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!

Macro and Credit - Orchidelirium

"What, if as said, man is a bubble." -  Marcus Terentius Varro, Roman author

Looking at the recent parabolic surge in Bitcoin (BTC), for us it first resonated with the Dutch Tulip Bulb Bubble of 1637 given the existence of 840 different crypto currencies for a total market capitalization of 85 billion USD. Yet, after our initial thoughts, we reminded ourselves for our chosen title analogy of the Orchidelirium Victorian era flower madness when collecting and discovering orchids reached extraordinarily high. Orchidelirium was seen as similar to Dutch tulip mania. What we find amusing when it comes to Bitcoin is that in November 2013 Nout Wellink, former president of the Dutch Central Bank, described Bitcoin as "worse than the tulip mania," adding, "At least then you got a tulip, now you get nothing". No offense to Nout Wellink but at least when you bought European High Yield in the past you used to get some yield, now you get nothing but at least, in case of default, there is some form of recovery given that what make most of the value are the expectations of the reimbursement of the principal. More recently, Dutch politicians have offered to ECB supremo Mario Draghi a solar-powered plastic tulip in reminder of bubble concern as reported by Bloomberg on the 10th of May in their article entitled "Draghi stays calm on stimulus as Dutch warn of risks with tulip". The latest parabolic surge in Bitcoin and other crypto currencies, while not powered by solar power but mostly by computer power and speculative endeavors, we find the analogy with Orchidelirium of particular interest given today there still exists some levels of orchid madness, that has sometimes resulted in theft of exceptional orchids among collectors such as the Ghost Orchid. Indeed we live in interesting times and no doubt some level of orchid madness can be felt but we ramble again.

In this week's conversation, we would like to look at potential cracks in the credit cycle such as slowing loan demand in particular in consumer credit in the US and other late credit cycle indicators such as the ebullient art markets and classic cars.

Synopsis:

• Macro and Credit - Is the US consumer "maxed out"?
• Final charts - Modern art, fine wines, & horses, are assets that tend to peak just before the start of a pronounced downturn

• Macro and Credit - Is the US consumer "maxed out"?

Back in March 2017 in our conversation "The Endless Summer" we concluded our long conversation asking ourselves if the US consumer was somewhat "maxed out". We indicated as well that this on-going "Endless Summer" had created a significant windfall for the holders of financial asset. While in recent conversation we have argued that we remained short-term "Keynesian" given the large inflows pouring into various asset classes, while longer term we do remain "Austrian". We are still very cautious for the second part of 2017. 

The "wealth effect" has globally lifted all boats but, in our book a credit cycle's length is around 10 years, so we do believe we are entering the last inning and that the final melt-up in asset prices could be significant before the usual "Bayesian" outcome. From our credit perspective, it appears to us that "cracks" in credit in the US are beginning to show up, particularly in the form of slowing loan demand. While we are not yet sounding the alarm bell, we think in the coming months it is going to be paramount to monitor credit demand and in particular consumer credit. 

You already know the story relating to Commercial Real Estate (CRE) and Commercial & Industrial Loans (C&I) from our recent musings. Despite the "Orchidelirium" over consumer confidence numbers post the US election, C&I growth is trending down (since the beginning of the year) and they are more reflective of what is happening in the real economy. As we indicated recently, weak loan demand tends to be associated with higher volatility yet markets are displaying very high complacency and seem to be oblivious to this recent negative trend, making this continuing rally, one of the most hated bull market in recent history.

From our credit and macro perspective, we live in a credit world hence the importance of tracking loan demand. The latest Fed Senior Loan Officer and Opinion Survey (SLOOS) showed that all is not well in the world of credit as per Wells Fargo note from the 17th of May entitled "Fed Survey Points to Slowing Loan Demand":

"The Fed’s Senior Loan Officer and Opinion Survey showed cooling loan demand for businesses and consumers in Q1. Citing uncertainty and lower risk tolerance, banks continued to tighten standards for CRE loans.

Business Loan Demand Tails Off

The Federal Reserve’s April 2017 Senior Loan Officer Opinion Survey (SLOOS), which roughly corresponds to Q1 2017, points to a general slowdown in loan demand for businesses and consumers. Reports of tightening lending standards varied across loan categories, however.
As shown in the below chart, large and small businesses demand for loans has been moderating since the start of 2016. Domestic and foreign banks reported weaker loan demand on net over the first quarter.

Notably, the slowdown in commercial & industrial (C&I) loan growth does not appear to be due to stricter lending standards, as banks reported no significant net tightening. The survey showed a modest net easing for C&I loans by domestic banks, but a slight tightening by foreign banks.
The SLOOS C&I lending data are contrary to the details within the GDP release. While the survey data point to a slowdown in business loan demand in Q1, the GDP report indicated a strong pickup in business fixed investment with outlays rising at a solid 9.4 percent annualized rate. The strength in business investment may reflect firms’ use of other sources of funding, such as bond issuance and stronger profits.

Consumer Loan Demand Cools

The Fed survey also showed a cooling in consumer loan demand, a finding consistent with the weaker pace of consumer spending in Q1. Lenders reported reduced demand for most consumer loan categories over the quarter, with particular softness in demand for credit card and auto loans (below chart).

