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 ! 

Macro and Credit - The Korsakoff syndrome

"A nation that forgets its past can function no better than an individual with amnesia." -  David McCullough, American historian

Watching with interest the continuation of "Mack the Knife" (King Dollar + positive real US interest rates) Emerging Markets bloody rampage with Gold continuing to suffer thanks to Gibson Paradox (negative correlation between gold prices and real interest rates), and also reminding ourselves it has been ten years since the onset of the Great Financial Crisis (GFC), when it came to selecting our title analogy, we decided to go for the Korsakoff syndrome. The "Alcoholic" Korsakoff syndrome is an amenestic disorder caused by thiamine deficiency (Vitamin B) associated with prolonged ingestion of alcohol (or QE...some might argue). This neurologic disorder is caused by lack of thiamine in the brain and is as well exacerbated by the neurotoxic effects of alcohol (or QE...).  The syndrome and psychosis are named after Sergei Korsakoff, a Russian neuropsychiatrist who discovered the syndrome during the late 19th century. There are seven major symptoms of alcoholic Korsakoff syndrome (amnestic-confabulatory syndrome): 

1. anterograde amnesia, memory loss for events after the onset of the syndrome
2. retrograde amnesia, memory loss extends back for some time before the onset of the syndrome
3. amnesia of fixation, also known as fixation amnesia (loss of immediate memory, a person being unable to remember events of the past few minutes)
4. confabulation, that is, invented memories which are then taken by the patient as true due to gaps in memory, with such gaps sometimes associated with blackouts
5. minimal content in conversation
6. lack of insight
7. apathy – the patients lose interest in things quickly, and generally appear indifferent to change.

Back in 2011, in our conversation "Anterograde and Retrograde Amnesia", we commented on the dollar liquidity crisis which was brewing at the time and severely impacted EM as well as the European banking sector as whole which was saved by the ECB's LTROs late that year. The difference of course this time around is thanks to the ECB support, European financials credit spreads have not exploded à la 2011. Yet, with the Fed busy withdrawing liquidity thanks to QT in conjunction with a rising US dollar, as a reminder, a liquidity crisis always lead to a financial crisis. That simple, unfortunately.

We touched on the various form crisis could take in our long February 2016 conversation "The disappearance of MS München". While we won't go again about the various forms a crisis can take, from a currency crisis to a credit crisis, everyone not suffering from the Korsakoff syndrome is rightly asking when this already long cycle will end and what to look for.

In this week's conversation, we would like to look at the potential signs marking the end of the cycle.

Synopsis:

• Macro and Credit - What to look for the Boom moving to Bust?
• Final chart - Boom to Bust? Follow high-yield corporate bond mutual funds flows...

• Macro and Credit - What to look for the Boom moving to Bust?

There is no doubt that liquidity issues always lead to financial crisis. This was the case in 2011 and the ECB prevented the meltdown in the European banking system with its LTROs which was followed by Swap agreements with the Fed. The normalization process followed by the Fed in conjunction with its QT is of course validating our much vaunted global macro reverse osmosis theory discussed on numerous occasions on this very blog hence the continues pressure applied on Emerging Markets thanks to the surge in the US dollar, providing a strong headwind on gold for the time being. 

Given the 10 year anniversary of the GFC, many pundits are questioning how long until the music stops given the flattening of the yield curve as a sign we are reaching the end of the credit cycle. Timing is of course everything, eventually perma bears will be right but the question is when. On this subject we read with interest CITI's latest Global Multi-Asset View entitled "For Whom the Clock Ticks: How Long Till End-Cycle" published on the 4th of September:

"Even a broken clock...

“A man with a watch knows what time it is. A man with two watches isn’t so sure.”
- Segal’s law

Probably the most common question any strategist gets asked is where we are in the investment cycle. Even those who don’t like our debt-equity clock seem to have a triangle or a wave or some equivalent alternative: the notion of the economic cycle, and how markets respond to it, is simply the foundation of how most people think about investing.

But recent months have revealed a problem – even for strategists purportedly using the same framework. While Rob and the equity strategists would put the hands on the clock earlier in “Phase 3” – say 7 o’clock (Figure 1) – Matt and the credit strategists argue markets are closer to Phase 4, or 9 o’clock (Figure 2) – if indeed they recommend using the clock these days at all.

