Macro and Credit - Inflationism

"For the merchant, even honesty is a financial speculation." - Charles Baudelaire

Watching with interest the Fed's additional dovishness with the continuation in the rally in high beta and in particular credit, marking the return of "goldilocks at least for this asset class, when it came to selecting our title analogy, given the potential stagflationary outcome thanks to the Fed being S&P500 dependent, we decided to go for "Inflationism". "Inflationism" is a heterodox economic, fiscal, or monetary policy, that predicts that a substantial level of inflation is harmless, desirable or even advantageous. Similarly, inflationist economists advocate for an inflationist policy. The contemporary Post-Keynesian monetary economic school of Neo-Chartalism, advocates government deficit spending to yield full employment, is attacked as inflationist, with critics arguing that such deficit spending inevitably leads to hyperinflation. Neo-Chartalists reject this charge, such as in the title of the Neo-Chartalist organization the Center for Full Employment and Price Stability. Also, a related argument is by Chartalists, who argue that nations who issue debt denominated in their own fiat currency need never default, because they can print money to pay off the debt similar to what we are hearing these days from the MMT supporters. Chartalists note, however, that printing money without matching it with taxation (to recover money and prevent the money supply from growing) can result in inflation if pursued beyond the point of full employment, and Chartalists generally do not argue for inflation. It also worth noting that Keynes described the inflation and economic stagnation gripping Europe in his book The Economic Consequences of the Peace. Keynes wrote:

"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some." [...]
"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." 

Keynes explicitly pointed out the relationship between governments printing money and inflation:

"The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance." 

The direct result of inflation is a transfer of wealth from creditors to debtors – the creditors receive less in real terms than they would have before, while the debtors pay less, assuming that the debts would in fact have been repaid, and not defaulted on. Formally, this is a de facto debt restructuring, with reduction of the real value of principle, and may benefit creditors if it results in the debts being serviced (paid in part), rather than defaulted on. In a context of "Japanification", the carry trade is back on and credit markets will definitely benefit from the global dovishness from central bankers. In  that context, we would tend to agree with our former esteemed colleague David Goldman's recent post in Asia Times from the 20th of March entitled "Fearing slower growth, Fed says no rate hikes this year":

"Markets expected forbearance from the Federal Reserve, but the US central bank Wednesday leaned further towards monetary ease than the optimists expected. The Fed envisions no change in interest rates until sometime in 2020, and not at all if the economy weakens further. It won’t reduce the $4 trillion securities portfolio it built up through so-called quantitative easing.

This is a market that rewards cowardice – holdings of stable income-earning assets like credit and real estate – more than it rewards bravery. I continue to believe that carry will be king in 2019 as the Fed keeps interest rates low." - source David Goldman, Asia Times

This is clearly a market favoring "coupon clipping" we think but we ramble again.

In this week's conversation, we would like to look at the growing "stagflation" risks, which have been on this very blog a scenario we highlighted could happen.

Synopsis:

• Macro and Credit -  The return of the "yield" hogs in the Chinese year of the pig
• Final charts - Oh my God they killed Macro volatility again!

• Macro and Credit -  The return of the "yield" hogs in the Chinese year of the pig

In our previous conversation we highlighted the fact that "Deleveraging" and Deflation were good for credit markets. As expected, the additional dovish tone from the Fed is leading towards a reach for yield across credit. We also indicated that as long as interest rates volatility was remaining muted, it would be hard to be negative on credit markets. Given last Tuesday, Merrill Lynch's Move index, which tracks implied volatility on one-month Treasury bill options fell to a reading of 43.68, the lowest since the index’s inception in 1988, no surprise to see a continuation of the rally in high beta credit.

Rentiers seek and prefer deflation and fixed income investors continue to benefit from central bankers accommodative stance in that context. This definitely doesn't put us into the perma bear camp but more into the "realistic" camp we think hence our "japanification" stance.

Looking at the latest data coming out of Europe in general and Germany in particular, with Eurozone Manufacturing PMI coming at 47.6 vs 49.5 expected and previously at 49.3, no wonder the 10 year German bund is going again negative. As well, France Services PMI fell to 48.7 from 50.2 and expectations of 50.6 and Manufacturing PMI declined to 49.8 from 51.5 clearly pointing towards recession for the Eurozone.

Global dovishness has indeed favored the return of the "yield" hogs as indicated by Bank of America Merrill Lynch in their Follow The Flow note from the 22nd of March entitled "Bond mania":

"Dovish central banks and uncertainty favour quality

The epic U-turn in central banks’ stance, the round of fresh stimulus from the ECB and most recently the announced end of quantitative tightening from the Fed, have spurred a global search for yields that mainly benefited fixed income securities.
As flows pour into fixed income funds in 2019, outflows from equity funds have gathered pace, spurred by a macro picture that keeps deteriorating in Europe as shown by the below-45 print in German manufacturing PMI.

Over the past week…

High grade funds recorded an inflow for the third week in a row, with the pace of inflows ticking up. High yield funds enjoyed their fourth consecutive week of inflow. Looking into the domicile breakdown, Global-focused funds gathered half of the flows, with the other half evenly shared between US- and European-focused funds.
Government bond funds saw inflows following two weeks of outflows.
Money Market funds recorded an outflow last week, reversing a two-week streak of inflows.
All in all, Fixed Income enjoyed strong weekly inflows, the second largest print since 2004 and the best 12-week streak since 2017.
European equity funds continued to record a weekly outflow for the sixth consecutive week, whilst the pace of outflows remains strong relative to historical standards.
Global EM debt funds recorded four straight weeks of inflows. Commodity funds saw an inflow last week, the tenth over the last twelve weeks.
On the duration front, long-term IG funds were the laggards as short- and mid-term IG funds recorded inflows." - source Bank of America Merrill Lynch

Back in March 2016 in our conversation "The Pollyanna principle" when it comes to "japanification" and the attractiveness of credit markets in a central banking dovishness context we wrote the following:

"The issue at stake we have discussed on numerous occasions is that many of these Southern Europe banking institutions are capital constrained and cannot increase their lending capacity until the NPLs issues have been resolved!
Maximizing the funding via TLTRO2 in no way helps SME credit availability. The deleveraging has well is an on-going  exercise. What the new ECB funding does is slow down the deleveraging but in no way provides sufficient resolution to the "stock". NPLs are a"stock" variable but, Aggregate Demand (AD) and credit growth are ultimately "flow" variables. Until the ECB understands this simple concept, the "japanification" process will endure hence our "Unobtainium" analogy of last week:

"Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day and now credit speculators are joining the party with both hand" - source Macronomics, March 2016

This means of course that thanks to the Bank of Japan and the ECB, we believe that the rally in credit has more room to go and that both central banks will again not be the benefactors of the "real economy".
One thing for sure, by applying the Pollyanna principle, we think that Investment Grade Credit will benefit strongly and that we will see large inflows into the asset class as per our final point and chart, for SMEs where not too sure..." - source Macronomics, March 2016.

If "Japanification" is still the trade "du jour" then, obviously, credit markets will benefit from it as we posited in our previous conversation. The new TLTRO might not do wonders for the European economy given many banks are still "capital" constrained due to still large legacy assets sitting on their balance sheets in the form of nonperforming loans, but, from a credit investors point of view, they will continue to enjoy the "bond" party rest assured.

This is what we suggested in our previous conversation:

"An allocation to credit rather than equities for these weaker players would seem prone to less "repricing" risk should buybacks dwindle and some dividends start to be cut in some instances." - Macronomics, March 2019

Clearly global growth deceleration is favoring the "D" word for "Deflation", therefore the D trade is back on and US long bonds are enjoying the bond party as well, not only the German bund. Gold miners and gold as well are benefiting as well again from the growing negative yielding "Bondzilla" the NIRP monster.

We have also recently advocated our readers to go for quality (Investment Grade) rather than quantity high yield given rising dispersion. We continue to view rising dispersion as a sign of cracks in credit markets and not as a sign of overall strength.

On that note we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note from the 15th of March entitled "Eliminate the Impossible":

"The last on our list of recent positive developments is some improvement in pricing of illiquid HY cap structures (Figure 1).

As a reminder, we noted in February that most of the rally to that point had been concentrated in large, liquid, higher-quality cap structures, i.e., relatively easy investments. Bonds in the opposite corner of the market remained largely bidless. This may have started to change in the last couple of weeks, as we are beginning to see some early signs of positive price momentum in that corner of the market. It remains modest so far, offsetting about one-third of the extent of the initial decline, but it nonetheless represents important progress.

Shifting gears to the other side of this equation, other factors that underpinned our recent defensive positioning remained largely unchanged or have even deteriorated further.

