Macro and Credit - The Armstrong limit

"Men go abroad to wonder at the heights of mountains, at the huge waves of the sea, at the long courses of the rivers, at the vast compass of the ocean, at the circular motions of the stars, and they pass by themselves without wondering." - Saint Augustine

Watching with interest the Japanese Nikkei index touching its highest level in 27 years at 24,245.76 points, with US stock indices having rallied strongly against the rest of the world during this year, and closing towards new highs, when it came to selecting our title analogy we decided to go for another aeronautic analogy "The Armstrong limit". The Armstrong limit also called the Armstrong's line is a measure of altitude above which atmospheric pressure is sufficiently low that water boils at the normal temperature of the human body. Humans cannot survive above the Armstrong limit in an unpressurized environment. Above earth, this begins at 18-19 km (59,000-62,000 feet) above sea level. The term is named after United States Air Force General Harry George Armstrong who was the first to recognize this phenomenon. Commercial jetliners are required to maintain cabin pressurization at a cabin altitude of not greater than 2400 m (8,000 feet). The Armstrong limit describes the altitude associated with an objective, precisely defined natural phenomenon: the vapor pressure of body-temperature water.  Back in August in our conversation the "Dissymmetry of lift", we discussed our Quantitative Tightening (QT) amounted to reducing global liquidity and tightening global financial conditions overall as well as less airflow to maintain growth (we are already seeing signs in Europe).  When it comes to airflow and liquidity relating to equity indices we touched in this subject in two previous conversations: "The Coffin corner" in April 2013, the other being "The Vortex Ring" in May 2014. When it comes to our analogy and our reference to the Nikkei and US equity indices we remember clearly that the Nikkei hit its all-time high on 29 December 1989, during the peak of the Japanese asset price bubble, when it reached an intra-day high of 38,957.44, before closing at 38,915.87, having grown six fold during the decade. Sure the S&P 500 has grown six fold during the decade since the collapse of Lehman Brothers but it's within 1% of its all time high. One question investors are starting to ask themselves is what is the "Armstrong limit" for US equities? Bank of America Merrill Lynch in their recent The Flow Show note from the 27th of September entitled "Jay stalking" have two very interesting charts when it comes to equity allocation from Global Wealth and Investment Management (GWIM) into equities and cash allocation levels:

- source Bank of America Merrill Lynch

One might indeed wonder what level is the "Armstrong limit" before boiling point we think...

In this week's conversation, we would like to look at once again at the US consumer which seems to be increasingly relying on his credit card as well as other signs that warrants monitoring at this stage in the cycle.

Synopsis:

• Macro and Credit -  What's the Armstrong limit for the US consumer's confidence?
• Final charts - The "profit" illusion

• Macro and Credit -  What's the Armstrong limit for the US consumer's confidence?

In continuation to our last conversation, we think it is essential for the US growth outlook and forward earnings to continue to focus on the state of the US consumer. After all, the first on the line in any case of trade war escalation is the US consumer who gets the price increase passed onto by corporations facing a surge in costs. With the US consumer confidence index climbing to 138.4 in September from 134.7 in August, the highest since September 2000 we are wondering if it is the absolute Armstrong limit.

On this question we read with interest Wells Fargo's take from their US Consumer Confidence note from the 25th of September:

"In the past 51 years, only 11 times has confidence been higher than it is today. Said differently, roughly 98% of the time confidence is lower than it is now. That’s good news for the consumer, but for how long?

Remember the Sock Puppet Commercials?

The last time consumer confidence was as high as it is today was in the year 2000. A number of financial and economic indicators from that era are similar to where they are today. The stock market was soaring to all-time record highs, the unemployment rate was below 4% and the economy was in its 10th year of uninterrupted expansion. Then, as now, there were few people seeing an end in sight.

While we still think the current expansion has room to run, we would be remiss not to make note of just how rare a thing it is to see confidence at these lofty levels. Only in 11 individual months since 1967 have we seen confidence higher than it is today. Nine of those months were in the year 2000. The other two were in 1999. This is the thin air of the high peaks.

The euphoria is not limited to the consumer sector. The ISM manufacturing index is at its highest level since 2004 and the NFIB Small Business Optimism Index, an indicator of small business confidence, is at its highest level on records that date back to 1974. The fact that these measures are at record highs does not preclude them from going higher, but one characteristic that they all share is a tendency to peak before a slowdown.

No Time Like the Present

There is an interesting dynamic going on between consumers’ assessment of the present situation, compared to expectations for the future. As seen in the middle chart, the present situation measure is running well ahead; in the prior cycle there was a similar divergence late in the cycle.

Some Things That Are Different From 2000

The below chart plots consumer confidence alongside both retail sales (ex-autos) and real income growth on a per-capita basis. Here we see something that Fed policymakers have been wringing their hands over throughout this cycle, which is: if the labor market is so hot, how come income growth is so tepid?

That slower income growth tempers our enthusiasm for the ability of consumer spending to sustain growth indefinitely. We will get the latest read on this when the personal income and spending numbers hit the wire on Friday of this week.

I Don’t Know Why I Go to Extremes

For now, the surge in retail sales cannot be denied and we would be foolish to bet against the consumer with such a solid backdrop for consumer confidence. The official write-up that accompanied the release stated that “Consumers’ assessment of current conditions remains extremely favorable, bolstered by a strong economy.” We would not disagree, but what takes the shine off the apple for us is that extremes, by definition, imply “reaching a high, or the highest degree.” If this is the extreme, there is nowhere to go but down." - source Wells Fargo

With US Personal Income rising 0.3% in August, slightly less than expected (0.4%) last Friday, then indeed slower income growth should indeed temper slightly your enthusiasm we think.