Our debate mirrors parallel discussions on the shape of the US yield curve. Many economists are dismissive of its current flatness, arguing that it has been distorted by QE, and that rising inflation should soon lead to higher yields and steeper curves. But others, including the San Francisco Fed, our rates strategists and our credit strategists, argue that its steady flattening poses a genuine and immediate problem for risk assets.

Settling these questions is of critical importance. This is especially true for equity investors, who face the dangerous challenge of riding a late-cycle bull market but avoiding the end-cycle carnage when it breaks. Credit investors lose out in both stages, but somehow they seem resigned to that.

While we always receive a steady stream of such questions, recent weeks have seen the trickle turn into a torrent – perhaps fuelled both by the yield curve and this year’s fading returns in most assets outside the S&P. These enquiries are coming not only from traditional asset managers but also from corporates, private equity,  infrastructure and other “alternatives” investors – counterparties whom we do not speak to regularly, and who may well change their positions only once or twice a cycle.

This note is designed at least to air our differences, if not necessarily to resolve them. First, we lay out how the cycle has worked traditionally, and explain why markets seem to follow a global cycle even in the face of regional and sectoral differences in growth and in earnings. Second, we examine the many ways in which this cycle has bucked the traditional pattern. Finally, we look for guidance in history as to what really triggers the transition to Phase 4, and hence what happens next. Unfortunately it is hard to provide definitive answers: we argue that much depends on whether you think the cycle is driven by fundamentals or by market movements, and on whether this cycle’s distortions have merely slowed down the clock’s alarm function, or broken it entirely.

How the cycle works

Our thoughts on how the cycle is supposed to work haven’t really changed over the decades. Companies go through regular phases of leveraging and deleveraging, and you can normally tell where you are in the cycle both from what they’re doing with their balance sheets and from the response in credit and equity markets. Here’s how we put it back in 2005:

Starting at 12 o’clock, in the depths of recessions companies go through intense periods of restructuring in order to reduce their debt burdens. Assets are spun off, dividends skipped and equity raised in order to generate cash and reduce the risk of bankruptcy by paying down debt. Once this activity gets underway, credit spreads rally sharply — the risk of default is perceived to be past its peak — even though equity markets remain in the doldrums because issuance is dilutive and earnings continue to fall.

Eventually, cost cutting and aggressive restructuring, accompanied by economic recovery, yields a rebound in profits (after 3 o’clock). In this next phase, both earnings growth and debt/EBITDA are improving, causing credit and equity to rally together. However, as the cycle matures, this progressively gives way to a period of lower quality earnings growth, in which share gains are often achieved at the expense of corporate leverage, for example through acquisitions or share buybacks (after 6 o’clock). This keeps equities rallying, but deteriorating balance sheets start to drive credit spreads higher.

Finally, the resultant balance sheet deterioration comes to a head, creating a crisis in which profits cannot be sustained, and both equities and credit sell off (after 9 o’clock). It’s time to take all risk trades off. This is usually associated with a recession which induces the retrenchment which eventually allows the cycle to start all over again.

By and large, we think this framework has held up pretty well, and it is not too difficult to discern its workings in the US over multiple decades. Equities and credit are sometimes positively correlated (Phase 2 and 4) but they can also be negatively correlated (Phase 1 and 3). This is visible in terms of the alternation between credit and equity market returns (Figure 3), and in terms of the cyclical leveraging and deleveraging of nonfinancial corporates’ balance sheets (Figure 4).

To be sure, not every cycle is driven by corporates, and the credit and equity market movements are not quite as regular as, well, clockwork. In the 1970s, movements in oil prices were larger drivers of the economy than corporate leverage per se, and emerging from the 1982-3 recession in particular, we cannot see a “Phase 1” in which credit rallied before equities.

But even when recessions were not actually caused by the non-financial corporate sector – as in 2008 – the broad patterns have still seemed to hold. The recession was preceded by a long period of leveraging up, in corporates as well as in households, and credit market returns turned south months (if not years) before equity market returns did. Understanding the workings of the cycle is a useful way to think about how you should invest.