Key among them is the degree of dispersion in the overall HY market and in CCCs that refuses to show any signs of improvement. To the contrary, its current readings are below year-end as well as both month-ends since then. The dispersion index measures the proportion of all bonds that are trading close to the index level (+/-100bps for overall HY and +/-400bps for CCCs). The rationale behind this measure is that dispersion tends to be low at times of high investor confidence and risk appetite and drops significantly as credit conditions tighten as buyers remain cognizant of risks and differentiate strongly between relatively stronger and weaker names (Figure 2).

About one-third of all CCCs continue to trade at distressed levels, whereas for most of last year that proportion stood at 20% or below. This outcome suggest that investors remain cautious in reaching for credit risk among the names that otherwise would have the highest upside from here if a low-default scenario were to play out in coming months.
Note that reopening in the CCC new issue market has done little so far to alleviate concerns surrounding these two real-time indicators (dispersion and distress). Perhaps, the newly minted CCCs are yet again viewed as carrying relatively stronger credit profiles compared to the rest of that space, although any comps here are particularly challenging given the highly idiosyncratic nature of this segment. In addition, the B3/below segment in leveraged loans also experienced a sharp slowdown around yearend and has only recovered modestly since then. The latest-3mo pace of activity here is running at less than one-fifth of its peak levels reached in the middle of last year.
Lastly, Moody’s has reported 17 global HY defaults in the first two months of 2019, of which 12 were among US issuers. These counts are the highest over the past year and compare to an average of 2.7 default events per month in the second half of 2018." - source Bank of America Merrill Lynch

Obviously their defensive position has been vindicated by the most recent weakness we have seen in the high beta space, with equities as well in the first line of the volatility hence our more positive stance on credit relative to equities as per our previous conversation for those who follow us regularly.

When it comes to the support for credit markets, namely "Bondzilla" the NIRP monster which we indicated on numerous occasions has been "made in Japan".

Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective. On this very subject we read another Bank of America Merrill Lynch's take in their Situation Room note from the 14th of March entitled "Japan 101":

"Japan 101

It is hard to imagine any country more transparent with investment flows than Japan. Hence, we know from the Japan Ministry of Finance’s weekly Data on securities investment abroad for medium and long term bonds as of March 8th that purchases are off to the strongest start to the year (¥5.76tr ) since 2012 (where the number was only slightly higher). This translates into $52bn of buying YtD, a dramatic change from sales of $6bn and $33bn during the same periods in 2018 and 2017 (Figure 1), respectively, and one of the key reasons the US corporate bond markets has been so strong this year, in our view.

Going forward, we can expect Japanese selling in a narrow window around fiscal year-end (March 31), where they tend to repatriate money (Figure 2).

It is also a straightforward assumption that Japanese purchases of foreign bonds accelerate in the new fiscal year starting April 1st, as seasonally about 75% of buying tends to take place in fiscal 1H, 25% in 2H.

EUR bonds and JGBs for life

Of course, this Ministry of Finance data covers all foreign bonds – not just US corporate ones. Luckily, Japanese lifers update on their investment plans twice a year – our most recent update is in the section “JGBs for life” in here: Situation Room 24 October 2018, which contained detailed plans for 2H of the Japanese Fiscal year (runs April 1-March 31). Clearly, heading into the first part of 4Q18 USD hedging costs had increased so much that they planned to shift hedged buying away from USD, into EUR – likely in a mix of European core corporate and sovereign bonds. Also, with rising rates and 30-Situation Room | 14 March 2019 3 year JGB yields already at 90bps+, they were getting ready to shift back into local government bonds as well. Of course, they planned to continue investing on a currency unhedged basis in the US.

Who let the doves out?

However, we suspect these plans had changed dramatically to favor much more US corporate bonds on a hedged basis by early this year as 1) market expectations for Fed rate hikes collapsed dovishly from about three over the following year heading into 4Q18 to none and 2) local 30-year JGB alternatives had plummeted as well to the 60bps range - far from the 100bps needed. Of course, they likely remained sizable buyers of EUR bonds, but probably less than originally planned.

While it is helpful that dollar hedging costs have come down somewhat over the past several months, as Libor-OIS tightened materially, that is not the main driver of increasing Japanese buying of US corporate bonds. We see this as US corporate yields have declined by roughly the same amount as dollar hedging costs (Figure 3), leaving yields after hedging relatively unchanged.

Instead, the main driver is the Fed’s dovish capitulation. The most common dollar hedging strategy for foreign investors involves a maturity mismatch with the underlying assets, as they roll short term – such as 3-month – forward fx rates. The cost of such strategy is driven by the difference between short term interbank rates, which in turn is driven mainly to relative monetary policy rates.
In early 4Q18 the Fed was the only major central bank hiking rates (3x priced in in 12months), as the BOJ and ECB were on hold. Foreign investors buying US corporate bonds rationally expected to be rolling into prohibitively expensive dollar hedges in 2019, leaving expected future yields after hedging costs on par with 90bps for 30-year JGBs (Figure 4).

Hence, US corporate bonds looked unattractive to Japanese investors. However, that all changed as markets priced out future rate hikes, and Japanese investors could thus have confidence dollar hedging costs would not increase. By the beginning of this year, Japanese investors could expect to keep, for example, 1.8% for dollar hedged 10-year BBB rated US corporate bonds, which compared very favorably to just 0.7% for 30-year JGBs.

Here to stay

We expect healthy Japanese and other foreign buying of US corporate bonds – which this year was always a key ingredient in our bullish call on spreads - to continue to help drive tightening for quite some time. Right now, the global corporate bond market – and USD is the biggest and most liquid chunk of that – is basically the only option for foreign investors. This changes when 1) valuations become unattractive – which will likely take a long time (Figure 4), 2) the market starts pricing in Fed rate hikes – which is not any time soon, or 3) US recession risk becomes too high – which should be years away, in our view." - source Bank of America Merrill Lynch

Not only Japanese Lifers have a strong appetite for US credit, but retail investors such as Mrs Watanabe, in the popular Toshin funds, which are foreign currency denominated and as well as Uridashi bonds (Double Deckers), the US dollar has been a growing allocation currency wise in recent years so watch also that space.

For Japanese investors increasing purchases in foreign credit markets has been an option. Like in 2004-2006 Fed rate hiking cycle, Japanese investors had the option of either increasing exposure to lower rated credit instruments outside Japan or taking on currency risk. During that last cycle they lowered the ratio of currency hedged investments to take on more credit risk.

This is confirmed by Nomura's Japan Navigator note number 815 from the 18th of March entitled "ECB and BOJ's policy impasse and risk of JPY appreciation":

"Lifers opt for credit rather than anticipating weak JPY

In an interview with Bloomberg last week, a major life insurer stated that it was offsetting the impact of currency hedging costs by selling FX call options (partly giving up the advantages of weak JPY), and by taking credit risk, generating returns of about 1% even after fully hedging. This former approach resembles that taken by two other major lifers interviewed recently (see page 7 of the 5 March Navigator), but this lifer seems to be more concerned about the minimal room JPY has to weaken than worried about the risk of stronger JPY. Regarding the latter, credit spreads are not only wider overall in the US than in Japan, but the yield curve is steepening (Figure 5), and as a result, lengthening  maturities have a greater effect in improving yields.

For this reason, if investors buy A rated US corporate bonds with maturities near 20yrs, they can bring in yields of about 1% even if they convert it to JPY using currency swaps with the same maturity. That said, we do not expect lifers to take risks on such long-term credit without a US economic downturn combined with a sense that the Fed will not turn hawkish again." - source Nomura

In relation to our "gold" outlook, while we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates. We believe that the real interest rate is the most important macro factor for gold prices.  Obviously the more our NIRP monster grows, the more inflows gold funds will get given Gibson 's paradox. That simple.

Returning to credit, we have been advocating going higher the quality spectrum and use the recent rally to reduce highly illiquid high beta exposure such as leveraged loans. US Leveraged Loan Funds have seen 17 Weeks of outflows totaling $21.8 billion. Regardless of the performance, it is indicative, we think of risk reduction due to illiquidity factor coming into play. When it comes to US High Yield, though everyone has been talking about the BBB monster in Investment Grade sitting on the edge of the downgrade cliff, discussions surrounding High Yield has been more muted. On that specificity, we have read with great interest Morgan Stanley's take from their Corporate and Credit Derivative Research note from the 22nd of March entitled "A High Yield Hedge":

"Trends in the high yield market over the past few years, in particular, have been somewhat different from what we have seen elsewhere. For example, when thinking about the excesses in credit, many (us included) talk about BBBs in IG, which have seen enormous growth in this cycle, or the leverage loan market, where credit quality has arguably deteriorated for years (higher leverage levels, weaker covenants, weaker structures, etc.). But the high yield market is often left out of the discussion. After all, high yield went through a mini default cycle in 2016, centered on Energy, and since then, issuance has steadily declined, leading to no growth in par outstanding, very different from the trends noted above. Some investors assume that as a result, high yield is more insulated from the fundamental risks present in other pockets of credit markets. In fact, for much of 2018 (at least for the first three quarters), we regularly heard the view that the resilience of HY (relative to the weakness in IG, for example) was a testament to healthier fundamentals in the former.