As a reminder from last week's conversation, and as per the below Macrobond chart, the University of Michigan Consumer Confidence turning points tend to coincide with significant S&P 500 12 months return. It is worth remembering this from an Armstrong limit perspective:

- graph source Macrobond (click to enlarge)

Also, keep that in mind when looking at the significant rise of the S&P 500, because we think that we are in the melt-up "euphoria" phase and have yet to touch the "Armstrong limit":

- graph source Macrobond (click to enlarge)

Or you could also ask yourself as well what is the "Armstrong limit" when it comes to the S&P 500 Profit Margins in this long in the tooth credit cycle:

- graph source Macrobond (click to enlarge)

You could as well ask yourselves when will we reach "peak" M&A, which is also a sign you generally see in late credit cycles:

- graph source Macrobond (click to enlarge)

In last week's conversation, "White Tiger" we indicated that although everyone is focusing on the flattening of the yield curve, from an inflationary expectations perspective we worry a lot for asset prices about a spike in oil prices if we do get geopolitical flares up in November between the United States and Iran:

"The issue of course for the stretched US consumer would be if Core PCE inflation continues to pick up slightly faster than core CPI if healthcare service price inflation accelerates while rent inflation gradually slows. This upside risk to healthcare prices and expected further labor market tightening, one could expect core PCE inflation to rise further, not to mention the issue with gas prices at the pump should oil prices continue as well to trend up. Remember that the acceleration of inflation is a dangerous match when it comes to lighting up/bursting asset bubbles." - source Macronomics, September 2018

So for us, from an Armstrong limit perspective, we are closely watching the evolution of oil prices:

- graph source Macrobond

An inflation spike is very much on our radar. Oil has extended its gains after the longest quarterly rally in a decade thanks to a slowdown in American drilling as well as supply concerns. The U.S. and Saudi Arabia have discussed market stability yet it seems there are some questions relating to spare capacity with traders highlighting a potential surge towards $100 a barrel at some point. 

From an Armstrong limit perspective relating to the state of the US consumer, oil prices matter because not only retail has been sustained by the rise in credit card use but housing is seeing headwinds already thanks to rising mortgage rates. The issue at hand is the size of energy costs for the US consumer relative to his consumer spending. On that subject we read with interest Wells Fargo's take from their note from the 28th of September entitled "What Good is a Bigger Paycheck if it All Goes to Gas Money?":

"Wages and salaries posted the largest monthly increase since January, but increasingly higher gas prices and other energy costs are commanding a larger share of consumer spending.

Income Gets Boost from Wages

Personal income increased 0.3% in August, which was a bit shy of the 0.4% that had been expected by the consensus.

More than two thirds of the increase was due to the fact wages and salaries notched a solid 0.5% gain. That was the best monthly increase since January and the latest indication that the hot job market is at last translating into meaningful improvement in wages.

Personal interest income, which comprises less than a tenth of overall income, was down for the second straight month and was in fact the only category of personal income that declined during the period.

Energy Costs Taking up Larger Share of Consumer Spending

Despite the slightly softer print on the income side, spending did not disappoint with the 0.3% pick-up in outlays, matching the consensus expectation. The fact that wages and salaries drove much of the increase explains why the saving rate was able to remain unchanged at 6.6%.

Consumer durable goods outlays slipped 0.1%, but every other major category of spending was either flat or positive to varying degrees. Echoing one of the themes from the August retail sales report in which gas stations reported faster sales than other types of stores, the biggest category gainer in terms of price was energy goods and services, up 1.9% on the month. This category includes spending on gasoline but also includes energy goods delivered to the home through utilities like electricity and natural gas. The takeaway is that higher energy prices in August might have been holding back spending in other categories. Excluding food and energy, spending was flat in August.

Inflation Dynamics

People are not suddenly buying a lot more gasoline. Prices, of course, are largely to blame. The energy prices category within the price indices has seen double-digit percentage gains in each of the past four months. Mercifully for consumers, prices for durable goods have also been lower in each of those past four months, ameliorating the impact of higher energy prices. The headline measure for the personal consumption expenditures deflator, the Fed’s preferred inflation gauge, slowed slightly to 2.2% from 2.3% on a year-over-year basis in July.

Existing tariffs on a variety of imports totaled roughly $100 billion in August; with this week’s additional tariffs on $200 billion going into effect, the price effects for consumers might become more tangible. The nation’s largest retailer this week warned that it might be forced to charge higher prices.
In its statement earlier this week, the Federal Reserve noted that “inflation on a 12-month basis is expected to move up in coming months” before eventually stabilizing near the Fed’s 2% target rate." - source Wells Fargo

Tariffs and rising gas prices do not bode well for the euphoric US consumer we think in the near future. Sure US equities, consumer confidence and even US High Yield have had a very good run in 2018 (CCCs have outperformed higher quality by a wide margin: +5.6% of excess returns) in comparison to the rest of the world, so it's highly likely that the "risk-on" euphoric mood will continue given financial conditions are still fairly accommodative (as per the most recent Fed SLOOs), but we think that 2019 could start becoming much more challenging as QT accelerates and depending on the Fed's hiking path as we are officially out of negative real rates for now.

In continuation to our “macro” long conversation “The Money illusion”, where we concluded that liquidity is a coward and where we repeated what we indicated back in June 2015 from our conversation "The Third Punic War", bear markets for US equities generally coincide with a significant tick up in core inflation, given the amount of buybacks since with the issuance of debt in many instances in our final charts below, we are wondering if there could be as well a "profit illusion" when it comes to the US markets.

• Final charts - The "profit" illusion

Sure, liquidity is a coward and as many have pointed out, with dwindling inventories on banks balance sheet and the very significant rise in corporate debt issuance in credit markets, one can indeed ask if "liquidity" is an illusion. On the question of the "profit illusion" our final charts come from our esteemed former colleague David P. Goldman who now writes in Asia Times and ask if buybacks are creating the illusion of profit in his article from the 28th of September entitled "Something strange is happening with US corporate profits":

"Are companies creating the illusion of higher profits through stock buybacks? 

It was reported earlier this week that S&P 500 companies bought back a record US$189 billion of their own shares in the first quarter of this year. The buybacks make results look better than they really are, as The Wall Street Journal reported.

The charts below show that raw, unadjusted US corporate profits actually FELL year on year, and corporates are creating the illusion of higher profits by buying back shares.

