Sunday, 17 July 2016

Macro and Credit - Eternal Sunshine of the Spotless Mind

"Right now I'm having amnesia and deja vu at the same time." - Steven Wright, American comedian
While watching with interest our home team France losing the Euro 2016 final against Portugal, being yet another case of "Optimism bias" coming from our fellow countrymen, and looking at the significant rally in various asset classes such as iShares iBoxx Investment-Grade Corporate Bond ETF, or LQD, taking in $1.1bn last Thursday, the largest ever recorded inflow as if "Brexit" had never happened, we reminded ourselves for our chosen title of the 2004 romantic comedy "Eternal Sunshine of the Spotless Mind". With various markets returning to dizzying heights such as the S&P500 or US High Yield markets, it seems to use that once again investors have found "romantic love" with risky asset classes and in many ways their bad memories have been erased, hence our title reference. As far as we are concerned, we haven't gone through the memory erasure procedure and we continue to feel that when it comes to credit in general and in in particular US High Yield, we are in the last inning of the game, particularly when we look at the most recent Fed Senior Loan Officers survey which clearly shows a slowly but surely deteriorating trend when it comes to financial conditions.

In this week's conversation we would like to focus on the on-going deteriorating trend in credit fundamentals and discuss why we think we are in the final inning and therefore one could indeed expect a final and important melt-up in risky asset prices which could last well into September. We will as well discuss Japan as there are indeed increasing "helicopter" noises in the background.

  • Macro and Credit - Bondzilla, the NIRP monster is more and more "made in Japan"
  • Macro and Credit  - US High Yield has gone through the memory erasure procedure but nonetheless, financial conditions are tightening
  • Final charts:  the Gold rush into gold funds is feeding on Bondzilla, the NIRP monster

