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 - The Money Illusion

"The greatest obstacle to discovery is not ignorance - it is the illusion of knowledge." -  Daniel J. Boorstin, American historian

Looking at the most recent print in US nonfarm payrolls in conjunction with stronger than expected 2.9% wage growth (AHE) in August, with US Annual core-CPI declining to 2.2% in August vs 2.4% expected, leading to a tentative rebound in gold prices, when it came to selecting our title analogy we decided to steer towards a reference to the seminal work done by Irving Fisher in 1928 in his book "The Money Illusion". In economics, the money illusion is also referred as price illusion. It is the tendency for people to think of currency in nominal, rather than real terms. In other words, the numerical/face value (nominal value) of money is mistaken for its purchasing power (real value) at a previous point in the general price level (in the past). The term "Money Illusion" was coined by maverick economist Irving Fisher in his book "Stabilizing the Dollar" though it was popularized by John Maynard Keynes in the early twentieth century. Irving Fisher was the first economist to produce what is now called "The Fisher equation" in financial mathematics and economics which estimates the relationship between nominal and real interest rates under inflation. The existence of money illusion is disputed by monetary economists who contend that people act rationally (i.e. think in real prices) with regard to their wealth. Eldar Shafir, Peter A. Diamond, and Amos Tversky (1997) have provided empirical evidence for the existence of the effect and it has been shown to affect behaviour in a variety of experimental and real-world situations in three main ways:

• Price stickiness. Money illusion has been proposed as one reason why nominal prices are slow to change even where inflation has caused real prices or costs to rise.
• Contracts and laws are not indexed to inflation as frequently as one would rationally expect.
• Social discourse, in formal media and more generally, reflects some confusion about real and nominal value.

Apparently "The Money Illusion" influences people's perceptions of outcomes. Experiments were conducted and have shown that people generally perceive an approximate 2% cut in nominal income with no change in monetary value as being unfair, but do see a 2% rise in nominal income as fair where there is 4% inflation, despite them being almost rational equivalents. This result is consistent with the "Myopic Loss Aversion theory" but this will probably be an interesting title for another post. The "Money Illusion" is indeed a cognitive bias which can vary depending on the "inflationary/deflationary" context. Numerous studies have documented a negative correlation between nominal yields and inflation. Modigliani and Cohn (1979) assumes that the valuations of the assets differ from their fundamental values because of two inflation-induced errors in judgment: the tendency to capitalise equity earnings at the nominal rate instead of at the real rate, and the inability to understand that, over time, the debts will devalue in real terms. What does it means? Simply that stock prices are overvalued during periods of low inflation. If indeed inflation accelerates, this will lead to some "repricing" and some reversion to the mean. For a bear market to ensue as we have repeated on numerous occasions on this very blog, you need inflation to "accelerate". Past history has shown, what matters is the "velocity" of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years. So, if QE could be seen as "deflationary" then QT could be seen as "inflationary". If the "money illusion" is "fading" and real wages starts accelerating, then the Fed will have no other choice but to pursue a more aggressive hiking pace. Of course if "inflation" is accelerating in conjunction with real wages, then again this will trigger "Bracket creep" being the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation for those who remember our post from January this year:

"Most progressive tax systems are not adjusted for inflation, as wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect overall is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate. That simple." - source Macronomics, January 2018

Yet another illustration of the existence of the "Money illusion" we think but we ramble again...

In this week's conversation, we would like to look at rising inflation creating therefore a shift in the "Money illusion" and what it entails down the line from a liquidity perspective.