A moderate share of banks reportedly tightened auto loan standards in Q1, marking the fourth consecutive quarter of net tightening. Banks stated widening spreads of loan rates over their cost of funds and raised the minimum credit score threshold over the quarter. For credit card loans, a modest share of banks reported easing lending standards, while terms on other consumer loans remained unchanged on balance. We do not take the softer consumer lending report as the start of a new trend and look for consumption to re-emerge in Q2.

CRE Lending: Continued Tightening

The April SLOOS showed that lenders are continuing to monitor pockets of risk in the commercial real estate (CRE) sector, as a significant net share of banks reported further tightening in most CRE loan policies (below chart).

In fact, a major share of banks cited a more uncertain outlook for CRE property prices, vacancy rates and other fundamentals, and reduced risk tolerance as reasons for tightening credit standards. In a recent speech, Boston Fed President Eric Rosengren noted that while a handful of favorable factors have helped support CRE valuations, “positive trends can sometimes evolve into prices that increase more than fundamentals justify.” Banks’ continued tightening of CRE credit should help ease financial regulators concerns of elevated pricing." - source Wells Fargo

While the slowdown in consumer lending is yet to show a similar trend seen recently in other segment such as CRE and C&I, it will remain essential to monitor the situation in the coming months. From our point of view, while equities market are still racing ahead and credit spreads tightening with a clear outperformance of high beta in that respect, it remains to be seen how long fundamentals will be deteriorating and if Q2 will see some sort of reversal. So far, credit weaknesses are simply being ignored by the Orchidelirium crowd. 

In similar fashion, we read with interest Bank of America Merrill Lynch Global Economic Weekly note from the 26th of May entitled "When is "intervention" "manipulation"?" asking themselves about the weakness in consumer credit:

"Are there cracks in consumer credit?

• Consumer credit creation has slowed, adding to concerns that consumer demand has weakened.

• We see several factors at play—some benign—which help explain the slowdown, prompting us to fade some of the weakness.

• We remain positive on the consumer outlook as fundamentals are solid but think it is wise to keep an eye on these indicators.

Credit slowdownThere are signs that consumer credit creation may be slowing. According to the New York Fed’s Quarterly Report on Household Debt and Credit, new mortgage originations dropped to $491bn in 1Q from $617bn in 4Q. Also it showed that the growth in the number of open credit card accounts decelerated in 1Q 2017, implying that demand for revolving credit may be slowing. In fact, respondents from the Senior Loan Officer Opinion Survey reported that demand for credit cards on net has slowed despite looser credit standards (Chart 2).

In this piece, we take a look at the potential causes of the slowdown in credit creation, specifically revolving credit, and what it means for consumer demand in the near term

Assessing the potential causes

A few potential reasons—some benign and some not so benign—appear to be at play for the slowdown.

1. Involuntary account closures:

The latest New York Fed’s Survey of Consumer Expectations (SCE) Credit Access report for February showed an uptick in involuntary account closures. Five percent of respondents reported that at least one credit account was closed by the respondents’ lender, up from 3.8% in the prior survey in October 2016 and the highest recorded since the survey began in late 2013. Breakdown by respondents’ credit score shows a notable pickup in account closures for less credit worthy consumers as 14.8% of respondents with credit scores at or below 680 reported an account closure, up from 9.6% in the prior survey (Chart 3).

This could be a potential sign that household finances may be stretched as households are beginning to have a more difficult time remaining current on their debt payments. Indeed, the New York Fed’s Report on Household Debt and Credit showed notable growth in seriously delinquent balances for credit cards and auto loans in the last two quarters (Chart 4).

We have already started to see pace of auto sales begin to moderate which we think could be a potential source of weakness for the economy. Further deterioration of the household balance sheet could slow consumer demand.

2. Perception vs Reality:

As mentioned above lenders are reporting looser standards. However, better consumer demand failed to follow. According to the NY Fed’s SCE Credit Access survey, close to 30% of respondents reported that they think they would be rejected for a credit card today, near comparable levels seen last year (Chart 5).

Additionally the same report noted that the application rate for credit cards fell to 25.3% from a high of 30.6% in June 2016, further corroborating the lack of increase in demand. What’s interesting is that application rates are down across the credit score spectrum suggesting it may be broad-based perception that credit is hard to obtain at the moment. Given that lenders remain constructive on lending standards, the slowdown may prove to be transitory.

3. The influence of Millennials:

In the wake of the Great Recession, Congress passed the CARD Act of 2009, a comprehensive credit card reform legislation to protect consumers. Under the bill, lenders cannot issue credit cards to a consumer under the age of 21 unless they prove they have independent income or obtain a cosigner. Given more restrictions to obtaining credit, many millennials are less “credit mature” in their 20s compared to the previous generations. Therefore, as millennials come of prime working age, many are having a tough time obtaining credit cards as lenders are unwilling to extend credit to individuals that have a short or no credit history, hampering credit creation. Moreover, due to the experience of the Great Recession millennials may be less inclined to buy using credit or are “convenience users” who pay off their entire credit card balance every month, limiting the need for multiple credit cards.