This is the rawest, simplest measure of profits, before tax and inventory/capital consumption adjustments, which are model driven. This is basically what corporations report on their income tax, and it doesn’t look terribly strong.

Are profits rising or falling? 

- source Asia Times - David P. Goldman

One could contend that the boiling frog which is a fable describing a frog being slowly boiled alive, could be related to the Armstrong Limit looking at the altitude reached by equities and some valuation metrics. As a reminder, the premise of the fable is that if a frog is put suddenly into boiling water, it will jump out, but if the frog is put in tepid water which is then brought to a boil slowly, it will not perceive the danger and will be cooked to death. The story is often used as a metaphor for our inability or unwillingness to react to or be aware of sinister threats that arise gradually rather than suddenly such as the markets we are seeing one could argue. Though some would add that "thermoregulation" by changing location is a fundamentally necessary survival strategy for frogs and other ectotherms, rendering the legend a "myth". From an Armstrong Limit perspective, we certainly hope that some investors have their "g-suits" on given the lofty levels reached in some instances. Also we do not know yet what is the Fed's own "Armstrong limit" in their current hiking path but we ramble again...

"There can be no rise in the value of labour without a fall of profits." -  David Ricardo

Stay tuned !

Macro and Credit - Volition

"The true test of a leader is whether his followers will adhere to his cause from their own volition, enduring the most arduous hardships without being forced to do so, and remaining steadfast in the moments of greatest peril." - Xenophon

Looking at the dizzy heights being reached in equities with uninterrupted flows into US Investment Grade with yet another warning coming from the wise wizard from the BIS, namely Claudio Borio in the latest quarterly report, when it came to selecting our title analogy, we reminded ourselves of the term "Volition" from psychology given our fondness for behavioral economics. Volition or will is the cognitive process by which an individual decides on and commits to a particular course of action such as the normalization process undertaken by the Fed. It is defined as purposive striving and is one of the primary human psychological functions. Volition means the power to make your own choices or decisions. As an example of the classical concept of volition, comes from Eliezer Yudkowsky while discussing friendly AI development and "Coherent Extrapolated Volition" in 2004. The author came up with a simple thought experiment: imagine you’re facing two boxes, A and B. One of these boxes, and only one, has a diamond in it – box B. You are now asked to make a guess, whether to choose box A or B, and you chose to open box A. It was your decision to take box A, but your volition was to choose box B, since you wanted the diamond in the first place. Now imagine someone else – Fred – is faced with the same task and you want to help him in his decision by giving the box he chose, box A. Since you know where the diamond is, simply handling him the box isn’t helping. As such, you mentally extrapolate a volition for Fred, based on a version of him that knows where the diamond is, and imagine he actually wants box B. In developing friendly AI, one acting for our best interests, we would have to take care that it would have implemented, from the beginning. The question one might rightly ask is relating to the volition of the Fed, is it really for our best interests? One might wonder.

In this week's conversation, we would like to look at the volition of the Fed in its normalization process and the potential upcoming impacts in 2018 should the Fed, once again be behind the increasing flattish curve.

Synopsis:

• Macro and Credit - When the going gets tough
• Final chart -  The Fed can't escape Newtonian gravity

• Macro and Credit - When the going gets tough

Back in April 2017 in our conversation "Narrative paradigm" we argued that when it comes to credit market the only easy day was yesterday. Given the significant role of beta thanks to cheap credit and the "carry play" supported by low rates volatility, it becomes increasingly difficult for us to be supportive of at least the European beta play with the level touched by European High Yield. We also indicated recently that we were expecting a significant pick-up in M&A activity in 2018. This means that some investment grade issuers could experience some sucker punches in the form of blowing out credit spreads in 2018 hence the need of reaching out for your LBO screener à la 2007. A raft of M&A transactions in 2018 would clearly reinforce the view of the lateness in the credit cycle. In terms of change of narrative and in continuation of the "synchronicity" we mentioned in our previous post, the Fed's volition should not be taken lightly.

Also, regardless of the economic narrative put forward by many, including November payrolls rising by a seasonally adjusted 228K and beating expectations of 200K, leaving the unemployment rate in the US to 4.1%, rising wage pressure remains relatively absent. On top of that, surging consumer confidence and modest income growth should trigger much stronger loan demand in our "credit book". One could argue that the credit impulse in the US is tepid at best, no offense to the volition of the Fed. This is indicated by Wells Fargo in their Interest Weekly note from November 29th entitled "Mixed Credit Trends Among Businesses and Consumers":

"In the ninth year of the current economic expansion, credit standards point to a varied, but stable, outlook. Recent data suggest business lending demand has fallen, while consumer demand has seen modest gains.

Banks Optimistic (Yet Cautious) Approach to Lending

Banks continue to relax lending standards on business, commercial and industrial (C&I) loans and mortgages, as banks’ willingness to make loans has gained some stability. A slowdown in banks’ willingness to lend is customary with late cycle expansion. As seen in the below graph, banks’ willingness to extend credit follows a cycle-like trend.

At the start of an economic expansion, banks appear very willing to extend credit. But as the cycle matures, they become less willing to extend credit, and, in turn, tighten their standards in a cautionary nature.

Banks have reported increased competition from other bank and nonbank lenders, which in part, has led to the easing of standards. Continued loosening of lending standards of C&I and mortgage loans points to sustained confidence in the current state of the expansion. However, banks continue to tighten standards on credit card and auto loans, which may signal some caution in the consumer sector as the economic cycle ages.

Slowly Growing Consumer Demand for Loans

With an unemployment rate of just 4.1 percent, and in an environment of modest income growth and surging consumer confidence, theory would suggest robust loan demand. Loan demand, however, remains muted, pointing to a change in consumer sentiment towards debt. Credit card demand has remained unchanged, while we have seen a recent uptick in auto loan demand (below graph).

