Monday, 17 April 2017

Macro and Credit - Narrative paradigm

"The first step towards philosophy is incredulity." - Denis Diderot, French philosopher

Watching with interest hard data becoming softer with the latest weak US CPI (-0.3%) and disappointing retail sales falling by 0.2% (0.1% fall expected), when it came to choosing our title analogy we reminded ourselves of the Narrative paradigm, a theory proposed by 20th century scholar Walter Fisher. It stipulates that all meaningful communication is a form of storytelling or reporting of events. It promotes the belief that humans are story tellers and listeners and are more persuaded by a good story than by good argument. Because of this, human beings experience and comprehend life and financial markets as a series of ongoing narratives, each with its own conflicts, characters, beginning, middle, and end. In his theory Walter Fisher believed that all forms of communication that appears to our reason are best viewed as stories shaped by history, culture, and character. The ways in which financial pundits and the Fed have been selling us the "Trumpflation" and "recovery" story justifying the hikes in interest rates have more to do with telling a credible story than it does in producing evidence or constructing a logical argument we would argue, hence our chosen title. These pundits, like the Fed are essentially storytellers and each individual chooses the ones that match his or her values and beliefs. Obviously, the test of the narrative rationality is based on the probability, coherence, and fidelity of the stories that underpin the immediate investment decisions to be made. Unfortunately, these "Jedi tricks" do not function well with us. We must confess that we never bought the strong dollar narrative story that everyone piled into. As of late, the latest raft of hard US macro data has pushed us to revisit a US long duration exposure. It seems to us that US GDP for Q1 2017 is going to be most likely more disappointing than Q1 2016, therefore we have gone with the narrative rationality of MDGA (Make Duration Great Again) from a tactical perspective but we ramble again...

In this week's conversation we would like to look at 

  • Macro and Credit - Foreign bonds allocation - Are the Japanese back in town?
  • Final charts - Credit, the only easy day was yesterday...

  • Macro and Credit - Foreign bonds allocation - Are the Japanese back in town?
At the end of March in our conversation "Outflow boundary", we argued that it was important to focus on what our Japanese friends such as GPIF, Lifers and Mrs Watanabe were doing in terms of foreign bonds allocations.  At the time we also added:
"The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment" - source Macronomics, March 2017
We also note that our tactical bullish US long bonds allocation since our recent post was validated:
"Now, if US long bonds yields such as 30 years continue receding, then indeed our contrarian stance of once again dipping our toes in long duration exposure (ETF ZROZ - TLT) and adding to Investment Grade credit with higher duration as well could be tactically enticing. We are watching closely the 3% level on the 30 year." - source Macronomics, March 2017
With the 30 year US bonds now at a yield of 2.89% supported mostly by geopolitical woes in conjunction with recent weaknesses in hard data such as CPI and retail sales. As we pointed out in our recent musings including our most recent one, we were eagerly anticipating a return of the Japanese investment crowd in US Treasuries and US credit thanks to an improving cross-currency basis. We also highlighted last week that European domiciled accounts had been front-running the Japanese investment crowd, which has now entered its new fiscal year. The big question one might ask in the current "Narrative paradigm" is as follows: are the Japanese back in town when it comes to their foreign bonds purchases?

One clear trend seen in recent years has been Bank of Japan's QE programme between December 2012 and June 2016 which has enticed large inflows into the US bond markets as displayed in Nomura FX Insights note from the 10th of April entitled "Where has the ECB QE Money gone":
- source Nomura

Is this time going to be different? We wonder. There is currently a clear avoidance in terms of allocation by the Japanese investment crowd for French Government bonds given the looming French elections. There is as well prevailing uncertainties from the new US administration when it comes to fiscal policies. What appears to be the case is that the current level of uncertainties is clearly slowing the return of the Japanese crowd this time around.

Also, the recent bout or "risk-off" with USD/JPY trading through the significant 110 level is somewhat probably dampening the velocity in the return of this specific investment crowd. On this subject we read with interest Bank of America Merrill Lynch Liquid Insight note from the 13th of April entitled "New fiscal year, new flow":
"New fiscal year, new flow
Japan entered the new fiscal year this month. Last week, we argued JPY strength may be overdone and that the USD/JPY’s medium-term uptrend has not ended despite a near-term possibility of further technical sell off through 110 where we stop out (Is JPY strength justified? 105 first or 117? 07 April 2017). In our view, global risk events may not fully explain the extent of JPY strength, and flow dynamics could have been behind the JPY strength. With new data from the balance of payment statistics, we argue the demand/supply balance of USD/JPY should be improving especially after an eventful April.
Japanese money in the new fiscal year
We have seen a notable slowdown in foreign securities purchases by Japanese investors since the US election in November (Chart of the day).

The slowdown probably reflects position unwinding among bank accounts and a wait-and-see stance among the Japanese real money community amid a volatile Treasury market in the final months of the Japanese fiscal year (Chart 1-Chart 2).

Banks could continue to unwind Treasuries, but it would involve little FX impact as they usually fund these investments in the USD, unlike real money accounts we discuss below.
Lifers – more USD buying
There is a seasonality of increased foreign bond purchases by insurance accounts during the early part of Japanese fiscal year. This year, we observe (1) rising yields in the JGB’s super long sector, but still at a relatively low level; (2) lower FX hedge cost; and (3) higher US yields, and (4) a lower USD/JPY (Chart 4).

True, it is unlikely they would be very aggressive in unhedged foreign bond investments as investors would balance across JGBs, hedged foreign bonds, and unhedged foreign bonds. For now, the USD/JPY at 110 may not attract strong demand, but we believe the USD demand will increase in the next few months once we go through April full of risk events or if we get renewed optimism for the US tax reform.
Trust accounts – market stabilizer
Trust accounts continued to sell rising assets and buy falling assets last quarter as the GPIF portfolio has presumably been close to its target for some time (Chart 5).