Synopsis:

• Macro and Credit - The Money illusion is fading
• Final charts - Always remember that liquidity is a coward

• Macro - The Money illusion is fading

As we indicated back in June 2015 in our conversation "The Third Punic War", bear markets for US equities generally coincide with a significant tick up in core inflation. Also in our January conversation "Bracket creep" we indicated the following:

"As pointed out by Christopher Cole from Artemis Capital in his must read note "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987",  the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion described. But flow wise, as we have pointed out in numerous conversations, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy" so far." - source Macronomics, January 2018

While the latest inflation figure for August is considered as a miss, the Fed has most recently appeared much more hawkish it seems. The big question therefore should be about the strength of inflation. Subdued real wage growth could be one of the reasons put forward for the surprise election of Donald Trump in the United States. The election could be marking a return of Main Street versus Wall Street which has experienced tremendous asset inflations thanks to low volatility and low "perceived" inflation. Yet it seems to us from a "macro" perspective that, indeed the "Money Illusion" is now fading on the back of "QT". 

Is inflation returning? On that subject we read with interest Wells Fargo Economics note from the 12th of September entitled "Inflation not as benign as first indicated by drop in PPI":

"Producer prices came in softer than expected in August, falling 0.1%. The miss stemmed largely from the volatile trade-services sector, which measures margins. The underlying trend in inflation continues to inch higher.

At the Margin

• PPI inflation unexpectedly slipped 0.1% in August. Goods prices were flat, but the miss came in large part from services, specifically a 0.9% drop in the volatile trade-services sector, which measures margins, not selling prices. Declining margins at machinery and equipment firms accounted for 80% of the decline in services this month and suggest producers may be struggling to pass on rising input costs related to recent tariffs.

Core Inflation Continues to Gradually Climb

• Our preferred measure of core inflation, which excludes food, energy and trade services, also came in a bit softer than expected –up 0.1%— as transportation & warehousing prices fell. The trend remains upward, however, with the “core-core” measure climbing to 2.9% over the past 12 months versus 1.9% the 12 months prior.
• Input prices eased a bit in August, but are still running ahead of final prices. Pressure on margins therefore looks to continue.

- source Wells Fargo

Additional escalation in the trade war would as we pointed out in various conversations put additional pressure on inflationary trends and on the US consumer we think. The question on everyone's mind is how are we shifting into a new inflationary state meaning that the "Money illusion" is finally fading?

On this subject we read with interest Bank of America Merrill Lynch's take from their Inflation Strategist note from the 13th of September entitled "Signs of life":

"The old normal shows signs of life

• Globalisation delivers a fall in price level masquerading as deflation. Both secular and cyclical deflation forces are fading.
• We update our long list of determinants of the low real rate era. Bernanke's "global savings glut" obviously has a place.

The three big picture inflation supports

Cyclical, secular and survivorship

We can be critical of the different ways output gaps are calculated, the numbers themselves and their usefulness as a single measure for encapsulating spare capacity in economies. Nevertheless, the reduction/elimination of slack that they signal, apart from being encouraging in its own right, should help towards resolving the question over how much of the “lowflation” experienced has been cyclical and how much secular.

Even when it comes to secular, long term trends, these shouldn’t necessarily be misconstrued as meaning a permanent shift to a new inflationary state. Whether it be the deflationary influence of globalization or the internet, to the extent that this means greater competition (so reduced pricing power), then it does perhaps reduce inflationary potential “permanently”.

However, in a shift from closed economies to open economies (globalization) or from weaker price discovery to stronger price discovery (the internet), a large part of the impact on prices is a one-off adjustment in the level not a permanent reduction in the inflation rate. It just looks like the latter because it doesn’t happen all at once. Inflation should firm if the pace of globalization slows.

Chart 2 suggests globalization is at least experiencing a pause. It shows the extraordinary shift in the openness of the global economy since the 60s but a leveling off in the trade share of GDP in recent years. And, as Governor Carney of the BoE has warned, “deglobalization” (an ugly word for an ugly concept) would threaten a meaningful build-up of inflation pressures.

Perhaps the last line of defense for inflation, as measured, is “survivorship bias”. If economies open up to trade with each other, production gravitates to their respective comparative advantages and (in principle) output is boosted and prices fall. In advanced economies, we have become used to falling goods prices. But, as Chart 3 illustrates simply, if goods prices fall and services prices rise steadily over time, then the overall inflation rate will rise because the index weighting for goods will fall, unless the relative price change prompts a consumption shift from services to goods.