The rise in demand for auto loans is likely attributable to rebound effects in auto-sales due to damage from the recent hurricanes in Texas and Florida. Consumer demand for mortgage loans has slowed, which is expected to reverse as existing home sales edge higher off a recent slowdown.
Without an increase in income growth, loan demand should continue to increase modestly. Our forecast calls for an uptick in disposable personal income in Q2 2018, due to the effects of the proposed tax reform, followed by a slowdown in disposable personal income growth through the last year of our forecast (2019). Such slowing in income growth suggests consumers may increasingly turn to borrowing to fund their consumption habits in the future.
Demand for business loans remains weak, yet increased strength in business investment suggests that firms have turned to other sources of funding to fuel capital spending (below graph).

The loosening of lending standards, coupled with our positive outlook for business investment, should drive C&I loan demand higher in the near future. However, as the cycle continues to mature, we project equipment spending to slow, likely resulting in a reduction in business demand looking further ahead. The current credit climate insinuates stability within lending practices as growth continues in the ninth year of the current economic expansion."  - source Wells Fargo

While the Fed's volition is to continue with its hiking cycle, financial conditions remain loose and the lack of pressure on wages means that consumers are increasing their leverage through consumer loans in an environment where there is increased competition for business from other players. There are two ways we think the first part of 2018 could play out, "Goldilocks" or "Stagflation" with a sudden rise in inflation expectations that would provide support for a bond bear market narrative with rising interest rates volatility. This is of course without taking into account rising geopolitical risk aka the dreaded "exogenous" factors. We sidestepped various political "exogenous" risks in the first part of 2017 with various elections taking place in Europe in particular. It remains to be seen what will be the trigger of the return of volatility which has so badly wounded many large global macro funds in recent years thanks to its absence. As far as interest volatility is concerned it is at the lowest level in more than 20 years as displayed in the below Wells Fargo chart from their 2018 US Corporate Credit Outlook published on the first of December:

- source Wells Fargo

It won't last rest assured as it is getting late in the game we think and we are already seeing a "synchronized" change in the central banking narrative. Yet some "beta" players continue to be oblivious to the change in the central banking rhetoric. It doesn't mean that the "Goldilocks" environment won't last a little bit more in 2018 for credit, but, we think you should start thinking about playing "defense". This is why back in July we recommended to tactically going for duration again particularly in credit. This has been paying off nicely in 2017 (MDGA - Make Duration Great Again) as indicated by Bank of America Merrill Lynch Credit Market Strategist note from the 8th of December entitled "Year of Duration":

"Year of Duration

That 30-year corporate bonds, which we define in the following as 15+ years, have performed well in 2017 (+11.48% YtD) is no surprise. After all we expected “equity-like” 8-9% total returns in our 2017 outlook piece (see: 2017 US high grade outlook: Let’s do the twist 21 November 2016) on the back of a 27bps decline in 30-year corporate yields (actual: -48bps YtD, Figure 1).

However the surprise has been that credit spreads and Treasury yields were almost equally responsible for this decline in yields (25bps tightening in spreads and 30ps decline in 30-year Treasury yields as of yesterday, Figure 2).

This positive correlation between credit spreads and Treasury yields for such large moves is noteworthy and counterintuitive, but not unseen in the post-crisis years.

How did duration become king?

There are many reasons corporate yield curves are flattening so much including first and foremost that the Fed plans to hike rates actively in an environment of weak inflation data (Figure 3, Figure 4).

This was highlighted by today’s mixed jobs report for November where, although headline nonfarm payrolls were strong at +228k (vs. +195k consensus, Figure 5), average hourly earnings grew only 2.5% YoY (vs. 2.7% expected, Figure 5).

There are many other reasons for flattening yield curves including Treasury’s refunding announcement, where they committed to meet any increased issuance needs using shorter maturities (see: On funding and refunding), the ongoing shift in Europe out of cash and way out the curves (see: QE is dead, long live NIRP), macro risks, etc.

Re-iterate 10s/30s spread curve flatteners

Unusually - and a testament to extreme investor need for both yield and duration – we have seen the 10s/30s corporate spread curve (non-fin, commodities) flatten 8-9bps this year, despite the fact that the 10s/30s Treasury curve has flattened 22bps. More broadly this environment of both flattening Treasury and spread curves has been in place since spreads began tightening in early 2016 (Figure 7). However, the past six months has seen little flattening of the spread curve – but the lack of steepening is actually very impressive as the Treasury curve has flattened 27bps over the same period of time. Needless to say if the Treasury curve continues to bull flatten our recommended non-banks spread curve flattener will not work. We are probably even now reaching levels where further bull flattening actually leads to steeper spread curves. Our house view (see: Global Rates Year Ahead) remains that the Treasury curve is too flat and eventually will re-steepen, which should be very favorable for our spread curve flattener trade. The trade also works with higher interest rates as long as the curve does not flatten.

- source Bank of America Merrill Lynch

As we concluded back in early June in our conversation "Voltage spike", the MDGA trade (Make Duration Great Again) has made a very good come back as indicated by the ETF ZROZ we follow, which delivered a 10.53% return so far this year. For 2018, we continue to favor style over substance, quality that is, over yield chasing from a tactical perspective. As well in another conversation of ours in June this year entitled "Goldilocks principle" we indicated:

"The relentless flattening of the US yield curve shows that in the current inning of the credit cycle, and with a Fed determined in continuing with its hiking path, from a risk-reward perspective, we believe long duration Investment Grade still offers support to the asset class and not only from a fund flows perspective with retail joining late the credit party. On another note the "Trumpflation" narrative has now truly faded to the extent that the deflation trade du jour, long US Treasuries (the long end that is) is back with a vengeance, while inflation expectations has been dwindling on the back of weaker oil prices (after all they still remain "expectations" from our central bankers perspective). " - source Macronomics, June 2017

Our call has been vindicated as well as our contrarian stance against the "bullish" dollar crowd. We continue to believe we will see further weakness ahead for the US dollar in 2018. If we do see additional pressure on the leverage play thanks to the carry trade due to central banking's volition, then one should expect a rise in the Japanese yen we think. As well we continue to see value in the long end of the US curve. Also while gold prices have been weaker recently, the recent pullback as for goldminers looks to us enticing, particularly in the light of a growing risk in "exogenous" factors. If credit options are cheap, gold/gold miners options are "cheaper" as well from a convexity reward perspective in 2018. When it comes to the bull run in credit spreads it has not yet ended and probably will last longer than many might expect, until we hit 11 that is on the "credit amplifier" in true Spinal Tap fashion. We do not see any value left (apart from playing the "dispersion" game with active credit management) in European High Yield at these levels. What is left is "carry" and clearly not enticing enough for us from a risk reward perspective in 2018. We would rather continue playing the US Investment Grade long duration play when it comes to credit allocation. What about US equities being priced to perfection and US High Yield? Given the strong correlations of both asset classes (close to 1 regardless of what some pundits would like to tell us), it is all a matter of "earnings" and they have been so far holding fairly well.