Through the third quarter of last year, we published several notes (see: US Corporate Credit Strategy Brief: I Can't Believe It's Not Beta, 25 Apr 2018) on why we thought HY was so resilient at the time (i.e., low supply and very strong earnings growth, among other factors), but more importantly, why we also believed HY was very much not immune from the broader macro challenges to come. Fundamentally, we agree, it is hard to point to specific metrics that seem as glaring in HY as in other credit markets, especially since 2016. For example, post the Energy recovery, leverage now looks weaker in IG than in HY (beta-adjusted), while both the growth in and deterioration in ratings quality of the IG and loan markets has also been much more extreme than that of HY over the same time period. However, in our view, this certainly does not mean high yield is out of the woods.

First, speaking to the growth (or lack thereof) in HY par outstanding since 2016, and what that may imply, we think some often forget that this has been a very long ten-year cycle. The HY market, in fact, has grown substantially (+112% since the end of 2008, based on the index we track), just all that growth took place in the first six years.

Leveraged finance markets have been consistently growing the entire time (other than a small blip lower in 2016), and that is what matters most, in our view, as these markets will always be closely tied together, especially in a credit cycle.

Yes, the driver of the growth in leveraged finance markets has shifted over the course of this cycle, as we show in Exhibit 6, with HY the main contributor early on and loans over the past few years, but we don't see this change in trend as overly surprising or abnormal.

As we point out in Exhibit 7, the story was similar in 2006/07 when the growth in HY par outstanding was minimal in the last two years before the financial crisis, while loans were growing at an exponential rate.

Second, while easily-tracked fundamental metrics like leverage don’t look as extreme in high yield, we think other harder-to-track, more qualitative measures are more problematic. For example, when digging into the quality of the companies in various markets, we would argue high yield is more exposed to sectors with longer-term operational challenges (as we originally discussed in Cross-Asset Dispatches: Why We Prefer Equities Over Credit, 3 Nov 2017). In investment grade credit, 30% of the index is made up of Financials, a sector where balance sheets are very strong, thanks in part to a decade of financial regulation. The large cap equity indices are skewed towards fast growing technology companies. High yield, in our view, is more heavily exposed towards “old economy” business and Energy. Many of these companies also have high leverage, but they have survived because of such cheap money for so many years. We are guessing some of them will have trouble through another recession, especially if credit conditions tighten for a prolonged period of time.

Third, because some of the fundamental challenges are more widely discussed in other markets, they are likely also a bit more "in the price." A good example is that the BB/BBB spread basis is at cycle tights, in part because, on the surface, long-term problems seem more material in low-quality IG than in HY. However, while we have been very vocal around the issues with BBBs, we would actually buy BBBs over BBs, simply because we think the potential challenges in high yield in a credit cycle are less appreciated than the risks elsewhere (like in BBBs).

Finally, for those who still believe HY will be relatively resilient through a credit cycle due to better fundamental trends, let’s look at recent evidence. For example, we have had two growth scares in this cycle, in 2011 and in 2016, and in both cases HY traded to ~850bp, very close to prior recession wides (i.e., the levels where HY peaked in 1990 and in 2002).

Some still argue while that may be true, 2016 in particular, was unique due to the collapse in oil prices, which is a much lower risk in the future. In our view, any hope that HY would be more resilient in the next growth scare (or outright recession) should have been thrown out the window after witnessing the price action in 4Q18. After all, once the weakness in 2018 became about growth/earnings growth rolling over, the resilience of HY ended. At that point, spreads widened by almost 250bp, and HY underperformed the leveraged loan market, despite seemingly weaker fundamental metrics in the latter.

We think it is clear that high yield is and will remain highly sensitive to changing growth expectations as well as to changes in credit conditions.

Going forward, our view has been clear – we think the weakness in 4Q was not just a temporary valuation adjustment in a broader bull market, or about one-off headwinds like trade. We believe credit is in a bear market and the credit cycle is slowly turning. Defaults should remain low in 2019, but we think default expectations may rise this year, and actual defaults could start trending higher the year after. We believe this is a good time to position for this view, especially in places where it is clearly not priced, like short-dated HY CDX." - source Morgan Stanley

Now if indeed High Yield is highly sensitive to changing growth expectations and if as we posited last week CFOs in the Investment Grade space decide to reduce CAPEX, buybacks and dividends to address leverage concerns from investors, then it will be more "credit" friendly and less so for "high beta" related equities from these issuers. In a "japanification" context, we therefore think that playing quality and duration is less prone to burst of volatility and will be more rewarding for "yield hogs" cowards than the high beta punters out there.

With a return of ultra dovishness from our generous gamblers aka our dear central bankers, given the new record low in rates volatility as per the Move Index cited earlier on in our long conversation, as per our final charts below it seems to us that macro volatility has been somewhat "killed" again...

• Final charts - Oh my God they killed Macro volatility again!

Back in November 2012, in our conversation "Why have Global Macro Hedge Funds underperformed", we argued that when volatility across all asset classes crashes, global macro strategies tend to suffer on both an absolute and relative basis. Our final charts come from HSBC Asia Chart of the Week from the 22nd of March entitled "The demise of macro vol" and highlights the fall in the volatility of activity data to record lows:

"Glued to your trading screens these last few years, you may well believe the world economy was roiled by one shock after another. Well, not quite. Financial markets have spiked and plunged, but underlying economic activity, at least across Asia, has been remarkably steady. In fact, it’s been ‘flat as a pancake’ to borrow a phrase from HSBC’s chief fixed income strategist Steven Major (see Fixed Income Asset Allocation, 12 March). Ah, ‘China’, you might say: the economy’s growth numbers have indeed been extraordinarily stable in recent years. But that’s actually been the case in virtually all Asian economies. The volatility of activity data has fallen across the board to record lows, well below the mid-2000s, when, if you recall, economists were celebrating the demise of macro volatility amid the ‘Great Moderation’. It’s hard to pinpoint the exact reasons for this – highly supportive, and swiftly reactive, monetary policy is probably one, as are structural factors like the growing share of services in output and much shallower inventory cycles in manufacturing. The fall in growth volatility, unsurprisingly, has been accompanied by a drop in inflation volatility. All this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for.

"I may as well tell you that if you are going about the place thinking things pretty, you will never make a modern poet. Be poignant, man, be poignant." P.G. Wodehouse

Our fist chart is simple enough: it compares the standard deviation of GDP growth in the 2000s (2002 to 2007, to be exact) and 2010s (2012 to 2018).

Note that in virtually all cases, growth volatility has declined markedly. The exceptions are Sri Lanka, Thailand, Taiwan, and Vietnam. In the first two, this is easily explained by local political uncertainty and environmental disruptions. In the latter two, the increase in volatility has been slight or from a comparatively low level. Note also that China is often singled out as having rather stable GDP growth numbers, but the drop in volatility has been nearly uniform.

The decline in growth volatility, unsurprisingly, has been accompanied by a fall in the volatility of inflation. Our second chart replicates the first, this time showing the standard deviation of headline inflation for different economies. Again, the picture is broadly similar: in most markets, volatility has fallen. This time, the exceptions are Australia, India, Japan, New Zealand, and Singapore, with most increases being marginal (India is a stand-out, but may reflect computational issues). ‘Wait’, you might object, the decline in headline inflation volatility may simply reflect more stable global energy and food prices…perhaps, but core inflation is showing pretty much the same trend.

This fall in macroeconomic volatility is generally something that policymakers and investors alike desire. From this perspective, the past few years were quite positive, even if GDP growth itself fell short of expectations in many parts of the world, including in Asia. Financial markets, of course, have at times been highly volatile, but, overall, risk assets have performed quite well, which may in part be attributable to the ‘demise in macro vol’.

The trouble is, the longer a period of low volatility endures, the more desensitized everyone becomes to risk: if things are fundamentally stable, and memories of deep recessions are starting to fade, the appetite to leverage up grows and investors are increasingly tempted to buy ‘on the dip’.

But take a look at our last chart. This shows the volatility of GDP growth in emerging Asia over time. Note that this has been extraordinarily low in recent years (blue circle).

However, periods of low volatility often precede a spike: for example, vol plunged in the mid-1990s before the Asian Financial Crisis and also trended lower in the mid-2000s before the Global Financial Crisis (red circles).