Implication for the economy

It’s unclear whether the slowdown in the growth of revolving credit is just a temporary soft patch or a more nefarious sign of a downturn in the economy. On one hand, we are starting to see some cracks in consumer demand. Even accounting for residual seasonality and warmer weather conditions dampening heating demand, personal consumption expenditures slowed notably to start the year. Also, the lackluster April retail sales report and a step back in auto sales since March does not inspire confidence that we will see a quick rebound. In this environment, a slowdown in credit creation stands out. On the other hand, we’ve had situations in the past where credit demand had receded during expansions only to reverse. Also, as previously mentioned, some of the potential factors at play for the pullback in credit demand could be more about changing demographics and tastes rather than a signal of weakness.

At this point, we are inclined to mostly fade the weak signals. The consumer backdrop is largely supportive. Job growth remains robust and given the low level of the unemployment, wage growth should head higher, albeit slowly. Also, aggregate household leverage has returned to healthy levels and the saving rate remains elevated (Chart 6).

This suggests that there may be another gear for consumption if households deemed it worthwhile to spend or it can be used as a buffer to stabilize against any potential negative shock that may hit the economy.

Bottom line

The jury is still out on credit conditions for the consumer. Credit demand seems to have slowed but lending standards remain favorable. On the other hand, we are starting to see pockets of stress on the household balance sheet that could spark weakness in the overall economy but so far it seems contained. We will be closely monitoring credit conditions for early warning signs of a slowdown in the economy. It squarely remains a risk to our outlook." - source Bank of America Merrill Lynch

Whereas it is too early to envisage some clear headwinds for the US economy thanks to weaker loan demand, it is clear to us that, in this late credit cycle, it remains very important to track SLOOs going forward. While default rates remain subdued in comparison to 2016, tightening in credit standards in conjunction with rate hikes will eventually weight on High Yield but for now, inflows remain strong and in particular in Investment Grade as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 26th of May entitled "Inflows into high grade continues":

"The convexity trade

Buy what they buy or buy convexity. IG funds continued to see strong inflows, as the ECB has been buying a larger volume of corporate bonds over the past couple of weeks. Additionally, flows into equity funds have improved over the past couple of months, on the back of a supportive earnings story in Europe. On the flip side, flows into high yield have slowed significantly, as the market now offers the lowest yield on record.

Over the past week…

High grade funds recorded another strong weekly inflow, the 18th in a row. High yield fund flows also remained in positive territory for a fifth week, but last week’s inflow was marginal. Looking into the domicile breakdown, as Chart 13 shows, inflows to European-domiciled HY funds with a European-focus were also marginal, while the inflows from global-focused funds were offset by outflows from US-focused funds.
Government bond fund flows last week were negative for a third week. So far this year, the asset class has suffered losses in 14 out of 21 weeks. Money market funds suffered a sizable outflow last week, the second in a row and the largest in 60 weeks. Overall, Fixed Income funds recorded their 10th consecutive weekly inflow, but this one was the smallest in five weeks.
European equity funds continued to see inflows for a ninth consecutive week. However, the pace has slowed down w-o-w. So far this year, the asset class has seen more than $15bn of inflows.

Global EM debt funds continued to see inflows, for a 17th consecutive week. The asset class has so far this year enjoyed stellar inflows of over $33bn. Commodities funds had their 11th week of inflows, predominately driven by inflows into gold funds.
On the duration front, positive flow numbers were recorded in mid-term and short-term IG funds, for the ninth and 23rd week in a row, respectively. However, flows into long-term funds were negative for a second week." - source Bank of America Merrill Lynch

With such a strong tide in credit funds and particularly High Grade, it is hard to see how the Orchidelirium can cease for the time being. Many portfolio managers we know are getting bored by the day by this one way market, with new highs daily, record low volatility, tighter credit spreads and steady inflows. Apart from an exogenous factor such as a geopolitical event, it's hard to think about what could be a catalyst for a reversal in this Orchidelirium.

Some would point out to the record levels touched by household debt surpassing 2008 peak as indicated in Wells Fargo's Interest Weekly note from the 24th of May:

"Household debt rose 1.2 percent in Q1 to $12.73 trillion, surpassing the $12.68 trillion mark set in Q3-2008. After accounting for population growth and inflation, however, households are not nearly as levered as 2008.

Aggregate Household Debt Returns to 2008 Levels

Household debt rose by $149 billion in Q1-2017, bringing the aggregate level of debt to an all-time high (top chart). Although the return to this level of debt has grabbed headlines, there are a few important considerations when comparing household borrowing today relative to a decade ago.
First, the composition of debt has changed significantly. There has been a shift away from mortgage lending and towards autos and education-related debt. As a share of total debt, student loans have more than doubled from a 4.8 percent share in Q3-2008 to a 10.6 percent share today. Auto lending has seen a similar, albeit more moderate, trend. Mortgage debt, however, remains $670 billion below its 2008 peak.