  • Macro and Credit - Bondzilla, the NIRP monster is 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". On the subject of this Japanese foreign allocation, we read with interest UBS Global Rates Strategy "What Japanese Investors Are Buying" from the 8th of July:
"Which government bond and credit markets benefit from Japanese demand?
We have previously described how Japanese investors have been significant net buyers of foreign assets – predominantly DM government bonds – in light of the BoJ’s negative interest rate policy. Net purchases have recently regained momentum, following a slowdown around the turn of the Japanese fiscal year. Today’s data of overseas purchases by destination for May highlights which markets are benefitting.
DM: US Treasuries on top; continued inflows into France, Canada, Italy
Japanese net buying of sovereign bonds recovered in May (¥1.8tn vs. ¥0.2tn in April), though still below the record level seen in March (¥5.5tn). US Treasuries made up for nearly 50% of all net purchases. France, Japan's historically preferred euro market, saw modest net buying of ¥159bn, roughly unchanged from April. Elsewhere, Canada and Italy saw continued net purchases, albeit at a slightly slower pace than in April.
EM: Reducing exposure to LatAm and High Yield
In May investors reduced positions in high yield EM markets. Mexico monthly outflows were the largest in five months; Brazil, Indonesia and South Africa were also net sold. China short-term bonds were net bought, other Asian markets were flat. Overall allocations into EM have been small relative to DM asset purchases, with the largest EM market (Mexico) accounting for less than 1% of all bond holdings.
- source UBS
What is as well of interest in UBS note is that since the implementation of NIRP by the Bank of Japan (BOJ), Japanese life insurance companies have gone into "overdrive":
"Japanese life Insurance companies’ net purchases of foreign long-term debt securities; subset of Figure 13 (¥bn). Lifers' hefty buying since Feb-16 continued in Jun-16 (¥1056bn, 3rd largest since the start of data in 2005), overall the 10th consecutive month of net purchases." - source UBS
No surprise therefore that "Bondzilla's size" has indeed been increasing at a rapid pace. This sudden acceleration in negative yielding bonds has been clearly "made in Japan" we think. The acceleration in "Lifers" bond purchases is as well confirmed by Nomura in their JPY Flow Monitor entitled "Foreign Investment continues amid increased uncertainty" from the 8th of July:
"Japanese foreign portfolio investment continued in June. Excluding banks, Japanese investors bought JPY2264bn ($22.6bn) of foreign securities in June, a slightly weaker pace than in May. Life insurance companies’ foreign bond investment accelerated again, while we judge most of them were on an FX-hedged basis. Pension funds and toshin companies remained net buyers of foreign securities too. Retail investors’ foreign investment is likely to stay weak for now, as risk sentiment among them deteriorates after the Brexit vote. Pension funds will probably remain dip buyers, even though the pace is likely slower than in 2015. May BoP data show that the current account surplus narrowed for the second month in a row, suggesting that the improved phase of the Japanese current account balance has likely ended for now, as oil prices recover and JPY appreciates." - source Nomura
If indeed "Bondzilla" is "made in Japan" this is clearly thanks to the acceleration of "Lifers" in the global reach for yield particularly since the implementation of NIRP by the Bank of Japan, but as pointed out by Nomura's note, this time around with a higher hedge ratio:
"Lifers continued strong foreign bond investment, likely with high hedge ratio
Life insurers bought a net JPY1056bn ($10.6bn) in foreign long-term bonds for the 10th month in a row. Although the pace of net buying has slowed over the past two months, this is the first time in three months that the pace of net buying has accelerated to above JPY1trn. Downward pressure on yields has strengthened globally in response to the decline in Fed rate hiking expectations after US NFP data early June and uncertainty over the Brexit referendum. 20yr JGB yields have fallen to almost 0%, forcing lifers to seek higher yields and shift to foreign bond investments. With JGB yields trending near 0% in all maturities, lifers are likely to continue to invest in foreign bonds at a high level
(Figure 2).
That said, we expect that most of their foreign bond investments will be FX hedged for the time being. After FX hedging, UST investment may not be so attractive owing to higher hedging costs. Nonetheless, Fed rate hiking expectations by year-end have almost completely disappeared. The Brexit vote has lowered USD/JPY, JGB and UST 10yr yields to the lower range of major lifers’ FY16 forecast, or even below, but on an unhedged based foreign bond investment may not accelerate anytime soon, amid increased political uncertainty (see “JPY: The shift into foreign assets by lifers should continue”, 27 April 2016). With risk tolerance falling, we think there is little chance that lifers will shift to unhedged foreign bonds in the near future.
In the medium term, we still expect their interest in investing in hedged foreign bonds to wane gradually, as a result of the expected rise in hedging costs. Nonetheless, the timing of their shift from hedged to un-hedged foreign bond investment will likely be delayed after the Brexit vote and associated market volatility." - source Nomura
From the above we think that the implications are as follows in the short term, we have most likely seen the lows for now on Developed Markets' long term sovereign bonds and in terms of the Japanese Yen, further depreciation of the currency depends on the implications of the deployment of some form of "helicopter money" in Japan. We must confide we have re-initiated therefore a short Japanese yen position and thinking about adding going long Nikkei but in "Euros" via a quanto ETF (currency hedged).  Given we have not fallen to a memory erasure procedure, we reminded ourselves clearly of our April 2015 conversation "The Secondguesser":
"1. To criticize and offer advice, with the benefit of hindsight.
2. To foresee the actions of others, before they have come to a decision themselves.
We have to confide, that we have continued to become clear "Seconguessers" as per definition number 2 above when it comes to "second-guessing" the "Black Magic" practices of our magicians of central bankers and their "secret illusions"." - source Macronomics, April 2015
On a side note, in our April conversation, we showed that flows had lagged performance in Emerging Markets. We think now the time is ripe to add on some EM equity expsore which can be relatively easily done through the ETF EEM. EM equity funds saw $1.6 billion of inflows recently...

