Monday, 5 December 2016

Macro and Credit - The spun-glass theory of the mind

"Success consists of going from failure to failure without loss of enthusiasm." - Winston Churchill
Looking at the results stemming from the Italian referendum in conjunction with the continued gyrations in financial markets on the back of rising FX volatility thanks to "Mack the Knife" aka King Dollar + positive real US interest rates, when it came to selecting our title analogy for this week's musing, we reminded ourselves of "The spun-glass theory of the mind" which is the belief that the human organism is so fragile that minor negative events, such as criticism, rejection, or failure, are bound to cause major trauma to the system (think Brexit, Trump's election). "The spun-glass theory of the mind" is essentially not giving humans, and sometimes patients, enough credit for their resilience and ability to recover, like central banks have been doing, dealing with economic woes with their "overmedication" programs (ZIRP, QE, NIRP, etc). In 1973, the brilliant University of Minnesota clinical psychologist Paul Meehl poked fun at what he called the “spun glass theory” of the mind which is the false notion that most of us are delicate, fragile, and easily damaged creatures that need to be handled with kid gloves. Since then, many researchers have shown that most people are surprisingly resilient even in the face of extreme trauma. Economies are similar, such as the United Kingdom which showed it was more than tremendously resilient while many pundits were predicting "trauma" and disaster should Brexit happens. In similar fashion, Nassim Nicholas Taleb in his book "Antifragile" showed that there's an entire class of other things that do not simply resist stress but actually grow, strengthen, or otherwise gain from unforeseen and otherwise unwelcome stimuli (Iceland). The main underlying concepts of both "The spun-glass theory of the mind" and "Antifragile" is that the majority of causal relationships are nonlinear and so are market movements (hence the relative ineffectiveness of VaR models - Value At Risk we discussed in February in our conversation "The disappearance of MS München"). Typically both have a convex section where the curve rises exponentially upward and is associated with a positive effect (antifragile) and a concave section that declines exponentially downward and has a negative effect (fragile). Think of the dose of a prescription drug. At first, as central banks increase the dose, the health benefits improve (convexity) for financial assets. But, beyond a certain dose side effects and toxicity cause harm (concavity), such as Debt-fueled economies given debt has no flexibility. Therefore highly leveraged economies cannot stand even a slowdown without risking implosion like our current situation, but we ramble again. 

How do you "hedge" in such a nonlinear world? The way to do it, we think, is to use a barbell strategy that positively captures the optionality of the variable (being long in the convex area and short in the concave area).  If indeed, we live in a nonlinear world and given correlations are less and less static and change more and more frequently, leading to larger and larger standard deviation moves such as typically going way up during downturns, it therefore eliminates Markowitz portfolio theory of diversification benefit. Just when you think your diversification will render your portfolio "antifragile" it brings instability and "fragility" to it. A barbell strategy should render your portfolio more "antifragile". Why is so? Markowitz portfolio theory causes investors to "over allocate" to risky asset classes such as "High Yield" and/or Emerging Markets and play the same crowded "beta" game. In similar fashion, "The spun-glass theory of the mind" cause central bankers to "overmedicate". One could conclude that "Overmedication" leads to "Over allocation". 


In this week's conversation we would like to look again at the importance of flows versus stocks from a macro and credit perspective, taking into account "overmedication" and "over allocation".

Synopsis:
  • Macro and Credit -  It's a question of flows versus stocks
  • Final chart - Could Japanese equities be antifragile in 2017?

  • Macro and Credit -  It's a question of flows versus stocks
Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity":
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."
Before we delve more into the nitty-gritty, it is important, we think to remind our readers of what is behind our thought process of the "stocks" versus "flows" macro approach.

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: 
"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on voxeu.org
We have always wondered in relation to the global rounds of quantitative easings the following:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"
Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy at least in Europe has been in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.

As we have argued before QE in Europe is not sufficient enough on its own to offset the lack of Aggregate Demand (AD) we think.

As a reminder, in our part 2 conversation "Availability heuristic" from September 2015, the liabilities structure of industrial countries is mainly made up of debt (they are “short debt”), in particular in Japan, the US and the UK. In contrast, the international balance sheet structure of emerging markets is typically composed of equity liabilities (“short equity”), which is the counterpart of strong FDI inflows that contributed to improve emerging markets’ external profile in the last decade. With a rising US dollar, what has been playing out is a reverse of these imbalances hence our "macro reverse osmosis" discussed again recently relating to violent rotations in flows. 

From that perspective, we read with interest Citi Research note from November entitled "How does active fund management survive in 2017?" where as well they tackle the very important point of stock versus flows:
"Is it the stock or the flow of QE that matters?
Essentially, central banks tend to think in "stock" terms
 “Reduce the quantity available to investors & prices will lift permanently”
 To us, QE flows seem very important empirically
Reduce the QE flow by just ~1/3 & markets are quite likely to fall
That makes an asset not priced to fundamentals but to policy …
… prone to non-linear reactions when perceptions of policy change" - source CITI
As we have seen in recent weeks, and as we have remarked in our conversation  "Critical threshold", higher yields leads to material fund outflows in the short-term as indicated by Bank of America Merrill Lynch Follow the Flow note from the 2nd of December entitled "Where's the money going?":
"High grade funds had their fourth week of outflows, and the third that exceeds the $1bn mark. High yield funds recorded their fifth week of outflows in a row; so far this year they have lost more than $10bn. As chart 13 below shows, the outflows this time came mainly from European and global funds, where on the other hand US high yield funds recorded an inflow.

