - source Bloomberg

Housing markets turn slowly then suddenly...Just a thought.

While the US elections stalemate and the return of buybacks should be supportive, US markets for many years have been levitating and defying gravitation provided by the central bank support. This support has been obviously fading during the course of 2018 with QT as per our final charts below.

• Final charts -  The invisible hand is fading...

If October has been murderous for various asset classes thanks to the conjunction of several factors such as the velocity in the rise of real rates, blackout period leading to smaller buybacks, escalating tensions in the trade war narrative between the United States and China as well as Italian worries, our final charts from Bank of America Merrill Lynch coming from their European Credit Strategist note entitled "The hunt for red October" from the 2nd of November clearly shows that the "invisible hand" coming from the central bank is fading:

"The end of the “invisible hand”…

Last month wasn’t unique, though. We think it reflects a bigger picture theme…namely that assets are now struggling to produce meaningfully positive returns in an era of less central bank liquidity. The “invisible hand” that once propped-up market prices is now significantly smaller.

Chart 1 shows that there are precious few assets that remain above water this year. In fixed-income land, US leveraged loans have produced total returns of around 4%.

In Europe, many government debt markets – with the exception of Italy – are up for the year, albeit only by a modicum. But note that the biggest loser of all during the QE era, namely cash, has turned into one of the best performing assets of 2018 (1.5% total returns).

…the start of abnormal markets?

This spectrum of returns, however, is also far from normal. Chart 2 shows the historical percentage of assets with positive vs. negative returns on a yearly basis (our sample contains over 300 equity, fixed-income, commodity and FX indices). 

This year, we find that only 23% of assets have produced positive total returns. As can be seen, historically this is a very low number. In fact, such a number is usually only observed in periods of financial crises (2008), debt crises (2011), or just plain old recessions. And yet despite the shocks and bumps lately, the global economy is still humming along fairly nicely in 2018.

In our view, after such a big drawdown last month, markets are likely prepped for a rebound in November. Yet, we caution that bounces in risk sentiment could still be shallow ones. After all, with so many assets trending lower this year, long-only investors are finding that there are much fewer ways to help them diversify and protect their portfolios." - source Bank of America Merrill Lynch

One could argue that, no matter what "stalemate" we have reached in the United States midterm elections, the "fall" in the fall is surely indicative that at some point winter is coming. Could housing woes be seen as leaves already falling? We wonder...

“How did you go bankrupt?" 

Two ways. Gradually, then suddenly.” - Ernest Hemingway, The Sun Also Rises

Stay tuned!

Macro and Credit - A Pyrrhic victory

“You were given the choice between war and dishonour. You chose dishonour, and you will have war.' - To Neville Chamberlain” - Winston S. Churchill

Looking at the results of the French presidential elections with keen interest given our involvement in the process, us being French, we reminded ourselves, for the title analogy of the definition of Pyrrhic victory, where the heavy toll negates any sense of achievement or profit. King Pyrrhus of Epirus suffered irreplaceable casualties in defeating the Romans at the Battle of Heraclea in 280 BC and the Battle of Asculum in 279 BC during the Pyrrhic War. In both victories, while the Romans suffered greater casualties but they had a much larger pool of replacements, so the casualties had less impact on the Roman war effort than the losses of King Pyrrhus. While financial markets are going through yet another relief rally thanks to the victory of the Media darling Macron, we would point out that, no matter what some pundits think, Marine Le Pen and her party are, to use a financial term and analogy "positive carry" (inequality and unemployment, immigration, terrorism, etc.). Let us explain ourselves. Most of the beneficiaries of what "populists" would label "crony capitalism" and the "elites" have been behind Macron's candidacy, so all in all they are today sighing with relief. Yet, we believe his upcoming victory would amount to a Pyrrhic victory, in the sense that, unless there are very important structural reforms implemented which have been postponed in France for the last 20 years (under Chirac, Sarkozy and Hollande), there is a high probability of another 5 years wasted under Macron. While the quotation we have used above from Winston S. Churchill sounds a little bit off the mark from a historical perspective, we do feel, to paraphrase Mark Twain, that history for France is not repeating itself, yet it rhymes with the troubled 30s. We could even rephrase Winston S. Churchill quote as follows when it comes to France: "You were given the choice between status quo to avoid bankruptcy and dishonour.  You chose status quo and you will have bankruptcy and dishonour. Unless we see some very bold structural changes in France, not only in order to reform inefficient and inept systems in place but with significant tax reforms and supply side policies as well, we do believe there is a very high probability that Macron's victory will be a Pyrrhic one down the line but we ramble again.

In this week's conversation we would like to look at what to expect in terms of the continuation and sustainability of the rally which climbed the most recent "wall of worry" of the French elections. 

Synopsis:

• Macro and Credit - Paris in Spring?
• Final chart - Bank of Japan, the ETFs whale

• Macro and Credit - Paris in Spring?

While this bullet point could as well be a title analogy on its own and a reference to 1935 black and white musical comedy film directed by Lewis Milestone for Paramount Pictures, the relief rally seen so far, from our perspective has been mostly a beta play, particular in the light of the performances on the Monday following the elections on French bank stocks. As we have pointed out in numerous recent conversations, we continue to remain short term "Keynesian" when it comes to us being "risk-on", yet we remain medium term "Austrian" when it comes to tracking the weakness in credit growth, surging delinquencies and the credit cycle being long in the tooth. From an equities allocation perspective, we do think that Europe and other markets offer better prospects than US markets given the most recent macro data. Yet, with the slowdown in US hard data, we think at current levels US credit offers still better prospects than European credit both for Investment Grade and High Yield for which oil prices matter a lot.

For now the market wants to rally and will rally, as we often see significant rally in late stages in the credit cycle. For the time being the allocation tool DecisionScreen for High Yield is still in the buying zone for the aggregate signal which comprises the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score), US GOV 10 Year Yield (1Y Z-Score).