Time waits for no man (but seemingly for a few corporates)

Note that we have never claimed that it has to be the same “time” for different regions, or even for different sectors. Indeed, while similar principles hold at the individual company level, with credit and equity prices responding to changes in  balance sheets, different companies can employ very different strategies. For example, while US-based Apple is reducing its cash pile with the primary intention of rewarding shareholders, China’s Anbang – after a previous spree of debt-fuelled acquisitions – is now making bond-friendly disposals and trying to shore up its balance sheet.

Aggregating leverage statistics across companies and sectors is as much an art as a science; we often joke that you can demonstrate that aggregate leverage is doing almost anything if only you try hard enough. To what extent when calculating net debt/EBITDA should the tech sector cash pile be allowed to offset the debt burdens shouldered elsewhere? Should you calculate median (net debt/EBITDA), median (net debt)/median(EBITDA), or use means? How as an investor in public equities should you treat the hundreds of billions in debt from private-equity-owned names?

Nevertheless, even given substantial variation at the company and sector level, it is possible to calculate overall averages (Figure 5).

It is almost remarkable how similar are the patterns those averages follow across regions and different data sources (Figure 6).

From the noise of individual companies’ balance sheet decisions, there emerges a global cycle.

We can see different levels of global correlation when we look at other important variables. While GDP growth is imperfectly correlated, with the US generally considered to be ahead of other countries, EPS growth by region is more closely related, especially recently. And, despite being more volatile, actual stock price returns (Figure 9) or credit spread changes (Figure 10) are all but indistinguishable across regions. Markets are highly correlated, even if fundamentals aren’t.

Beyond this, it seems to us that there is a strong element of reflexivity to the process. Company balance sheet decisions, and investor calls on what to buy and sell in credit and equities, are not taken in a vacuum: they influence one another. When Vodafone bought Mannesmann in 1999 in what was then the largest ever M&A deal, its stock continued to rally. This increased the likelihood that AOL would end up buying Time Warner. When Enron filed for bankruptcy in 2001, the environment of increased investor nervousness added to the risk that WorldCom would subsequently do so in 2002. Market movements – and investors’ and corporates’ responses to them – are themselves significant drivers of the cycle.

But how have markets been moving this time round, and what does that tell us about the all-important transition to Phase 4?

Who stopped the clock?

In fundamental terms, this cycle things seem to have proceeded pretty much as usual. A period in which profits were growing faster than debt, from 2009 to 2012, has been followed by one in which debt has been growing faster than profits. As a result, overall corporate leverage has risen well beyond that reached in 2008, to the highest level ever recorded outside of an actual recession (Figure 4, Figure 5, Figure 6). Presumably one reason this has been possible is that record-low levels of interest rates have made interest payments look manageable, even with record-high levels of debt (Figure 11).

When broken down by sector, the pattern is more varied, but probably no more so than normal.

The sectors seemingly most intent on leveraging up are those which it might be reasonably argued ought to be most able to bear it: Utilities, Healthcare, Consumer Staples and Telecoms. That said, in many cases they are now running with substantially more leverage than ever previously (Figure 12).

A second group of sectors – traditional cyclicals – have likewise spent most of the past few years leveraging up. But they are not running with significantly more debt than in previous cycles (Figure 13).

Energy and Materials seem almost to have come out the other side, and are now engaged in deleveraging following a leverage peak in 2015 (eg Glencore making disposals and Anglo American buying back bonds). These are also the sectors which have led to the recent deleveraging visible in the overall statistics for US HY and Emerging Markets (Figure 6).

Finally, Industrials and IT have bucked the broader trend entirely, and have largely been reducing indebtedness since the early 1990s (Figure 14).

A second group of sectors – traditional cyclicals – have likewise spent most of the past few years leveraging up. But they are not running with significantly more debt than in previous cycles (Figure 13). Energy and Materials seem almost to have come out the other side, and are now engaged in deleveraging following a leverage peak in 2015 (eg Glencore making disposals and Anglo American buying back bonds). These are also the sectors which have led to the recent deleveraging visible in the overall statistics for US HY and Emerging Markets (Figure 6). Finally, Industrials and IT have bucked the broader trend entirely, and have largely been reducing indebtedness since the early 1990s (Figure 14).