Government bond funds had yet another outflow, the eighth in a row, reflecting rising QE-tapering risks. Money market weekly fund flows were relatively subdued recording a negative flow. Overall, fixed income funds flows remain largely negative, and over the past four weeks almost $20bn has flown out of European domiciled funds.
European equity funds flows switched aggressively to the negative side again, post a short stint of inflows. Last week the asset class had its biggest outflow in eleven weeks. Outflows so far this year are just shy of $100bn.
Global EM debt fund flows remained negative for the fourth week in a row; nonetheless we note a significant improvement in the trend, with the latest outflow being significantly smaller than that of the previous two weeks. Commodities funds also were in negative territory for a third week, as higher inflation expectations support reflation trades.
On the duration front, short-term IG funds flows remained negative for a second week. Mid-term funds had their fourth outflow in a row but riding an improving trend; while long-term funds recorded a marginal inflow." source Bank of America Merrill Lynch
Whereas central banks tend to focus their attention on "stocks", we'd rather focus ours on "flows", from a macro perspective as well as from a fund perspective. Evidently the consequences of "Mack the Knife" aka King Dollar + positive real US interest rates can also be seen in the "Great Rotation" from Europe and Emerging Markets towards the US hence validating our "macro osmosis process":
"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment." - Macronomics, August 2013.
As a reminder, more liquidity = greater economic instability once QE ends for Emerging Markets. Now if indeed "flows" matter, we took a keen interest in reading the impact  "Mack the Knife" has had on Emerging Markets as indicated by Bank of America Merrill Lynch in their GEMs Flow Talk note from the 1st of December 2016 entitled "Reported foreign holdings of local debt dropped 6% in November so far":
"EPFR weekly fund flows
• EPFR measures mutual funds and ETFs (AUM about $225bn)
• This week’s outflows were less than last week which was less than the prior week.
• EPFR outflows in the 3 weeks since the election were:
-4.0% for EXD
-3.7% for LDM
• Part of that is ETFs, whose outflows since the election as a % of ETF AUM were:
-8.1% for EXD
-7.3% for LDM
2013 lessons were learned well, take fast action
Outflows have been faster than in 2013 (Chart 1)

• Largest 3 week outflow in 2013 was only -4.2% for all currency funds.
Foreign holdings of local debt sharp drop – $40bn implied
• We track $640bn of foreign holdings of local debt
• We observed 6.2% outflows for the month of November in 4 countries (India,
Indonesia, Hungary and Turkey) with foreign holdings of $107bn.
• If all countries had the same average outflow of 6.2%, then applied to the $640bn
of foreign holdings, this implies we could have had a $40bn total outflow in Nov.
Since the election – $35bn potential outflow
• We observed 5.5% outflow since the election.
• If we apply this rate to the $640bn foreign holdings, it implies a $35bn total
outflow in the few weeks since the election." - source Bank of America Merrill Lynch
We recently pointed out that "macro tourists" and levered carry players alike did play the second half of 2016 more aggressively hence the extension of their credit risk and duration risk leading to faster deleveraging and consequently outflows and pain inflicted. Obviously we guess that your next question is going to be how much more additional outflows could be expected particularly from the impact of a rising US dollar is having on Asia for example given capital outflows matter and matter a lot, so does a US dollar shortage as well although Stanley Fischer from the Fed thinks as of late there is no liquidity issue. Regarding this matter we read yet another Bank of America Merrill Lynch note from their Connecting Asia series entitled "Flow and flight":
"We examine two of the most pressing issues facing Asia investors in the Post-Trump election victory world.
The first, is how much capital reversal and outflow in Asia is yet to run amid USD strength, rising yield differential with the US and CNY depreciation. Thus far, some USD24bn in foreign bond and equity portfolio flows are being unwound and compares with the maximum drawdown of USD55bn during the GFC – see front page chart.

The countries that we find are at the sharp end of this outflow are Korea, India, Indonesia and Malaysia.
The second is how investors should evaluate Asia FX and rates vulnerability to the tail risk of rising trade protectionism and confrontation. The brief answer to this is that China, Korea, Taiwan and Thailand appear most vulnerable, while Indonesia and India may be the least.
Ultimately, the combination of capital outflows and rising trade protectionism discussed in this report, suggests that FX risk premiums and volatility for CNY and KRW will rise. From an FX hedging strategy perspective, we continue to recommend low delta 6M USD call, CNH puts such as our year-ahead top trade recommendation for USD/CNH 7.60 strikes.
Portfolio drawdowns – how much more to go?We highlight the maximum drawdown Asian markets have previously seen in terms of outflows. This gives us a sense of the worst case scenario as far as outflows are concerned relative to FX reserves. The bottom line is:
• The largest outflow Asia saw on a cumulative basis was ~USD 55bn during 2008. In comparison to this, Asia has seen about USD 24bn of outflows since October 2016 (see Chart 1 for cumulative outflows during other risk off periods).
• Equity outflows so far have been around 9.9bn USD since October 2016, led by. India, Taiwan and Thailand. When compared to historical drawdowns, the larger equity markets of Korea, Taiwan and India stand to lose the most, although only in Korea’s case does the worst case scenario account for a substantial portion of FX reserves (19%, see Table 1).

• Bond outflows, so far have been about 14bn USD since October 2016, with most seeing outflows of at least 2bn USD. When compared to historical drawdowns, Malaysia stands to lose the most, with the worst case scenario representing about 6.3% of current FX reserves (see Table 2).

- source Bank of America Merrill Lynch
While obviously the biggest "known unknown" lies in the foreign trade policies which will be adopted by the new US administration. As we pointed out in our last musing, measures that would restrict global trade would no doubt be bullish for gold in that particular case. For now, in relation to gold we still remain neutral.

But moving back to credit and nonlinearity, one way of "mitigating" dwindling policy support given recent talks from the ECB in tapering its stance would be to "embrace" a barbell strategy as pointed out by Citi Research note from November entitled "How does active fund management survive in 2017?":
"Barbell when repression is at risk of being wound down
Belly of the credit curve holds disproportionate amount of unpaid β" - source CITI
What would be an interesting barbell credit wise in our opinion? We would favor US credit markets obviously from a flow and currency perspective. We would go long US investment grade credit than European investment grade and even selectively long European non-financial High Yield issuers due to lower leverage than their US peers. But should you want to play the beta game from a "barbell" perspective, then again US High Yield via its derivatives US CDX High Yield, given that it is less sensitive to convexity and interest rate risks and less exposed to CCCs (10% versus 16% weight in cash index), should the risk-on environment persist on the back of favorable macro data. 

From an allocation perspective, we are already seeing once again decoupling between US credit and Europe, because, as we stated on many occasions, the Fed tackled earlier one "stocks" issues on banks balance sheet, which in effect, enabled a stronger credit income and better economic growth relative to Europe, whereas the ECB has in no way alleviated the burden of "stocks" plaguing peripheral banks in the form of nonperforming loans, therefore in no way repairing the broken credit mechanism that stills explain the on-going "japanification" process and much weaker growth prospects. To that effect, if indeed the US reflation story is playing out, then again it makes sense to "over allocate" to US credit as once again decoupling could be on the menu between both regions. This is clearly illustrated by Bank of America Merrill Lynch in their European Credit Strategist note from the 2nd of December entitled "The Italian job":
"The last month has presented something rather rare: a truly decoupled global credit market. For instance, US high-grade spreads went 2bp tighter in November, while Euro high-grade spreads went 16bp wider. And the phenomenon seeped into high-yield credit too: US spreads tightened by 24bp in November, while European spreads widened by 47bp. After the moves of the last month, headline IG spreads in Europe are now wider than US high-grade spreads out to almost 10yrs in maturity.