- source DecisionScreen

It remains to be seen how long US High Yield will continue its upward trajectory. This of course to a large part as we discussed recently 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 remains very strong as per the below chart from MacroCharts.pro we also used in several conversations:

Correlation 0.938, R2 0.881 - source MacroCharts.pro

Same goes for the correlation between the S&P500 and the synthetic CDS High Yield US index CDX:

Correlation 0.987, R2 0.973 - source MacroCharts.pro

Of course when it comes to Bayesian learning history shows the final phases of rallies have provided some of the biggest gains. But we are driveling again given in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":

"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent), then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

So all in all, you can probably see we are not part of the "permabear" camp, though we are acutely aware of the lateness stage we are in the credit cycle. It might be "Paris in the Spring" and "risk-on" for the time being, but, we do feel more cautious as we stated about the second part of 2017.

Given we have climbed the "French wall" of worry for the time being, while European investors had already been front running their Japanese peers, we do expect higher overseas demand for US Investment Grade credit thanks to improved cross-currency basis. On this subject we read with interest JP Morgan's Credit Outlook and Strategy note from the 20th of April 2017: 

"The US election results were followed by strong market optimism that US growth and corporate results would benefit. UST yields went from 1.83% on November 7 (the day before the election) to a peak of 2.61% on March 13th. The S&P rallied 12% from pre-election to its recent peak, and JULI spreads tightened by 24bp as well, to their recent low. Currently the UST 10yr yield is at 2.23%, unwinding 37bp or 50% of its post-election move. In contrast, the JULI is just 7bp wider so has unwound 30% from the post election tightest level, and the S&P is just 2% off of its recent peak, still up 11% post election, so it has given up 15% of its post election rally.

These developments suggest that markets have become less optimistic on growth and inflation picking up, while maintaining most of the optimism that drove equities up and credit spreads down on the election results. The move lower in UST yields reflects, in part, a flight to quality with the French election and increased geopolitical tension, but this "flight" didn't meaningfully hurt risk markets. There are several factors that can explain at least part of the strength of credit and equity markets even with rates markets suggesting rising risks to growth. These include:

1) Solid earnings expectations:

Consensus equity analysts estimates are for 7.4% revenue growth and 8.9% EPS growth in 1Q17 vs 1Q16, for the S&P500. Excluding Energy revenue and earnings growth forecasts are 5.3% and 5.1%. The weaker USD so far in 2017, down 4% in trade weighted terms, is a contributing factor to better earnings, as is the recovery in Energy prices and higher interest rates helping bank earnings. These earnings forecasts are much stronger than nominal GDP growth in 1Q17, which is likely to come in at just 4.1% higher than 1Q16. This is the most straightforward driver of the outperformance of credit and equities vs. US rates. That said, if low US rates are correctly predicting a slowdown in US growth, then earnings optimism will fade as well.

2) The regulatory reforms and pro-business agenda of the new administration as a driver of better corporate earnings, separate from the macroeconomic drivers of growth. It will be difficult to quantify the earnings impact of actual and potential regulatory relief, but it is hard to argue that it is not positive for corporate earnings over time. Related to this, potential changes to Dodd-Frank and new appointments at the Fed are fueling optimism in the Financial sector for some types of regulatory relief. As the legislative path of reform continues to be challenging for the new administration it is logical to assume there will be increasing focus on reforms and appointments that the executive branch can institute without congressional approval. M&A has been quiet recently but there is a lot of M&A discussion, particularly in the TMT sector. The assumption is that the new administration will be more likely to approve transactions that might have been blocked by the prior administration. This may or not be positive for credit markets, but it is usually positive for stocks.

3) The Fed rate hiking cycle is directly supportive of US bank earnings.Net interest margin rose for most banks in 1Q17. The most recent Fed hike was on March 15 so only a small portion of its impact was reflected in higher earnings in 1Q, while 2Q will reflect the full impact of this hike, and perhaps the beginning of the next Fed hike, which we continue to expect on June 14.

4) Lower sovereign yields in Europe have increased the need to diversify and are contributing for overseas demand for US HG credit. The 10yr bund is now at 33bp, down from a 2017 peak of 48bp on January 26th. The percent of JPM’s global sovereign bond index offering a negative yield was at a recent low of 17.6% on March 13, and has since ticked up to 21%. In the first part of 2016 low global bond yields contributed to overseas demand for US credit. This impact faded in the 2nd part of 2016 and in early 2017, but has increased once again. Some of the recent move lower in European sovereign yields is tied to the risks seen around the French election so may dissipate (or get worse) after Sunday’s vote.

The FX-hedged pickup of USD credit vs European and Yen credit has narrowed recently.

For Euro based investors USD credit, hedged with a 3m FX swap, now offers a pickup of 31bp. This is on the low end of the 31-68bp three month range.

For Yen based investors this pickup is now 63bp, also near the bottom of the 58- 93bp range. Still, with sovereign bond yields so low the need for diversification remains. The decreases in spread pickup for European and Japanese investors buying USD HG corporates is primarily due to a decrease in US HG corporate yields. The annualized cost of the USD/EUR and USD/JPY 3m FX hedges has remained relatively stable recently while the absolute unhedged yield differences have decreased.

Even taking account of these factors, the extent of the difference between UST and equity/credit spread movements over the past few weeks seems extreme.

The drivers of the equity rally and credit spread rally post the election were then described as tax reform (including overseas cash tax repatriation relief), infrastructure spending and fiscal stimulus. All of these are, at a minimum, delayed, and there is growing skepticism that the magnitude of corporate tax relief and infrastructure spending will match the Administration’s goals.

Some of the macro data would support higher UST yields as well, with consumer and business confidence near multi-year peaks and PMIs also very strong. 

Global Economic Activity Surprise indices reached multi year peaks in March but have receded since then. The Fed has raised rates in 2016 and a couple of weeks ago signaled that it would change its balance sheet reinvestment policy later in 2017. These factors might have been expected to keep UST yields high, but instead they have declined.