Whether it be this “survivorship bias” or the tendency of economies to consume proportionately more services as they advance (and as their populations age), Chart 4 shows the mild but meaningful shift from goods to services in CPI baskets. 

We suggest that perceptions of r*, the neutral real policy rate consistent with growth at trend and inflation at target, have been framed by the experience of a prolonged period of economic slack and an even longer period of globalization. The impacts of both on inflation are probably fading and the real policy rate required to keep inflation pressures in check will likely rise gradually to a considerably higher level than currently priced.

Real rate drivers - the usual suspects

It is worth periodically rounding up the “usual suspects” cited as causes of the low real rate world we have been in. Here we list suggestions from a variety of sources and throw in a few of our own. We do not claim that it is exhaustive and readers would no doubt add and subtract from what we have below.

Thinking in terms of potential longer-dated real rates drivers – those shifting the supply and demand for savings and investment – it is perhaps useful to split them into those drivers that might have shifted the savings curve and those that might have shifted the investments curve.

Most items we list are self-explanatory and we do not want to go over well-trodden ground in a lot of detail before getting to our main contentions. However, some of the drivers we identify should actually be broken-down into arrays of sub-drivers. In particular, we suggest that there are many facets to the apparent change in capital/labour preference that has subdued capital investment, so we carve out a sublist for that driver.

Causes of investment curve shift to the left?

• The long shadow of the crisis – reduced expected real returns, greater uncertainty over those expected returns or greater risk aversion to that uncertainty
• A decline in innovation, reducing opportunities
• The cost of equity capital has fallen, but nothing like as much as the risk free rate.
• Falling prices of investment goods (and inelastic demand).
• Capital/labour substitution – replacing the former with the latter.

Causes of savings curve shift to the right?

• The “Global Savings Glut” (GSG), especially imported savings from reserve accumulators.
• Demographics – a falling dependency ratio. Workers can save more because they are supporting fewer dependents.
• Precautionary savings accumulated because of crisis.
• Rising inequality raising the average propensity to save."  - source Bank of America Merrill Lynch

We would like to add a couple of comments to the above  relating to the GSG theory put forward by former Fed president Ben Bernanke relating the reasons for the Great Financial Crisis (GFC). Once again we would like to quote our February 2016 conversation "The disappearance of MS München" on this subject:

"The "Savings Glut" view of economists such as Ben Bernanke and Paul Krugman needs to be vigorously rebuked. This incorrect view which was put forward to attempt to explain the Great Financial Crisis (GFC) by the main culprits was challenged by economists at the Bank for International Settlements (BIS), particularly in one paper by Claudio Borio entitled "The financial cycle and macroeconomics: What have we learnt?": 
"The core objection to this view is that it arguably conflates “financing” with “saving” –two notions that coincide only in non-monetary economies. Financing is a gross cash-flow concept, and denotes access to purchasing power in the form of an accepted settlement medium (money), including through borrowing. Saving, as defined in the national accounts, is simply income (output) not consumed. Expenditures require financing, not saving. The expression “wall of saving” is, in fact, misleading: saving is more like a “hole” in aggregate expenditures – the hole that makes room for investment to take place. … In fact, the link between saving and credit is very loose. For instance, we saw earlier that during financial booms the credit-to-GDP gap tends to rise substantially. This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income." - source BIS paper, December 2012

Their paper argues that it was unrestrained extensions of credit and the related creation of money that caused the problem which could have been avoided if interest rates had not been set too low for too long through a "wicksellian" approach dear to Charles Gave from Gavekal Research.