“Politics” has been the undoing of European credit lately. Italy heads to the polls on Sunday amid a climate of rising global populism. And ECB tapering noises have driven a pattern of rising rates and wider spreads in Europe over the last month (note, though, BofAML base case is for an €80bn QE extension until Sep-17).
Yet, even with all the political hiccups that Europe has encountered over the last 5yrs, genuine decoupling of credit markets has not been common. Chart 2 shows that there have only been 3 periods over the last 10yrs when European and US credit spreads went in different directions.
Decoupling – the new norm for ‘17
We think decoupling between US and European credit will be a lot more common in 2017 though. In fact, our US credit strategy colleagues forecast US high-grade spreads to tighten by 20bp next year. In Europe, we expect high-grade spreads to widen by 20bp.
Much of the divergence in views is simply down to technicals – which shouldn’t come as a surprise given how technicals have been the be-all and end-all of credit markets for the last few years. In the US, we expect Republican tax proposals to lead to a big drop in US high-grade net supply next year. But in Europe, we expect shareholder-friendly activity (M&A, in particular) to broaden out in 2017, and contribute to a further jump in supply. This should leave the Euro market with too many bonds and not enough buyers.
Get in quick…
In fact, lingering QE tapering noises may just coax European companies to speed up their spending and issuance plans, for fear of missing the (low-yield) boat. This means the risk of supply being front-loaded in the first half of next year, leading to some heavy indigestion for the Euro credit market.
Recall that this is not too dissimilar to what US companies did in 2014 as the Fed drew closer to their first interest rate hike. As chart 3 shows, US M&A volumes were brisk in the middle of 2014. Then, as better US data pushed yields higher, issuers moved quickly to fund the M&A backlog, leading to some big months of US high-grade supply in September and November 2014.
This also caused a big decoupling in credit markets: US high-grade spreads widened by almost 40bp in the second half of 2014, while European high-grade spreads went slightly tighter. We fear the same bad technicals could be at work in Europe next year if companies rush to issue ahead of any potential QE tapering." - Bank of America Merrill Lynch
If indeed we get this "reflationary" case playing out, then again we might have a situation where US credit continues to outperform European credit in 2017.

Going forward, when it comes to following a potential deterioration in US High Yield we encourage you to keep an eye on a possible flattening of the CDX HY curve, being the derivatives proxy for the US High Yield market. As per Credit Market Analysis (CMA) latest chart, it is worth following the trend to see if indeed the CDX HY series 27 will be getting flatter as we move towards 2017. We noticed that one year protection has started to move upwards albeit very slowly, while it is yet a meaningful move for the moment contrary to what we had back in November last year where 1 year was only 50 bps apart from 3 year, you should keep an eye on the shape of the curve:
- source Credit Market Analysis

Right now, it is hard to be as sanguine as we were in November regarding US High Yield given at the time of the fast flattening movement we were seeing at the end of 2015. We continue to see a risk-on environment for the time being, although as we pointed out last week when discussing credit conditions in the US for Commercial Real Estate, it does appears to us that some segments including our CCC credit canary are already experiencing tightening financial conditions. The most important indicator to track, risk wise is "Mack the Knife" aka King Dollar + positive real US interest rates. 

Finally for our final chart and if the "spun-glass theory of the mind" is correct, then indeed we think if the US dollar continues to shine, then it makes sense to "over allocate" to Japan given earnings are higher there.

  • Final chart - Could Japanese equities be antifragile in 2017?
While the risk-on mode is still prevailing thanks to the strong beliefs in the reflation story playing out, from an equity perspective, corporate earnings and payouts remain the principal drivers of equity returns. To that extent, our final chart comes from Barclays Global equity and cross-asset strategy note from the 28th of November entitled "Reassessing the rotations" and displays earnings in Japan relative to the US and Europe:
- source Barclays


While it remains to be seen how long the "reflationary story" continues to play out, for now it is indeed "risk-on", but no doubt there are many political events lining up in 2017 that could put a spanner in the works. One thing is clear to us though, is that when it comes to markets commentators and some members of the sell-side, 2016 has proven with both Brexit and the US election that the spun-glass theory of the mind is alive and well...

"Success breeds complacency. Complacency breeds failure. Only the paranoid survive." -  Andy Grove, former CEO of Intel.

Stay tuned!

Tuesday, 29 November 2016

Macro and Credit - From Utopia to Dystopia and back

"For other nations, utopia is a blessed past never to be recovered; for Americans it is just beyond the horizon." - Henry A. Kissinger
Hearing about the passing of Cuban leader and revolutionary Fidel Castro also an accessory ambassador to the Rolex brand, and given the continuous rise in government bonds yields, while thinking about what should be our title analogy, we thought about the current situation. Our current situation entails we think a reversal of the 1960s utopian revolutionary spirit towards a more populist and conservative political approach globally. Also, it seems as of late that there has been somewhat since the Trump election an opposite movement in the financial sphere from financial dystopia aka financial repression from our central bankers towards utopia aka a surge in inflation expectations leading to large rotations from bonds to equities and rising "real yields". Also, another reason from our chosen title is the recent UK bill requiring internet firms to store web histories for every Briton's online activity. The most famous examples of "Dystopian societies" have appeared in two very famous books such as 1984 by George Orwell and of course Brave New World by Aldous Huxley. Dystopias are often portrayed by dehumanization, totalitarian governments, environmental disasters or other characteristics associated with cataclysmic declines in societies. Dystopia is an antonym for Utopia after all, used by John Stuart Mill in one of his parliamentary speeches in 1868. Dystopias are often filled with pessimistic views of the ruling class or a government which has been brutal or uncaring. It often leads to the population seeking to enact change within their society, hence the rise in what is called by many "populism". What is important we think, from our title's perspective is that financial repression goes hand in hand with dystopia given that the economic structures of dystopian societies oppose centrally planned economy and state capitalism versus a free market economy. One could infer that central banks' meddling with interest rates with ZIRP, NIRP and other tools is akin to a dystopian approach also called financial repression. Right now we think that on the political side, clearly, the pessimistic views of the ruling class has led to upsetting the outcomes of various elections this year such as Brexit and the US election thanks to "optimism bias" from the ruling class. So all in all, Utopia has led to political Dystopias, creating we think inflationary expectations for now and therefore leading to euphoria in equities or what former Fed supremo Alan Greenspan would call "irrational exuberance" when effectively, it is entirely rational given market pundits expect less "financial repression" to materialize in the near future but we ramble again...