There are countervailing factors in the macro data, which are getting the focus of the Treasury market, however. Bank lending slowed in the later part of 2016 and this trend has continued, despite the strong consumer and business confidence figures, which might have been expected to lead to more loan demand.

Auto sales have also slowed, and retail sales growth overall has been modest.

GDP growth in 1Q is coming in weak, though there has been an historical pattern of weak 1Q initial prints, which are then revised higher. CPI last month came in very weak, though again the magnitude of the drop seems overdone and may be revised in subsequent updates. This more cautious data, if truly predicting weaker growth, would be expected to impact stocks and corporate spreads, as well as Treasury yields, but this has not been the case so far." - source JP Morgan

As John Maynard Keynes aptly said:

 “The market can stay irrational longer than you can stay solvent.”

While it is indeed "Spring in Paris" with new records being broken in the equities space as we type, and pundits including us are watching with interest the divergence between hard data and soft data including retail woes, rising delinquencies and weaker credit growth in the US that portend most likely towards a weak US Q1 GDP print on Friday, you might rightly ask yourselves if indeed, when it comes to chasing this really fundamentals matter anymore. Earnings wise, no doubt the picture seems to be better, when it comes to US equities and the continuing surge. Yet, as we pointed out on numerous occasions and particularly for Fixed Income allocations, flows matter and they matter more and more particularly when you think that "Bondzilla" the NIRP monster is "made in Japan". We keep hammering this, but the Japanese investment crowd and their allocations should never be underestimated. These guys mean business when it comes to flows as we pointed out in our conversation "Drums Along the Mohawk" in early April:

"The February sell-off in French government bonds was significantly large and amounted to all Japanese purchases for Q3 2016 as per the table below. 

 - source Bank of America Merrill Lynch

 - source Bank of America Merrill Lynch

Indeed, if the French elections delivers yet another sucker punch à la BREXIT, this "exogenous" factor could precipitate additional pressure on French government yields given Japanese investors have been the largest purchasers of French debt since 2012 and hold 13% of it. When it comes to flows for foreign bonds, "Bondzilla" the NIRP monster is indeed Japanese and you would be wise to track is appetite when it comes to country allocation." - source Macronomics, April 2017

So yes, Macron's Pyrrhic victory in the first round of the French elections in conjunction with the recent start of Japan's new fiscal year might explain the recent rally in French debt but it is could be coming from a renewed appetite from foreign investors in particular "Bondzilla". He had offloaded a sizable chunk of French bonds in February as indicated in the table above we used in our previous post.

When it comes to Japan and their appetite for risky assets, if indeed Japan is Bondzilla when it comes to foreign bonds, for domestic ETFs it is indeed a whale.

• Final chart - Bank of Japan, the ETFs whale

Whereas it is very important to track Japan flows, regardless of the fundamentals narrative when it comes to valuation when it comes to Fixed Income, it is interesting to focus as well to Bank of Japan who has indeed become a "Tokyo Whale" in the domestic ETFs market. On that subject, our final chart comes from Société Générale Cross Asset note from the 21st of April entitled "Where is the Tokyo Whale - Analysing the impact of equity ETF purchases by the Bank of Japan":

"The “Tokyo Whale” in the ETF market...

The term “whale” is frequently used to qualify big money participants in the market. The Bank of Japan has often been qualified as the “Tokyo Whale” since it became a major participant and holder in the Japanese government bond (JGB) market. Recently, this situation was replicated in the ETF market. At end-March 2017, BoJ’s cumulative ETF purchases were ¥13.1tn, with Japanese equity ETFs subject to BoJ purchases totalling ¥21.3tn assets. Based on the price performance of the Nikkei 225 and Topix indices and as dividends are not reinvested in Japanese equity ETFs but distributed, we can estimate the mark-to-market value of historical purchases. We assume the BoJ’s current ETF holdings stand around ¥15.7tn ($144bn), i.e. approximately 75% of the total assets in Japanese equity ETFs (orange line on below chart).

Eligible ETFs are physically replicated, which implies the ETF providers hold the underlying index constituents. From the estimated BoJ ETF holdings and index constituents list, we can deduce how much of the Japanese equity market is indirectly held by the BoJ through these ETFs.

... but also, indirectly, in the Japanese stock market
BoJ implicit holdings are quite small at the index level but significant on some specific
stocks

Comparing the BoJ’s ETF holding amounts per benchmark to each index’s market capitalisation is not relevant as many companies are common to the three (or two) indices. We have totalled the estimated amounts held for each stock through the three benchmark exposures and concluded that the BoJ may indirectly hold around 3.2% of the Nikkei 225 market capitalisation, 2.0% of the TOPIX and 3.1% of the Nikkei 400. These figures may seem quite low compared to the respective 75% and 40% estimated BoJ ownership of the Japanese ETF and government bonds markets. The impact at the stock level, however, can vary greatly from one stock to another." - source Société Générale

So you might ask yourselves, how long can this rally in equities continue? Well if indeed Central Banks such as the Bank of Japan, the SNB and others are now in the "investment business", the sky's the limit but we ramble again...

On a final note we think Macron's potential victory will be a Pyrrhic one given the growing divisions in France à la 30s and he would be wise to remember the latin words "Arx tarpeia Capitoli proxima", (“the Tarpeian Rock is close to the Capitol”) which some have interpreted to mean that "one's fall from grace can come swiftly". As a reminder to be hurled off the Tarpeian Rock was, from a certain perspective, a fate worse than mere death, because it carried with it the stigma of shame. The standard method of execution in ancient Rome was by strangulation in the Tullianum. The rock was reserved for the most notorious traitors, and as a place of unofficial, extra-legal executions such as the near-execution of then-Senator Gaius Marcius Coriolanus by a mob whipped into frenzy by a tribune of the plebs.

"History repeats itself, first as tragedy, second as farce." -  Karl Marx

Stay tuned!