Second, although household debt has surpassed its previous peak, this ignores a series of other factors, such as population growth, inflation and growth in real output. As illustrated by the dark line in the middle chart, nominal debt per capita still remains short of its 2008 level. After adjusting for inflation, blue line, it is even clearer that the average household’s debt portfolio is smaller relative to a decade ago. When viewed through this lens, the recent growth in household debt looks much more modest.

Loan Quality Fairly Stable on Trend

In terms of loan quality, household debt delinquencies remained roughly flat in Q1, although there were some differences between categories of loans. Auto loan delinquencies ticked modestly higher and have risen very gradually over the past few quarters (bottom chart). Credit standards on autos have tightened from already relatively constricted levels; the median credit score for a newly originated auto loan was 706 in Q1, a 6 point increase from Q4 and well above the 686 reading in Q3-2007 on the eve of the Great Recession. Mortgage debt drove most of the growth in Q1. As we have highlighted in other reports, a mild winter weather likely pulled forward some housing activity that would typically take place in the spring. This in turn helped spur a strong first quarter for the housing market, with real residential construction expenditures rising at a 13.7 percent annualized rate. Auto loans and student loans grew $10 billion and $34 billion, respectively, while credit card balances declined by $15 billion.

On balance, the recent growth in household debt is a broad sign of strength rather than consumer weakness. Student loans remain a long-term secular challenge, and other areas, such as autos, warrant close monitoring as new data become available. That said, household leverage remains lower than it was in the 2000s credit bubble while the personal saving rate is higher. Despite the Q1 weakness, we expect real consumer spending to rebound in Q2 amid an ever-tightening labor market and healthy consumer confidence." - source Wells Fargo.

Yet, the latest batch in soft macro data such as retail sales and New Home Sales falling by 11.4% the most since 2015, it remains to be seen if indeed as in Q1 2016, that the soft patch we had in Q1 2017 with the now revised 1st Quarter GDP at 1.2% will be offset going forward by better macro data in Q2 2017. With US durable goods orders falling by 0.7% in April for the first time in 5 months we are wondering if the trend in softer macro is going to continue while confidence is very strong in another rate hike by the Fed in June. 

• Final charts - Modern art, fine wines, & horses, are assets that tend to peak just before the start of a pronounced downturn

Back in July 2016, in our conversation "Who's Afraid of the Noise of Art?" we quoted one of the recurrent themes of our friends at Gavekal research, namely that it has “never been so expensive to be rich” particularly if you want to snap up a classic Ferrari it seems. Kudos to our central bankers and their obsession with the "wealth effect":

"As most of our readers will know, modern art, fine wines, & horses, are assets that tend to peak just before the start of a pronounced downturn of the economic cycle. And interestingly, over the past couple of months, these assets have really been shooting up, breaking several records on the way" - source Gavekal, July 20th 2006.

History does indeed rhyme and we must confide that at this stage of the "credit cycle", we are afraid of the Noise of Art given back in 2006 our Gavekal friends indicated the following:

 "Usually, the last thing to go up in prices are rare automobiles" - source Gavekal Five corners, July 20th 2006.

This time it's different? We don't think so. Our final chart comes from Knight Frank's most recent wealth report and displays the stellar performance of classic cars in recent years:

"The Drive to Quality

For classic cars, “2016 was the year of the slowdown,” says HAGI’s Dietrich Hatlapa. For anybody not familiar with the market, that looks like a slightly downbeat claim as annual growth was still a very respectable 9%. But set against total growth of 151% over the past five years, it is clear that the market has dropped down a few gears. “Those who were in it just for the money have moved on,” says Mr Hatlapa. “The market is now more in the hands of the collectors and specialists, which I think is good news for the real enthusiast.”

According to data from the Kidston 500, another market-tracking index, of the cars put up for sale at the top international auctions during 2016, 78% sold by number – down from 84% in 2015 – while the proportion of cars selling for below their low estimate rose by 20%.

The pattern is the same in the US, says Brian Rabold, Vice President of Valuation Services at specialist insurer Hagerty. The firm’s Blue Chip index, which tracks the value of 25 of the European, US and Japanese cars most prized by US collectors, fell by 1% last year. “Over the past year or so we’ve seen a shift from a sellers’ to a buyers’ market,” he says. “People are becoming more selective. Last year there were 26% fewer auction sales of cars over US$1m in North America.” He also notes a shift in interest towards new models like the Porsche 911R. “Our top 1,000 clients are buying cars from the 2000s like never before.”

But despite the slowdown, the rarest cars in the right condition with the most desirable provenance will continue to set world records, says Mr Hatlapa.

Simon Kidston, who set up the Kidston 500, agrees: “Yes, the pace of deal making is noticeably slower, and the headline figures don’t convey that the underlying mood is much more reflective and uncertain amongst buyers and sellers. But until there are better, more mobile and tax efficient havens for cash, the market is likely to remain active and capable of reaching new peaks when fresh discoveries emerge from hiding.”

As if to prove the point made by Mr Hatlapa and Mr Kidston, a Ferrari 1957 335 Sport became the most expensive car to go under the hammer ever, in euro terms at least, when it was sold by Artcurial in Paris for €32m.