In this week's conversation we would like to look at what to expect in 2017 from an allocation perspective, while since our last conversation there has been some sort of stabilization in the rise of "Mack the Knife" aka King Dollar + positive real US interest rates, it appears to us that the first part of 2017 could get complicated.
Synopsis:
  • Macro and Credit -  Erring on the wider side
  • Final chart - Gold could shine again after the Fed

  • Macro and Credit -  Erring on the wider side
As we have pointed out in recent musings, credit investors since the sell-off in early 2016 did not only extend their credit exposure but, also their duration exposure, which as of late has been a punishing proposal thanks to convexity particularly for the low coupon / long duration investment grade crowd. While total returns have still been surprisingly strong in the second part of 2016, particularly in High Yield in both Europe and the US, the "beta" players should be more cautious going forward. 

We think that the goldilocks period for credit supported by a low rate volatility regime has definitely turned and slowly but surely the cost of capital is rising. 

For instance, in the US while the latest Senior Loan Officer Opinion Surveys (SLOOs) has pointed to an overall easing picture as of late as per our previous conversation, in the US, Commercial Real Estate is already pointing towards tightening financial conditions as indicated by Morgan Stanley in their CRE Tracker note from the 18th of November:
"CRE Lending Standards Tighten For the Fifth Straight Quarter in 3Q16
•The Federal Reserve’s Senior Loan Officer Opinion Survey showed CRE lending standards continued to tighten in 3Q16, marking the fifth straight quarter of net tightening.

•Overall, standards tightened at a stable pace, with 29.5% reporting net tightening compared to 31.3% in 2Q16. Large banks have been tightening more than other banks, but the 3Q16 release shows that large banks’ tightening pace has slightly slowed.
•Tightening has been most pronounced in multifamily loans, and in 3Q16 other banks upped their tightening pace in this category.

•Loan demand continues to strengthen but has decelerated quarter-over-quarter: only 5.8% reported a net increase in demand compared to 12.0% in 2Q16. Demand is stronger for construction loans relative to the other two types.

•Our studies have shown that tightening lending standards and/or decreasing loan demand tend to lead to declining CRE property prices.
- source Morgan Stanley

While we have tracked our US CCC credit canary issuance levels as an indication that the credit cycle was slowly but surely turning, the above indications from the US CRE markets is clearly showing that the Fed is about to hike in a weakening environment, should they decide to fulfill market expectations in December. Obviously while the market is clearly anticipating their move and has already started a significant rotation from bonds towards equities, the move from Dystopia to Utopia and Euphoria will have clear implications for credit spreads in 2017, and should obviously push them wider we think. 

This thematic is clearly as well the scenario being put forward by most of the sell-side crowd when it comes to their 2017 outlook for credit. For instance we read with interest Morgan Stanley's take on the macro backdrop for credit for the US entitled "From Cubs to Bears":
"We are cautious on US credit for 2017: Across the spectrum, credit markets will likely finish 2016 with the best returns in many years – certainly better than we anticipated. If we had to boil the rally from February-October down into two factors, we think the recovery in oil/energy explains the first half, and the massive global reach for yield driven by low rates and easy central bank liquidity explains the second. In our view, fundamental risks are still very elevated, and while sentiment has become bullish around the impact of a Trump presidency, any way we look at it, credit is moving out of the 'sweet spot'. Specifically, the days of ultra-low rates, ultra-low volatility, and ultra-easy Fed policy are in the rear-view mirror. All while valuations are considerably richer than this time last year – not a great setup for 2017.
More specifically, our cautious call on US credit is based on three key points, which we expand on in the first section below:
  1. A less benign environment: We would not underestimate the impact central banks have had on markets. Now, eight years into a cycle, we expect inflation to rise, the Fed to hike quicker, and the dollar to break out. Fiscal stimulus helps growth, but there are clear offsets, like tighter financial conditions. This is a backdrop where mistakes are more likely and costly.
  2. Fundamentals are weak, late-cycle risks have risen, and the Fed could push us to the edge quicker: Markets anticipate defaults one year in advance. Lower defaults in 2017 are in the price. Rising defaults in 2018 are not.
  3. Credit is priced for a benign environment as far as the eye can see: IG spreads adjusted for leverage and HY default-adjusted spreads have rarely been tighter. In addition, higher Treasury yields make the 'reach for yield' argument for US credit much less compelling.

Adding everything up, we do not think this is the point in the cycle to reach for yield, and most of our recommendations are up-in-quality as a result. And we note that better growth does not always equal better returns. In the second half of cycles, negative excess return years come more frequently than you might expect, and we expect to see one in 2017.
Moving Out of the Macro 'Sweet Spot'
The US economic environment is becoming less supportive of credit markets. Our economists forecast US GDP to grow at 1.9% in 2017, 0.3pp higher than the baseline, given our expectations around fiscal stimulus. Why not a bigger number? First, it is important to remember that the underlying headwinds to growth that have driven a subpar expansion for eight years have not gone away just because Trump was elected. Second, our economists assume that a material tightening in financial conditions offsets some of the benefits of fiscal stimulus. For example, we now expect the Fed to hike twice in 2017 and three times in 2018, the dollar to rally by 6%, and 10Y Treasury yields
to hit 2.75% in 3Q, (2.50% at year-end), very different from our prior forecasts of low rates and ultra-accommodative Fed policy. These risks may rise further later in 2017, if markets begin to worry that Yellen will be replaced with a much more hawkish Fed chair. Third, right now investors seem to be focused on all the benefits from stimulus, but downplaying the risks to Trump's policies that were so concerning in the run-up to the election. It doesn't take much for sentiment to swing back in the other direction or for current lofty expectations around fiscal stimulus to disappoint.
Either way, there is much greater potential variability around our forecasts, given all of the unknowns. For example, in our bear case where we assume Trump takes a hard line on trade, GDP growth is hit by 0.6pp, even assuming material tax cuts and infrastructure spending.
~2% growth by itself is manageable, but unlike earlier in this cycle, the Fed is not adding stimulus, but instead withdrawing liquidity. And remember, even with fiscal stimulus, the Fed is still tightening into a much more anemic growth environment than inpast rate hike cycles (Exhibit 3), significantly later in the cycle, and with profits growing considerably slower.
Due to this subpar recovery, markets have become very dependent on central banks, and when the liquidity spigot turns off, credit has consistently had problems. In fact, over the past two years, the Fed has struggled to get in even one hike a year. We would not dismiss the impact on markets if the Fed has to step on the brakes more quickly, given how much central bank policy may be supporting valuations, given the starting point on growth, and with the US economy much later in a cycle than when the Fed has begun hiking in the past.