Borio claims that the problem was that bank regulators did nothing to control the credit booms in the financial sector, which they could have done. We know how that ended before." - source Macronomics, February 2016

Indeed, conflating financing and savings is the main issue when it comes to the GSG theory. From a "Wicksellian" perspective, one would argue that low rates for too long leads to mis-allocation of capital. For instance if one looks at CAPEX expenditures in US High Yield since 1997, one can see in the chart below from Bank of America Merrill Lynch that prior to the onset of the GFC, capital raised through bond issuance went into more leverage thanks to a buying spree with Acquisitions/LBOs. Of course a feature of a late credit cycle does lead to seeing more LBOs and acquisitions:

- graphs source Bank of America Merrill Lynch

As we pointed out in our October 2017 long conversation relating  to inflation entitled "Who's Afraid of the Big Bad Wolf?", we had over-inflation of asset prices and too low inflation thanks to the "Money Illusion". The Fed, subdued inflation expectations and inflation with its various QE iterations. We indicated at the time:

"Credit cycles die because too much debt has been raised

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 still fairly 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

Financial conditions remain very loose and with the fiscal boost coming from the Trump administration, no wonder the Fed is becoming more hawkish. You have been warned. 

But returning to real rate drivers, Bank of America Merrill Lynch in their note highlight what has mattered most for the "Money illusion" to take place:

"What has mattered most?

Over the past ten years, bond market participants would almost certainly cite risk-free bond buying by central bank reserve accumulators and the duration extinguished by quantitative easing, mitigating the impact of heavy government bond supply as the crisis lifted debt/GDP levels.

However, real rates were already in long-term decline well before the crisis. Taking a longer time frame, a Bank of England Working Paper by Lukasz Rachel and Thomas D. Smith (No. 571, “Secular drivers of the global real interest rate”, December 2015) claimed to be able to account for 400 of the 450 basis point fall in long term real interest rates over the preceding thirty years.

Exhibit 1, clipped from their paper, suggests that the global savings glut has only had a small walk-on part in the unfolding real rate drama.

In their analysis, the big four drivers were: lower growth, demographics, an increase in the spreads between risk-free real rates and the real rates experienced in the real economy (including, for instance, the real cost of equity finance), and the falling relative price of capital. For this last to be a driver of lower real rates one must assume that demand for capital goods is price-inelastic.

They concluded that: “most of these forces look set to persist and some may even build further. This suggests that the global neutral rate may remain low and perhaps settle at (or slightly below) 1% in the medium to long run.” In their forecasts, they see demographics delivering most of this increase, as the Exhibit shows. Chart 6 shows how this relates to an end to the downtrend in the world dependency ratio, with upswings well underway in advanced economies.

Later, we will discuss the interaction between risk-aversion, driving the “spreads” component in the Exhibit, and the global savings glut, in order to contend that this can be a force for a bigger upward adjustment in real rates in the future.

The replacement of capital with labour has many aspects

As before, we will list what we see as potential causes of this phenomenon, rather than discuss them in any detail. They should be self-explanatory. We would also stress that the ordering should not be regarded as signalling an attempt to rank them in order of importance.

Drivers of the trend shift from capital to labour

• Increasing labour market flexibility
• A global “labour supply glut”, resulting from:

o A falling dependency ratio
o Globalisation
o A post-crisis workforce that needed to re-skill and price itself back
into work

• A change in firms’ perceived capital-labour risk/cost efficient frontier since the crisis
• Capital intensive goods production has been driven out of advanced economies (their comparative advantage being in services)
• Production reflects consumption. Advanced economies consume fewer goods and more (labour intensive) services
• As a result of the above, the modern advanced economy business is capital-light

Ben Bernanke memorably used the term “global savings glut” to describe excess savings circling the world in pursuit of a return. Admittedly, the world saving rate was a little higher in 2005 (when he coined the term) than now but the overall increase in the world savings rate over time has not been great, while that for the OECD has seen a gentle decline.

The glut that is generally understood to have exerted downward pressure on nominal and real yields refers to the savings recycled from surplus countries to deficit countries as large current account imbalances emerged.