In the US, the annual Monterey sales also delivered new benchmarks. An historic 1962 Shelby Cobra went for over US$13m with RM Sotheby’s, making it the most expensive American car to sell at auction. A 1955 Jaguar D-type grabbed the record for the priciest British car to go under the hammer when it fetched almost US$22m. And, dispelling the myth that nobody is interested in older cars any more, Alfa Romeo joined the party with a 1939 8C Lungo Spider making just under US$20m – a new record for a pre-war vehicle.

However, the most expensive car sold last year was handled privately by Mr Kidston. The exact price achieved for the 1962 Ferrari 250 GTO has not been revealed, but it exceeded the highest sum ever paid at auction (US$38m for another 250 GTO sold by Bonhams) for a classic car and was possibly the biggest deal ever struck." - source Knight Frank - The Wealth Report 2017

However, there is more under the hood that meets the eye. As we indicated back in our July 2016 conversation, we have kept a close eye during the last couple of months on our interesting, yet entertaining exercise of building up a "virtual garage" made up of "classic cars" of interest and monitored on an ongoing basis their valuation by using the website "mobile.de". What we have continued to notice since we added a few cars in our "virtual garage" is some interesting price revisions taking place. For instance a Ferrari Dino 246 GTS was parked in February 2017 at the price of €449,000 and now is offered at €397,000. Another Ferrari Dino 246 GT was parked as well in February for a price tag of €375,000, now it is offered at €315,000. A Ferrari 250 GTE was parked in May 2016 for €475,000 and is now offered for €395,000. Rarities such as some 1955 Mercedes-Benz 300 SL Coupé Gullwing are still commanding an impressive 1,600,000 EUR price tag and are yet to show any price revisions at the moment. 

What we find of great interest is the "Cantillon effect" and the significant rise in price appreciation for classic cars can be directly link we think to our central bankers generosity and their "dear wealth" effect and some form as well of Orchidelirium. Yet, the classic car market continues to face some headwinds as per the latest read from the Hagerty Market Index which is an inflation adjusted open ended index (similar to the DJIA or NASDAQ Composite) based on change in dollars and volume of the market:

- source Hagerty

Furthermore in a period of Orchidelirium and in similar fashion to 2006 we are not surprised to see records being broken in art auctions as per last week in New York as reported by ArtNet:

"A staggering $1.6 billion worth of art changed hands during New York’s auction gigaweek last week. The three houses stuffed 11 sales of Impressionist, Modern, postwar and contemporary art into just five days. The combined total is up $400 million from the equivalent sales in May 2016, which made $1.2 billion. What should market-watchers take away from the onslaught? Here are our parting observations:

Biggest Trend: Big-Ticket Lots

Top-heaviness seems to increasingly define the evening sales. Both Christie’s and Sotheby’s were deeply reliant on a few top items. Consider Sotheby’s postwar and contemporary sale, where the record Basquiat, which sold for $110.5 million, represented a third of the evening’s $319.2 million total. Throw in the second-priciest lot of the night, a Roy Lichtenstein that fetched $24 million, and the two items account for about 42 percent of the sale.

Biggest Winner: Christie’s

All told, Christie’s made $833.9 million from its four sales last week, besting rival Sotheby’s by nearly $200 million. The publicly-traded auction house made a combined $635 million from its five sales. Meanwhile, Phillips, which did not hold Impressionist and Modern auctions, made $128.9 million last week.

Biggest Loser: The Owner of This Wade Guyton

It’s easy to focus on record prices and dizzying numbers, but don’t forget: Not everyone who puts an artwork up for auction makes money. To wit: One unlucky collector bought Wade Guyton’s Untitled (2005) at Christie’s New York in March 2014 for $1 million. It sold at Phillips last week for $670,000—a $330,000 loss. Ouch.

Most Likely to Make Auctioneers Nervous: Big-Ticket Withdrawals

Each house withdrew a major lot at the last minute last week—an indication of just how skittish consignors can get in the absence of guarantees. At Phillips’ contemporary art evening sale, the consignor of the second-highest estimated work, Gerhard Richter‘s Abstraktes Bild (1994) (est. $15–20 million), got cold feet. (“It is the consignor’s decision to take the painting out of the sale and we have to respect that,” Phillips’ chairman Cheyenne Westphal said after the auction.) The evening before, Christie’s withdrew Willem de Kooning‘s Untitled II (1977), which had a hefty estimate of $25–35 million. But perhaps the biggest disappointment was Tuesday’s last-minute withdrawal of Egon Schiele‘s painting Danaë (1909) (est. $30–40 million) from Sotheby’s Impressionist and Modern art sale. Not only was it the priciest lot of the evening, it was also the cover lot of the catalogue. The painting’s $30 million low estimate had represented some 20 percent of the low estimate of the sale overall.