Macro and Credit - The Great Wall of China hoax

"The secret of life is honesty and fair dealing. If you can fake that, you've got it made." -  Groucho Marx

Looking at the Chinese currency falling against "Mack the Knife" aka King Dollar + positive real US interest rates, moving in sympathy with Bitcoin sailing through the 1000 threshold, with 2016 closing on arguably the epic failure of Mainstream Media (MSM) being the most prominent feature as pointed recently by Ray Dalio from Bridgewater Associates, we reminded ourselves for our title analogy of the Great Wall of China hoax faked newspaper story concocted on June 25, 1899 by four reporters in Denver, Colorado about bids by American businesses on a contract to demolish the Great Wall of China and construct a road in its place. The story was reprinted by a number of newspapers. We found it interesting that this hoax was created at the height of imperialism during late 19th Century when Great Britain obtained its 99 year lease for the New Territories, extending the Hong-Kong colony that had been ceded in 1841 while Germany seized the Chinese port of Kiaochow and used it as a military base, and French leased Kouang-Tchéou-Wan from China. Of course, this hoax coming at the very height of imperialism is reminiscent of our October 2016 musing "Empire Days" in which we pointed out that the "status quo" was failing:

"It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "status quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us." - source Macronomics, October 2016

The hoax began with four Denver newspaper reporters, Al Stevens, Jack Tournay, John Lewis and Hal Wilshire, who represented the four Denver newspapers - the Post, the Republican, the Times and the Rocky Mountain News. met by chance at Denver Union Station where each were waiting in hopes of spotting someone of prominence who could become a subject for a news story. Seeing no celebrities and frustrated with no story in sight and deadlines due, Stevens remarked: 

"I don't know what you guys are going to do, but I'm going to fake it. It won't hurt anybody, so what the Devil." 

The other three men agreed to concoct a story and walked on 17th Street toward the Oxford Hotel to discuss possible ideas and came up with a story in which the Chinese planned to demolish the Great Wall, constructing a road in its place, and were taking bids from American companies for the project. Chicago engineer Frank C. Lewis was bidding for the job. The story described a group of engineers in a Denver stopover on their way to China. That's how the hoax began and spread like wildfire, even making a comeback in 1939 as an urban legend due to Denver songwriter Harry Lee Wilber claiming in a magazine article that the 1899 hoax had ignited the Boxer rebellion of 1900. The cultural historian Carlos Rojas comments that the original hoax being perpetuated by a second hoax, a "metahoax," illustrates the ability of the Great Wall to "mean radically different things in different contexts."

By now, you are probably asking yourselves where are we going with our analogy? Have we already lost the plot early on in 2017? Recent geopolitical events have clearly shown that in some instances MSM like to fake it. This of course can have some unintended consequences leading to a hoax becoming a metahoax as pointed out by Ray Dalio from Bridgewater Associates in his latest missive:

"If you have a society where people can't agree on the basic facts, how do you have a functioning democracy?" Distorted pictures lead us to make bad decisions. In my opinion, if people don't correct such inaccuracies and don't fight against this problem, continued distortions in the media will prevent the public's accurate understanding of what is happening, which will threaten our society's well-being. We in the financial community now openly talk about fake or distorted media being used to manipulate market prices to the harm of many, and similar conversations are taking place in most areas.
This is not just a fringe media problem; it is a mainstream media problem. And while it is widely recognized, there is no discussion underway about how to rectify it." - source Linkedin Pulse, Ray Dalio, Bridgewater Associates

Fake news and fake prices thanks to central banks meddling with interest rates for too long can obviously lead to "unintended political" consequences as we have seen last year. Given 2017, is the 100th anniversary of the Russian revolution, we will not be surprised to see some more "sucker punches" being delivered in various asset classes and issuers (such as what we have seen with French issuer Vinci in 2016, Japanese Toshiba, UK retailer Next as of late). Both the MSM and central bankers are losing their aura, this will have some "unintended consequences" on asset prices rest assured.

Before we go into the nitty gritty of this year's musing, we would like to extend dear readers our best wishes for 2017 and we are looking forward to more discussions and comments. Moving to what we will cover in this conversation, we would like to turn our attention to the impact "Mack the Knife" is going to have on housing demand, and therefore gradually and most probably putting a dent into the much vaunted "Trumpflation" story. While the feel good effect on the year might be lasting some more thanks to better macro data from PMIs overall, it remains to be seen how long hope and complacency will trump reality...

Synopsis:

• Macro and Credit -  Japan as a base case - when low yield assets become nonperforming assets
• Final chart - Chinese credit is currently under-pricing rising risks in CNH

• Macro and Credit -  Japan as a base case - when low yield assets become nonperforming assets

In numerous conversations we have pointed out about our difficulty in embracing the recovery mantra story playing out in the United States thanks to lack of solid evidence in wage growth which would as well confirm the reflation story playing out, in a world awash in debt which, is no doubt weighting on growth prospect. As an illustration of political hope versus economic reality, no offense to ex French Prime Minister Manuel Valls but, his 1.9% GDP growth hypothesis in his just published political program for the presidential run of 2017, where he indicates that he will reduce the budget deficit while increasing public spending by 2.5% is hogwash. It just doesn't add up when public spending is already close to 58% of GDP (we are still laughing about this). No matter how ambitious a political program is, even with the benefit of the doubt, that market pundits seems willing to give, it seems to us that expectations are going to get at some point a reality check in 2017. 

When it comes to fake prices and fake inflationary expectations, Japan comes to our mind given its prolonged monetary easing stance and its consequences, leading to a vicious cycle of low growth where Europe seems to be heading thanks to a similar "japanification" process, and unresolved nonperforming loan issues in large swath of the European banking system. Japan is as well of interest, not only due to poor demographics (as in Italy these days) but also from the perspective of low-yield assets becoming nonperforming. To that instance Japanese real estate is a good illustration of the process as highlighted by Deutsche Bank in their Real estate sector note from the 4th of January entitled "Investment strategy for 2017: time to heed warnings of intellectuals":

"Heading for a world predicted 150 years ago

We believe the election of Donald Trump as US president and the UK's Brexit decision are outcomes of overly successful capitalism instead of heightened populism. These events expose the risks of capitalism that were predicted by Karl Marx, Adam Smith, and other intellectuals in the past. Japan has not recognized the trend changes, and we expect Japan’s real estate market to worsen in 2017.