The big risk out there is, as we pointed out the return of the "Big Bad Wolf" aka inflation. This would force the hand of central banks and lead to a more rapid pace in rate hikes leading to some significant repricing on the way. Inflation is our concern numero uno and this would we think be the trigger for higher volatility. This is as well the view of Deutsche Bank from their Asset Allocation note from the 4th of December entitled "What to make of volatility at 50-years lows":

"In our view the leading candidate for a shock that would lead to a sustained increase in vol is a sharp increase in inflation

As noted above, exogenous shocks have historically played a significant role in increasing and sustaining vol at higher levels. Shocks in general of course tend to be inherently unpredictable. Our economists forecast is for a gradual rise in inflation. But in the current context a sharp increase in inflation sticks out as a leading candidate for a shock that raises volatility in a sustained manner in 2018 given the extent to which it is priced in and the likely reaction of monetary policy:

• Slow inflation priced in. The slowdown in US inflation beginning in March this year had large impacts across asset classes and looks to be priced in (The Growth-Inflation Split, Sep 2017).
• Few expect a sharp pickup in inflation. The market and FOMC narrative around low inflation with widespread buying into structural declines and a breakdown of traditional relationships looks to have gotten carried away (Six Myths About Inflation, Oct 2017). This suggests few are expecting a sharp pickup in inflation.
• Four fundamental reasons to expect inflation to move up. First, the lagged impacts of inflation to the growth slowdown during the dollar and oil shocks points to a pick up. Second, the labor market continues to tighten and in our reading there is no reason to believe the traditional Phillips curve has broken down, just swamped by other factors. Third, the direct drag from the past appreciation of the dollar should begin to pass through. Fourth, idiosyncratic factors together have had a strong negative run but tend to mean revert over time. Acting in concert, the four factors clearly have the potential to create a sharp move higher in inflation.
• A sharp pickup in inflation is likely to be interpreted as a sign of the economy overheating and the Fed embarking on hiking until it ends the cycle. Fed hiking to keep inflation in check has been a—if not the —leading driver of recessions historically. Market expectations of Fed hikes are currently of course far below the Fed’s guidance and a sharp pickup in inflation is likely to entail a significant re-pricing. We don’t see Fed rate hikes from current low levels as ending the cycle any time soon (Is Unprecedented Monetary Policy Easing Creating Secular Stagnation? Jul 2016). But we do see faster rate hikes against the backdrop of a sharp pickup in inflation as having the potential of raising and sustaining vol at higher levels as concerns about the end of the cycle grow." - source Deutsche Bank

Make no mistake, inflation is the "Boogeyman" for financial markets. From the long interesting report from Deutsche Banks, three graph stand out when it comes to heightened risk for large "sigma" events in 2018 given how coiled the volatility spring is:

- source Deutsche Bank

No matter how high your "interval of confidence" is, your VaR model is looking/asking for trouble, particularly your "liquidity" hypothesis. It is time to build some cheap "convexity" defenses as we posited above, not to mention the need for your LBO screener with rising M&A risk and the sucker punches they can deliver to your Investment Grade portfolio à la 2007. Just some thoughts for 2018.

When it comes to the relentless flattening of the US Yield curve as a harbinger for rising recession risk in a classical macro way, we read with interest Deutsche Bank's take from their Global Market Strategy note from the 1st of December entitled "The Fed, the Curve and Risk Assets in the Great Rate Normalization about the recession risk transmission:

"Recession risk transmission

The sharp curve flattening has given renewed life to worries that recession risks are on the rise. Given the flattening, our recession probability metrics – one using the outright slope of the 1s10s yield curve, and one that adjusts the 1s10s curve for the level of 1s – both suggest that November’s flattening was worth a ~6pp increase of the probability that a recession will begin in the next 12 months.

Holding all other inputs equal (the u-rate vs nairu, aggregate hours worked growth, core CPI ex-shelter, and the change in oil prices) puts the probability of a recession beginning in the next 12 months at 16.4% on the unadjusted model, and 26.4% when we adjust the curve for the level of front-end rates. This is still low.

The parallels between the current environment and the Greenspan conundrum are inevitable given the apparent insensitivity of long-end rates to the Fed’s hiking cycle – particularly in the context of a balance sheet unwind that many expected to put sustained steepening pressure on the curve. There is no “conundrum” in our mind – the Fed is simply hiking into a very low neutral rate, with no evidence that inflation is set to materialize to allow them to move faster. This cycle is following a somewhat similar path, however, to the mid 2000’s cycle from the perspective of recession probability.

Now 2 years into the current cycle, the recession probability is at a similar spot to mid-2006 (which was just months away from being within the 12 month window to the start of the great recession).

The risks presented by a flattening yield curve have a clear transmission mechanism to broader conditions as the Fed’s balance sheet shrinks. Before the Fed began to pare its balance sheet we discussed why a steep curve is important to a successful QE unwind – if the curve flattens too much, banks will have no incentive to hold securities over cash earning IOER, meaning non-banks will likely be the marginal buyers of securities no longer owned by the Fed, and deposits will leave the system. This in turn carries meaningful risks to loan growth, which had caught a fair amount of attention given the slowing earlier in the year. Our financial conditions index suggests that C&I growth should be accelerating, though that has not really materialized yet.