Better stay nimble…" - source HSBC

 So while some central banks have decided that in order to acquire the resources they required, have printed notes for the balance to paraphrase Keynes, their inflationism policies, all of this, ultimately, stokes leverage as borrowers and lenders become increasingly desensitized to risk…careful what you wish for indeed...

"Speculation is only a word covering the making of money out of the manipulation of prices, instead of supplying goods and services." -  Henry Ford

Stay tuned !

Macro and Credit - Lethe

"Forgiveness is the fragrance that the violet sheds on the heel that has crushed it." - Mark Twain

Looking at the continuation of the rally seen in January, with markets being more oblivious to macro data given the return of the central banking support narrative, when it came to selecting our title analogy we decided to go for Greek mythology and the reference to the underground river of the underworld named "Lethe". The river of "Lethe" was one of the five rivers of the underworld of Hades. Also known as the Ameles potamos (river of unmindfulness), the Lethe flowed around the cave of Hypnos and through the Underworld, where all those who drank from it experienced complete forgetfulness. 

In similar fashion, every investors drinking again from the "river of liquidity" provided by central banks including the large infusion from China's PBOC are experiencing complete forgetfulness given the significant rise in anything high beta such as small caps in the US up 18%, Emerging Markets up 10% (EEM) and US high yield up by 6% (HYG) to name a few. In Classical Greek, the word lethe (λήθη) literally means "oblivion", "forgetfulness", or "concealment". It is related to the Greek word for "truth", aletheia (ἀλήθεια), which through the privative alpha literally means "un-forgetfulness" or "un-concealment". While the privative "alpha" might means "un-forgetfulness", the on-going rally is purely of one of "high beta" given the return of the "carry" trade thanks to low rate volatility and global central banking dovishness. 

In Greek mythology, the shades of the dead were required to drink the waters of the Lethe in order to forget their earthly life. In the Aeneid, Virgil (VI.703-751) writes that it is only when the dead have had their memories erased by the Lethe that they may be reincarnated. One might wonder given the global surge of zombie companies from China to Japan, including the United States and Europe, if indeed the central banking Lethe river will enable them to become reincarnated but we ramble again...

In this week's conversation, we would like to look at the state of the credit cycle through the lens of the much discussed auto loan sector in the US.

Synopsis:

• Macro and Credit - The road to oblivion?
• Final chart - It's not only central banks, buybacks got your back...

• Macro and Credit - The road to oblivion?

Given the definition of "oblivion" is a state in which you do not notice what is happening around you (very weak global macro data), usually because you are sleeping or very drunk (thanks to central banks being reluctant in removing the credit punch bowl), we wonder how long the return of "goldilocks" will last following the baby bear market we saw during the fourth quarter of 2018. 

Sure it’s  a great start  in 2019, yet, the slowdown we are seeing is real with US December retail sales down -1.2% against a consensus of +0.1%, or the fall in US manufacturing output with motor vehicles posting their biggest fall since 2009. As we pointed out in previous conversations, global growth has been slowing and Korea, being a good "proxy" for global trade, has seen recently unemployment surging to 4.4%.

No wonder given the on-going US versus China trade spat, and with global growth decelerating that China has decided to doubling down on leverage with its financial institutions making a record 3.3 trillion yuan of new loans, the most in any month back to at least 1992 when the data began. The slowdown in Chinese car sales as well has been significant. Passenger vehicle wholesales fell 17.7 percent year-on-year, the biggest drop since the market began to contract in the middle of last year, while retail sales had their eighth consecutive monthly decline, industry groups  reported this week.

No surprise the "D" for "Deflation" trade is back on. We are back to $11tln of bonds globally with a negative yield according to the WSJ. The rise has been significant according to David Rosenberg and is up 16% since October. So yes TINA (There Is No Alternative) is back on the menu and gold is as well rising in sympathy with everything else thanks to the "Lethe" river flowing again.

If retail sales are indeed weakening and delinquencies on US auto loans are rising and with existing home sales coming in well below expectations at a 4.94 million annual rate, then the Fed's latest FOMC dovish comments appears for some pundits warranted. The sustained rebound in oil prices has been supportive of US high yield in particular and high beta in general.

While investors took another bath into the central banking river of "Lethe", when it comes to credit in general and the US consumer in particular, we do see cracks forming up into the narrative as the credit cycle is gently but slowly turning as we argued last week looking at the next Fed's quarterly Senior Loan Officer Opinion Survey (SLOOs) will be paramount. If some parts of Europe are stalling and in some instances falling into recession, when it comes to the US, we have a case of deceleration. After all "recessions" are "deflationary" in nature, and most central banks have been powerless in anchoring solidly inflation expectations. 

When it comes to the state of credit for US consumers given its important weight in US GDP, we read with interest the US PIRG report published on the 13th of February relating to auto loans and entitled "The Hidden Costs of Risky Auto Loans to Consumers and Our Communities":

"The loosening of auto credit after the Great Recession has contributed to rising indebtedness for cars, increased car ownership and reductions in transit use.

• Auto lending rebounded from the Great Recession in part because of low interest rates (fueled by the Federal Reserve Board’s policy of quantitative easing) and a perception by lenders that auto loans had held up better than mortgages during the financial crisis. As one hedge fund manager noted in a 2017 interview with The Financial Times, during the recession, “consumers tended to default on their house first, credit card second and car third.”
• A 2014 report by the Federal Reserve found that a consumer’s perception of interest rate trends had as strong an effect on the decision of when to buy a car as more expected factors like unemployment and income.
• Low-income borrowers are particularly sensitive to changes in loan maturity according to a 2007 study, suggesting that the longer loan terms of recent years may have been an important spur for the rapid rise in auto loans to low-income households.
• A 2018 study by researchers at the University of California, Los Angeles, tied the fall in transit ridership in Southern California to increased vehicle availability, possibly supported by cheap auto financing.

The rise in automobile debt since the Great Recession leaves millions of Americans financially vulnerable — especially in the event of an economic downturn.

• Americans are carrying car loans for longer periods of time. Of all auto loans issued in the first two quarters of 2017, 42 percent carried a term of six years or longer, compared to just 26 percent in 2009. Longer repayment terms increase the total cost of buying an automobile and extend the amount of time consumers spend “underwater” — owing more on their vehicles than they are worth.
• Many car buyers “roll over” the unpaid portion of a car loan into a loan on a new vehicle, increasing their financial vulnerability in the event of job loss or other crisis of household finances. At the end of 2017, almost a third of all traded-in vehicles carried negative equity, with these vehicles being underwater by an average of $5,100.
• The increase in higher-cost “subprime” loans has extended auto ownership to many households with low credit scores but has also left many of them deeply vulnerable to high interest rates and predatory practices. In 2016, lending to borrowers with subprime and deep subprime credit scores made up as much as 26 percent of all auto loans originated.
• Auto lenders — and especially subprime lenders — have engaged in a variety of predatory, abusive and discriminatory practices that enhance consumers’ vulnerability, including:

• Providing incomplete or confusing information about the terms of the loan, including interest rates.

• Making loans to people without the ability to repay.

• Discriminatory markups of loans that result in African-American and Hispanic borrowers paying more for auto loans.

• Pushing expensive “add-ons” such as insurance products, extended warranties and overpriced vehicle options, the cost of which is added to a consumer’s loan.

• Engaging in abusive collection and repossession tactics once a consumer’s loan has become past due.

- source US PIRG, February 2019

In similar fashion to the predatory practices leading to the Great Financial Crisis (GFC) and tied up to subprime loans we can find many similarities in auto lending. One could argue that the depreciation value of the collateral is even more rapid than for housing and probably less "senior" when it comes the recovery value potential. 

As we pointed out in October 2017 in our conversation "Who's Afraid of the Big Bad Wolf?", 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 pretty 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." - Macronomics, October 2017 

This is why on this very blog we follow very closely financial conditions and the Fed's quarterly SLOOs as well a fund flows. 

Returning to US PIRG report we also think it is very important to look at what has been happening in the auto loans sector:

• "7% of auto loans are 3+ months delinquent . Auto loan delinquencies climbed to $9 billion in 2018. 
• Transportation is the second-leading expenditure for American households, behind only housing. Approximately one hour of the average American’s working day is spent earning the money needed to pay for the transportation that enables them to get to work in the first place.
• Americans owed $1.26 trillion on auto loans in the third quarter of 2018, an increase of 75 percent since the end of 2009.
• The amount of auto loans outstanding is equivalent to 5.5 percent of GDP — a higher level than at any time in history other than the period between the 2001 and 2007 recessions." - source US PIRG, February 2019

Given that the auto industry is notoriously cyclical,  and that the production of motor vehicles and parts dropped 8.8 percent in January, the steepest decline since May 2009 you might want to start paying attention, particularly when consumer spending is down 1.2% which is the biggest drop since 2009.