In addition, less easy liquidity could become a global theme next year. Our economists expect the ECB to announce tapering at its June meeting, and a shift in the BOJ's 10Y yield target in 4Q17 – very different from the risk-supportive environment from central banks immediately post Brexit.
Lastly, even with this rate rise, the market is still only pricing in ~1.5 hikes in 2017 – thus risks are asymmetric. If growth disappoints, the Fed has little ability to release a verbal dose of monetary stimulus like this past year, when rate hike expectations quickly dropped from 3 to almost 0. Alternatively, if this is the year where inflation starts rising, there is plenty of room for rate hike expectations to rise. In addition, with IG and HY spreads 37bp and 204bp tighter vs. when the Fed hiked last December, credit markets also do not have the same shock absorber as last year." - source Morgan Stanley
The last point is particularly true given that the second half rally saw credit investors piling on more duration and more credit risks, meaning more instability in credit markets at the time where "Dystopia" has been fading in financial markets. As we pointed out in our previous conversation, we think the market is trading ahead of itself when it comes to its expectations and utopian beliefs. Like any good behavioral therapist we tend to focus on the process rather than the content and look at credit fundamentals to assess the lateness of the credit cycle. 

There is no doubt in our mind that we are moving towards the last inning of the credit cycle and there has been various signs of exhaustion as of late such as our CCC credit canary issuance indicator or as above tighter lending conditions for CRE which is trading at elevated valuation levels, but on these many points we agree with Morgan Stanley's take that fundamentals are clearly showing signs of deterioration in the credit cycle that warrants caution we think:
"Elevated Fundamental Risks Late in the Cycle
Markets are very late cycle, according to our indicators, and even compared to this time last year, fundamentals are weak. To provide a few examples on the first point: The Fed is expected to continue hiking, and looking at the shadow fed funds rate, has already tightened policy by a similar amount as in past cycles. Lending conditions have tightened (measured by the % of banks tightening C&I, CRE, auto, and now consumer loans), and leverage is very high. Margins, M&A, and auto sales look like they have possibly peaked. In addition, leading economic indicators have rolled over, employment has slowed from the peak in early 2015, and productivity has declined. Along similar lines, looking at our cross-asset team’s indicator, the US may have entered the 'Downturn' phase of the cycle earlier this year.
The deterioration in corporate balance sheet quality also indicates elevated cycle risks.
For example, as we show below, leverage is at or near record levels across credit markets. In addition, the leverage increase has been broad-based (outside of financials), and the ‘tail’ in the market has grown substantially. For example, the highly leveraged tail has doubled since 2011 in high yield (two-thirds of this tail is ex-commodities) and 30% of the IG market is levered over 4x today, compared to only 11% in 2010.

This deterioration in credit quality should not come as a surprise – low rates and ultra-easy liquidity for eight years have had negative side effects. What should be concerning is that, historically, the sharpest rise in leverage tends to occur in recessions when earnings collapse. Hence, the fact that leverage is this high in a growing economy means that it will likely peak at a much higher level than in the past when a downturn finally hits. We would also note that leverage is not the only area of concern, with interest coverage and cash/debt also trending lower in most markets.

In an environment of higher rates and better growth, as markets are seemingly anticipating, could leverage come down? We think it is possible, but unlikely. First, better growth should, if anything, encourage more aggressive corporate behavior, which is why historically, the biggest declines in leverage come after a credit cycle. Second, we would not dismiss the underlying headwinds to a big pickup in earnings at this stage in the expansion, especially if the dollar rallies 6% as we expect. Yes, corporate tax cuts could help, although even there we need to wait for the details – if tax cuts are paid for in part by getting rid of tax preferences and there is a tighter noose around what is considered domestic income, the aggregate benefit may be lower. But bigger picture, weak productivity and rising wages are a few of the many headwinds to profitability that probably aren't going away. Lastly, even if leverage does drop modestly, higher rates are an offset when thinking about future defaults. Ultimately, we think the damage has been done looking at fundamentals, and better growth, higher rates, as well as faster rate hikes if anything, push us to the cycle edge more quickly. We note that the later years in an equity bull market when growth is strong are often not bullish for credit. For example, in 2000, HY excess returns were down 16.3%. 
Assessing credit quality in aggregate, we think the fuel for a default/downgrade cycle is clearly present. And with banks tightening lending standards now across C&I loans (albeit only modestly per the latest survey), CRE, and autos, and no longer easing for consumer lending, this credit cycle is actually playing out as one would expect in a long, slow default wave. Yes, the defaults so far have been predominantly commodity focused, but in our view, it is normal for the problem sector to drive the stress early on.
The key question of course is one of timing – when do default/downgrade risks start to spread beyond commodities in a bigger way? In our view: Sooner than most think. We discuss our default and downgrade expectations in more detail in the forecasts section below. But in short, default rates will likely drop in 2017, which we think is in the price, with the HY energy sector 955bp tighter since the wides in February.
However, according to our numbers, defaults will start rising again in 2018, likely peaking in 2019. Without going into the details, we base our assumptions on the lag between when the indicators we track have turned historically and when defaults have subsequently spiked, as well as the status of those metrics today.
If our estimates are correct, this default wave will last ~4.5 years in total (having begun in 2016), similar to the 1999-2003 cycle. And we think there are logical reasons to assume a prolonged cycle. For example, the prevalence of cov-lite loans and somewhat elevated interest coverage will not make overall default volumes lower, in our view, but could mean defaults take longer to materialize. In addition, if a recession occurs while rates are still generally low, the tailwind of falling yields will not be there this time around, which could slow the bounce off the bottom.
Last and most importantly, if defaults start rising again in 2018, the market should price that in next year. As we show below, years when defaults rise more than 2%, spreads tend to widen by 283bp on average the year prior, as the market prices in those risks. Or said another way, the fact that defaults will drop in 2017 should have little bearing on spreads in 2017.
As a result, the only way to rationalize today’s valuations is to assume a benign default environment for several years, which we believe is a low probability. Looking back in time, we only have one good example of when defaults rose temporarily due to one sector and then subsequently dropped without a near-term recession. That took place in 1986, yet even then, defaults only fell for two years, and subsequently rose into the 1990 recession. Also we would note the Fed was not hiking at the time, but instead cut rates by ~200bp in 1986 to cushion the blow – very different from today." - source Morgan Stanley

Furthermore, a continuation in the rise of "Mack the Knife" aka the US Dollar and real rates, then again US earnings could come under pressure and financial conditions will no doubt get tighter and hedging costs for foreign investors pricier, which could somewhat dampen foreign appetite from the like of the Japanese investor crowd and Lifers in particular, leaving in essence very little room for error when it comes to credit allocation towards the US, hence we would favor quality (Investment Grade) and low duration exposure until the dust settle, meaning some sort of stabilization in current yields gyrations from a US allocation perspective.