Putting these numbers together, Matt thinks aggregate leverage is higher than might be expected outside of a recession, and hence more reminiscent of late Phase 3 than early Phase 3. But low interest rates and the predominance of increased leverage amongst the more defensive sectors help explain why this has not yet been seen as a problem for markets as a whole. Moreover, there are even signs that aggregate leverage is beginning to decline given recent strong profit growth and helpful US tax cuts.

But Rob’s primary reason for thinking this is Phase 3 is not based on fundamentals but more on market movements – in particular, the current outperformance of equities relative to credit is classic Phase 3. Other Phase 3 characteristics, such as narrowing market leadership, are also evident (Global Equity Quarterly: Narrowing Bull Market)." - source CITI

The reason the credit clock has been much slower than usual is of course due to the Korsakoff syndrome, namely that central banks intervention have been very supportive of credit spreads in many instances, providing as well some support to many "zombie" companies which should have been eliminated but managed to survive thanks to the low interest rates environment. Record low levels of interest rates have made interest payments manageable even with higher leverage creeping up thanks to the distortion created by our central banking deities.

While EM have been on the receiving end of the latest summer heat thanks to the strong dollar, the S&P 500 and US stocks have been racing ahead while the rest of the world has been languishing. Credit wise both US High Yield and US Investment Grade have had a less torrid time than EM High Yield or EM equities. Indicators of aggressive issuance such as the percentage of the CCC credit bucket accessing the primary market has remained fairly stable still and revenues even for US High Yield remain overall solid as per the below Bank of America Merrill Lynch chart:

- source Bank of America Merrill Lynch

The most recent quarterly Fed Senior Loan Officer Opinion Survey (SLOOs) points that financial conditions still remain favorable. Overall credit remains fairly stable for now at least in the US as pointed out by CITI's comprehensive report:

"A central banker in the works

Most importantly, the steady leveraging-up by companies since 2012 has simply not been accompanied by spread widening on anything like the same scale as in previous cycles. Indeed, even with non-financial corporate leverage higher than the levels seen in 2008 and (on some universes) 2001-2, credit spreads are not far off traditional cyclical tights, especially in US HY (Figure 15).

The pattern in € HY and $ and € investment-grade is similar, if slightly less extreme. Even long-term charts – over which period it becomes difficult to difficult to obtain consistent universes for both spreads and leverage – suggest that something is awry (Figure 16).

If it were just credit spreads which were behaving in this fashion, the signal could perhaps be ignored, or dismissed as an excessive focus on headline debt levels rather than interest coverage and debt sustainability. Indeed, the rating agencies invoke just such an argument when asked why such high debt levels have not led to an increase in downgrades.

But the same time period – since 2012 – which has seen leverage rising and spreads tightening also reflects a breakdown in other market relationships. Equity volatility traditionally correlates with metrics designed to capture policy uncertainty (the number of references to uncertainty in the news, for example). But since 2012 uncertainty has been high, and yet volatility across markets has been setting new record lows (Figure 17). 

Changes in consensus earnings expectations used to correlate with equity market moves in every region, yet since 2012 that relationship has broken down too, even if it is now beginning to re-establish itself (Figure 18, Figure 19).

Matt has argued loudly for several years that all these breakdowns are due to QE, and “too much money chasing too few assets”. He thinks that as central banks pull back, both credit and equities are vulnerable, and cites in his support continuing strong correlations between global central bank purchases and market movements. As was visible in February this year, the central banks have effectively “broken” the normal clock functioning, and credit can no longer be relied upon to lead equities in the way it has done historically.

Rob sees it slightly differently. QE intentionally decoupled credit spreads (kept falling) from corporate leverage (kept rising). Even as balance sheets moved through 6 o’clock, so central bankers kept risk asset pricing back at 5 o’clock. The reason that equity volatility fell is that it is highly correlated to credit spreads (Figure 20), and QE kept spreads falling.