On the subject of the severity of rising delinquencies in the US auto loan sector, we read with interest Wells Fargo's Economics Group Weekly Economic and Financial Commentary from the 22nd of February:

"Canary in the Camry?

Seven million Americans are seriously delinquent on their auto loans, according to the New York Fed. The current number of borrowers 90 days behind on their auto loan payments vastly exceeds the maximum reached in the height of the last recession. With wage growth picking up and job growth still incredibly strong, is this a harbinger of widespread financial distress or something more benign?

Due to the centrality of cars to the economic and personal stability of so many, consumers typically prioritize auto loan payments over other liabilities—even mortgage or credit card debt. Thus, a growing number of consumers transitioning into delinquency on their auto loans can be an indicator of significant financial distress. Yet, this alarming number of delinquent borrowers is to a large extent simply a consequence of an increase in the magnitude of the auto loan market. Lenders originated a record $584 billion of auto loans in 2018, increasingly to prime borrowers, who still comprise a much larger share of outstanding debt than subprime borrowers. The portion of vehicle purchases financed by debt has remained stable, and the flow into serious delinquency in Q4 only reached 2.4%. Still, this marks a noticeable deterioration in performance—this is up from the 2012 cycle low of 1.5%, and is concentrated among the young and the subprime. While the headline of seven million may not indicate a systematic threat, it can offer clues into where financial hardship is the most acute." - source Wells Fargo

Could that be the reason for restaurant sales declining in four of the past five months and at a pace we haven't seen in the last 25 years? We wonder.

If credit quality in the US has been deteriorating particularly in Investment Grade credit with a large part of the market close to the high yield frontier in the BBB segment, in similar fashion when it comes with auto loans and as posited on numerous occasions on this very blog we do expect recovery rates to be much lower in the next downturn. On the subject of the trend for recovery rates for auto loans, we read with interest Bank of America Merrill Lynch ABS Weekly note from the 23rd of February entitled "Spreads stall heading into SFIG":

"Consumer Portfolio Services, Inc (CPSS or CPS) - sponsor of $2.3bn in subprime auto loan ABS; lender with an auto loan portfolio of $2.4bn

Management continues to believe competition is aggressive. CPSS implemented a new credit underwriting scorecard mid last year, which lead to better quality originations.

The company’s originations grew in 2018 relative to 2019, which led to 2% growth in the company’s managed portfolio. Management indicated that incremental originations in 4Q18 were driven by turndowns from banks and other lenders.

The thirty day delinquency rate for the company’s managed portfolio was 12.35% at the end of 4Q18, up 254bp YoY. The net charge off rate for the quarter was 7.19%, down 5bp YoY. Management attributed higher delinquencies to lower portfolio growth and denominator effect. Net losses for the full year were 7.74% compared to 7.68% in all of 2017. Recoveries declined 170bp YoY to 33%. Management said unemployment is the primary driver of performance, and the employment picture is strong today.

The company’s total blended cost for on-balance sheet ABS debt 4.25% in 4Q18 compared to 3.82% for the 4Q17. Management noted that EU risk retention impacted the company’s January ABS transaction." - source Bank of America Merrill Lynch

To repeat ourselves, credit cycles die because too much debt has been raised. Given the Fed has shown its weak hand as it is clearly "S&P500 dependent", the latest dovish tilt from the Fed will encourage more aggressive issuance as the competition is ratcheting up in the weakest segment of consumer lending. So all in all the "Lethe" liquidity river is flowing strong with many pundits oblivious to cracks forming into the credit narrative. We think that in the ongoing high beta rally, it is more and more important to play the capital preservation game, meaning one should start reducing in earnest the "illiquid stuff" such as the now "famous infamous" leveraged loans regardless of their recent "strong" performance.

For now, investors have dipped again into "Lethe" hence the return of the "goldilocks" narrative following a short bear market during the final quarter of 2018. Bad news have been good news again thanks to the dovish tone embraced by central banks globally but, we remain very cautious when it comes to equities given the velocity in revised earnings. In that context, playing defense by favoring credit markets, including Investment Grade appear to us more favorable as the rally in equities has been very significant and potentially overstretched as many pundits are placing their hope on a trade deal being made between China and the United States. Sure "goldilocks is back but we are cautious given the late stage of the credit cycle. On that point we agree with Morgan Stanley from their CIO Brief from the 21st of February:

"The Trouble with ‘Goldilocks’The Goldilocks narrative has reappeared: inflationary pressures have receded, giving central banks cause to pause on policy tightening; global growth is slowing, but not enough to be truly concerning; and investors are increasingly optimistic about US-China trade. However, we think that investors should be skeptical of the Goldilocks narrative, as fundamental data is weak and earnings are challenged.

We are not looking to add exposure, and have reduced some emerging market beta into strength. We remain short the broad USD and overweight international over US equities." - source Morgan Stanley.

A dovish Fed in that context make selected Emerging Markets still enticing, yet from an allocation perspective, dispersion for both equities and credit markets have been rising. So, you need to be much more discerning in 2019 when it comes to your stock/credit picking skills.

Though we are getting concerned for the damage inflicted to earnings in recent months on the back of the trade war narrative and deceleration in global growth, there is no doubt that central banks are back into play and it should not be ignored. Bank of America Merrill Lynch made some interesting comments in their "The Inquirer" note from the 18th of February entitled "Is Global Monetary Reflation here?":

"In the last week, it seems like global central banks have started a possible process of monetary easing, in line with our views (The Inquirer: Planet Earth to Policymakers: Please Reflate 31 December 2018). If so, this would be very positive for Asia/EM stocks.
In the US, Fed governor Lael Brainard raised the possibility of ending balance sheet contraction by year-end 2019, ahead of schedule; in Europe, the possibility of a TLTRO came from Commissioner Benoit Coeure, and China printed a massive January Total Social Financing number, RMB4,640bn from RMB1,590bn in Dec 2018, above market expectations of RMB3,300bn and the BofAML forecast of RMB3,500bn. Global monetary reflation is possibly on the way. As of now, we remain bullish. We expect the world's central banks to reflate monetary policy, a view we have held since late last year.
Paraphrasing Mike Tyson, everyone's got an investment strategy, until they get punched in the face by a shrinking Central Bank Balance Sheet. Monetary and liquidity analysis (different from "fund flows") was popular in financial markets three decades ago. We remember having a standalone research product in the mid-1990s called "Liquidity Analysis" replete with central bank balance sheets, commercial bank entrails, and the net supply and demand for equity. These days, eyes glaze over when we bring up base money growth, money multipliers, and monetary velocity. However, as the last decade has taught us, we should pay attention to this stuff. Our global strategist, Michael Hartnett, has maintained a consistent focus on liquidity and central bank balance sheets
as part of his toolkit.
1) We think the biggest risk to equities in Asia and EMs is the potential mismanagement and premature contraction of central bank balance sheets. Conversely, it is also the most lucrative opportunity. The correlation of EM equities with the major central banks balance sheets is 0.94 in the past three years. World equities have a similar correlation of 0.94 since 2009. Central bank balance sheets are the most important driver of stock prices, in our view, by lowering risk premia, and cutting off deflation risk. The rest is detail, in our view.

2) We think the Fed is the most flexible in course correcting - they have the alacrity of market strategists and change their minds if the facts change. Just last week, Fed Governor Lael Brainard suggested that the Fed balance sheet contraction should end by 2019, rather than 2020-21. A host of Fed governors changed their minds about rate hikes from December last year to early January. While being bearish the USD was consensus at our CIO conference on Jan 18, 2019, we think US Fed flexibility is an under-appreciated asset for the USD, which refuses to fall.

3) However, we worry that in Europe, Japan, and most importantly, China - a total of USD40tn in GDP, or half the world's total - a misreading of the secular decline in monetary velocity, and the general drop of money multipliers, will lead to lower nominal earnings growth, a return to deflationary dynamics, and asset market dislocations. EM/Asian equities tend not to like this scenario.

The world monetary base is shrinking, only the sixth time since 1980 - each prior episode resulted in massive losses in Asian/EM equities (1982: -31%, 1990: -14%, 1998: -28%, 2000: -32%, 2008: -54% for EMs). In all five cases, Asia was in recession.