And…the Best-Selling Artist of the Week: Jean-Michel Basquiat

Not only is the American artist responsible for the most expensive single work of art sold last week—the $110.5-million canvas Untitled (1982)—he also cleaned up at all three auction houses. All told, the 27 Basquiat works on offer in both the day and evening sales sold for a total of just over $200 million. Here’s the breakdown.
Christie’s: $57,863,500
Sotheby’s: $130,905,004
Phillips: $12,976,000
Total: $201,744,504" - source ArtNet

Absence of guarantees are indicative of tightening financial conditions as well in the art market. If you read again our July 2016 you well learn that auction guarantees have proliferated since the financial crisis. Irrevocable bids were part of financial machinations that distort the art market. When highly valued works with prearranged bids come up for auction, in many cases there is no genuine bidding and they were bought by the guarantors. In the past, so-called irrevocable bidders were compensated with a part of the auction house’s sales commission only if another buyer purchased the artwork that they had backed. Now, by opting for a fixed fee, they are guaranteed a payout and can get the artwork effectively at discount. Auction houses have resorted in the past to "vendor financing" but as well as paying some buyers to bid on its artwork. If potential buyers are not even agreeing on fixed fee to make at least a minimum bid as per Sotheby's 2016 incentive, then we are not surprised there were big-ticket withdrawals. Yet another indication of deterioration in the "credit" cycle coming this time around from the art market.

So not only there is a risk for yet another soft patch in Q2 and other macro releases and additional pressure from loan demand and consumer credit, but we think you should also keep a close eye on what is happening in the art market also at risk of facing a "soft patch". While "classic cars" have enjoyed "stellar returns" for the savvy and wealthy investors, they continue to show sign of slow down and price revisions.

"The stock market is filled with individuals who know the price of everything, but the value of nothing." - Philip Arthur Fisher

Stay tuned!

Macro and Credit - Wirth's law

"People don't buy for logical reasons. They buy for emotional reasons." -  Zig Ziglar, American author

Watching with interest the unabated compression in credit spreads since the election of "Machiavellian" Macron in France, leading to a significant outperformance in beta (the carry game) as shown by the tighter levels reached for Itraxx CDS 5 year subordinated index (-55 bps since his election), we reacquainted ourselves with Wirth's law. Wirth's law, also known as Page's law, Gates' law and May's law, is a computing adage which states that software is getting slower more rapidly than hardware becomes faster. The law is named after Niklaus Wirth, who discussed it in his 1995 paper, "A Plea for Lean Software". The Swiss computer scientist is best known for designing several programming languages, including Pascal, and for pioneering several classic topics in software engineering. In 1984 he won the Turing Award, generally recognized as the highest distinction in computer science, for developing a sequence of innovative computer languages. In similar fashion, while High Frequency Trading has become faster, one could argue that volatility and velocity have become slower more rapidly, thanks to central banks meddling. Also, in similar fashion secondary trading in bonds have become slower, while yields continue to trade tighter. As posited by a good friend at an execution desk in a large private bank, it's a good thing primary markets are so ebullient, because secondary trading has become much slower with spread tightening so much, reducing the need to rotate existing position, while inflows are pouring into anything with a yield in true 2007 fashion but we ramble again.

In this week's conversation we would like to look again at the wage conundrum in the US, given when it comes to "inflation" and "Unobtainium" (another cryptocurrency using Bitcoin's source code) we still think as per our conversation "Perpetual Motion" from July 2014 that real wage growth is indeed the "Unobtainium" piece of the puzzle the Fed has so far been struggling to "mine" :

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014

Back in our January conversation "The Ultimatum game" we looked at jobs, wages and the difference between Japan and the United States in relation to the "reflation" story or "Trumpflation". We argued that what had been plaguing Japan in its attempt in breaking its deflationary spiral had been the outlook for wages. Without wages rising there is no way the Bank of Japan can create sufficient inflation (apart from asset prices thanks to its ETF buying spree) on its own. 

Synopsis:

• Macro and Credit - Attempts in exploiting the Phillips curve have failed
• Final chart - Trumpflated

• Macro and Credit - Attempts in exploiting the Phillips curve have failed

Back in June 2013 in our conversation "Lucas critique" we quoted Robert Lucas, given he argued that it was naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:

"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes." - Robert Lucas

We argued at the time that Ben Bernanke's policy of driving unemployment rate lower was likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  We also indicated in our past musing the following:

"In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:
"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - Milton Friedman

The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed"

As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion. 

What is happening in the United States has already been laid bare in Japan given over the years, wage growth - in both per worker and per hour terms - has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.

When it comes to the repeating interrogations of some sell-side pundits on this matter we read with interest Bank of America Merrill Lynch US Economic Viewpoint note from the 11th of May entitled "What's up with wages?" as it seems to us many still doesn't get it:

"Wage wars

The unemployment rate is 4.4%, companies have the most job openings available since 2001 and workers are quitting at the fastest rate since 2007. All else equal, this seems like an equation for “normal” pace of wage growth of 3.5-4.0%. But instead we are averaging a mid-2% pace for wages. In this piece, we address the theoretical and empirical reasons for the slow response in wages. We also look at wage dynamics on an industry level, relying on the expertise of BofA Merrill Lynch equity research analysts. Our bottom line is that wages should continue to head higher, but it will likely remain slow and uneven between industries.