However, there are reasons to be a little uncomfortable with that seemingly axiomatic received wisdom without further elaboration. To the extent that current account surpluses represent the excess savings of countries, there are equal and opposite savings shortfalls in current account deficit countries (notably the US and UK).

Conventional wisdom used to have it that countries with persistent current account deficits needed to pay higher prospective returns to attract and retain foreign capital. Investors have a natural preference for domestic assets, so need to be paid a premium for accepting foreign market risk. Therefore, without any change in global saving, an increase in imbalances would be expected to depress real yields in surplus economies but raise them in economies with savings shortfalls.

Conventional wisdom upended

If the above framework is accepted, then a mild increase in the global saving rate accompanied by the development of large global imbalances would have exerted a downward “income effect” on real yields but an upward “substitution effect” on real yields in economies on the negative side of the global imbalances identity. The net impact on real yields in the US (with the greatest need for imported savings) would have been ambiguous. What has upended this logic has been the change in the risk preferences of the exporters of savings.

When an economy is “self-sufficient” in savings, domestic savers have diverse risk appetites; they invest across the risk spectrum. And when an economy does have a savings shortfall but is financed by foreign private capital, risk appetite also tends to be diverse (FDI, equity portfolio acquisition, etc). Up until the late 90s, this was the norm.

So our contention is that the rise of the reserve accumulators, in pursuit of risk-free government paper, crowded-out risk appetite. The substitution effect became one of increasing risk-free investment appetite surpluses and risk-taking appetite shortfalls. Therefore the nature and sign of the substitution changed.

Chart 9 shows the IMF’s presentation of these global imbalances.

In Chart 10, we regroup and simplify the picture. By unifying European creditors and debtors (which appear above and below the zero line in the IMF layout) we change the outline of the picture a bit.

However, the main thing highlighted by Chart 10 is the surplus share recorded by China and the oil exporters up until the last few years. It’s a major oversimplification, obviously, but these are perhaps the most conspicuous reserve accumulators pursuing risk-free external assets.

But that era appears to be over, insofar as we accept IMF forecasts for the development of imbalances. The present and near future of imbalances looks simpler than the past – Europe will be financing the US.

The flows will be private capital, not public reserves, so have the potential to restore the old regime where a US savings shortfall delivers higher not lower risk-free real rates. This also suggests that even though the spread between US and Euro real rates has widened significantly, there’s more to come.

Was the equity risk premium a casualty of this risk appetite shift?

The BoE working paper discussed earlier discussed widening “spreads” as an important driver of low real rates. No doubt the crisis was a major contributor to a gapping wider in the equity risk premium and a shifting preference towards government bonds will reflect other things, like the aging of the average saver. However, we would suggest that if global imbalances have extinguished risk appetite in the way we have described, then this also played a big part in the late-90s bond-equity “correlation flip” shown in Chart 11 and the widening gap between bond and equity earnings yields.

In this context, the post-millennium US experience of debt-financed equity buybacks (widely pilloried as “short-termism” and “financial alchemy” looks, more objectively, to be a rational response to a dramatic increase in the relative cost of equity finance. It’s been about giving investors what they want.

New normal looking more like old normal than we thought

In this note we have discussed very big picture influences that are likely evolving very slowly. However, the underlying messages seem clear. A closing of the global output gap appears to be coinciding with a waning in the deflationary influence of globalisation, resulting in firming global inflation, or at least a higher r* to keep inflation in check. This would be aggravated if globalisation is actually in retreat.

That a global savings glut depressed risk-free real rates is universally accepted but perhaps the bigger global real yield depressant from global imbalances was the extinguishing of risk appetite – “bad” savings driving out “good” savings. The global imbalances are still with us but the composition is changing in a way that should restore risk appetite and lift US real yields, both outright and (especially) relative to European." - source Bank of America Merrill Lynch

We disagree on the above a GSG was not the reason risk-free rates were depressed, no offense to Bank of America Merrill Lynch but we would rather side with the wise wizards at the BIS than with the reckless wizards such as Ben Bernanke at the Fed and others.