Karl Marx, Adam Smith, and other intellectuals from the past predicted these risks 150 years ago. Continuing deregulation leading to a world dominated by "survival of the fittest" naturally breeds success for those with capital and intelligence. It fosters dominance by the elite. Capitalism is fundamentally aggressive. Various regulations have been enacted for dampening this aspect of it. However, continuous deregulation has created a "winner takes all" world and expanded disparities between rich and poor.
Several intellectuals understood the risks of capitalism. For example, Karl Marx warned that "successful capitalism means victory for those with capital and knowledge, and when left unaddressed, creates a society with large disparities and monopolies and leads to higher prices." Adam Smith, known for the "invisible hand," wrote "The Theory of Moral Sentiments" in 1759 prior to the "Wealth of Nations" (1776). In this book, he acknowledged that competition is important, but explained that the spirit of fair play and consideration for others is an essential premise. Even Max Weber, who argued that making money is good, noted that capitalism requires high moral sensitivity in order to succeed.
In Japan, Sontoku (Takanori) Ninomiya famously stated that "economic activity that ignores morality is a crime, and morality that forgets economic activity is nonsense." Japan also had the “Sanpo Yoshi” spirit exemplified by Omi merchants that calls for benefits to the buyer, seller, and local communities together. In other words, risks of capitalism were predicted in both the east and the west.
However, it is getting difficult to find a new frontier beyond extension of the frontier to the middle class through deregulation. Capitalism appears to be reaching its limits in its current form. Natural redistribution (trickle-down theory) has failed, and calls for redistribution are making headway among the middle class. We believe this sentiment is behind the results seen in the election of Trump as US president and the UK's Brexit decision. The world may be entering a chaotic age as it seeks new types of capitalism.
Important elections will take place in Europe in 2017, including legislative elections in the Netherlands in March, presidential votes in France in April and May, legislative elections in France in June, and a general election in Germany in September. Results in Italy's national referendum in December 2016 forced the resignation of Prime Minister Matteo Renzi. We believe people may follow the Italian case in quite a few countries and expect disruptions and crises to pick up momentum worldwide in 2017. 

NIRP transforms low-yielding properties into non-performing assets

We believe that lowering nominal interest rates via the NIRP (negative interest rate policy) weakens the financial intermediary function and leads the Japanese economy to deflation. As a result of the prolonged monetary easing in Japan, companies have accumulated low-yielding investments, leading the country into a vicious cycle of low growth. We see the risk of low-yielding assets becoming non-performing and triggering a significant setback to the NAV in Japan during 2017 in light of the approaching limits to monetary easing amid increased uncertainty in global political and economic conditions.

String of failures

Measures such as monetary easing that exceeded market expectations, a consumption tax hike amid a recovering economy to spur fiscal structural reform, and a strong ROE emphasis on shareholders have been adopted by the BoJ, the government, and the private industry, with each of them considered optimal. However, all have contributed to deterioration in Japan's economy and its real estate market. This is a classic example of the proverb, ‘the road to hell is paved with good intentions’. Excessive monetary easing has increased the risk of a surge in real interest rates and deleveraging, an excessive bias towards ROE has led to lower wage growth for general employees and reduced capex, and the consumption tax hike has caused consumer spending to stagnate.

To avoid the extreme ultimate decision

As countries worldwide reconsider their positions due to widened disparities driven by overly successful capitalism, Japan has yet to reflect on this. It remains one step behind, as it moves forward with minor government and deregulatory policies. Japan should realize that it needs to foster stronger ethics and morals and pursue policies that break away from excessive focus on ROE and encourage long-term investment and higher wages for employees. Unless these changes are adopted, we see increasing likelihood that Japan will be faced with the ultimate decision.

Bursting of "quiet bubble" to accelerate in 2017

In 2016, the real estate market started heading towards the end of the “quiet bubble”. We see this move picking up pace in 2017. We see hardly any factors supporting optimism. We determine our target prices for the real estate sector by using a residual income model. We also take NAV into account. Downside risks include: 1) a rise in risk premiums due to a decline in bank lending to the real estate sector; 2) the hasty implementation of a hike in consumption tax and/or income tax, or a decline in government spending due to a rush toward fiscal restructuring; and 3) deepening NIRP amid another monetary easing. Upside risks include: 1) significant salary increases in private sector companies, and 2) consumption tax and income tax cuts as well as large-scale fiscal spending." - source Deutsche Bank

As clearly highlighted by Ray Dalio in his latest missive, playing a hoax for too long, ultimately has unintended consequences and bring about political instability. The impact of globalization have been clearly leading to some political discontent given it has fostered dominance from the elites as highlighted by Deutsche Bank in their note. We touched on the impact of globalization back in February 2015 in our conversation "The Pigou effect" and we indicated Populism was bound to happen as predicted by the maverick Sir James Goldsmith and his 1993 insightful book The Trap which was followed by The Response:

"We also took into interest in the wise but gloomy comments from Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February 2015: 

“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey. “And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian 

This struck a chord with us as it indeed reminded us of Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. 

He violently criticized the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais. 
In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided above): 

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

While MSM is still wondering why there is a global rise in populism and why Trump got elected, for us it  fairly is very simple, the social contract between society and the economy has been truly broken. 