There is the theory

The standard model for estimating wage inflation (or price pressure more broadly) is the Phillips Curve. The idea is pretty simple – if the unemployment rate is above NAIRU (non-acceleration inflation rate of unemployment, aka full employment), wage inflation should decelerate. As the unemployment rate approaches NAIRU, the pace of deceleration slows and once we cross through full employment, wage inflation begins to accelerate. This makes sense in theory, but less so in practice, leading to many claims of the death of the Phillips Curve (Chart 1).

In our view, it still provides a viable framework but we should accept that the Phillips Curve is relatively flat implying slow response of wage inflation to moves in the unemployment rate.

The pace of wage inflation is also influenced by productivity growth. In this environment of weak productivity growth, firms may be more hesitant to raise wages. Productivity growth has averaged 0.5 – 1.0% yoy over most of this recovery, which is a historically slow pace of growth. Without productivity growth, it becomes harder for companies to justify raising wages since the output per worker has failed to increase.

And then the data

We can examine the relationship between the unemployment rate and wage growth using historical data. We do this in two ways – descriptive (correlations) and empirical (regressions) analysis. The simplest is just to compare unemployment slack – defined as the unemployment rate less NAIRU – versus wage growth (Chart 2).

There is a general relationship where an increase in labor market slack depresses wage growth and a decline in slack underpins it, but from the quick glance of the eye, the relationship has fallen apart since the Great Recession.

We can also look at the JOLTS survey to gauge the degree of wage pressure in the system, by examining openings and quit rates. When times are good and the labor market is tight, workers have the ability to voluntarily quit jobs, often for a better opportunity and higher pay. According to the JOLTS survey, the quit rate is running at 2.1% (quits level as a % of total employment), hovering close to cycle highs. Using a longer history derived by Haltwanger et al, the current quit rate is consistent with wage growth of about 3.5% yoy based on the historical relationship (Chart 3).

It is standard to examine job openings in the context of the unemployment rate, which is depicted as the Beveridge Curve. This shows the relationship between the unemployment rate and the job vacancy rate (proxied by job openings). A shift out in the curve implies a higher level of unemployment rate for a given vacancy rate, implying less efficiency in the labor market and deterioration in the matching process. The curve clearly shifted out after the recession but seems to be turning back in most recently, implying more efficient job matching which in turn could underpin wages (Chart 4).

Another key source of wage growth is job-to-job transitions. Theory suggests that a worker will switch jobs when a better match comes along and that should lead to higher wages. Evidence bears this out. NY Fed economists find that even after controlling for worker characteristics, those who came into their current job through a job-to-job transition have higher wages than those who experience a period of nonemployment. In the past, the unemployment rate and the job-to-job transition rate have co-moved. But during the current recovery this relationship has weakened as the unemployment rate has returned to pre-recession levels while job-to-job transitions remain subdued (Chart 5).

The modest recovery in the job-to-job transition rate could explain the lackluster wage growth we have experienced during the recovery. It’s hard to know with certainty the reason for subdued job switching, but mismatch between jobs and worker skills may be holding back job switching and thus wage growth."  - source Bank of America Merrill Lynch

Obviously we are part of the crowd claiming the death of the Phillips curve. Back in our January conversation "The Ultimatum game" we argued that the Phillips curve was dead because because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property.

At the time we concluded our conversation as follows:

"In similar fashion and as highlighted above in our quote from David Goldman, the United States need to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017

Subdued job switching is due to a mismatch between jobs and worker skills. To repeat ourselves, what matters is the quality of jobs but we should add that to ensure Americans are great again, they need to get better skills for the jobs being advertised and that goes through training. For instance, Labour Market Training targeted to unemployed job seekers has a long tradition in Sweden. It is all about upskilling unemployed adults in the end. Since the mid-1990s in Sweden, it has become a central labour market policy instrument. The purpose of labour market training is to provide unemployed persons basic or supplementary vocational training. Another objective is to promote both occupational and geographical mobility to support structural changes in the economy and to strengthen the position of disadvantaged groups in the labour market (source Eurostat, 2012). As we indicated before about the limitations of the Phillips curve is that if unemployed workers lose skills, then employers prefer to bid up of the wages of existing workers when demand increases.

Furthermore we disagree with Bank of America Merrill Lynch but they do recognise that using the Phillips curve for modelling purposes has its limits:

"Models are useful but they also have their limits. This was quite salient during the Great Recession. Chart 6 shows the forecast of a simple wage Phillips curve and actual average hourly earnings wage growth from 2008-2015.

The model predicted an earlier drop in wage growth during the recession and a relatively quick rebound during the recovery. In actuality, we got the reverse: wage growth declined at a slower pace and has only steadily picked up since the recession.
Models are built on past relationships. Once those relationships change, the models become less reliable. Structural shifts (e.g. demographics, mismatch) in the labor market could be affecting wage growth. The unemployment rate gap can’t capture all these complexities of the US labor markets. But the wage Phillips Curve is the “best bad” model we have.
Given our forecast for the unemployment rate (bottoming at 4.2%), our models suggest average hourly earnings should reach 3% by early next year while the ECI gets there by early 2019 (Chart 7).