Obviously for Europe, in terms of credit, the story is slightly different given the on-going support from the ECB but clearly the risk lies more into a rise in political "Dystopia" rather than financial "Utopia" given the on-going deleveraging process of the European banking sector. To that effect, whereas there has been a very significant rally in the European banking sector when it comes to equities as of late in conjunction with the US sector thanks to less "Dystopia" and rising yields, we still favor high quality European financials credit in the current environment. Even European High Yield is more enticing thanks to lower leverage than the US. To illustrate the "japanification" process in Europe and the reduced "credit impulse" largely due to peripheral banks being capital impaired thanks to bloated balance sheets due to nonperforming loans (NPLs), we would like to point out once more to the difference in terms of deleveraging between Europe, the US and Japan when it comes to their respective banking sector as highlighted as well by Morgan Stanley in their European Credit Outlook note from the 28th of November entitled "As Good As It Gets":
"In our base case, we expect bank credit to outperform non-financials because valuations are less distorted, technicals remain supportive, fundamentals at the system level continue to improve (albeit at a slower pace) and regulatory pressures on the sector are easing. The earnings squeeze on account of negative rates and flat curves is also likely to ease, at least in some parts of the system, on account of recent moves in bond yields. Moreover, the possibility of ECB purchases (while lower now) is still an important source of optionality.
Banking on favourable technical and valuations: 
Delving into some of the factors listed above, we note that the positive, but subdued, lending impulse has been a favourable set-up for bank credit. It has helped to ease concerns of financial conditions and at the same time has kept the supply technical supportive. As shown in Exhibit 28, net issuance
of senior unsecured paper and covered bonds from European banks are barely positive. The need for funding is modest and the avenues are many, with the ECB still an attractive alternative to bond markets. Against this backdrop, we expect senior bank supply to remain muted in 2017. Another important factor that informs our view is regulations. As our bank analysts have been highlighting for some time now (see The Potential for MREL, September 23, 2016), MREL is likely to be supportive for bank debt. They believe that non-preferred senior/'Tier 3' will be the MREL of choice for most banks, increasing structural protection for opco seniors and far lower needs to issue senior debt." - source Morgan Stanley
We hate being "party spoilers" for our equities friend and their "optimism bias" but, in the current deleveraging and "japanification" process, we'd rather go for financials credit wise thanks to the technical support and lower volatility of the asset class compared to equities. No matter how strong the rally has been as of late in equities, for credit there is a caveat, you need to pick your issuer wisely in Europe. Europe is still a story of subdued credit growth given that the liquidity provided by the backstop of the ECB has not meaningfully translated into credit growth for the likes of Portugal and Italy and in no way resolved the Damocles sword hanging over the Italian banking sector and their outsized NPLs issue.

Overall as "Dystopia" is fading, marking a return of bond volatility, we would be surprised to see a continuation of the strong rally seen in the second part of 2016 for credit markets in 2017. Whereas we have not seen signs of clear stabilization for "Mack the Knife" aka King Dollar + positive real US interest rates, hence our neutral stance for the time being on gold, in our last chart, we would like to point out that gold could shine again following the Fed in December.

  • Final chart - Gold could shine again after the Fed
Whereas Gibson's paradox, thanks to  "Mack the Knife" has reversed meaningfully during the month of November, we could have a surprise rally after the Fed's decision in December according to our final chart from Deutsche Bank's "Mining Chart of the Week" note from the 25th of November:
"After five of the last eight US interest rate hikes, gold has rallied
The gold price has declined 7% so far in the month to reach a nine-month low on expectations of a US rate hike in December and improved sentiment that recessionary risks are fading with hopes of a Trump-led fiscal stimulus. The precious metal now looks less shiny; but what’s next? History teaches us that gold can rally after the Fed has hiked. As we show on this week’s chart, since 1976, in five instances out of eight, gold rallied with rising Fed rates.

Reading through the Chart
We find it interesting that even in an environment of flat/rising US GDP growth and rising interest rates, gold can rally – this happened in 1977-78, 1993-95, and 2004-06." - source Deutsche Bank
Whereas investors have been anticipating a lot in terms of US fiscal stimulus from the new Trump administration hence the rise in inflationary expectations and the relapse in financial "Dystopia", which led to the recent "Euphoria" in equities, the biggest unknown remains trade and the posture the new US administration will take. If indeed it raises uncertainty on an already fragile global growth, it could end up being supportive of gold prices again. As a bonus chart we would like to point out Bank of America Merrill Lynch's chart highlighting the relationship between gold and global trade from their Metals Strategist note from the 21st of November:
"Trade is an unknown
Trade, the other cornerstone in US President-elect Trump’s plan, has been discussed contentiously. In our view, measures that would restrict global trade would do a lot of damage to economic activity. Against this backdrop, we note that trade has been subdued anyway, and this may not change imminently given developments including a shift in economic activity from DM to EM has run its course for now. Of course, this raises uncertainty over the strength of global growth, which is supportive of gold (Chart 67).
Having said that, we believe a wholesale crackdown on US and global trade cannot be in the interest of the US president elect and we are cautiously optimistic that outright trade wars may not be the core agenda for 2017, so we track developments in this area mostly as a bullish unknown for gold." - source Bank of America Merrill Lynch
Whereas the markets and US voters have so far embraced the utopian idea that the new US Administration could make America great again, it remains to be seen if this state of euphoria is warranted.

"The euphoria around economic booms often obscures the possibility for a bust, which explains why leaders typically miss the warning signs." -  Andrew Ross Sorkin

Stay tuned ! 