When it comes to the benefits of "helicopter money", we read with interest Bank of America Merrill Lynch's take from their Japan Watch note from the 15th of July entitled "Japan for “whatever it takes”; monetaryfiscal coordination not helicopter money":
"The monetary-fiscal hand-off
In recent months we have been writing more about the importance of and prospects for fiscal easing. In March we argued that “while monetary policy may be over-stretched in places, we think there is plenty of scope for fiscal policy to support global growth.” In particular, “low interest rates and sufficient fiscal space in many countries make now an opportune time for increased public-sector investment spending.” However, we worried arbitrary political constraints on policy would limit spending, delaying more decisive action until the inevitable recession arrives.
It has taken a long time, with monetary ammunition running low, but finally fiscal easing seems to be starting to kick in. In May, we noted that fiscal expansion had started in a number of regions, including the US, Europe, and China, although much of that easing has been more by accident than design. At the time, we thought Japan would delay its second consumption tax, but could not be certain they would not make another policy mistake.
Japanese for “whatever it takes”
Recent news makes us increasingly confident Japan will join the fiscal expansion and both Europe and the US will increase their stimulus efforts. Policy decision making in Japan often seems like a ritual kabuki play. In the first act, facing whether to delay the consumption tax hike, Prime Minister Abe met with three advocates of easy policy—Paul Krugman, Joseph Stiglitz and Christina Romer. Then at the G-7 meeting in Japan in late May, he warned of risks of a Lehman-like economic crisis. Recall that earlier he had said that only a major event similar to the 2011 earthquake or a Lehman-like crisis could delay the tax hike. Weeks later, in the second act, there was no sign of Lehman II in sight, but sure enough the consumption tax hike was delayed.
In the third act, policy was put on hold awaiting the results of the upper-house election, which returned a solid victory for Abe. He then announced work on a “bold” stimulus package, which major Japanese media outlets suggest to be at least ¥10tn. Former Fed Chairman Bernanke was invited to offer policy advice in the fourth act this week. It is not hard to imagine what Bernanke told them.
The fifth and final act, in our view, will be a major stimulus package, of ¥15-20tn in total, financed by at least a ¥10tn supplementary budget, likely coupled with additional easing by the Bank of Japan at end-July. We look for the BoJ to double its ETF purchases to around ¥6tn annually and potentially lift its JGB purchase pace in line with the increased issuance from the fiscal stimulus plan. Inclusion of municipal and agency bonds is also possible, but given their small market and limited liquidity, we see this as a more symbolic gesture. We do not expect a further cut in interest rates at this time, but we would not completely rule it out either. The BoJ would need to find a way to minimize the adverse impact upon banks from a more negative policy rate.
Risk markets have responded well to this potential program: Japanese equity markets just about reversed their post-Brexit funk, having risen 9.5% since 24 June. The global spillover is palpable; US stocks are up 8% over the same period, while most European markets have rebounded as well. The USDJPY also weakened to above 105, having touched 100 after Brexit. This is a fairly small retrenchment: the yen has appreciated over 12% against the USD on net this year alone. A top advisor to Abe suggested this week that Japan cannot defeat deflation with the USDJPY around 100." - source Bank of America Merrill Lynch
Once again, you probably want to think about "front-running" the Bank of Japan hence our interest in going long the Nikkei index but currency hedged.