The lagged relationship between C&I loans and the Senior Loan Officer survey points to a pick-up in loan growth, but only into the ~5% y/y range, not the double digit range of years past. This has failed to materialize, however, and is a going risk amid the Fed’s balance sheet wind down.

It is still sufficiently early into the Fed’s balance sheet unwind that banks’ reaction function is hard to gauge – securities holdings have risen since the end of September, while cash holdings have been more or less stable and deposits have shown some recent volatility but might still be on an upward trend. So the limited evidence does not yet suggest that this is posing an imminent risk to the economy, but the flatter the curve gets, the more likely banks are to eschew securities for cash, increasing the risk that deposits leave the system, and banks have to pull back on lending."  - source Deutsche Bank

There you have it, no matter how strong the "volition" of the Fed is, the exercise is difficult to execute. While there is no imminent threat to the positive narrative from a fundamentals perspective, the relentless flattening of the Us yield curve is difficult to ignore on top of rising geopolitical exogenous factors. We could easily entertain a blow out of oil prices on the back of exogenous factor in an already tensed Middle East, which would no doubt spill into the inflation expectations surprises on the upside and lead to some repricing and heightened volatility. As we pointed out in our bullet point, when the going gets tough...volition or not.

In our last conversation, we pointed out that "volatility" conundrum was not a paranormal phenomenon, and no matter our strong the Fed's volition and "Forward Guidance" (or imprudence), what the US yield curve is telling us is that no matter how strong the Fed's volition is, they cannot escape Newtonian gravity:

"When it comes to the paranormal phenomena of the low volatility regime instigated by our central bankers, no offense to their narrative" but modern physics still works and normalisation of interest rates should lead to some repricing and a less repressed volatility in conjunction to a fall in the "free put" strike price set up by our central planners in 2018. You probably do not want to hold on too long on "illiquid parts" of your portfolio going forward, given, as many knows, liquidity is indeed a coward." - source Macronomics, November 2017 

Our final chart below points towards the gravitational pull the Fed is facing.

• Final chart -  The Fed can't escape Newtonian gravity

No matter how strong the spells of the "wizards" at the Fed have been in recent years as pointed out by the wise wizard of the BIS aka Claudio Borio, the Fed's volition is one thing, Newtonian gravity is another. Our final chart comes from Bank of America Merrill Lynch's Weekly Securitization Overview from the 8th of December entitled "The gravity of the yield curve" and displays the 2Y10Y versus the US unemployment rate:

"Given the magnitude of recent yield curve flattening, we revisit our framework where we look at the 2y-10y spreads relative to the unemployment rate back to 1989 (Chart 1).

The flattener has moved more slowly than we anticipated back in 2014, dropping by about 50 bps per year over the last 4 years. Given where unemployment already is, and expectations that it will move lower in the year ahead, we see a strong gravitational pull lower on the curve. Moreover, given that the Fed likely has 4-5 rate hikes in store over the next year (including December 2017), while inflation readings remain low, dropping an additional 50 bps on the curve over the next year seems very achievable, particularly after the 30 bps drop in the 2y-10y spread in the past six weeks.

We note that flattening is not the house call: BofAML rates strategists believe the curve will steepen due to easier fiscal policy, higher deficits, and a higher inflation expectation and the Fed will require higher 5y-10y yields as a precondition to flattening or inverting the curve. We recognize that the flattening process has already taken longer than we expected a few years back, due to multiple “dovish” Fed hikes or pauses, and we acknowledge the potential for what we think would be steepening detours along the way.

Newton's law of gravitation resembles Coulomb's law of electrical forces, which is used to calculate the magnitude of the electrical force arising between two charged bodies. Both are inverse-square laws, where force is inversely proportional to the square of the distance between the bodies. In similar fashion, the relationship between the US 2Y10Y and the US unemployment rate could be seen as inverse-square laws when it comes to the ongoing flattening stance of the US yield curve but we ramble again...

"A man of genius makes no mistakes; his errors are volitional and are the portals of discovery." -  James Joyce

Stay tuned!

Macro and Credit - Voltage spike

"The trouble ain't that there is too many fools, but that the lightning ain't distributed right." - Mark Twain

Watching with interest continuous records being broken in the surge in equities indices in conjunction with continuing flows in credit and tightening credit spreads, we reminded ourselves for our title analogy of what a "Voltage spike" is. While an energy spike, is measured not in volts but in joules; a transient response defined by a mathematical product of voltage, current, and time, the current melt up in asset prices is measured daily by the indices reaching new record highs. Yet, hard macro data at least in the US continues to be on a soft side hence the continuation in the flattening of the yield curve.

In this week's conversation, we would like to look at the flattening of the US rates market which followed a somewhat disappointing Nonfarm payrolls number last Friday.

Synopsis:

• Macro and Credit - Is the rates market pricing the end of the US cycle?
• Final charts - Econ 101 - Higher demand leads to tighter credit spreads

• Macro and Credit - Is the rates market pricing the end of the US cycle?

The slightly weaker tone coming as of late from the US job market has led to somewhat a "Voltage" spike" in the sense that there is indeed a growing disconnect between what the US rates curve is currently telling us and the unabated run in risky assets as investors have truly decided to "carry on". 

As we have clearly highlighted in our recent musings, as the credit cycle is slowly but surely turning, we do expect a significant final melt-up in asset prices. Until inflation rears again its ugly head and central banks have to counter it by hiking aggressively, it is difficult with current inflows and apart from an exogenous event to be bearish in the short term. Therefore we remain "Keynesians" as the animal spirits switch to "euphoria", yet we are also medium term "Austrians". As we have repeated in numerous conversations, we are more concern with the second part of 2017., Italian elections in the 3rd quarter will be important to scrutinize particularly in the light of unresolved issues with the Italian banking sector and their nonperforming loans (NPLs) woes. 

Clearly as of late, some financial pundits have been puzzled by the significant rally in both bonds and equities in a sort of goldilocks scenario playing out for the leveraged crowd and "risk-parity" players alike. This "Voltage spike" warrants close monitoring and maybe some sort of "surge protection" being set up given the level of complacency in this low volatility environment. In relation to the growing disconnect between the US yield curve and equities, we read with interest Bank of America Merrill Lynch's Global Liquid Markets Weekly note from the 5th of June entitled "Let's hope the rates market is wrong":

• The rates market is pricing in a high risk of the end of the US cycle. The stability of rates markets could be a warning rather than a reassurance for carry trades.