But now that has changed. As central banks step back, so the credit and equity markets will catch up with fundamentals. This year’s rise in spreads and volatility finally marks the move into Phase 3 that, without QE, would have started in 2012. Rob thinks that QE has held the clock back, not broken it." - source CITI

One could indeed agree somewhat with Rob from CITI that, indeed the Korsakoff syndrome associated with prolonged ingestion of QE has clearly distorted the "credit clock" and slow down the normal aging process thanks to financial repression and low interest rates. Now with QT in full swing, the tide is slowly but surely turning, with the over-leveraged players being the first one taken to the cleaners such as the house of straw of short-vol yield pigs and now the house of sticks of macro EM tourists carry pigs.

What about record high corporate margins? Surely trade war and surging PPI will eventually put a dent in corporate margins one might argue as corporations pass on price increases onto their customers. CITI discusses as well this issue in their note:

"Time is an illusion. Lunchtime doubly so.

Unfortunately a closer examination of both market and fundamental data in this cycle does relatively little to shed light on this debate, or at a minimum can be construed as arguing in both directions.

One potential end-cycle sign is compression of corporate margins, at least as proxied by companies’ unit labour costs (usually the major driver of their cost base) relative to output prices (tracked by the broad GDP deflator). In the US in 1979, 1989,1999 and 2007, labour costs rose more rapidly than output prices as the cycle matured, labour gained in pricing power and corporate profit margins were  squeezed (Figure 21).

Something similar happened for the Euro area in 1999, 2007- 8 and in 2012 (Figure 22).

Each time, this was a useful warning that companies were resorting to leverage in order to support earnings growth, and of the consequent vulnerability of the equity market.

Rob agrees that you may get a rolling over in “per unit” margins in the macro data, even as overall profit margins of listed corporates keep rising. But a combination of strong volumes and high margins are enough to keep profits rising and the bull market rattling along (Figure 23).

Overall profit margins don’t collapse until the recession begins, volumes fall and companies are left with excess fixed cost bases. As such profit margins are a coincident indicator with the stock market, which is why Matt doesn’t like them. They don’t give any prior warning; they always look great right up to the last minute.

The trouble is, this time round, while there is some evidence of margin compression in the Euro area, US unit labour costs have been oscillating without any clear trend. However you look at it, the sort of earnings growth and especially revenue growth we have seen in 2017-18 simply defies traditional models for what is “supposed” to happen at this stage of the cycle." - source CITI

There is indeed a "Dissymmetry of lift" between the US and Europe, leading to the current growth differential outcome with Europe slowing at the moment while the US showing signs of expansion with the latest ISM. Some would argue it could be a peaking sign in this credit cycle. Also as we have argued various times, a sudden acceleration and surge in oil prices would obviously ignite more inflationary expectations (or scare) and lead to a more hawkish Fed. This would of course be much more negative for asset prices overall and lead to the famous bust after the boom.

Another interesting discussion within CITI's note has been around mutual fund flows. Those who read us on a regular basis know that we look at mutual fund flows as an indicator of investors mood and confidence. This we think is quite interesting:

Yet another potentially useful late-cycle indicator is mutual fund flows. You might reasonably have expected Phase 3 to be associated with strong flows into equities. A strong rotation from bonds into equities is very visible in 1997-2000, and is notable by its absence this time round, perhaps suggesting Phase 3 has much further to run (Figure 24).

But both 1985-87 and 2005-2007 were associated with exuberance in fund flows in general – an exuberance which now seems to be running out of steam. Another way to think of fund flows is in terms of total inflows to all risky assets (bonds, equities and hybrid funds combined) relative to inflows to money market funds and deposits. This seems to follow a regular cycle with respect to deposit rates (Figure 25).

In Phases 1 & 2, emerging from recession, when deposit rates are low, and valuations are cheap, investors do most of their saving in risk assets. As the cycle matures and as deposit rates rise, they steadily move some of their savings in deposits. Eventually in Phase 4, they sell all risk assets, prices fall, deposit rates are cut and the, eventually, the cycle starts again. This year’s tremors in markets may be a sign that just such a phase is being reached already.

Yet here too, the signals are ambiguous. Fund flows both influence market returns and are influenced by them (Figure 26).