Why should this time be different? The US Fed's projected balance sheet contraction of about USD40bn a month will likely reduce the US monetary base 13.8% this year (after contracting 10.7% last year), and the global real monetary base by 1.6%. After spending seven years telling us that the Fed B/S expansion was equivalent to rate cuts, we are now told that the opposite - B/S contraction is like "watching paint dry". Ostensibly, this comes from heroic assumptions of a rise in the US money multiplier, even a potential doubling in three years. The Lael Brainard "end-QT earlier" is helpfully walking back some of this prior aggressive QT fervor. And that’s a good thing -that’s the main impetus to growth in old, indebted and unequal societies.
4) Apart from China, which has control over its money multiplier through the high reserve requirement ratio, most large economies have seen falling money multipliers for the last two decades. Stopping QE - or slowing the QE-induced growth of the monetary base - will likely lead to a sharp drop in M2 growth (M2 is simply the monetary base multiplied by the money multiplier). Couple that with the secular drop in monetary velocity from the declining incremental productivity of debt, and slower nominal global GDP (and EPS) growth is highly likely. Rising indebtedness globally, demands a stronger money supply growth rate to maintain a desired level of economic (and earnings
growth). This is an identity, not a theory. This is increasingly true for China, with its 253% debt to GDP ratio. A lack of Chinese monetary stimulation is likely to impose more severe costs on growth there. The world's central bankers seemed oblivious to this until last week, and even now it is not clear where they stand. Welcome back to the secular stagnation debate. And the potential threat of a "too tight policy mistake".

Chair Ben Bernanke during his testimony about the Federal Reserve Board’s semiannual report on monetary policy said that he equated $150-200 billion of QE as being equivalent to a 25bps reduction in short term rates. So 600billion in QE2 was equivalent to a 75bps reduction.
https://www.c-span.org/video/?298238-1/monetary-policy-report (at 32 minute)

Fed Balance sheet contraction is NOT watching paint dry. Math question: If USD100bn of expansion was equivalent to a 14bp fall in the fed funds rate, a USD400bn contraction is equivalent to? (answer: a 56bp rise)" - source Bank of America Merrill Lynch

It seems to us that Jerome Powell has finally done the math hence the "u-turn" as seen in the increasing use of "patience" in the most recent FOMC notes. This explains why investors have returned to becoming oblivious to the deteriorating macro picture given once again they have taken a dip into the "Lethe" river thanks to the rescue of central banks.

Another strong support as well to the "high beta" rally narrative and "risk-on" environment as per our final chart has been the return of stocks buybacks which have received some strong critics as of late from the US political "left" side.

• Final chart - It's not only central banks, buybacks got your back...

Since 2012, multiple expansion through share buybacks have provided a strong support to US equities. Not only Jerome Powell has made au-turn but he has also told markets that balance sheet contraction aka QT is ending sooner rather than later, in 2019 that is. Our final chart comes from Bank of America Merrill Lynch Equity Flow Trends note from the 19th of February entitled "Buybacks on pace for another record year" and shows that in similar fashion to 2018, the return of buybacks on top of the central banking "Lethe" river provides additional support to the "oblivious" crowd of investors jumping with both feet on the high-beta wagon:

"Buybacks remain strong in Tech and Financials, but have broadened out across other sectors YTD: notably, Staples and Materials buybacks are on track to handily exceed 2018 levels (Chart 1).

The current pace of buybacks would suggest a record year in these two sectors plus Financials and Utilities; Industrials and Discretionary buybacks, while below post -2009 records, are also set to eclipse last year’s levels." - source Bank of America Merrill Lynch

If "R" is for Recession and "L" is for Leveraged then "G" is for Gold. With the recent return of the river of unmindfulness, no wonder, the strong "bull" market has been "reincarnated" and the zombie companies can continue to "live" another day but we are ranting again...

"To err is human; to forgive, divine." - Alexander Pope, English poet

Stay tuned !

Macro and Credit - Cryoseism

"Praise out of season, or tactlessly bestowed, can freeze the heart as much as blame." -  Pearl S. Buck

Watching with interest the weakening tone in February in credit markets following the stellar month of January, in conjunction with confirmation of a global slowdown, and with no resolution in sight between China and the United States in relation to their trade spat, and also with the weaker tone for financial conditions coming out of the quarterly Fed Senior Loan Officer Opinion Survey (SLOOs), when it came to selecting our title analogy, given the lower than usual temperature experienced in various part of the world including ours, we decided to go for "Cryoseism". "Cryoseism" also known as an ice quake or a frost quake, is a seismic event that may be caused by a sudden cracking action in frozen soil or rock saturated with water or ice. As water drains into the ground (liquidity in asset markets), it may eventually freeze and expand under colder temperatures (global growth and trade deceleration), putting stress on its surroundings. This stress builds up until relieved explosively in the form of a cryoseism. Cryoseisms are often mistaken for minor intraplate earthquakes.  Initial indications may appear similar to those of an earthquake with tremors, vibrations, ground cracking and related noises such as thundering or booming sounds. Cryoseisms can, however, be distinguished from earthquakes through meteorological and geological conditions. Cryoseisms can have an intensity of up to VI on the Modified Mercalli Scale. Furthermore, cryoseisms often exhibit high intensity in a very localized area (such as leveraged loans) in the immediate proximity of the epicenter, as compared to the widespread effects of an earthquake. Due to lower-frequency vibrations of cryoseisms, some seismic monitoring stations may not record their occurrence. Although cryoseisms release less energy than most tectonic events, they can still cause damage or significant changes to an affected area. There are four main precursors for a frost quake cryoseism event to occur: (1) a region must be susceptible to cold air masses, (2) the ground must undergo saturation from thaw or liquid precipitation prior to an intruding cold air mass, (3) most frost quakes are associated with minor snow cover on the ground without a significant amount of snow to insulate the ground (i.e., less than 6 inches), and (4) a rapid temperature drop (global trade) from approximately freezing to near or below zero degrees Fahrenheit, which ordinarily occurred on a timescale of 16 to 48 hours.

In this week's conversation, we would like to look at what the latest Fed's quarterly Senior Loan Officer Opinion survey means for credit in general and high yield/high beta in particular. 

Synopsis:

• Macro and Credit - This recent rally is not on solid ground
• Final chart - Credit pinball - Same player shoots again?

• Macro and Credit - This recent rally is not on solid ground

In our most recent conversation, we pointed out to the cautious tone from investors, urging CFOs in the US to take the "deleveraging" route given the continuous rise of the cost of capital, which appears to be somewhat validated by the latest Fed Senior Loan Officer Opinion Survey (SLOOs). The Fed’s latest SLOOs points towards tightening financial conditions: "demand for loans to businesses reportedly weakened."  But, we think we will probably have to wait until April/May for the next SLOOS to confirm (or not) the clear tightening of financial conditions. If confirmed, that would not bode well for the 2020 U.S. economic outlook so think about reducing high beta cyclicals. Also, the deterioration of financial conditions are indicative of a future rise in the default rate and will therefore weight on significantly on high beta and evidently US High Yield.

In our early January conversation "Respite", we pointed out to our 2018 call, namely that analyst estimates were way too optimistic when it comes to earnings for 2019. If indeed Europe is a clear case of Cryoseism, with so much liquidity injected and not very much to show for macro wise in terms of growth outlook making it a very bad grade for the confidence tricksters at the helm of the ECB vaunting in recent days the great success of QE, the savage earnings revision pace we have seen so far clearly show the recent rally is not on solid ground. On the subject of earnings revision we read with interest Morgan Stanley's take from their US Equity Strategy Weekly Warm Up from the 11th of February entitled "Earnings Recession Is Here":

"Earnings expectations for 2019 have fallen sharply, but consensus still embeds a material reacceleration in 2H19. History tells us to expect further downward revisions, higher volatility and a drag on prices. We lower our base case 2019 S&P 500 EPS growth forecast to 1%.

Our earnings recession call is playing out even faster than we expected. When we made our call for a greater than 50% chance of an earnings recession this year, we thought it might take a bit longer for the evidence to build. On the back of a large downward revisions cycle during 4Q earnings season, it's becoming more clear. Consensus numbers have already baked in no growth for 1H19 (1Q projected growth is actually negative) with a hockey stick assumed in 2H19 that brings the full year growth estimate to ~5%.

History says be skeptical of the inflection forecast. The projected y/y EPS growth in 4Q19 is ~9.5%. This compares to an average projected rate of growth of 1% over 1Q - 3Q19, an inflection of ~8.5%. Since the early 00s, we have seen this kind of inflection happen a few times, but these inflections were all related to 1) comping against negative or slower EPS growth or 2) tax cuts mechanically lifting the growth rate. Neither of those forces are at play this year. In fact, it's the opposite making the achievability of these estimates even more unlikely.