When it comes to the options Abe and Kuroda have to reverse the deflationary woes of Japan, Bank of America Merrill Lynch makes some interesting points:
"Can Abe-Kuroda beat high expectations?
Implicit fiscal-monetary coordination
Expectations of fiscal and monetary easing are building in the financial markets, but there seem to be different ideas about the degree of coordination.
1. Implicitly coordinated fiscal-monetary easing: The government unleashes huge economic measures with a supplementary budget of more than ¥10tn. The BoJ expands monetary easing, potentially including through increased purchases of JGBs. The two are “synchronized” with roughly concurrent announcements.
2. Explicit coordination between the government and BoJ: In addition to the above fiscal-monetary easing, the government and BoJ announce an accord of commitment to fiscal expansion financed (semi-)directly by the BoJ’s JGB purchases until the inflation target is met (from the 13 July Sankei Shimbun’s front page).
3. Debt monetization: The BoJ restructures its existing JGB holdings to zero coupon perpetual JGBs, and/or the government issues perpetual bonds to the BoJ directly. (leaving legal issues aside; where there is a will there is a way).
Options (2) and (3) could be called the soft and hard versions of helicopter money, and the likelihood of either being adopted in the near term is low, in our view. This is because (1) Japan's economy, with its 3.3% unemployment rate, can hardly be defined as in crisis; (2) such drastic policies could shake the JGB market and JGB investors; and (3) there have been no cases of developed economies resorting to dropping helicopter money in recent history, and considerable uncertainty surrounds the consequence of such a plan.
We, especially those based in Tokyo, find it hard to believe anyone or any groups in Japan, including the Abe Administration, the MoF, the BoJ, or the public, aspires for hard helicopter money at the moment. Even if they did, nobody seems to have the political capital to pull it off and conduct it for a prolonged period of time. As such, “implicitly coordinated fiscal-monetary easing” – or some other bold fiscal expansion, and expansion of the existing monetary easing – is the most likely possibility." - source Bank of America Merrill Lynch
While it is always hard to fathom the impossible, where we slightly disagree with Bank of America Merrill Lynch is that we could have yet another case of "Optimism bias" and that Japan decide to be even bolder. We touched on the "boldness" of Japan in our April conversation "The Coffin corner":
"There are old wise central bankers (Paul Volcker) and bold bankers (Ben Bernanke now joined by Haruhiko Kuroda ); we have no old central bankers, just bold central bankers". - Macronomics.
"Looking at the desperate attempts by the Bank of Japan to cancel out the deflationary forces at play by increasing the "angle of monetary attack" with the "bold" central pilot banker Kuroda pulling very strongly on the stick, we wonder if Japan will indeed endure structural failure in the end. Maybe Kuroda is a gifted pilot such as pilots from the famed Lockheed U-2 spy plane, but, maybe he isn't.
We found most interesting that the "Coffin Corner" is also known as the "Q Corner" given that in our post "The Night of The Yield Hunter" we argued that what the great Irving Fisher told us in his book "The money illusion" was that what mattered most was the velocity of money as per the equation MV=PQ. Velocity is the real sign that your real economy is alive and well. While "Q" is the designation for dynamic pressure in our aeronautic analogy, Q in the equation is real GDP and seeing the US GDP print at 2.5% instead of 3%, we wonder if the central banks current angle of "attack" is not leading to a significant reduction in "economic" stability, as well as a decrease in control effectiveness as indicated by the lack of output from the credit transmission mechanism to the real economy.
In similar fashion to Chuck Yeager, Alan Greenspan made mistakes after mistakes, and central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate! Maybe our central bankers like Chuck Yeager, just ‘sense’ how economies act or work.
We believe our Central Bankers are over-confident like Chuck Yeager was, leading to his December 1963 crash. Central Bankers do not understand stability and aerodynamics..." - source Macronomics, April 2013
If central bankers are now joining force with Ben Bernanke advising directly the Bank of Japan there is indeed a strong possibility they will go for "bolder" policies such as "helicopter money". This policy is fraught with danger we think and agree with Nomuras's take on the subject from their Japan Trade Ideas note from the 15th of July entitled "The danger of helicopter money":
"The adoption of helicopter money by Japan is being discussed a lot more frequently these days. Until recently it was principally by international investors, but, with “Helicopter” Ben Bernanke meeting both BOJ Governor Kuroda and Prime Minister Abe this week, local media is giving it much more coverage. According to a Bloomberg article on Thursday, Mr Bernanke suggested during an April meeting with Abe adviser Etsuro Honda that “helicopter money – in which the government issues non-marketable perpetual bonds with no maturity date and the Bank of Japan directly buys them – could work as the strongest tool to overcome deflation.” Mr Honda said he relayed this message to Prime Minister Abe, although according to another key official, Koichi Hamada, the former Fed Chairman reportedly stuck to more orthodox policies in his meeting with Mr Abe on Tuesday (Bloomberg).
The two main sources of helicopter money views cited by international investors that I have met in recent months are Mr Bernanke’s blog and Adair Turner’s book “Between Debt and the Devil: Money, Credit, and Fixing Global Finance.” 
Mr Turner's suggestion for JGBs is as follows: That debt could be written off and replaced on the asset side of the Bank of Japan’s balance sheet with an accounting entry – a perpetual non-interest-bearing debt owed from the government to the bank. The immediate impact of this on both the bank’s and the government’s income would be nil, since the interest which the bank currently receives from the government is subsequently returned as dividend to the government as the bank’s owner. So in one sense a write-off would simply bring public communication in line with the underlying economic reality. But clear communication of that reality would make it evident to the Japanese people, companies, and financial markets that the real public debt burden is significantly less than currently published figures suggest and could therefore have a positive effect on confidence and nominal demand.”