While we find it quite easy to imagine a scenario in which fund outflows drive markets lower and trigger a growth slowdown, it is by no means a foregone conclusion. We seemed to be embarking on just such a negative path in February 2016, but then an unusual (from the perspective of these charts) rally in markets – admittedly following more central bank intervention – halted the outflows and triggered two years of further inflows. While central bank easing now feels much less likely, positive market returns in equities, driven by earnings growth and share buybacks, may well suffice to spark inflows of their own
accord.

If Matt is right, further central bank withdrawal should mean the inflows fizzle out and turn to outflows, conclusively creating a bear market not just for credit but also for equities. If Rob is right, central bank withdrawal and renewed corporate releveraging should cause credit spreads to widen, but equities may yet have further to rally. They become the only game in town. But equally, it would not be that surprising – especially given the example of the Energy and Materials sectors, and the broad-based deleveraging thanks to earnings growth – for us to skip Phases 4 and 1 entirely, and go straight back to the “organic” deleveraging associated with Phase 2, in which both credit and equities rally. This is, in effect, what markets did during 2017. But was that fundamentals, or the effect of extraordinary central bank policies? Once again, this cycle defies easy categorization." - source CITI

We think, when it comes to Matt King's argument about inflows fizzling out and turning to outflows, creating a bear market is an interesting proposal. In our final chart below we would like to provide additional support to Matt King's view

• Final chart - Boom to Bust? Follow high-yield corporate bond mutual funds flows...

To add more ammunition to this hypothesis we would like to point out towards a Wharton paper written by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein published in September and entitled "Mutual Fund Flows and Fluctuations in Credit and Business Cycles" (h/t Tracy Alloway for pointing this very interesting research paper on Twitter).

This paper points to using flows into junk bond mutual funds as a gauge of an overheated credit market to tell where we are in the credit cycle. Could that be finally a reliable "Boom to Bust" indicator?

"Several measures of credit-market booms are known to precede downturns in real economic activity. We offer an early indicator for all known measures of credit booms. Our measure is based on intra-family flow shifts towards high-yield bond mutual funds. It predicts indicators such as growth in financial intermediary balance sheets, increase in shares of high-yield bond issuers, and downturns of various measures of credit spreads. It also directly predicts the business cycle by positively predicting GDP growth and negatively predicting unemployment. Our results provide support for the investor demand–based narrative of credit cycles and can be useful for policymakers.

A large body of literature in macroeconomics and finance studies the link between credit markets and macroeconomic cycles. A pattern that emerges from the data is that credit booms precede downturns in macroeconomic activity. This pattern attracts considerable attention from academics and policymakers: if credit markets are at the root of macroeconomic fluctuations, then it is important to better understand what drives credit cycles and identify leading indicators to try and design policies that will moderate them.

In this paper we show that investor portfolio choice toward high-yield corporate bond mutual funds is a strong predictor of all previously identified indicators of credit booms. An increase in our measure in year t predicts credit booms marked by the other indicators in the literature in years t+1 and t+2. These other indicators include the proportion of low-quality bond issuers (Greenwood and Hanson, 2013; López-Salido, Stein, and Zakrajšek, 2017), the degree of reaching for yield in the bond market (Becker and Ivashina, 2015), balance sheet growth in financial intermediaries (Schularick and Taylor, 2012; Krishnamurthy and Muir, 2015), and various measures of credit spreads (Gertler and Lown, 1999), in particular the excess bond premium (EBP) recently proposed by Gilchrist and Zakrajšek (2012).

In addition, our measure, as a leading indicator of credit booms, positively predicts GDP growth and negatively predicts unemployment rates in years t+1 and t+2 (before they turn in the reverse direction in year t+3)."  - source Wharton paper, by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein 

Prolonged ingestion of QE surely is a way leading to many credit investors getting the Korsakoff syndrome such as the Macro EM tourists that piled into the 100 years bond issued by Argentina, causing them memory loss of their fiduciary duty but we ramble again...

"We live in a world where amnesia is the most wished-for state. When did history become a bad word?" - John Guare, American playwright.

Stay tuned !