So the poor "schmucks" or "deplorables" as some politicians were calling them that were initially sold the "greatness" of "globalization" are now realizing they have been fleeced and obviously they are not happy about it:

U.S. Wage Growth Since 1973* Upper / High Income: +52% Everyone Else: -4.6% 

Distribution of U.S. Household Wealth to the Bottom 90% 

2016: 22% 2005: 30% 2000: 31% 1995: 32% 1985: 37%

Young Americans living w Parents*

2016: 40%2000: 31%1990: 30%1980: 30%1970: 23%1960: 23%1950: 22%

*18-34 yr olds - H/T Lawrence McDonald

This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, 22nd of July 2014

Clearly the latest spat between president elect Donald Trump and Ford might be an illustration of the US administration's trying to counter the fundamental aggressiveness of US capitalism that strongly benefited from the Fed's generosity. Put it simply, it might look as an attempt (or a hoax) to favor Main Street against Wall Street. It remains to be seen what the new US administration will set in motion and to paraphrase Groucho Marx, maybe faking is making it after all and the deplorables might have once again been conned, we shall see.

But, moving back to low yields becoming nonperforming, we remain very wary of the destructive trail of "Mack the Knife". 

While we continue to see pressure building up on China and capital outflows, we are eagerly waiting for the 7th of January where we sill the publication of the latest state of Chinese FX reserves. On that subject Bank of America Merrill Lynch in their Asia FX Strategy Watch note from the 4th of January anticipates that China FX reserves have fallen by $25 billion in December:

"We forecast China’s FX reserves to fall by USD 25bn in December to USD 3,027bn. Our forecast is less than the Bloomberg consensus forecast for a fall of USD 42bn to USD 3,010bn in FX reserves.

We estimate an intervention effect of USD -15bn in December, which is less than the USD -40bn reading for November (Chart 1). Onshore FX volume rose from USD 670bn to USD 740bn in December; an increase in onshore FX volumes are associated with a larger estimated intervention effect. Some of that impact on the estimated intervention effect may have been offset by the narrower average CNH-CNY basis of -55bps in December, from -167bps in November, leading to our smaller than consensus forecast decline in China’s FX reserves.

Our estimate of the valuation effect in December is USD -10bn. While the USD continued to strengthen against the EUR, GBP and JPY, the rate of USD appreciation
was less than the previous month.
As China’s FX reserves falls towards the USD 3trn level, we believe officials may act to contain RMB depreciation expectations because:

1. The USD 3trn could be of psychological importance to investors and officials. We show in our year-ahead report that this will ultimately be crossed in 2017, though capital controls are being engaged to sure-up credibility.
2. Capital outflows from China picked up to USD 205bn 3Q 2016, especially through trade credits and the use of CNH.
3. Inflation has maintained its upward trend in 2016, especially according to the PPI measure, raising concerns over FX inflation pass-through.

Indeed, the USD/CNY fixing rate has been notably lower than that implied by the 16:30 closing rate and the basket implied change throughout December 2016. Furthermore, FX purchases by individuals are now under greater scrutiny than before as the annual USD 50,000 limit was reset on 1 January 2017." - source Bank of America Merrill Lynch

On top of the unabated outflows from China thanks to "Mack the Knife", US rate hikes envisaged by the Fed will no doubt have an impact not only on US housing but, on the US economy as a whole as pointed out in Deutsche Bank aforementioned note:

"Are there any adverse impacts from the US rate hike?

We view 2017 as the start of major changes in trends as we mentioned above. The FRB increased the interest rate in December 2016 despite the increased possibility of major changes in global tides. We agree that conditions are healthier in the US than in Japan and Europe, which have adopted negative interest rates. However, the US rate hike may weaken its economy.

We are particularly concerned about auto loans and student loans in the US, which are now at all-time highs, having increased to $1.1tr and $1.3tr, respectively. Home mortgage loans have not recovered to the level before the Lehman collapse but are substantial. We believe that the US rate hike holds the risk of causing a downturn in housing demand.

 (click to enlarge)

We expect the rate hikes to gradually have a negative impact on the US economy and thus force a rate reduction in 2017 rather than further increases in rates. Hence, we believe investors should consider the potential for a shift back to yen appreciation. The risk of the economies in the emerging countries needs to be closely monitored as well. Even if faced with such conditions, the BoJ lacks additional options as it is already approaching limits of monetary easing.

The only possible action by the BoJ is widening negative interests. However, this may further undermine financial intermediation in the economy and accelerate a deflationary trend. We believe widening the negative interest rate would be a critical failure that adversely affects not only the real estate and stock markets but also the entire economy.

We expect a new era of global disruption over the long-term horizon, while we believe it will become apparent in 2017 that the US rate hike will have an adverse effect on the global economy and that Japan will not be able to cope with the impact. The environment for the Japanese real estate market is likely to present even stronger headwinds, in our view." - source Deutsche Bank

Of course, if the reflationary story turns out to be a hoax in a world where growth is stifled by high levels of debt, it will materialize itself at some point in 2017 and one would expect, the bond bears to retrench and yields to resume their downward trajectory during the course of the year. While hope is the ongoing "winning" strategy", at some point reality could reassess itself. On a side note, we have turned slightly positive on gold and gold miners over the course of December.

But moving back to Japan being a case study for monetary experiments, the impact of monetary policies have clearly shown their effect on real estate as pointed out by Deutsche Bank in their long interesting note:

"When expanded low-yield properties become nonperforming assets

As a result of the prolonged monetary easing in Japan, companies have accumulated low-yielding investments, leading the country into a vicious cycle of low growth.

In fact, Mitsubishi Estate's yield on leased properties has slumped from over 9% (FY3/00) to the 5% range, and Sumitomo R&D’s yield has fallen below 5%. A flurry of designation of special economic zones led by deregulation has created incentives for investment in low-yield assets. Low-cost finance also enables it.

Cumulative free cash-flow deficits at Mitsui Fudosan, Mitsubishi Estate, and Sumitomo R&D totaled ¥1.9tr from FY3/00 to FY3/16, due to continuous excessive investments over a long period (free cash flow: operating cash flow -
capex).

As long as the current level of large investments continues, these companies cannot buy back shares or raise dividends significantly because they simply do not have the necessary funds.

Locations that previously did not have offices have suddenly transformed into cutting-edge office districts, further heightening supply. The office stock in Tokyo's 23 wards has increased 1.7x since 1991. Rents, meanwhile, are at all-time lows following repeated ups and downs over economic cycles because of flat demand.