When consensus is embedding an inflection further out, downward revisions, some drag on price returns and higher volatility are all to be expected. We examined what tends to happen when consensus embeds a big jump in growth 4 quarters out compared to the next three quarters. We found that the numbers for all 4 quarters ahead tend to fall but the growth quarter tends to fall the most. If current estimates move in line with history, we could see a full year decline of ~3.5% in S&P earnings. There is a wide range of potential outcomes though, so today we only take our base case forecast down to 1% y/y growth. We also found that equity returns can still be positive in this environment, but they will likely be weaker than they otherwise would have been and the odds of outright price declines are substantially elevated. Whether prices move higher or lower, volatility tends to rise meaningfully., with average year ahead price volatility realizing ~5% more than the full period average.

Lowering our earnings forecast. On the back of this work, we lower our Base Case 2019 S&P 500 EPS growth forecast to 1% from 4.3%. While our earnings numbers are coming down, our bull, base, and bear case year end price targets remain unchanged as a lower rate environment provides support for year end target multiples. The bottom line--our base case year end target of 2750 is a lot less exciting than it was a month ago." - source Morgan Stanley

In their executive summary of their interesting note Morgan Stanley indicates the velocity in the earnings revisions as of late. This rapid move clearly shows that the euphoria seen in January where anything high beta rallied hard is not on solid ground. Debt-financed buybacks after all fell to 14% of the total among US companies at the end of last year, the lowest level since 2009 according to JP Morgan data. Buybacks since 2012 has been an important "pillar" in terms of support to US equities in recent years thanks to multiple expansion rest assured.

On top of that there are an increasing percentage of companies with negative earnings: S&P 500 - 7%; Nasdaq - 47%; Russell 3000 - 28%; Russell 2000 - 37%. For us, "high beta" is very "junky". If fundamentals are deteriorating such as global trade and global growth and earnings revisions are "savage" then regardless of central banks' u-turn, it isn't enough we think to provide the same support we saw in recent years and quarters. The cavalry was indeed late after the December massacre, but the overall macro picture ain't rosy.

Given the velocity in earnings revision/recession Morgan Stanley have drastically revised their outlook according to their note:

"Earnings Recession Is Here; Adjusted EPS Forecast Lower

With 4Q18 results season nearing completion we have been taking a closer look at 2019 guidance. Downward revisions have come even faster and steeper than we expected and the full year earnings growth number now sits just above 5% with a material upward acceleration projected in the 4th quarter of the year. At the start of a downward revisions cycle, history tells us not to count on that kind of upward inflection.

On the back of the recent downward revisions, we lower our earnings forecasts for 2019 as we think it is becoming increasingly clear we are in the midst of the earnings recession we called for in our year ahead outlook. Specifically, we are adjusting our 2019 EPS growth number down to 1% (from 4.25%) while noting that despite support from buyback accretion and a weaker dollar by year end, risks skew to the downside. We make minor changes to our 2020 growth assumptions and bull/bear case earnings estimates as well. Our revised forecasts are shown in Exhibit 1.

While our earnings numbers are coming down, our bull, base, and bear case price targets remain unchanged as a lower rate environment provides modest support for year end target multiples. With a more dovish Fed and our Interest Rate Strategy colleagues now projecting a year end 10Y UST yield of 2.45%, we revisit our Equity Risk Premium / 10Y yield matrix (Exhibit 2).

We highlight our target range of ~15 - 16.5x forward PE for the S&P. Our range below has a diagonal tilt as we believe lower yields will be accompanied by higher uncertainty on growth leading to a higher ERP while higher yields may reflect a more optimistic outlook on growth, allowing for ERP compression.

Don't Count on a 4Q19 Inflection in EPS Growth

We are increasingly convinced that consensus earnings expectations for 2019 have further to fall and that the optimistic uptick currently baked into 4Q19 estimates is unlikely to happen. A modest further decline in earnings will deliver the earnings recession we called for. Equity returns can still be positive in this environment, but they will likely be weaker than they otherwise would have been and the odds of outright price declines are substantially elevated. Whether prices move higher or lower, volatility will likely rise meaningfully. So in essence, we are still looking at a bumpy, range bound market at the index level and think investors should continue to try and take advantage of the swings in price in both directions.

The Market Needs a 4Q19 Growth Inflection To Support Full Year EPS Growth

In our year ahead outlook we argued that 2019 had a greater than 50% probability of seeing an earnings recession defined very simply as two consecutive quarters of negative y/y earnings growth. Following a steep downward revisions cycle over the last few months, consensus forecasts are quickly getting there. From the end of November, earnings growth expectation on the S&P fell from ~9% to their current level of around 5%. With an expectation of negative y/y growth in 1Q19 and very marginal growth in 2Q19, the mid-single digit full year number embeds a heavy ramp up of earnings growth in the back half of the year, and in 4Q19 in particular (Exhibit 3).

Importantly, since consensus bottom-up numbers are really just a reflection of company guidance this earnings slowdown could have real knock-on effects to corporate behavior like spending and hiring which then puts further pressure on growth.

Furthermore, company managements tend to be an optimistic group. As such, we're not surprised they are calling for a trough in 1Q. However, we would advise against taking too much comfort in these calls for a trough in 1Q19 of the down cycle from the same people who didn't see it coming in the first place. In addition to a trough in 1Q, consensus estimates are now forecasting a big second half inflection in growth.
Anything is possible, but we have little confidence in such an inflection given sharply falling top line growth and disappointing margins in the face of very difficult comparisons for the rest of this year. If we accept that an earnings recession is here, the key questions are how deep will it be and how long will it last? Again, it's hard to know, but we can look to history for some context on how expectations for a large upward inflection in earnings usually play out." - source Morgan Stanley

Again, analysts going into 2019 have been way too optimistic when it comes to earnings. A usual trend but given the amount of liquidity injected into the system by central banks no wonder we are seeing growing risks of "cryoseism" in 2019. Volatility is firmly back.

As we stated before, where oil prices goes, so does US High Yield and in particular the CCC ratings bucket given its exposure to the Energy sector. No wonder Energy rallied strongly over the month of January:

- graph source Bank of America Merrill Lynch (click to enlarge)

In its January 2019 Senior Loan Officer Survey, the Fed said that a net positive percentage of domestic banks reported increasing the premiums charged on loans to large and middle-market firms. Historically, this tends to be a reliable signal of a pending recession. Both the supply and demand for household and business credit is either slowing or contracting. This is yet another "Cryoseism" sign that the epic high beta rally seen during the month of January is not on solid ground. So sure the rally in US High Yield has been very significant but, if indeed financial conditions continue to deteriorate, it doesn't bode well for the asset class down the line.

As we mentioned on numerous conversations, like any good behavioral psychologist we tend to focus more on flows than on stocks. We stated as well at the end of the year that for a rebound in credit markets, fund flows need to see some stabilization the latest dovish tilt from central banks globally have enabled such a bounce as indicated by Bank of America Merrill Lynch in their Follow The Flow report from the 8th of February entitled "Reaching for yield":

"Equities record first inflow, HY inflow surpass $1bn

Dovish central banks globally have instigated a risk assets rally. The reach for yield is back amid lower government bond yields. Inflows into high-yield funds have strengthened over the past weeks and equity funds recorded their first inflow in a while as light positioning has become a tailwind for the asset class.

Over the past week…

High grade funds flopped back to negative territory. Last week’s outflow reversed part of the inflow from week ago, ending a two week streak of inflows. However, the outflow was driven by one single fund and removing it would result into a $1.1bn inflow. High yield funds on the other hand continued to see stronger inflows w-o-w.
We note that last week’s inflow was the largest since September last year. Looking into the domicile breakdown, US-focused funds recorded the lion's share of the inflow, while Europe-focused funds recorded a more moderate inflow. Note that the inflows into global-focused funds were marginal.
Government bond funds recorded a decent inflow this week; the third in a row. Money Market funds recorded a strong inflow last week. All in all, Fixed Income funds recorded another inflow, though the pace has slowed down w-o-w.
For a change European equity funds recorded their first inflow after 21 consecutive weeks of outflows. Note that during this period total outflows reached $45bn.

Global EM debt funds continued to record inflows, the fifth weekly one. Note that last week’s inflow was the strongest since July 2016. Dovish Fed and lower dollar has become a tailwind for the asset class recently. Commodity funds recorded another inflow, the ninth in a row.
On the duration front, we find that the belly underperformed recording the vast majority of the outflow last week. Long-term and shot-term IG funds also recorded outflows last week, but to a lesser extent." - source Bank of America Merrill Lynch

A dovish Fed in conjunction with lower rate volatility have led to Emerging Markets benefiting from the return of the "carry" trade.