Wednesday, 23 November 2016

Macro and Credit - Critical threshold

"If you wish to be a success in the world, promise everything, deliver nothing." - Napoleon Bonaparte
Watching with interest the violent rotations in fund flows with Emerging Markets debt funds recording a $6.64 (-1.9) billions of outflows last week, the largest ever in terms of $AUM thanks to "Mack the Knife" (King Dollar + positive real US interest rates) while financial-sector funds experienced as well some monster flows to the tune of $7.2 billions, in effect validating somewhat our "macro reverse osmosis" discussed again in our previous conversation, we reminded ourselves for this week's chosen title as an analogy the definition of "critical threshold". Critical threshold is a notion derived from the percolation theory, which by the way ties up nicely when it comes to fluid movements and osmosis and refers to a threshold, that summons up to a critical mass. Under the threshold the phenomenon tends to abort, but, above the threshold, it tends to grow exponentially hence the risk for osmosis and flows to become at some point excessive, which would mean deflation bust and defaults for some. In cases the phenomenon is not sudden and take times to operate (such as a gradual surge in the US dollar) we would have used a critical phase or phase transition as a title for this week's musing but not this time around given the violence of the moves we have seen as of late.

In this week's conversation we would like to look at the violent flows rotations and what it entails in terms of critical threshold and risks as we move towards 2017 given the on-going killing spree of "Mack the Knife" on gold and US Treasuries and EM as well.

Synopsis:
  • Macro and Credit -  Is reverse osmosis finally playing out?
  • Final chart - The dollar is their currency but our problem for 2017

  • Macro and Credit -  Is reverse osmosis finally playing out?
While last we week we reacquainted ourselves with our reverse osmosis macro theory relating to the acceleration of flows out of Emerging Markets, the latest raft of data relating to flows of funds clearly points out to a buildup in "Osmotic pressure" and a risk to break through the "critical threshold" and a significant "margin call" on the huge US dollar shortage that has been building up. On our twitter feed in fact we recently joked that the Fed was not behind the curve, but, that the curve was behind the Fed (watch the flattening...). The acceleration in the rise in US yields and in particular real yields have accelerated as of late, putting additional pressure on gold, Emerging Markets alike. If indeed the dollar rally continues to run unabated then, in continuation to our previous conversation, there is no doubt in our mind that trouble will be the outcome for the leveraged "macro tourists" carry players in the Emerging Market space. When it comes to trends, we do follow funds flows as indication of rising instability. To that effect, we read with interest Deutsche Bank's Weekly Fund Flows note from the 21st of November 2016 entitled "The great unwind?":
"Expectations of a looser US fiscal policy added fuel to the reflationary fire, triggering a bond sell-off across regions and classes on the one hand while also arranging for a strong return of equity inflows on the other hand. investors moved away from bonds at the highest weekly pace since the taper tantrum in 2013, as rising inflation expectations prompted outflows in both credit and sovereign bond fund categories, with US mandates bearing the brunt. In tune with the market, last week’s post-election flow data also saw a renewed appetite for DM equities as the reception of Trump's plans on tax cuts and infrastructure spending resulted in the highest weekly inflows for US equity funds since Dec’14 (see chart below).

If such stimulus in combination with reduced business regulation were to lead US GDP growth higher (as our US economists expect), we could finally see a normalisation of flows whereby money rotates out of over-allocated bond funds ($1tn of inflows since 2009) and into DM equities ($400bn of inflows since 2009). Last week’s bond-to-equity pull was strong in the US, and if rates continue rising this should go on.
Meanwhile another rotation seems to be in the making, as a rising dollar accompanied by fears of trade renegotiation spelled panic over emerging market fund flows. The run for EM bonds, which already looked increasingly  tired the past two weeks, took a big hit with highest redemptions since Jul’13 (see chart below) and the highest outflows in dollar terms since 2004.

EM equity fund redemptions also climbed to a one-year high. We remain particularly worried about intensifying EM capital flight on the back of a stronger dollar, and think EM redemptions are likely to continue." - source Deutsche Bank
If indeed when it comes to "credit" we look at the "credit impulse", in order to gauge the strength of economic growth, when it comes to flows and financial markets we like to look at Deutsche Bank's liquidity pulse, being the standard deviation from the mean of the relative between the current flow (4-week average as % of NAV) and the average size of flows in the last 13 weeks to get a better idea of the "critical threshold". Below are a couple of charts relating to equities and pointing towards a rotation from EM to DM with US equity funds talking the bulk of the flows:
- source Deutsche Bank

Whereas so far US equity funds have been receiving most of the inflows whereas EM has been on the receiving end of the "reverse osmosis" theory, given the surge in "Mack the Knife", it looks to us that once again a weakening Japanese yen against the dollar should go hand in hand with a surge of the Nikkei index, currency hedged. particularly in the light of the liquidity pulse which has yet to surge meaningfully.

When it comes to bonds and flows it is a different story as the velocity in the surge of US yields has translated into outflows from bonds funds and particularly EM funds towards equities for the time being:
- source Deutsche Bank

If indeed the pressure from "Mack the Knife" continues to build up, then obviously "de-risking" will be de rigueur, which should lead to additional significant outflows. So all in all not only we should be seeing additional capital outflows from EM under pressure but, in the financial sphere, if the trend is indeed your friend, there is further pain ahead in this "Great rotation" currently playing out. Furthermore, while there has been some additional pressure in the High Yield space seeing $3.8 billion of outflows, marking a third straight week of leakage for the asset class. A continuation of both a flattening of the yield curve and a surge in the US dollar will eventually start hurting credit and spreads could start widening at some point. As pointed out from a recent BIS paper entitled "The dollar, bank leverage and the deviation from covered interest parity" (H/T fellow blogger Nattering Naybob) we quoted recently on our tweeter feed:
"The highly significant coefficient on the US dollar index is -0.49, which implies that a one percentage point (aggregate) appreciation of the dollar is associated with a 49 basis point decline in the growth rate dollar-denominated cross-border bank lending. The estimated coefficient for lending to banks is even larger in absolute value (-0.61), implying that the decline is even stronger for interbank lending." - source BIS
In their long report the BIS indicated that a strengthening of US dollar has adverse impacts on bank balance sheets, which, in turn, reduces banks’ risk bearing capacity. An appreciation of the dollar entails a widening of the cross-currency basis and a contraction of bank lending in dollars. So all in all, our "exuberant" equities friend should be wary of outflows, the surge of "Mack the Knife" and a flattening of the yield curve, because in our book, once you've passed the critical threshold, there is more pain ahead with contraction of credit and consumption, if our murderous friend continues its rampage. If you forgot what a global credit crunch looks like, then you should be concerned by the devastation that can bring in very short order a US dollar shortage. 