Before we move on to our final charts regarding the "liquidity illusion", we would like to quote the wise words of Irving Fisher from his 1928 book:

"We may now summarize our findings
1. The problem of what to do about our unstable money is one of prime importance
2. It has been all but overlooked because of the Money Illusion
3. This Illusion is the more serious because every man finds it harder to free his mind of this Illusion as to the money of his own country than of foreign money.
4. This Money Illusion so distorts our view that commodities may seem to be rising or falling when they are substantially stationary, wages may seem to be rising when they are really falling, profits may seem to exist when they are really losses, interest may be believed to be rewarding thrift when no real interest exists, income may seem to be steady when it is unsteady, bond investments may seem to be safe when they are merely a speculation in gold. It makes a unit of weight appear to be a unit of value; it hides a chief cause of the so-called business cycle; it has enabled political financiers to employ unsound finance with burdens heavier but with complaints less than if sound finance had been employed; it has led to unjust blame of "profiteers" and of the "money lenders"; and above all it has held back stabilization by concealing the need of it.
5. The present fixity of weight of our dollar is a very poor substitute for a fixity of value or buying power.
6. By actual index number measurement our dollar rose nearly four fold and fell back to the starting point again between 1865 and 1920.
7. Most of the dollar's fluctuations were while the dollar was a gold dollar (1879-1922).
8. They were largely peace time fluctuations; most of them occurred while America was at peace (1879-1898, 1899-1917, and 1918-1922), and much of them when there were no important wars elsewhere (1879-1914 and 1918-1922).
9. These fluctuations through serious shrink into insignificance in comparison with the thousand-fold, million fold, billion-fold, and trillion-fold fluctuations in Europe.
10. The cause of a falling or rising dollar is monetary inflation or deflation and that , in practice, it is seldom or never necessary to specify that the inflation or deflation is merely relative since it is also absolute as well.
11. To go back to the cause of inflation or deflation, the extreme variability of money is chiefly man-made, due to governmental finance, especially war finance, as well as to banking policies and legislation; but also due in part to discoveries or exhaustion in gold mines, and changes in metallurgical art.
12. The tremendous fluctuations of money produce tremendous harm analogous to what would result if our physical yardstick were constantly stretching and shrinking but far greater

• a. because the money yardstick is used so much more generally
• b. because it is so much more used in time contracts, because stretching and shrinking are unseen.

13. This harm includes a constant robbery of Peter to pay Paul - amounting to sixty billion dollars in six years in the United States alone - a net loss to all Peters and Pauls taken together, confusion and uncertainty in all financial, commercial and industrial relations, constituting much what is called the business cycle, producing depression, bankruptcy, unemployment, labor discontent, strikes, lockouts, class feeling, perverted legislation, Bolshevism and violence. In short the harm is threefold: social injustice, discontent and inefficiency." - source Irving Fisher, The Money Illusion.

He also added that credit control must always be an important part of any program for stabilization. This is leading us to our final charts relating to the "liquidity illusion" in credit markets.

• Final charts - Always remember that liquidity is a coward

As a reminder, a liquidity crisis always lead to a financial crisis. That simple, unfortunately. In our February 2016 conversation "The disappearance of MS München" on this subject we quoted Dr Jochen Felsenheimer and Philip Gisdakis from their 2008 book Credit Crises:

"Asset price inflation in general, is not a phenomenon which is limited to one specific market but rather has a global impact. However, there are some specific developments in certain segments of the market, as specific segments are more vulnerable against overshooting than others. Therefore, a strong decline in asset prices effects on all risky asset classes due to the reduction of liquidity.
This is a very important finding, as it explains the mechanism behind a global crisis. Spillover effects are liquidity-driven and liquidity is a global phenomenon. Against the background of the ongoing integration of the financial markets, spillover effects are inescapable, even in the case there is no fundamental link between specific market segments. How can we explain decoupling between asset classes during financial crises? During the subprime turmoil in 2007, equity markets held up pretty well, although credit markets go hit hard." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