Going forward, a traditional risk-off market, as we currently observe, would likely be met by selling of domestic bonds (and potentially foreign bonds) and buying of domestic and foreign equities by pension funds. Reflation trade would be met by selling of foreign and domestic equities and buying of foreign bonds (and potentially domestic bonds) by pension funds.
Exporters’ hedging
Another source of the earlier USD/JPY weakness may have to do with Japanese exporters’ hedging activity into the fiscal year-end. Japan’s trade balance has been rising in light of stable oil prices and rising real exports (Chart 7).

There is a possibility the final months of the fiscal year generated additional USD selling.
As FY17 starts, we think corporate hedging should be more orderly, unlike last year. According to the BoJ’s tankan survey, large manufacturers had assumed an average USD/JPY rate of 117.5 heading into FY16, while the year actually opened at 112s, which led to a severe USD selling pressure last April, in our view (Revisiting the dollar’s 100 yen scenario 07 April 2016). This year, corporates assume an average USD/JPY rate of 108.4 (Chart 8).

Though this may suggest some near-term pressure, the assumption itself seems conservative, in our view. While the improving trade balance may support the JPY over the medium-term at margin, we believe corporate USD selling will be spread out and less intense this year." - source Bank of America Merrill Lynch
Whereas the Narrative paradigm has been so far seen in renewed optimism for US tax reform, the latest raft of hard data makes us wonder how many weeks before we seen again "Bondzilla" the Japanese NIRP monster's appetite return. Our current stance, given the weaker tone in both geopolitical rising tensions in conjunction with a much softer tone in hard data, has pushed us, was we indicated earlier on in our conversation to play the duration game again, in effect front-running the Japanese investment crowd before they are back in town, yet this time around in 2017 with a delay we think. On that point we agree with Bank of America Merrill Lynch's conclusions:
"Flow in the new fiscal year will likely put widening pressure on JPYUSD basis but the magnitude will be less this time
As highlighted above (and here), lifers are expected to start investing in foreign bond markets after the French election, but in the early part of the Japanese fiscal year. Lifers’ outward flow usually pushes JPYUSD basis wider as they try to hedge FX risk. This will likely be no different this time, but we expect the widening pressure will be less and it would be difficult to see JPYUSD basis go wider to last year’s level. At the current level of USDJPY, lifers will be more open to keep their foreign bonds unhedged and some of the contributing factors to the tightening of USDJPY basis since the start of the year are structural." - source Bank of America Merrill Lynch
No doubt the Lifers will come into play in terms of their foreign bonds allocations, and this will also have some impact in the already volatile USDJPY currency pair. What is of interest of course, when it comes to the "Narrative paradigm" is that there are already early signs of the Japanese investment crowd dipping their toes back into foreign bonds as indicated by UBS in the Global Rates Strategy note from the 10th of April entitled "What Japanese Investors Are Buying":
"French bonds overtake US Treasuries as main force behind Japanese selling Japanese investors' post-US presidential election trend of considerable net selling of overseas bonds continues. Weekly flow data underscores how Japanese investors sold ~¥5.4 trillion of foreign bonds from the time of the election to the end of Mar-17.
Today's more granular data release of which individual sovereign bond markets were bought and sold in Feb-17 highlights that French bonds have overtaken US Treasuries as the main force behind the overall selling pressure. This suggests that political risks as of February overshadowed the increasingly attractive currency-hedged pick-up over JGBs offered by French bonds. Separately, we note that the last week of Mar-17 saw the largest net purchases of overseas bonds in six months. However, as this follows the typical pattern around Japan fiscal year-end (.Figure 4), we would caution interpreting this as a sign of a sustainable rebound in Japanese demand for overseas bonds.
 - source UBS

While, yes it might be seen as too early to embrace yet the "Narrative paradigm", in the light of the recent weakness in both the US dollar and hard macro data, we would rather be a little bit early and start tactically adding at least on the long end of US Treasuries, rather than wait for additional signs from the Japanese investor crowd. Some says fortune favors the brave, we would posit that in most occasions it favors the bold contrarian but we ramble again here.

Finally, for our final charts below, as we posited in previous conversations, when it comes to the situation in credit and in particular in 2017, we would rather go for US credit, given it seems to us that Euro High Yield is "priced to perfection" and when it comes to US High Yield we closely follow what oil prices are doing and much less sanguine than we were back at the end of 2015. Yes, the credit cycle seems to be turning, but, it is slowly turning.

  • Final charts - Credit, the only easy day was yesterday...
Whereas the second part of 2016 saw a very significant rally in general for US High Yield and in particular for the US energy sector, the rally so far this year has been significant as well, making us wonder if there is any "juice" left given the performance so far. Yet something we would agree with Barclays from their Global Strategy Chart book from the 10th of April is that when it comes to credit we would favor US Investment Grade over Euro Investment Grade. On top of that agreement we also think that, when it comes to credit overall, the only easy day was yesterday:
"Credit was strong in 2016n but easy gains likely behind us" - source Barclays
As we pointed out, foreign demand remains key to not only US credit but as well for US Treasuries, so overall, let's see if indeed the Japanese Investment crowd and Bondzilla the NIRP monster find again their appetite while the "Narrative paradigm" surrounding the "Trumpflation" story fades away.

"Skepticism is a virtue in history as well as in philosophy." -  Napoleon Bonaparte

Stay tuned!