The assertion that there would be no immediate difference from the current situation is not strictly correct. The average yield on the BOJ’s current JGB portfolio is about 0.42%. While some of the income from this will indeed be returned to the government, a large portion is used to 1) pay higher rates to banks on most of its deposits than the official minus 0.1% policy rate; 2) cover losses and build reserves against losses on its riskyasset purchases; and 3) subsidize its efforts to lower yields across the curve – the central bank is currently buying JGBs at an average yield of around -0.26%, well below its cost of funds.
While restructuring the asset side of the BOJ’s balance sheet may seem like a worthwhile idea, the picture is not nearly as rosy when we take into consideration its liabilities. Narayana Kocherlakota, former president of the Federal Reserve Bank of Minneapolis, has pointed out that, The apparent attractiveness of the helicopter approach ignores something important: Money has a cost, too. When the Treasury spends the $100 billion, it will appear in bank accounts. Banks, in turn, will deposit the money at the Fed – a liability on which the central bank pays interest.”
Mr Bernanke acknowledges this problem in his April blog on helicopter money. “Moneyfinanced fiscal programs (MFFPs), known colloquially as helicopter drops, ….present a number of practical challenges of implementation, including integrating them into operational monetary frameworks and assuring appropriate governance and coordination between the legislature and the central bank. As my former Fed colleague Narayana Kocherlakota has pointed out, the fact that the Fed (and other central banks) routinely pay interest on reserves has implications for the implementation and potential effectiveness of helicopter money. A key presumption of MFFPs is that the financing of fiscal programs through money creation implies lower future tax burdens than financing through debt issuance. In the longer run and in more-normal circumstances, this is certainly true…..In the near term, however, money creation would not reduce the government’s financing costs appreciably, since the interest rate the Fed pays on bank reserves is close to the rate on Treasury bills. Here is a possible solution. Suppose that the Fed creates $100 billion in new money to finance the Congress’s fiscal programs. As the Treasury spends the money, it flows into the banking system, resulting in $100 billion in new bank reserves. On current arrangements, the Fed would have to pay interest on those new reserves; the increase in the Fed’s payments would be $100 billion times the interest rate on bank reserves paid by the Fed (IOR). As Kocherlakota pointed out, if IOR is close to the rate on Treasury bills, there would be little or no immediate cost saving associated with money creation, relative to debt issuance. However, let’s imagine that, when the MFFP is announced, the Fed also levies a new, permanent charge on banks – not based on reserves held, but on something else, like total liabilities – sufficient to reclaim the extra interest payments associated with the extra $100 billion in reserves. In other words, the increase in interest paid by the Fed, $100 billion * IOR, is just offset by the new levy, leaving net payments to banks unchanged. (The aggregate levy would remain at $100 billion * IOR in subsequent periods, adjusting with changes in IOR.)”
Adair Turner’s suggestion for getting round this IOER cost of money-financed deficits is as follows: the rate would have to be zero on at least some reserves to ensure that money finance today does not result in an interest expense for the central bank in the future or in central bank losses that would need to be paid for by government subsidy and ultimately by taxpayers. Setting a zero interest rate for reserve remuneration might in turn seem to impair the central bank’s ability to use reserve remuneration as a tool to bring market interest rates in line with its policy objective. But central banks can overcome this problem, for instance, by paying zero interest rates on some reserves, while still paying the policy rate at the margin.“
So it turns out that for helicopter money to work as its advocates envisage, there needs to be a scheme in place to stop/offset IOER payments to banks. Without that, losses at the central bank will rise quickly when policy rates rise. In the current policy framework, the average yield in the BOJ’s portfolio has been gradually dropping, which is why I think it will be slow to raise rates in the future and I particularly like long-term conditional bear steepeners on the front part of the curve. However, the average yield will recover gradually as the central bank re-invests maturing JGBs at higher yields, allowing the BOJ eventually to raise rates without incurring too many losses. This would not be the case if the central bank has locked up its portfolio in perpetual bonds. With JGB yields the lowest on record, locking in 10yr borrowing costs of -0.24% and 40yr costs of 0.23% seems like a much more sensible policy.
From a strategy perspective, I would treat helicopter money as a very low-probability, high-risk event. It may start out with some seemingly good, risk-on results, but, given the points mentioned above, it is easy to imagine eventual panics among policymakers and/or investors. Rather than his prescription for Japan, I prefer Mr Turner's approach for the euro zone, “If the European Investment Bank funds infrastructure investment, raising money with long-term bonds that the ECB buys, we edge closer to money finance without quite crossing the line.” As outlined in last week’s report., I believe that Japan’s policy mix has reached a stage where it makes sense to begin transitioning from QQE quantity and rates to QQE quality (such as ETFs) and fiscal policy. Nomura expects the BOJ to focus on a combination of rate cuts and ETF purchases at its policy meeting at the end of this month. Although there is very little chance, in our view, of a helicopter-type policy being adopted in Japan any time soon, the current debate could prompt a greater willingness to stretch the boundaries of monetary policy. For example, the central bank has traditionally limited its risky-asset purchases such as ETFs to amounts where potential mark-to-market swings can be comfortably absorbed by its earnings/reserves. Perhaps running the risk of a little negative equity is the right amount of crazy for the BOJ." - source Nomura
And perhaps indeed that running the risk of negative equity is not the right amount of "crazy" for the bold pilots running the Bank of Japan. And if indeed money has a cost too, ultimately the cost will be beared by Japanese taxpayers and in the process the Japanese currency could depreciate rapidly in conjunction with horrendous liquidity problems for the foreign investors still holding to their Japanese Government Bonds (JGBs).