When it comes to the aforementioned "risk bearing capacity for banks" think about rising hedging costs because as per the below chart from a Nomura note from the 17th of November entitled "Japanese investors' foreign bond buying (Oct 2016)", since late October, USD/JPY basis has been widening again. So, dear investors you can not only expect rising hedging costs going forward but a higher cost of capital, which entails credit spreads widening at some point:
"USD basis costs fell after the adoption of new MMF regulations in the US, but …
We attribute the rise in USD basis costs until early October to new MMF regulations, which were implemented on 14 October. The valuation method for prime MMFs (primarily investing in commercial paper issued by corporates) held by institutional investors was revised in such a way that these instruments could incur losses.
This likely prompted a shift from prime MMFs to government MMFs (which invest more than 99.5% of their funds in cash, government bonds, and government bond repos). This made Japanese banks USD funding via commercial paper more difficult. USD Libor also rose on expectations that USD funding would become tighter for Japanese banks, which led to a widening of USD/JPY basis.
Once the new regulations were implemented, the tightening of USD funding materialized, and USD/JPY basis began to narrow. Since late October, however, USD/JPY basis has been widening again. Moreover, USD Libor may rise if a Fed rate hike at the December FOMC meeting becomes more likely, which could translate into higher currency-hedging costs, in our view." - source Nomura
USD libor, dear friends, will rise if the Fed hikes in December FOMC meeting (100% certainty according to market pundits). This will accentuate even more currency-hedging costs. So what could be the consequences given Japanese Lifers and their investment friends have been large buyers in 2016 of foreign bonds, this could lead Japanese investors to look back into domestic issues or switch some of their appetite towards cheaper alternatives such as Euro denominated bonds longer than 10 years.

As a reminder from our July 2016 conversation "Eternal Sunshine of the Spotless Mind", Bondzilla the NIRP monster has been more and more "made in Japan":
"As we have pointed out in numerous conversations, just in case some of our readers went through a memory erasure procedure, when it comes to "investor flows" Japan matters and matters a lot. Not only the Government Pension Investment Funds (GPIF) and other pension funds have become very large buyers of foreign bonds and equities, but, Mrs Watanabe is as well a significant "carry" player through Uridashi funds aka the famously known "Double-Deckers". This "Bondzilla" frenzy leading our "NIRP" monster to grow larger by the day is indeed more and more "made in Japan"." - source Macronomics, July 2016
Unfortunately for the "macro tourists" out there, playing the leveraged carry trade, if there is something that carry players hate most is bond volatility! It is therefore difficult for us to envisage some stability in the Emerging Markets space until US interest rates stabilize. We have yet to see some sort of stabilization.

Also, we believe that the most predictive variable for default rates remains credit availability and if credit availability in US dollar terms vanishes, it could portend surging defaults down the line for stretched EM dollar denominated leveraged players. Right now, when it comes to the US, the latest Senior Loan Officer Opinion Surveys (SLOOs) point to some easing as of late as indicated by Bank of America Merrill Lynch in their HY Wire note of the 21st of November entitled "Don't be a hero":
"We use three main criteria to forecast HY default rates: the Senior Loan Officer Opinion Survey (SLOOS), credit migration rates, and real rates in the economy. When combined, these three inputs have an 85% correlation over the next 12 month trailing default rate at any given point in time. This makes sense because looser lending conditions, a higher proportion of upgrades, and lower real rates all make it easier for an issuer to secure funding and hence maintain balance sheet liquidity. For Loans we use a two factor model - rates don’t have a meaningful impact on the asset class, especially since they are floating in nature.

"Our HY model is most sensitive to the lending standards as reported by senior loan officers on a quarterly basis- a measure that has declined from a relative high of 11.6% in April of this year to 1.5% today (Chart 18). The survey reflects the ability of medium sized enterprises (annual sales greater than $50mn) to get funding from regional banks. Since HY issuers fit this criterion, this survey is also well correlated with their ability to tap the bank lending market. Another way to assess issuer access to funding is by tracking the proportion of risky companies that have been able to tap the HY capital markets on a trailing 12-month basis. While this too has a high predictive power of defaults (Chart 17), it doesn’t add enough incremental explanatory power to justify adding an additional variable. Further, the lead time of the risky issuance model is less consistent than the lending survey. Hence we choose to rely on SLOOS for the purpose of our model. Just like for bonds, SLOOS is a good indicator of the level of default rates for loans a year later. However, in the case of loans, the default rates are more sensitive to the asset class’s migration rates than the lending survey, quite the opposite of bonds.
Another interesting point to note about the SLOOS report is that it does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. On the other hand, it undershoots when defaults are driven by idiosyncratic events in individual sectors such as what we witnessed in the 2015 commodity bust. Our forecasted default rate for 2015 thus happened to be lower than the realized headline default rate but higher than the ex-commodity rate" - source Bank of America Merrill Lynch
The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years has ended.

Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...). With rising interest rate volatility, one would expect leveraged players, carry traders and tourists alike to start feeling nervous for 2017.

Also, rising rates can easily curtail the US consumer which would ultimately disappoint earnings growth and sales as the ability to use cheap funding wane with rising interest rates, meaning less potentially less buybacks regardless of the US repatriation factor vaunted by some pundits. This leads us to our final chart as in the end, for us Europeans, the US dollar might be their currency but our collective problem in 2017 we think.


  • Final chart - The dollar is their currency but our problem for 2017
The continuation of a surging US dollar and a flattening of the US yield curve could represent a significant headwind for 2017. This is as well indicated in the final chart we selected from Bank of America Merrill Lynch HY Wire note of the 21st of November entitled "Don't be a hero" displaying the USD appreciation versus YoY EBITDA growth (ex-Energy):
"Given the strengthening dollar, a fall in earnings growth and a pickup in treasury yields, we’re concerned that unless sales growth accelerates meaningfully in 2017, ex-Commodity fundamentals may disappoint relative to 2016. And although we were becoming emboldened by what appeared to be stronger revenue growth in Q3, as more companies report we are finding that unfortunately our optimism may have been misplaced; sales growth for Q3 now stands at just 3.7% whereas 11 days ago it was 8%." - source Bank of America Merrill Lynch
If optimism is somewhat misplaced, it could well be that our eternal equities optimists friends could be somewhat getting ahead of themselves in their "reflation" wishes. But that's another story as for now it's rally time in the equity world and we don't want to be the party spoilers for now.

"In politics stupidity is not a handicap." - Napoleon Bonaparte
Stay tuned!
 
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