Monday, 10 April 2017

Macro and Credit - Drums Along the Mohawk

"The most persistent sound which reverberates through man's history is the beating of war drums." - Arthur Koestler, Hungarian novelist

Looking at the brief return of "exogenous" factors thanks to the escalations in Syria, leading to some interesting market gyrations in conjunction with a weaker Nonfarm payrolls number with, no surprise an Atlanta Fed revised GDPNow report for US 1st quarter GDP to a miserable 0.6%, made us remember for our title analogy of John Ford's 1939 historical technicolor film called Drums Along the Mohawk. The film was John Ford's first color feature movie and was a box office success. It tells the story of settlers on the New York frontier during the American Revolution suffering British, Tory and Indian attacks on their farm before the Revolution ends and peace is restored. The time of the story is July, 1776, and the spirit of revolution is in the air. The valley's settlers have formed a local militia in anticipation of an imminent war. The latest change in the rhetoric when it comes to the events in Syria, could no doubt spur some renewed volatility in the markets in conjunction with the upcoming French elections. It seems to us that along the Markets' Mohawk Valley, drums are indeed resonating and the eerily calm volatility akin to the one seen in the last months of 2006, as per our previous week's musing could face a significant regime change in the upcoming weeks, should "exogenous" factors return to the forefront. 

In these days and age of delusions and populism, beating the war drums have always been a short cut for politicians to garner support in very short order. Couples of examples come to our mind:
-The crumbling military government of Argentina with their Falklands adventure
-The response from Prime Minister Thatcher against Argentina's incursion solidifying her political base and garnering very large support.
-The second war in Chechnya which boosted the popularity of Russian president Putin
-The invasion of Iraq in 2003 by the Bush administration
-The Libya operation for French president Sarkozy
-The Mali operation for French president Hollande

 To name a few...

In this week's conversation we would like to look at Financial markets gyrations during "exogenous" factors such as "conflicts" and what Q2 entails in terms of potential surge in volatility. 

  • Macro and Credit - Delusions and gyrations
  • Final chart - Fiscal stimulus, if you give it, earnings will come...

  • Macro and Credit - Delusions and gyrations
In somewhat a similar replay to Q1 2016, we expect US GDP for 1st quarter to disappoint. The recent weakness in the latest Nonfarm payroll report and our recent call to extend duration exposure has made us dip back slightly into long US treasuries. When it comes to our gold mining exposure, we are quite satisfied by the year to date performance overall and we will continue to add opportunistically. As our readers know by now, we didn't embrace the herd mentality spirit of the long US dollar crowd and so far the performance for the first quarter has validated our stance. We continue to prefer in terms of positioning other markets than the US when it comes to equities. 

As we await for the return of the Japanese investment crowd in US credit thanks to an improving cross-currency basis, it seems European domiciled accounts have been front running as of late the Japanese crowd which is now entering their new fiscal year as indicated by Bank of America Merrill Lynch in their Follow The Flow note from the 7th of April entitled "Blame it on the Basis":
"More into risk assets
Last week we recorded inflows across a broad range of risk assets. Inflows have been recorded across equities, EM debt, commodities and HY funds. Inflows into high grade bonds have also strengthened. This was mainly driven by inflows into dollar IG bond funds that over the past two weeks have accounted for almost half of the total flows into this space. This move into USD credit from European-domiciled accounts was probably motivated by the recent tightening in the EUR–USD cross-currency basis.
Over the past week…
High grade funds flows remain strongly on the positive side for the eleventh week in a row. Last week’s inflow was also the largest since August ‘16. The inflows came equally from USD and EUR focused funds to the tune of $1.3bn.

High yield fund flows switched to positive after three weeks of outflows. Looking into the domicile breakdown, as charts 13 & 14 show, the largest part of the inflow came mainly from Europe-focused funds, followed by US-focused HY funds.
Government bond funds flows remained positive for the second week but inflows were marginal. Money market funds weekly flows turned strongly positive after a brief week of outflows. Overall, fixed income funds recorded their third consecutive inflow, and the highest in 36 weeks, supported by strong credit inflows. 
European equity funds flows remained on positive territory for a second week.
Global EM debt fund flows continued on a positive trend for the tenth week in a row and the third consecutive one over the $2bn mark. Commodities funds saw their fourth week of inflows; nonetheless we note the recent weakening in the magnitude of the inflow.
On the duration front, inflows continued in short-term IG funds for the 16th week in a row. Mid-term funds posted another strong inflow and the highest in nine weeks. Flows in long-term funds were lower than the previous week but remained positive for the fourth week in a row." - source Bank of America Merrill Lynch
When it comes to the Japanese investment crowd and their appetite for foreign bonds, one clear picture worth mentioning has been their recent distaste for French government bonds which they have been shunning in anticipation of the French elections. On that specific point we read with interest Bank of America Merrill Lynch's take on Japan selling pressure on French debt from their Japan Rates and FX Watch note from the 10th of April entitled "Japan BoP: New fiscal year, new flow:
"Trump shock done for now; France and seasonality the themes in April
After a painful three consecutive months of sales in foreign bonds after Trump’s victory, Japanese investors finally stopped selling with a small net purchase of ¥39.0bn in March. The continued bleeding from banks is likely over with only small net sales of ¥367.8bn compared to the previous three months with monthly net-sales over ¥1tn. If US treasuries continue to trade in a range with no further progress in Washington, we would not expect another month of selling as a result of the impact caused by Trump’s victory. On the other hand, the French election will continue to one of the key determinants of Japan’s bond flow into April and may cause another round of de-leveraging with much depending on the evolution of the polls.
- source Bank of America Merrill Lynch

The February sell-off in French government bonds was significantly large and amounted to all Japanese purchases for Q3 2016 as per the table above. Indeed, if the French elections delivers yet another sucker punch à la BREXIT, this "exogenous" factor could precipitate additional pressure on French government yields given Japanese investors have been the largest purchasers of French debt since 2012 and hold 13% of it. When it comes to flows for foreign bonds, "Bondzilla" the NIRP monster is indeed Japanese and you would be wise to track is appetite when it comes to country allocation.