Alongside excessive investment in rental assets, inventory assets have risen sharply and the turnover ratio has dropped to an all-time low. For example, Sumitomo R&D's inventory assets have increased by ¥720bn, from ¥128.3bn in FY3/00 to ¥846.7bn as of end-FY3/16.

Meanwhile, Sumitomo R&D's real estate sales rose modestly from ¥150.5bn in FY3/00 to ¥274.8bn in FY3/16, reducing the turnover rate from 1.17 to 0.32, an all-time low. Similarly, Mitsui Fudosan's turnover ratio dropped to an all-time low of 0.4.

Low-yielding assets have been accumulating in Japan due to the prolonged monetary easing climate. We believe the BoJ's negative interest rate policy, which lowers nominal rates, is worsening the situation, since the policy further undermines the function of financial intermediation and thereby encourages deflation.

Japan, which is approaching the limits of monetary easing, has limited response options and faces significant risk of low-yield assets becoming nonperforming assets if the yield upswing, yen strength, or other factors create headwinds for the economy amid heightened uncertainty in global political and economic conditions in 2017. We believe this implies the possibility of significant erosion in the NAV." - source Deutsche Bank

Clearly the prolonged downturn of the Japanese economy in conjunction with the implementation of Negative Interest Rate Policies (NIRP) have led to excessive investment in rental assets and inventory assets have risen accordingly.

But, for us, the greater distortion coming out from NIRP is the distortion it is creating in terms of "credit allocation". As we pointed out in our conversation "Goodhart's law", back in June 2013, there is "good credit" (infrastructure and productive investments) and "bad credit" (real estate):

"Credit is like cholesterol, there is bad cholesterol that can’t dissolve in the blood (Low-density lipoprotein) and good cholesterol (High-density lipoprotein).

When too much LDL (bad cholesterol) circulates in the blood, it can slowly build up in the inner walls of the arteries that feed the heart and brain. This condition is known as atherosclerosis, and heart attack or stroke can result.

In 2008, we came very close to a global heart failure. The world had a stroke.

But, what led to the bad cholesterol in the first place? Bad credit. So betting on a government making the right choice of allocation with "fiscal stimulus" is wishful thinking, we think.

Government policies favoring housing bubbles have led to mis-allocation of credit (bad cholesterol), like in the US, the UK, Hungary, Ireland and Spain. Bad cholesterol (the "credit stroke) has led to "Balance Sheet Recession" (Japan).
Government policies favoring infrastructure investment is good cholesterol:
One can posit that President Eisenhower when he signed the 1956 bill that authorized the Interstate Highway System in 1956 was of great benefit to the US. In his parting speech of the White House on the 17th of January 1961, he warned about the risk of bad cholesterol (military complex) but that's another story..." - source Macronomics, June 2013

In terms of Japan, there is clearly indication that NIRP is already leading to "bad credit" as per Deutsche Bank's report:

"Excessive monetary easing has increased the risk of a surge in real interest rates and deleveraging, an excessive bias towards ROE has led to lower wage growth for general employees and reduced capex, and the consumption tax hike has caused consumer spending to stagnate.

The first problem is BoJ’s policy. We believe its monetary easing policy has been excessive. We are not negative about monetary easing, but we believe this has started doing more harm than good.

The worst setback has been the decline in demand for non-real estate loans since the adoption of the NIRP, creating tightening rather than easing effects. Recent data actually show a 7.2% increase in loans to the real estate industry versus a slowdown to 1.4% in other areas (Figure 11).

The NIRP has proved dysfunctional in Japan due to record-low loan-deposit ratios (demand for bank loans is low and has moved little in response to lower interest rates). In addition, the NIRP, which lowers nominal interest rates, promotes deflation by weakening financial intermediation. Slowing loan growth to industries other than real estate is evidence of this.

Furthermore, the BoJ has adopted yield-curve controls because the volume of JGB holdings at banks that can be sold to the BoJ has already reached a limit. This has raised the risk of investors pricing in the limitations of monetary easing. We believe this is a problem too.

The BoJ's introduction of measures to control the yield curve amid NIRP promotion of deflation negates any benefits from lower interest rates. Yield-curve controls that prevent yields from declining are contradictory to the NIRP's reduction of the nominal interest rate. We believe this presents a nightmare scenario for the real estate sector.

Put differently, we see expected revenues declining, risk premiums rising, and risk-free rates trending upward. This means the three key determinants for stock prices in the real estate sector should move into a direction that is detrimental for the sector.

Our worst-case risk scenario would be widening of the negative interest rate by the BoJ that prompts banks to impose account management charges on large deposits. We believe this would start triggering further deleveraging.

Many Japanese companies are effectively debt-free and take bank loans mainly to maintain friendly relations with banks. If they are charged management fees for those accounts, we suspect many of them would reduce their deposits as much as possible and work to repay their loans.

Banks would then suffer not only a narrowing lending spread but also a drop in the lending balance. Japan would experience credit contraction (deleveraging), and as a result, slip into deflation again, in our view.

It is also important to consider market risk. The BoJ's massive JGB purchases have lowered JGB liquidity. Therefore, we see the risk of a sudden steep rise in interest rates if some type of shock occurs.

Furthermore, dark clouds are gathering over upbeat lending in the real estate industry because restrictions may be imposed on loans to the industry (as reported by some media sources). In fact, banks’ outstanding loans to the real estate industry have climbed to a record high of 14.8% of total loan value. We believe this already exceeds the acceptable level.

Second culprit is excessive focus on ROE

We believe the second culprit is an excessive focus on ROE. The behavior of Japanese corporations changed considerably after the 1997 financial crisis, and companies have stopped increasing employee compensation even with profit growth.
Since then, their more shareholder-centric stance has resulted in a greater tendency to distribute profits to shareholders rather than use them to boost employee compensation. If we assign 1997 a base value of 100, dividends would now be 500 while employee compensation is still 100.