• •Either way, the high implied end of cycle risk in US rates is not just at odds with equities, but is a risk for commodities, EM, breakevens and the periphery. Internal inconsistencies

The rates market is pricing in a considerable chance of the US economy rolling over. The fact that UST 10y rates have traded in a very tight range for the last two months has been interpreted as a reassuring signal for carry trades everywhere. In fact it should be a warning signal. Rates are where they are, not because the world economy is in a sweet spot with growth neither too hot nor too cold, but because the market is caught between having to reprice rates lower (a high implied risk of rate cuts for next year) or higher (price out end-of-cycle risks, price in an active Fed and a deteriorating supply-demand gap for fixed income). If the US rates market is right, then the rest of the FICC space, let alone equity markets, are mispriced.

Commodities don’t do well in a slow-down

Commodities are cyclical, and our bullishness in crude is predicated in part on the cycle remaining intact – but moving beyond this tautology, we analyse the performance of commodity strategies below. Commodity beta works best in high and rising nominal rates macro regimes, but underperforms in rising real rate environments. Commodity alpha strategies on the other hand would be at risk in a scenario where inflation fails to get traction. Commodity alpha is therefore exposed to the global reflation trade being aborted, while commodity beta would be at risk even if the cycle remains intact, but the Fed moves ahead of the curve.

EM is goldilocks squared

In our recent discussions on EM we have primarily focused on the risks to EM from higher rates, given our short duration bias. However, the end-of-cycle risks priced by the US rates market are an even bigger risk to EM. For the EM carry trade to remain successful, rates need to stay low, which given the secular shift in supply demand dynamics for fixed income, and the US in particular, is a tall order, longer term. Crucially, however, pricing out the end-of-cycle risks in US rates, by themselves, would be a challenge to EM. And not pricing them out would suggest that the cyclical support for a bullish EM story falls away.

EUR breakevens are hoping for global reflation

Following the US election, long-dated EUR breakevens repriced as aggressively in the euro area (EA) as in the US and remain close to the ECB’s target. We have been bearish breakevens all year, since we believe the ECB is exiting policy accommodation prematurely and do not see any reason to be optimistic about a trend change in the EA’s inflation dynamics. But if the cycle in the US is slowing down, as suggested by the US rates market, then there is even less reason to be hopeful that this repricing of EA inflation risks to be sustained – leaving aside the fact that even for the US our economists see headline inflation slow considerably. The EA remains leveraged to global growth (Chart 2).

Periphery, still caught between a rock and a hard place

We have been bearish the periphery since last autumn, arguing that the ultimate victim of a more hawkish ECB would not be the Bund market, but BTPS. The periphery faces a mechanical repricing as the ECB steps away from artificially supporting prices, as well as higher risk premia given questionable debt dynamics on an inflation trajectory below the ECB’s target. However, what has supported the periphery so far is the fact that activity data has outperformed on a global basis. But as argued in the inflation discussion above, the euro area remains a highly leveraged bet on global growth. If the cyclical outlook in the US deteriorates as implied by the rates market, the last remaining argument for being constructive on the periphery would fade very quickly." - source Bank of America Merrill Lynch.

Obviously the price action particularly in the long end of the US yield curve in conjunction with serious inflows into Investment Grade credit as well, has put back into the forefront the MDGA trade (Make Duration Great Again) which we mentioned back in April in our conversation "Narrative Paradigm".  Clearly, if indeed the bond markets is not buying the "reflation" story anymore and US data continue to veer on the soft side, then indeed from a tactical allocation, it makes sense to turn more positive on the duration front.

In this credit cycle, clearly investors not only have taken on more duration risk but, given the performance of beta and in particular the beta segment such as in High Yield CCC, credit risk has been embraced in full making sensitivity to price movements much more significant to "Voltage spike". We agree with Bank of America Merrill Lynch's take from their note in relation to the growing disagreement between rates and equities, someone eventually is wrong:

"Not sustainable

Rates and equities are pricing two very different scenarios for the US and the world economy more generally. Rates are pricing a very slow pace of Fed hikes and the end of the tightening cycle after only one more hike next year, with a relatively high probability for a US recession. Equities, on the other hand, are the only Trump trade still alive and, at all-time highs, are pricing fast growth ahead. Implied market volatility is also at historic lows, suggesting no concern about a sharp adjustment. US data is mixed and do not give a clear indication of whether rates or equities will have to adjust. The FX market is more consistent with what the rates market is pricing, or the USD should have been stronger, in our view.

However, this is clearly not sustainable, in our view. We expect a reality check in the months ahead, most likely after the summer. We have been warning that although market volatility could remain low this summer, it will increase right after, as this fall is packed with events—more Fed hikes (or not), unwinding Fed balance sheet, possible Yellen replacement, US tax reform, ECB QE tapering and policy sequence, German and possibly Italian elections, and Brexit negotiations. In a good case scenario, the USD will have to appreciate against the JPY and rates will sell off. In a bad case scenario, equities and EM assets will sell off." - source Bank of America Merrill Lynch

We do share similar concerns for the second part of 2017. For the time being, markets have climbed numerous wall of worries so far in 2017 (French elections) and apart from an exogenous factor such as a geopolitical event, it is hard to turn significantly bearish. As John Maynard Keynes aptly put it: 

"The market can stay irrational longer than you can stay solvent."

While no doubt in our minds that eventually the "perma-bear" crowd will be right, namely that China will face some credit crisis at some point, markets will tank and what is overvalued will deflate accordingly, credit will widen and distress credit will show up again, at the moment, we do think we are moving towards the "euphoria" stage. 

Whereas as in our late 2015 musings it was evident that the shape of the high yield credit curve was pointing out to trouble ahead for credit in early 2016 and by extension equities thanks to the rapid depreciation in oil prices and weaker earnings, as things currently stand, regardless of the narrative of some doomsday pundits, it is hard for us for time being to see the catalyst. If inflation rears back its ugly head, it will be a different story for many asset classes rest assured. 