Whereas fund flows continue to be supportive for now, another factor to take into account other than "exogenous" factors such as geopolitical events has been the weakening in hard data as of late. As we mentioned in numerous previous conversations, we believe the credit cycle is ending slowly but surely ending. On this specific subject we mentioned we have been monitoring closely the trend in C&I Loans as they are more reflective of what is happening in the real economy. Given financial conditions have been both tightening for Commercial Real Estate (CRE) and for C&I Loans, it remains to be seen if we are going through a soft patch à la Q1 2016, or if there is indeed more to it with some recent rise in delinquencies in both mortgages and auto loans. The below chart from Bank of America Merrill Lynch displays US C&I Loans versus EU Corp Loans since 1985:
- source Bank of America Merrill Lynch

Last three months changes for C&I loans have been negative with January ending at -0.1%, February at -0.4% and March at -0.7%, clearly indicative of a deteriorating trend. The big question obviously is if this continued trend will prevent the Fed from hiking in June with odds currently above 60%. The latest patch of soft data does indeed make us wonder whether there is more clarity awaited in regards to US fiscal stimulus and reforms, or if there is more to it. On that subject we read with interest Bank of America Merrill Lynch analysis from their Credit Market Strategist note from the 7th of April entitled "Is soft the new hard data?":
"Is soft the new hard data?
This week saw some softness in hard data as auto sales and jobs growth declined sharply. While two observations do not make a trend, this occurrence nevertheless is noteworthy as on the one hand very positive sentiment indicators suggest activity should pick up (Figure 1), while on the other hand loan data suggests everybody is in wait-and-see mode pending details of fiscal stimulus (=tax reform) - which highlights the risk of softer hard economic data.

For example, weekly bank asset data shows that C&I lending has not increased since September 7 last year (Figure 2), the first period of no growth for at least six months since the 2008-2011 aftermath of the financial crisis, and prior to that after the early 2000s recession (Figure 3).

At the same time, consumer loan growth has slowed substantially - up just 1.4% since the US elections compared with 3.1% the same period the prior year (Figure 4). 

As tax reform by House Speaker Ryan's own account is not going to happen anytime soon, and likely will be watered down as the Border Adjustment Tax (BAT) is replaced by a Value Added Tax (VAT) and the elimination of net interest deductibility for corporations, the biggest near term risk to our bullish outlook for credit spreads we maintain is a correction in equities - most likely prompted by weak hard data." - source Bank of America Merrill Lynch
Is there something more ominous at play or are we going through a soft patch like in Q1 2016? We believe it will be essential to track the evolution of consumer credit in the coming weeks from a credit perspective. There is as well a possibility that the "Trumpflation" trade is continuing to fade and that investors were somewhat delusional in their expectations. For the continuation of the rally in equities, earnings will be key and so will be the guidance provided apart from "exogenous" factors that could trigger renewed bouts of volatility.

Moving back to the subject of "exogenous" factors and their impact on financial markets gyrations we read with interest Nomura's take on the subject from their Japan Compass note number 433 from the 8th of April entitled Financial market movements during US wars":
"Flows tend to be risk-on at outbreak; rates market and USD movements depend on Fed policy
Markets have become risk-off and bond yields have fallen in response to the US launching air strikes against Syria.
However, we do not recommend investors buy bonds aggressively; at least until the Fed suggests that it will address this new geopolitical risk by weakening its hawkish stance.
In the past, the outbreak of a war by the US has led to risk-on flows (i.e., reflecting the US’s military dominance). However, as Russia supports President Bashar al-Assad of Syria, we believe the US is unlikely to start a war and overthrow the president, as in past conflicts, but will likely seek another resolution (or the conflict would simply fade without escalating further). In these circumstances, we believe the equity market will remain under pressure for some time, until uncertainties are cleared.
We also note that the Trump administration’s move toward reorganizing the National Security Council in such a way as to weaken its pro-Russia, far-right proclivities. If this leads to a higher support rating for the Trump administration, markets may react with risk-on flows, in our view.
In previous cases of US wars (e.g., Gulf War, Iraq War), markets tended to: 1) become risk-off as the event that triggered a war occurred; and 2) become risk-on as the US or multi-national force took military action. However, these tendencies clearly took place only in equity markets, and the rates and currency (USD) markets tended to move more in line with central bank policies.
The previous two US wars occurred during the Fed’s easing cycles (i.e., when economic conditions were poor, which may have made encouraged the US government to seek military options).
The US’s military action against Syria was unexpected, and the context and pretexts are not as clear as in the Gulf War and Iraq War (Iraq’s invasion of Kuwait, 9-11 terrorist attacks and Iraq’s possession of WMD). Unless the conflict is resolved in one way or another, the equity market would likely remain under pressure. A resolution may not materialize as a full-scale war. Before the Iraq War, e.g., Iraq accepted UN nuclear weapons inspections.
In contrast with the Gulf War and Iraq War, the Fed is in its hiking cycle now, with macroeconomic conditions improving in the US. Considering the rates and currency markets moved more in line with Fed policy during these two wars, and were not affected much by investor concerns over military risks, we believe these market movements will depend on the resilience of the economy in view of the geopolitical risks.
When Iraq invaded Kuwait, the Fed was apparently more wary of a macroeconomic slowdown caused by higher crude oil prices than a rise in inflation expectations (the US economy actually entered a recession and the Fed began cutting rates)." - source Nomura
Obviously the asset class most susceptible to large variation thanks to "exogenous" factors linked to geopolitical tensions remain oil in the current situation. As highlighted by the Euchre on his twitter feed, Kuwait's invasion by Saddam Hussein in the early 90s was a good illustration of exogenous factors impacting significantly oil prices:

- source The Euchre - Twitter feed

And, as far as we are concerned when it comes to Drums Along the Mohawk, where oil goes, so does High Yield CCC as per our short term graph below displaying the correlation between both asset classes:
- source

This is not a surprise given the large weight in the CCC sector of the Energy sector, which has been issuing in drove in recent years.