We believe the domestic demand economy cannot grow without corresponding growth in employee compensation. On the other hand, executive compensation has been increasing. This would be understandable if management generated strong results, but in one case, executive compensation increased by more than ¥200m YoY even when the firm made a loss due to failed M&A and other initiatives. This is the tragedy of Japan copying the negative aspects of a shareholder-centric stance.

Shareholders are not a company's only stakeholders. Other stakeholders include clients, employees, and the society to which the company belongs. Although shareholders can easily cut off their ties by selling their shares, clients and employees are unable to end their relationship so easily. From this point of view, shareholders are not even the most important stakeholders.

We are not suggesting that companies ignore shareholders. Rather, we believe that insufficient attention given to employees and other stakeholders could destabilize a society. This is already happening in other advanced nations. In our opinion, it is a big problem for Japanese companies when managements fail to consider the experiences of other nations as related to its own issues." - source Deutsche Bank

The Japanese story, to some extent is clearly indicative of the challenges faced by the new US administration. This is for us the biggest headwind for the Fed, given it has accentuated through its loose policies the rift between the have and the have not. We have reached the limit of what monetary policies can do and the toxicity it has brought in terms of mis-allocation. It remains to be seen how the new US administration can encourage real wage growth and the latest Ford episode, lack for us an essential part to ensure a real recovery taking place and not a hoax, namely that the new Donald Trump administration needs more than having companies investing "in America", because if the new elected president wants to "make America great again", it certainly needs to learn from the Japanese experience and ensure US companies invest "on Americans" we think.

Deutsche Bank's note also clearly makes some solid points relating to the Japanese tragedy:

"Need to avoid ultimate decision

We see voters worldwide are calling into question the widening disparities caused by capitalism's overwhelming success, as evidenced by Trump's victory in the US presidential election, the UK's decision to exit the EU, and the resignation of Italian Prime Minister Renzi as a result of a national referendum in December.

However, the changing trend poses risks that were predicted long ago by intellectuals like Karl Marx and Adam Smith. Continuing deregulation funnels control to the elites, expanding disparities between rich and poor in a "winner takes all" scenario. Furthermore, it is difficult to find new frontiers because they have already been expanded to the middle class, raising the specter that capitalism in its current form will disappear. Natural redistribution (trickledown theory) has failed, and calls for redistribution are making headway among the middle class.

Even as the “quiet bubbles” approached their demise in 2016 and will likely accelerate in 2017, Japan remains mired in a dilemma. Instead, it seems to be standing still as a laggard, unaware of the growing chaos and crisis and the major changes taking place worldwide.

At this juncture, we believe Japan needs to foster a spirit of fair play that takes into account the interests of all parties and cultivates strong ethics and moral values, stop focusing too much on ROE, and enact policies that encourage long-term investment and higher wages for employees, as were outlined in the writings of Adam Smith, Karl Marx, and other intellectuals in the past. Without these changes, Japan may not be able to avoid the ultimate decision.

Specifically, companies are expanding shareholder returns to boost their share prices and increasing M&A because their own R&D reduces ROE. Innovation cannot be achieved this way. Companies should not refrain from long-term investments. Honda's ASIMO, linear-motor bullet trains, hydrogen engines, carbon fiber, and Japan's other impressive technologies obtained through long-term investment would not have been realized in a world focused on ROE.

We also believe that profits should be fairly allocated to employees, not just to shareholders and executives. Unless this happens, the cycle of "widening disparity → excess savings → low rates and low growth → asset price gains → bubble collapse → monetary easing" will continue unabated. Nevertheless, it seems that this cycle is at its limits.

We see need for tighter regulations, not just deregulation. This is particularly important in the real estate industry. Locations that did not have offices are suddenly being transformed into cutting-edge office districts, further heightening supply as a result of continuous deregulation. Therefore, rents are at all-time lows after repeated ups and downs during economic cycles.

We believe it is possible to achieve strong economic growth by ending sluggish consumption and increasing new products through innovation if Japan stops focusing excessively on ROE, and ends wage-curtailment for ordinary employment and restraints on capital investment. It is also time to halt deregulation and restore strong ethics and morality, along with more measured competition.

We believe the "quiet bubbles" started to collapse in 2016, and expect the downturn to accelerate in 2017. The economy and the real estate market will likely remain sluggish because of inadequate policies being pursued in the public and private sectors. We find almost no factors that support optimism. We believe Japan will likely face an ultimate decision unless the reforms we discussed above are enacted." - source Deutsche Bank

The wise words of Sir James Goldsmith from 1993 we mentioned back in June 2013 in our conversation  "The Pigou effect"  still resonate with the above and the risk for capitalism's demise:

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

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

The ongoing rise in populism thanks to globalization and aggressive capitalism, in search of maximizing ROE and shareholders return have had the desired effects in leading towards a surge in populism, it remains to be seen how the new US administration will ensure that the economy serves the US society, or put it simply, make sure Main Street gets its fair share of the pie which has been lacking in recent years thanks to the Fed's bold monetary policies which were a boon to Wall Street.

In similar fashion, China is playing a difficult balancing act in trying to deflate its induced credit bubble while ensuring social stability which is illustrated in our final chart.

• Final chart - Chinese credit is currently under-pricing rising risks in CNH

Our final chart illustrates the complacency between upwards pressure on the Chinese currency thanks to "Mack the Knife" and China credit risk and comes from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 4th of January entitled "Let's get technical". It displays the rise of USD/CNH 3 months ATM (At the Money) volatility versus China exposed names 5 year CDS index:

- source Bank of America Merrill Lynch

If "Mack the Knife" continues its unabated run, it remains to be seen how long China related credit is going to be able to hold the line. When it comes to Great Wall and hoaxes, it remains to be seen if indeed The Great Wall of Mexico will be one after all, but we ramble again...

"This nation is notorious for its ability to make or fake anything cheaply. 'Made-in-China' goods now fill homes around the world. But our giant country has a small problem. We can't manufacture the happiness of our people." - Ai Weiwei, Chinese artist

Stay tuned!