Looking at several indicators we track such as indicators of aggressive issuance such as the ones published by Bank of America Merrill Lynch, clearly CCC issuers have regained access to the primary market for the time being including shale players it seems (16.4% face value of the market):

- source Bank of America Merrill Lynch High Yield Chartbook

Another indicator we look at is Cov-Lite issuance as a percentage of market size. Since 2014, the market seems to have been cooling-off slightly (we are not talking about the much discussed subprime auto-loans here):

- source Bank of America Merrill Lynch High Yield Chartbook

Inflows are still pouring in Fixed Income including in the beta play such as High Yield simply because the percentage of negative yielding assets remain elevated at 17% based on Global Fixed Income Index (GFIM):

- source Bank of America Merrill Lynch High Yield Chartbook

High Yield fundamentals have improved with nearly all issuers reporting Q1 earnings and EBITDA growth is much better with ex-commodities earnings improving 16.9% year over year, the 3rd consecutive double digit gain according to Bank of America Merrill Lynch:

- source Bank of America Merrill Lynch High Yield Chartbook

The on-going "Voltage spike" clearly shows that 2017 is playing out as a reverse 2016, namely strong performance in the first half of the year and much more caution for the second part. That's our scenario and it seems to be playing out accordingly so far. We do share with Bank of America Merrill Lynch's High Strategy team their cautious stance for the second part as indicated in their strategy note from the 2nd of June entitles "Looks aren't everything":

"High yield fundamentals continue to improve

With nearly all issuers having reported Q1 earnings, we once again take the opportunity to examine credit fundamentals across the high yield universe. For the 5th consecutive quarter, year over year revenue growth improved and jumped from 2.36% to 8.90%, the best reading in 3 years. Energy saw the biggest improvement with 31% top line growth, although Technology (+21%) and Commercial Services (+11%) saw double-digit gains as well. On the opposite end of the spectrum, Transportation, Capital Goods, and Media saw declines of 11%, 4%, and 1% respectively (Chart 1).

EBITDA growth proved resilient as well with ex-Commodities earnings improving 16.9% year over year, the 3rd consecutive double digit gain. This translated into a modest natural deleveraging across the ex-Commodities universe, where net debt to EBITDA levels fell to 4.18x compared to 4.52x at their peak last year. Finally, the US HY issuer weighted default rate continued to fall and now stands at 4.53%, just slightly above our 4.0% forecast for the end of 2017. Given this improving fundamental backdrop—the best we have seen in several years—do we think high yield’s 15 month long rally will extend into the 2nd half of this year?

Don’t eat the forbidden fruit

We view this as unlikely. Although healthy fundamentals may create temptation to invest in riskier pockets of the market, we think political uncertainty and an economy that struggles to gain momentum will likely cause a selloff later this summer. With 0.5% real wage growth, falling used car prices, negative C&I loan growth, and little capex investment, we find many similarities between today’s economy and that of 2013/2014 and question the ability for additional compression in such an environment. Additionally, given rich valuations, we think upside is limited here, particularly in high beta/lower quality paper. Instead, our bias is to reduce exposure to CCC risk and move profits into higher quality paper." - source Bank of America Merrill Lynch

As we indicated last week, we monitor very closely consumer credit trends in the US for the time being. Also we have voiced our concerns as well in various conversations with the negative trend in C&I loan growth more indicative on how the "real economy" is behaving. Given the significant outperformance of beta in the credit space and in particular the CCC bucket, we do have difficulties in seeing more upside from there but clearly Keynes earlier quote comes to mind in a NIRP world. 

In our book, when it comes to the slowly but surely turning of the credit cycle, the sequence always starts with a flattening of the US yield curve, then, financial conditions grind tighter and some highly leverage players credit start widening, before the impact reach more players and credit spreads start to widen, defaults rates start creeping up and then of course the rosy tainted glasses eternal optimist crowd in the equity space finally gets the story right, and equities reprice in the end. Obviously, we are not there yet. Liquidity providers aka central bankers are still deeply involved in the "wealth effect" game, which makes this current "bull market" still the most hated in history particularly with the latest "Voltage spike" we are seeing with new record levels being reached.  

Credit wise we continue to expect credit spreads to go tighter, that is until the flow of liquidity provided by our generous gamblers diminishes. Clearly we are not there yet as per the final chart below.

• Final charts - Econ 101 - Higher demand leads to tighter credit spreads

When it comes to looking at additional indicators of interest when it comes to "Voltage spike", while we already discussed some fundamental indicators, we continue to look at inflows in the asset classes as an indication of the direction of credit spreads. Our final chart comes from Bank of America Merrill Lynch Credit Market Strategist note from the 2nd of June entitled "All news is good news" and displays the record inflows being the driving force for tighter credit spreads:

"Econ 101

Economics 101 dictates that under certain assumptions higher demand creates higher prices (tighter credit spreads) and increased supply. The US high grade corporate bond market satisfies these assumptions, as inflows to HG bond funds and ETFs are tracking a record $130bn YtD, up about $85bn from the same period last year (Figure 27).

Supply for the first five months of the year is $650bn, just $25bn above last year’s pace. Acknowledging that this story is highly simplified, it nevertheless represents one of the key reasons high grade credit spreads have tightened 11bps this year to 119bps – making good progress on the path to our year-end target of 105bps (Figure 28).

 - source Bank of America Merrill Lynch

Given Bondzilla the NIRP monster is "made in Japan" and is finally back after 5 months of uninterrupted selling with the most recent weekly capital flows data showing Japanese investors bought 732 billion yen ($6.6 billion) of foreign bonds last week, bringing total buying in the past four weeks to 3.696 trillion yen ($33.3 billion) you shouldn't be surprised by the "Voltage spike" in US Treasury yields and credit either. So get ready to MDGA, just a thought...

"I just go where the guitar takes me." -  Angus Young AC/DC

Stay tuned!