While everyone, in many instances have been sounding the alarm, when it comes to valuations and in particular US High Yield, oil prices remain a key support for High Yield as indicated by the weak performance experienced in the first half of last month as highlighted by Bank of America Merrill Lynch in their High Yield Strategy note from the 4th of April entitled "1st half pain, 2nd half gains":
"Strong back half of March not enough to offset weak start
Driven by a combination of lower oil prices and uncertainty surrounding Healthcare and tax reform, the first half of March proved to be the worst two-week performance for high yield since the election slump that occurred last November. Not surprisingly given the reasons behind the pullback, the two worst performing sectors through March 14th were Health Care (-2.32%) and Energy (-2.97%). However, a mid-month 25bp hike from the Fed and respite from oil weakness provided markets with sufficient confidence around the growth and inflation trajectory that performance was able to turn around in the 2nd half of the month. Although high yield was unable to recoup the 180bps in losses accumulated during the first two weeks, a +0.7% return from the 14th to the 31st helped limit losses on the month to just -0.21%. This brought the YTD total return down slightly, though the figure remains at a respectable +2.7% (+11.4% annualized). With the first quarter of 2017 in the books, we take a moment to reassess the strategic outlook for high yield during the remaining 9 months of the year." - source Bank of America Merrill Lynch
Of course recent fund flows in conjunction with rising oil prices have validated once again a strong appetite for High Yield in recent weeks, hence the second half of March rally in the asset class. Does that mean we remain defensive? Once again we would like to re-iterate our short-term Keynesian somewhat "bullish" stance, yet we remain medium term Austrian from a credit cycle perspective and we will watch very carefully the evolution of credit conditions as well as oil prices. We continue to believe we are starting to notice some early signs in the deterioration of the credit cycle. As we posited recently, 2017 could indeed play the reverse of 2016, namely that the second part of the year could see a weaker tone in and upset this on-going "risk-on". 

  • Final chart - Fiscal stimulus, if you give it, earnings will come...
While Drums are beating Along the Mohawk, and given recent weakness with hard data becoming soft, the "Trumpflation" trade which has been running since the elections on renewed hope for Fiscal stimulus, makes us wonder if earnings as we enter earnings season will materialize on top of markets pundits hoping for a delivery. Our final chart comes from Nomura's Rates Weekly note from the 7th of April entitled "Risk markets, what's left in the easing tank" and displays the S&P 500 profitability metrics, showing clearly that easy money rather and multiple expansion rather than earnings have been in the driving seat of the rally since 2012:

"We think Figure 2 is self-explanatory from the standpoint that easy money drove asset valuations to lofty levels. However, just like Greenspan’s comments in the late 1990s, markets can remain irrational for longer too. Current stock market dynamics, relative to profitability metrics (and by extension P/Es) look eerily like the 1999-2001 experience.
Back then, the view was that earnings would eventually come as “the internet” would revolutionize the world; it did, but it took years to do so from an efficiency standpoint and profits never materialized for many because they seized to exist post the crash. Stimulus (and prospects of a new fiscal policy) has clearly driven markets, so wouldn’t the reverse be true if the economy does not accelerate and/or we do not get the full US fiscal plans?" - source Nomura
Markets since the US elections have no doubt been trading on hope some fiscal stimulus would materialize with the new US administration. Yet recent softening in hard data and disappointing earnings could potentially have an impact, not only Drums Along the Mohawk...If the US administration does give it, will earnings return? We wonder...

"Nothing is more sad than the death of an illusion." -  Arthur Koestler, Hungarian novelist

Stay tuned!

Monday, 3 April 2017

Macro and Credit - Mexican divorce

"Friendship is the marriage of the soul, and this marriage is liable to divorce." - Voltaire

Watching with interest Theresa May the Prime Minister of the United Kingdom triggering the article 50, therefore putting in motion BREXIT, when it comes to our title analogy we reminded ourselves of the Mexican divorce. In the 1960s, some New-Yorkers used to travel to Mexico to obtain a "Mexican divorce". At the time, a divorce in Mexico was easier, quicker, and less expensive than a divorce in much US States. It is also mentioned in Jack Kerouac's famous book "On the Road" and often referred to as a "quickie Mexican divorce". Mexico doesn't require spouses to be present at a divorce hearing as they can send a lawyer to represent them. This "fast-track" process differed very much with the American divorce procedure which can be cumbersome to say the least. In the 1970s though, in accordance to Mexican Federal law recommendation, many courts stopped accepting divorce petitions from non-residents. With the advent of no-fault divorce in the United States, obviously Mexican divorces became much less popular as a result. On a side note, "No-fault divorce" is a divorce in which the dissolution of a marriage does not require a showing of wrongdoing by either party and without requiring the petitioner to provide evidence that the defendant has committed a breach of their marital contract. What is of historical intellectual curiosity to us is that the first modern no-fault divorce law was enacted in December 1917 during the Bolshevik Revolution given marriage was perceived as a "bourgeois institution". Also, the state of New-York in August 2010 was the last state to pass no-fault divorce law. It remains to be seen if BREXIT will entail down the line the implementation of additional "no-fault divorce" for additional European countries seeking their exit from a much flawed currency union but we ramble again...

In this week's conversation we would like to look at the prospects and risks for credit in Q2 2017. 