Our final charts come from Bank of America Merrill Lynch's Credit Market Liquidity report from the 12th of September and highlights the "buy-side" versus the "sell-side" imbalance after the GFC and seems to be on every credit investors mind these days, rightly so:

"The ECB has been tapering its QE programme, and asset purchases will finish by the end of this year. Credit market liquidity is becoming more challenging with market participants seeing fewer bids when they need them. We think that when bond market liquidity becomes more challenging, the CDS market is the vehicle to manage risk. Bond trading frequencies have slowed down over the past years; trading volumes in the CDS market are rising rapidly, both in the index and the options market.
The “buy-side” vs. “sell-side” imbalance is the largest it has ever been. In a world of growing buy-side assets but lower street liquidity, sharp corrections are more common. Dealer inventories of corporate bonds are clearly way down on where they were in ’07, but banks also appear more nimble in managing their mark-to-market risks and overall exposures on their securities portfolios.

The CSPP has dominated the European credit market in recent years. The ECB has bought more than €167bn of euro-denominated corporate debt (and this is still growing, albeit slowly). The CSPP has been pivotal in improving the credit market’s strength and resilience. But we can see a shift in market liquidity for the worst in recent months amid rising markets volatility.

Liquidity has been challenging according to the findings of our analysis, and credit investors seem to think that it will deteriorate as the buyer of last resort withdraws and they will be the only buyers left in the market (chart 3).

With inflows drying up and possibly continuing to do so as the rates cycle between US and Europe pushes money out of the latter, liquidity will likely become more challenging (more here).

The trend of selling in secondary to participate on primary is the new norm as inflows have stopped. If macro deteriorates further and investors need to replenish their cash balances to cover weaker fund flows technicals, the bid for bonds would weaken more, we think. No wonder that the key concern for credit investors is that “market liquidity evaporates”; the August 2018 survey reading was the highest since H2 2015 heading into the February 2016 sell-off and amid HY market weakness (on the back of a flare-up in the Greek debt saga, EM risks and oil prices tanking).

Our liquidity indicator at the most distressed levels

Arguably it is difficult to quantify liquidity. So many metrics (bid/offer, turnover, volumes and trade counts), but none of these have the ability to measure “illiquidity aversion” and to what extent risk-aversion has dominated the market. We think the volatility market is providing unique and eye opening insight on the current state of the “illiquidity scare” for market participants.

In our Hold your breath for a bumpy ride note, we highlighted an interesting and rather unique phenomenon that recently emerged in the European credit index options market. Amid significant volatility during the Italian BTP sell-off, we have seen an increase in hedging demand. As a result implied vols have moved well above the levels justified by the underlying spread market. But not only that, as not only have vols underperformed (moved more than) the underlying market, but implied vol skews were heavily bid too, steepening to the highest levels we have seen historically (chart 4).

We think we could gain significant insight on risk aversion from examining the correlation between the forward moves of the implied vol skew (payer vs. receiver implied vol differential) vs. the preceded moves in the underlying implied vol market. In simple terms, the higher the correlation the stronger the need for tail hedging going forward post a vol shock in credit. Currently we find that the level of positive correlation (steepening of implied vol skew, post a rise in implied vols) is the highest we have ever seen, according to our data.

In our opinion this clearly reflects the high levels of risk aversion and illiquidity fear during the recent sell-off. It seems that investors hit the “panic” button harder than at any other time in history. A continuation of outflows, a weak macro and declining market liquidity could ultimately push too many investors to the exit." - source Bank of America Merrill Lynch

It seems that some credit investors are getting wary about the "liquidity illusion" in credit markets and some are already lining up for the exit as no one wants to really pick up the tab of the very large credit punch bowl offered by our "generous gamblers" aka our dear central bankers but we ramble again as we are not there yet and equities continue to surge oblivious to the on-going shift in the "Money Illusion". Oh well...

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

Stay tuned !