- source Bank of America Merrill Lynch 

Unfortunately as posited by Robert Lucas it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data and yes indeed, demographics mismatch is putting clearly a spanner is this outdated Phillips curve model we think.

Clearly the relationship between labor market slack and wage growth is weakening. Japan is a good example of this "deflationary" curse were the labor market has become very tight as indicated by Société Générale Asian Themes note from the 12th of May entitled "Government of Japan to finally implement labour reforms":

"Current state of Japan’s labour market

Japan’s labour market is at its tightest level since the early 1990s 

Japan’s unemployment rate fell to below 3% to 2.8% in February 2017, and the job/applicant ratio has reached a high level of 1.45. Both measures have improved significantly since Prime Minister Abe took office in December 2012 and started Abenomics. The unemployment rate was at 4.3% and the job/applicant ratio was 0.83 in December 2012. Japan’s NAIRU (nonaccelerating inflation rate of unemployment) was previously believed to be at roughly 3.5%; however, the unemployment rate has remained continuously below that level over the past year. The job/applicant ratio has increased to levels not seen since the early 1990s. Looking at the breakdown, compared with the start of Abenomics in December 2012, the number of job openings in February 2017 has increased by 31.1%, while the number of job seekers has decreased by 24.0%."

- source Société Générale

Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June 2016 in our conversation "Road to Nowhere":

"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.

While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016

We concluded at the time:

"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016

Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street"." - source Macronomics, October 2016.

Yet for Japan, for some pundits, there might be hope given the intent of the Japanese government to implement labour reforms as indicated by Société Générale in their note:

"The government has proposed a set of labour reform plans to alleviate pressures from labour shortages

The government has announced a set of labour reform plans that it considers crucial for the sustainability of Japan’s labour market. The key focus is the concept of ‘equal wage for equal work’ and limiting overtime. These measures to improve working conditions should motivate marginally attached workers to return to the labour market. Addressing labour reform is an important tool for preventing Japan’s potential growth rate from declining due to declining labour inputs in an ageing society.

Progress until now and further progress on labour reforms should help Japan’s economic recovery continue

The various labour policies the government has implemented since the start of Abenomics have started to bear fruit. The number of women in the labour force continues to increase, younger generations are securing jobs, and the government has started to address the issue of accepting foreign workers as well. These measures have already helped to counteract the decline in the ageing workforce to a certain extent. Implementation of additional reforms will likely further help the sustainability of Japan’s labour market over the medium to long term. In turn, alleviating the downward pressure on labour input should boost the potential growth rate and strengthen Japan’s economic recovery." - source Société Générale.

 Back in our January conversation "The Ultimatum game", we indicated the following:

"Re-anchoring inflation expectations can only come from increasing wage growth and some significant labor market reforms in Japan. Not only wage growth is still eluding the Japanese economy, but, productivity has been yet another sign of "mis-allocation" of resources which has therefore entrenched the deflationary spell of Japan in recent years." - source Macronomics, January 2017.

The issue of course we are seeing in both Japan and the rest of the world is that the older generations is averse to inflation eating away their assets while the young generations are more comfortable with relatively high wages and the resulting inflation. Unfortunately rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions and so far the money has been flowing downhill where all the fun is namely the bond market and particularly beta (the carry game) which can be illustrated by the outperformance in the CCC bucket in High Yield so far this year.

When it comes to Japan and wages per worker, more recently it decreased for the first time in 10 months (-0.4%), contrary to expectations for an increase. It remains to be seen how the Japanese government is going to slay the deflationary demon plaguing its economy.

• Final chart - Trumpflated

For inflation expectations to remain anchored, acceleration in wages are essential for both the US and Japan. When it comes to assessing the "Trumpflation" trade, as of late it has been fading. Since the beginning of the year we have been fading the strong dollar investment crowd and we continue to expect further weakness. Our final chart comes from Credit Suisse Global Equity Strategy note from the 18th of May entitled "Reassessing the reflation trade". It shows that the reflation trade index which had propelled much higher stocks on hopes for a global reflationary play is moving back into negative territory:

"The deflating of the reflation trade

As the first chart below illustrates, this combination of an improving global cycle, significant year-on-year commodity price rises and the election of Donald Trump drove expectations of a broad-based reflation in the global economy. The reflation surprise index (proxied here simply by adding the Citi economic and inflation surprise indices for the US) rose to a post-2011 high in the first quarter following an extended period in negative territory. Now, however, the reflation surprise index is back into negative territory as US macro surprises roll over, and inflation starts to surprise on the downside, rather than the upside, as earlier rises in commodity prices fall out of the annual comparison.

US small caps, the US dollar and US nominal yields have all given up much of their post- US election gains. Similarly, GEM equities have gained back their losses over the same period." - source Crédit Suisse

As we indicated in previous conversations, markets were trading on great expectations and hope. It looks to us that for the time being, there is a need to get reacquainted with more realist expectations from the new US administration.

"Logical consequences are the scarecrows of fools and the beacons of wise men." - Thomas Huxley

Stay tuned!