  • Macro and Credit - That late 2006 feeling for credit
  • Final charts - Get ready for the Boomer slowdown

  • Macro and Credit - That late 2006 feeling for credit
Q1 was clearly a continuation of "risk-on" thanks to the Trumpflation trade initiated in November, with Emerging Markets (EM) racing ahead when it comes to equities. Clearly the big loser was the long US dollar crowded traded and we saw gold making a comeback as of late. In the credit space, EM and High Yield continued their race ahead, moving closer to being priced to perfection. Yet, it feels that we are indeed moving closer towards the highs in the current tight spread environment from a credit perspective, hence our late 2006 feeling towards the asset class as a whole. As we posited in a previous conversation we continue to feel that 2017 could play out as a reverse of 2016, namely that the disappointment could come in the second part of the year, contrary to what played out in 2016 with a spectacular rally in US High Yield in the second part of the year. One thing for certain, is although this credit cycle appears to be somewhat longer than usual, technically, credit continues to be well bid thanks to a strong demand for yield products in conjunction with plentiful of supply. For instance, inflows, in Investment Grade credit continue to be strong, while in High Yield, the recent weakness manifesting itself with outflows has somewhat waned, As we argued in our conversation last week, given April is the new fiscal year in Japan, thanks to a better cross-currency basis, we could see a return of the Japanese Lifers in the foreign bonds market, at the time where core inflation is receding, making yet another compelling support argument for US Investment Grade credit, providing higher yields relative to Europe. While there might be hopes for a Mexican divorce when it comes with European politicians' woes relating to BREXIT and much uncertainties building up in the face of upcoming French elections, there is still room for some additional compression à la 2006, but not much left for the global yield hunters. On the subject of the on-going bull market for credit we read with interest Bank of America Merrill Lynch's take in their Credit Market Strategist note from the 31st of March entitled "Lower foreign core inflation=better sleep":
"Lower foreign core inflation=better sleep.
Our view continues to be that the biggest longer term risk for the bull market in high grade credit spreads is upside to foreign core inflation as that would re-price foreign central bank accommodation – particularly the ECB and BOJ. Such scenario could lead to significant compression between US and foreign yields, which would threaten the foreign inflows - that buy close to 100% of net supply in our market - and lead to a rates shock domestically and large outflows. However, this risk no longer keeps us up at night as there is not a trace of acceleration in core inflation to be found in Europe or Japan.

Quite the contrary was today’s disappointing 0.7% YoY reading on Eurozone core CPI inflation for March, down from 0.9% the prior month. For context the all-time low was 0.6% in 2015, a reading eerily similar to where we are today.
Happy New (fiscal) Year.
April is the start of the new fiscal year in Japan. It is also the time of the year where Japanese insurance companies significantly increase their purchases of foreign bonds, including corporate bonds. Most Japanese investors hedge FX risk using rolling 3-month forwards. Adjusted for these hedging costs, USD credit continues to offer higher yields relative to their EUR denominated counterparts - although less so than a year ago. Combined with bigger size, stronger liquidity and less political risk this suggests that the USD corporate bond market should continue to attract the majority of the Japanese demand for foreign bonds.

1Q=Excess demand.
Much focus this year has been on the record high grade new issue supply volumes –$401bn in 1Q, or $38bn (10%) higher than in the same quarter last year. However, arguably the bigger story is the surge in demand, as we forecast a record $80bn inflow to high grade bond/ETFs in 1Q, or an even bigger $66bn increase over the same period last year.