Given that bad news has become good news again during the month of January, given the dovish tilt taken by most central banks, high beta has come back to the forefront thanks to the central banking cavalry. 2019 has clearly started on a very strong tone as indicated by Bank of America Merrill Lynch in their European Credit Strategist note from the 8th of February entitled "Play it again Sam":

"As the expression goes…it’s always darkest before dawn. Year-to-date, high-grade spreads have rallied 18bp and high-yield has tightened by 72bp in Europe. These are impressive moves. For the investment-grade market, 2019 is shaping up to be one of the best ever starts to a year outside of 2012 – a time when the ECB’s life-saving LTROs energised a huge rally across the market.

An epic central bank “blink”

In 2018, only 13% of assets across the globe posted positive total returns…and only 9% of assets managed to outperform US 3m Libor. Jump to 2019 and the picture couldn’t be different. As Chart 1 shows, 98% of assets across the globe have positive total returns so far this year (the second best outcome since 1990).

The clearest instigator for such a bullish reversal, in our view, is that central banks are now undergoing one epic reversal in their monetary policy stance. In 2019, the Fed has already pivoted to being on-hold, the ECB has moved the balance of risks to the downside, Australia has stopped hiking and India has delivered a surprise rate cut.

When the most important central bank in the world changes tack, others must follow…or risk unwanted currency appreciation. True to form, as Chart 2 shows, the number of global central bank rate cuts over the last 6m is now greater than the number of central bank rate hikes (although the picture is less dramatic when excluding Argentina).

And when central banks flip-flop, so do markets. With interest rate vol at record lows now in Europe, this means a green light for carry trades and a return of the thirst for yield.

Cash spreads can still squeeze…but watch out for March indigestion

In credit land, the Street looks particularly offside in this tightening move, reflective of low inventory levels. And with earnings blackout still in place, cash bonds could still squeeze tighter in the short term (especially non-financials). We think the real challenge for the credit market will emerge in March, given that supply is seasonally highest then (14% of yearly issuance). A €50bn+ month of supply, for instance, could herald a return of big new issue premiums and widening pressure on secondary spreads.

Hubris 101– it never ends well

We’ve seen this central bank movie too many times in the past, though, to forget that markets always overshoot amid a yield grab. And that’s exactly what we worry about this time. After all, 30yr Bund yields at 72bp, 5y5y Euro inflation swaps at 1.48% (the lowest since Nov ’16) and rising BTP spreads signal the market’s doubt over the efficacy of another dose of monetary support, in our view.

Our concern is that Euro credit spreads are now increasingly dislocated from European economic data, and at best are pricing-in a Euro Area recovery that may take longer to materialise than the consensus thinks.

Chart 3 shows that European high-yield spreads have closely tracked the Eurozone manufacturing PMI New Orders index over the last 20yrs (72% correlation of levels, since mid-98).

New Order indices are a more forward-looking, and relevant, indicator in our view. But note that this index is still falling and is now far below the 50 recessionary threshold (47.8). Yet, with the market having rallied strongly year-to-date, our regressions point to Euro high-grade spreads being roughly 20bp too tight, and Euro high-yield spreads a more concerning ~200bp too tight.

China…China…China!

Credit spreads are likely discounting a revival in the Eurozone cycle. Our economists expect Euro Area data to begin rebounding as we approach 2H ‘19. But the point is we’re not there yet…and the data flow thus far – especially industrial production – suggests that the Euro Area rebound may, if anything, take longer to materialize.

As an open economy, the Eurozone needs a thriving global economy to grow strongly. Germany, in particular, is exposed to non-European export markets. And given how Germany is integrated into other European countries’ supply chains, German weakness means a broader spill-over to Eurozone growth. But the external environment has been very unfriendly to Germany of late. Chart 4 shows how non-Euro Area trade has faded, with trade wars and China’s slowdown being culprits.

Weaker non-EZ trade means less of a buffer for the Eurozone to counter rising political uncertainties.

That means Euro credit markets need to see two things pretty soon to justify today’s spreads: firstly a US-China trade “agreement”, and secondly signs that China’s stimulatory efforts are finally paying dividends (and supporting broader Asian growth).

• While a US-China trade compromise is our base case, it’s not yet clear whether the US administration has moved on from their concerns over European car imports. On this front, investors should keep an eye on the US Department of Commerce’s Section 232 report on the national security threat of motor vehicle and auto part imports. Bad news here would weigh further on global trade volumes to the detriment of the Eurozone.
• While China has engaged in a number of stimulatory measures lately (RRR cuts, tax cuts for small businesses and a perpetual bond-for-bill swap), credit growth dynamics have yet to materially rise. Chart 5 shows that the ratio of China Total Social Financing to China M2 remains subdued, for instance.

• And importantly, while US and Euro credit markets have seen a material tightening in 2019, (high-grade) credit spreads in China remain elevated.

QE Infinity, and the real meaning of “pushing on a string”

The dovish leanings of policy makers this year have been manna for financial markets. For over a decade, central banks have been able to cajole asset prices higher with their repeated interventions. In fact, Chart 7 shows how effective the ECB has been since 2009 in propping up sentiment: growth in the ECB’s balance sheet has always been enough to counter spikes in European policy uncertainty.

But after ~$11tr. in central bank balance sheet growth since The Global Financial Crisis (GFC) (using the “big 4”), the limits of monetary policy are being reached. Central banks have much less capacity to effect economic change this time around. 

Chart 8, for instance, shows where interest rates would be if central banks repeated their post-Lehman easing cycle, from today.

Understandably, some of the numbers would be far out of the realms of possibility. Hungarian interest rates, for instance, would drop to -10%, Eurozone deposit rates would fall to -4% and US interest rates would be heavily in negative territory (-2.5%).

Moreover, as the expression “pushing on a string” reflects, successive rounds of stimulus over the last decade look to have produced incrementally less economic growth, we think.

In Chart 9, we show what has happened historically to (1) global GDP momentum; and (2) global debt-to-GDP levels, in periods when global central bank balance sheets have expanded notably. Since 2006, we find five such periods.

Since then, however, periods of central bank balance sheet expansion look to have produced a much weaker impulse to the global economy.

• The second round of stimulus post-GFC (‘10/’11) was followed by a decline (-0.9%) in the OECD Lead Indicator, which was driven by strong deleveraging (-9pp in the global debt/GDP ratio),
• And the short, but visible increase in global central bank balance sheets between late ’17 and early ’18 was not even enough to propel growth upwards: the OECD Global Lead Indicator fell by 0.3% over the following 12m.

In summary, we caution that markets should not get carried away by central banks’ newfound dovishness. After so much support already, and with $58tr. of global debt being added since the GFC, recreating the impact of past support now looks much tougher for central banks." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch, "carry on" but do not get "carried away". If financial conditions will gradually continue to tighten as per the latest SLOOs, there is more potential for "Cryoseism". No matter how much liquidity has been injected by central banks, the massive issuance in credit markets in recent years have led to the illusion of "liquidity". For this illusion, you just have to check the secondary market in credit markets to gauge its depth. The next quarterly SLOOs will be paramount as per our final chart below.

• Final chart - Credit pinball - Same player shoots again?

Are we seeing yet another case à la second part of 2016 which saw a significant rally in credit markets and in particular in high beta US high yield thanks to the recovery in oil prices and a more dovish tone from central banks? One might wonder. Our final chart comes from Bank of America Merrill Lynch's Credit Market Strategist note from the 8th of February entitled "Happy New Year, welcome back" and displays the SLOOs versus US Investment Grade corporate spread. Is this a similar situation to the early recession fears of 2016 or is this time different? We wonder:

"Lather, rinse, repeat

Back in late 2015/early 2016 US recession fears were overblown as investors extrapolated from weak manufacturing data a high recession risk. This exact same scenario played out late 2018/very early 2019 as markets forgot that the manufacturing sector is only 17% of the US economy and the remainder is strong (see: Fool me once, fool me twice). Back then the Fed’s senior loan officer survey showed in response a shift toward tightening lending standards. The same thing is understandably happening this time as the survey period for the fresh Fed survey was the last half of December, which represented the height of recession fears (Figure 7). Like back in 2016, as recession fears are proven wrong, this will pass and banks will once again go through a period of loosening lending standards well before the next downturn. For banks the problem is a lack of loan demand, as the cost of debt has increased materially. Absent recession that means banks will soon be back to loosening standards and undercutting yields in the corporate bond market in order to gain business." - source Bank of America Merrill Lynch

Earnings were decent but the outlook is deteriorating fast. Also financial conditions seems to be tightening, We have seen stabilization in fund flows but this rally is not on solid grounds particularly with weakening buy-backs as CFOs are urged to become more defensive by investors of their balance sheet. You have been warned. It is still capital preservation time. Carry on but don't get carried away...

"Sometimes the early bird gets the worm, but sometimes the early bird gets frozen to death." - Myron Scholes

Stay tuned !