Excess demand for corporate bonds is the main reason why credit spreads have tightened 8bps this year to 122bps. Going forward we expect strong demand and a slowdown in supply – i.e. continued excess demand – and another 17bps of spread tightening to 105bps by year-end.
See it twice and it’s a pattern.
Much attention this week was devoted to the lack of buying and even selling of 30-year corporate bonds in the overnight market. However, since we saw the exact same pattern during the same week last year this could be a repatriation-related seasonal associated with the March 31st end of the Japanese fiscal year. That is our best guess. It could also be exhaustion in Taiwan after the insurance companies have bought $19.7bn of mostly 30-year paper in the in USD Formosa market - a 54% increase over the same period last year. If overnight buying of the back-end does not resume on Monday it was probably the latter story as Taiwanese markets are closed Monday and Tuesday next week." - source Bank of America Merrill Lynch
Overall in the credit space it's difficult to be "bearish" in an environment very similar to what we experienced first end in late 2006. There is continuous pressure on yields, thanks largely to strong demand and inflows. While we do remain for the time being "Keynesian" as the "animal spirits" continue to chase yield, we remain over the medium term more "Austrian" and very wary of the slowly but surely turning credit cycle as the Fed turns up the pressure to financial conditions with its on-going tightening bias. Relating to our reminiscence of 2006, we read with interest JP Morgan's Global Strategy note from the 30th of March:
"A look back at 1Q17 - what were the biggest surprises; a look forward to 2Q17 - what are the risks
Back in 4Q16 when thoughts first turned toward the outlook for the coming year, the mental playbook for 2017 was for something like 2005 through 2006. That is, a relatively low volatility environment where credit spreads mostly moved sideways-to-ground-tighter; where there was some compression; and where the synthetic structured credit bid of the 2005-06 period substituted for today’s central bank purchases.
To-date, this thesis seems to have been largely well-founded. Even when stocks recently traded lower and there was much talk of a more meaningful correction and the end of the reflation trade, credit spreads proved to be relatively resilient, with the possible exception of North American High Yield. Perhaps this reflects that calling the end of the reflation trade has been relatively consensual ever since the election of the New Administration in the US, such that positioning in global credit markets has never really been over-extended. Everyone’s been looking for the proverbial bogeyman for some time.
Back to our original 2017 investment thesis: if we really think 2005-2006 is the parallel period for today’s credit market environment, then it matters whether we think we're in 2005 or have migrated into 2006. 2005 was followed by 2006, i.e. more of the same. 2006 was, of course, followed by 2007 and we all remember what happened then!
Indeed, there are some interesting parallels, explicit and implicit, which can be drawn between the credit market environment today and the run-in to 2007. Firstly, in High Yield: Attack of the Loans, 22 March, Daniel Lamy highlighted how first-lien leverage in the loan market has risen to new highs, though a differentiating factor between today and late 2006 through early 2007 is a much lower level of end-investor leverage.
Secondly, how should we assess the market impact of any tapering by the ECB (and possibly the BoJ) if we regard this as the current day analogue of the structured credit bid going into reverse? J.P. Morgan's European Economics team expects the ECB to start tapering its asset purchases in 1Q18, with the likelihood that this is flagged at some point through 2H17. To the extent the announcement of CSPP last March impacted credit spreads globally, this could be significant." - source JP Morgan
From our perspective, we think, the current period is more akin to 2006, given how fast credit has tightened under the "Trumpflation" trade. While the recent weakness we have seen when it comes to US High Yield has been coming from the renewed pressure on oil prices since the beginning of the year. On this very subject we agree with JP Morgan's take when it comes to US High Yield:
"US High Yield
One of the key risks for high-yield investors in 2Q17 is the uncertainty surrounding Oil prices amid abundant supply and uncertainty ahead of a 5/25 OPEC decision to extend production cuts. Oil prices are off more than 10% versus the February high, and a key component for the high-yield outlook going forward is the forecast for tighter balances and higher prices into the summer months. While we are not worried about mid-$40 Oil prices, something much lower would likely prove disruptive. WTI Oil prices of $40 or below would likely not only disrupt the elevated level of complacency around credit risk, but probably more so, would translate into higher equity volatility and disrupt capital market activity.
The second risk for high-yield investors as we embark on 2Q17 is the current level of complacency around interest rates. At the March meeting, the Fed delivered a dovish hike when the Committee left its interest rate “dots” unchanged for 2017. 10-year US Treasury yields are now down 25bp since, which is providing a demand boost for higher quality credits. Should Treasury yields resume a climb above the prior recent high (10yr 2.65%) in response to a more hawkish central bank narrative, demand for high-yield credit would suffer. Recall, the bulk of the $7.1bn of retail outflows in March occurred alongside the rise in Treasury yields ahead of the Fed
Biggest surprise of 1Q17
The biggest surprise for us in 1Q17 was simply how well the market performed in January (+1.29%) and February (+1.42%) following a solid December (+2.20%). For context, the high-yield market had provided investors with gains in 12 of the past 13 months before March’s correction. And high-yield bonds yields had declined comfortably beyond our target by early March (5.95% actual versus 6.50% target) after residing above 7.00% in mid-November. Of course, driving these benign conditions were a number of factors. For one, Oil prices rose to a multi-year high by the end of February before sliding throughout March. Second, US Treasury yields defied consensus and declined throughout much of the quarter, despite optimism surrounding Trump’s pro-growth agenda. Third, stocks rose to a record high and volatility approached a record low. And lastly, overseas demand for $-based credit assets exceeded our expectation amid a continued dearth of alternatives. The byproduct of all of this: HY new-issue volume has positively surprised us, driven predominantly by a wave of refinancing activity." - source JP Morgan
Currently the aggregate signal we are getting from the tool DecisionScreen remains bullish US High Yield with a Sharpe Ratio of 2.11 since inception. This aggregate rule comprises the following input, BB Financial Conditions Index US (3M Z-Score), US Budget balance (Level), G10 Economic Surprise (5Y Z-Score) and finally US Government Bond 10 year yield (1Y Z-Score):

- source DecisionScreen

It remains to be seen how long US High Yield maintains its elevated valuation level. This of course, is depending on the trajectory that will be taken by oil prices in the second quarter. As far as US High Yield and the S&P 500 are concerned, correlation between both asset classes remain very strong as per the below chart from we also used in our last conversation:
- source MacroChart
Correlation 0.987, R2 0.974 on both asset classes. We shall see how the relationships evolve during the second quarter of this year. We do feel valuations for both US equities and European High Yield are stretched though. Probably from an allocation perspective, European equities versus US equities remain more favorable while US credit is still more enticing than European credit from a valuation perspective we think.

From a yield perspective, given the on-going financial repression still going on in both Europe and Japan, US Investment Grade remains still enticing thanks to strong technicals yet, it remains to be seen how the scenario for risky assets is going to play out during in the second quarter. For US High Grade, we read with interest JP Morgan's case given we expect Japanese to be attracted again to the asset class in the near future:
"US High Grade
Our current YE forecast is 140bp, just a few basis points tighter than the current level. When the forecast was developed in November 2016 spreads were at 160bps; the post-election rally brought them most of the way towards our YE17 target. While we are comfortable that the current level of UST yields, US growth and bond supply is consistent with our YE spread target, if growth accelerates and/or UST yields rise meaningfully, this is likely to support lower spreads.
A more bullish scenario of strong growth and higher UST and European yields would be positive for spreads for both Technical and Fundamental reasons. Note that JPM’s US 10yr YE17 yield forecast is 3.00% and Bund forecast is 0.90%. Higher UST yields would be bullish for both US and European Financial issuers as it would improve interest earnings. Financial issuers represent 30% of the USD HG credit market and a rally in this sector would be supportive of the index. It would also be supportive for technicals, as there is a strong negative correlation between UST yields and bond spreads in the long end of the curve. This is because higher 10yr and 30yr UST yields tend to attract more buying from pension funds, insurance companies and sovereign wealth funds. Under the bullish macro case described above, we see HG bond spreads reaching 125bp, close to the post crisis peak of 122bp reached in June 2014.
A more bearish economic outlook would have the opposite effect. A mildly bearish scenario with lower growth, lower UST yields and presumably lower oil prices as well (JPM’s YE Brent forecast is $48/bbl) would lead to wider spreads. Energy issuers represent 10% of the HG bond market and they would contribute to wider spreads. Also, Financial issuers and long end bonds would likely widen with lower UST yields. We would expect spreads to reach 160bp under the mildly bearish scenario. A recession scenario would lead to much wider spreads. Given the rise in leverage over the past few years for HG issuers, a recession would likely lead to more downgrades to HY. UST yields would fall further, contributing to wider spreads as well. In February 2016, when recession fears were high, the US HG bond market spread peaked near 250bp, and we would forecast a similar result when/if the next recession occurs." - source JP Morgan
No doubt those exogenous factors such as a different expected outcome at the end of April for the French presidential elections could put a spanner to the continuous grind tighter in credit spreads. Oil as well remains a dominating factor when it comes to assessing the potential for further weakness in US High Yield.

On a side note and in relation to the dangers of "exogenous" factors, back in February 2016 in our conversation "The disappearance of MS München", we mentioned "rogue waves" akin to exogenous factors, that sunk the MS München, a 261.4 m German LASH carrier in December 1978.

Last Friday a 266,000 ton South Korean bulk carrier called Stellar Daisy, a Very Large Ore Carrier (VLOC)  disappeared off the coast of Uruguay en route from Brazil to China, hours after issuing a distress signal. The Marshall Islands-flagged vessel measured 323.86 in length and had a beam of 58 meter. In this case we are talking about a huge ship. While in that specific case, it doesn't look a "Rogue Wave" was involved, it seems probably, the very large vessel had some structural damage with cracks in hull. Though when did those cracks or crack appear, is unknown, in similar fashion we do not know, what exogenous factors will trigger, cracks in the credit cycle, yet, normalization in the Fed's monetary policy is akin to tightening financial conditions.

In the case of Stellar Daisy, ensuing water ingress during voyage, which in itself, wasn’t deadly, most likely caused liquefying, cargo shift, developing 15 degrees list and finally, fatal disaster.  There are reports of iron ore sinter feed (or sinter feed) shipments from Brazilian ports, including Ponta da Madeira, Tubarao and Itaguai, liquefying en route. Liquefaction of mineral ores, resulting in cargo shift and loss of stability, has been a major cause of marine casualties for many decades. In cargoes loaded with a moisture content in excess of the Flow Moisture Point (FMP), liquefaction may occur unpredictably at any time during the voyage. Some cargoes have liquefied and caused catastrophic cargo shift almost immediately on departure from the load port. some only after several weeks of apparently uneventful sailing. While the risk of liquefaction is greater during heavy weather, in high seas, and while under full power, there are no safe sailing conditions for a cargo with unsafe moisture content. Liquefaction can occur unpredictably even in relatively calm conditions on a vessel at anchorage or proceeding at low speed.

To end our side note, we believe that liquefaction and "liquidation" in financial markets can occur unpredictably in relatively calm market conditions and during low economic growth periods like ours, particularly with the rising appetite in the retail space for passive investments such as ETFs.

Whereas "Trumpflation" and "reflation" have so far been the "trade du jour", there is we think still considerable deflationary forces at play is this low yield, low growth environment. One of these forces, is clearly the growing cohort of Boomers in the United States which in many ways represent additional headwinds as per our final chart below for US consumption, still a hefty part of US GDP.

  • Final charts - Get ready for the Boomer slowdown
The deflationary headwinds facing Developed Markets, while at bay thanks to the current "reflationary" trend have not disappeared. For instance, US GDP and its heavy reliance on consumption. Our final chart comes from Wells Fargo Economics Group note from the 24th of March entitled "Boomer Spending: Bracing for the Slowdown". This chart displays the spending by age bracket and illustrate the predictable pattern in consumption in again population over time, hence the deflationary headwinds it represents over time:
"Consumer Spending: Boomers Shift from Tailwind to Headwind
Spending follows a predictable pattern as consumers age. As earnings rise and families grow, household spending increases through middle-age before falling as the kids move out and the house (ideally) gets paid off. Over the past few decades, falling outlays among older households were
masked by the rising earning and spending power of the Boomers as they entered their prime working years. With adults age 65+ expected to rise from 20 percent of the adult population to 25 percent over the next 10 years, there is no offset to the slowdown in senior spending this time around.
More than three quarters of the Boomers are already over the age of 55, when household spending begins to decline (below chart).

With retirement age households spending 25 percent less than younger households, the aging of the Boomers stands to weigh on consumer spending, the powerhouse of the U.S. economy, in the years ahead. Spending could be hampered further in the near term if Boomer households try to shore up their retirement savings by putting more money away now, although this at least would limit the drag on spending further down the road.
What Areas of Spending Will Be Hit Hardest?
The degree to which businesses will need to brace for the spending slowdown as more Boomers reach retirement age varies by industry. Not surprisingly, one segment where spending rises with age is healthcare (out-of-pocket and government). In every other major category, however, spending among households over the age of 65 falls. Apparel, dining out and transportation (vehicles purchases, finance charges and gasoline) see the largest drop off, with average annual expenditures for households 65 and over falling by at least than one-third (below chart).

Discretionary Spending Pressured by Healthcare and Housing
But will Boomers spend the same way as older generations after turning 65? Healthcare looks set to account for a greater share of spending among Boomers than previous generations. Rising insurance premiums have more than offset out-of-pocket savings on prescription drugs due to Medicare Part D. Of course, a substantial share of healthcare spending is paid for by the government, and, with the rising number of beneficiaries, total healthcare spending is likely to remain one of the strongest segments of consumer spending in the years ahead.
Housing is also taking up a higher share of senior spending as more households reach age 65 without having paid off their home or are renting, leaving them exposed to future price increases (bottom chart).

In contrast, seniors are saving at grocery and clothing stores, helped by relatively low inflation in these categories the past two decades. This should limit the hit to discretionary spending, but won’t change the fact that Boomers will still be spending less overall, generating a drag on consumer spending." - source Wells Fargo
While the "Trumpflation" / "reflation" trade continues its course in both equities and credit as we enter the second quarter, it is clear to us that, structural issues such as the ability to spend by Boomers overall remains a clear long term headwind for the US economy as a whole but, as well for other similar Developed Markets (DM).
"The older you get the stronger the wind gets - and it's always in your face." - Pablo Picasso

Stay tuned!
View My Stats