So overall its risk-on again and most likely in Japan but then again, if we are tactically short term bullish, our long term appreciation of the credit cycle is telling us we are in the last inning as shown by the continued deterioration in financial conditions which we develop in our next point.

  • Macro and Credit  - US High Yield has gone through the memory erasure procedure but nonetheless, financial conditions are tightening
What is ultimately driving default rates you might rightly ask?

For us and our good friends at Rcube Global Macro Research, the most predictive variable for default rates remains credit availability.  Availability of credit can be tracked via the ECB lending surveys in Europe as well as the  Senior Loan Officer Survey (SLOSurvey):
"Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans. We have used the net percentage of banks tightening standards for commercial and industrial loans to small firms as tightening credit standards should have a direct effect on the credit market." - source UBS.
For the US you need to follow the Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans.

From a medium term perspective and assessing the "credit cycle" we believe the latest US Senior Loan Officer Survey points to yet another "warning" sign in the deterioration of the on-going credit cycle which has been so far pushed into "overtime" by central banks with ZIRP and their various iterations of QEs.

As we indicated in our "Bouncing bomb" October 2015 conversation, given the strong inflows in the asset class (US High Yield in particular), we remain Keynesian bullish short term when it comes to credit:
"While we have been "tactically" short-term "Keynesian" bullish, when it comes to our recent "credit" call, we remain long term "Austrian" bearish, particularly when it comes to our "credit" related "Bouncing bomb" analogy and the High Beta gamblers. We would recommend moving into a higher quality spectrum in terms of "credit ratings" and exposure." - source Macronomics

From a tactical and leverage perspective, we would continue to be overweight European High Yield versus US High Yield and remain more inclined towards US Investment Grade credit versus Europe.

We would not at the moment go against the "flow" given the latest inflows so far in US High Yield have been very significant, hence our tactical "Keynesian" bullishness, but then again the latest survey is validating our heigtened concerns as highlighted bu Deutsche Bank in their US Fixed Income Weekly note from the 8th of July:
"Bank lending standards continue to tighten for the business sector. The Fed’s Senior Loan Officer Survey (SLOS) measures lending standards of the largest commercial banks. Similar to tax receipts and motor vehicle sales, the SLOS data do not get revised. There are four broad categories of lending: commercial and industrial (C&I), commercial real estate, consumer, and residential mortgages. On balance, the SLOS data are flashing a cautious signal. In Q2, the net percentage of commercial banks tightening lending standards for C&I loans increased a little over three percentage points to 11.6%, which was the highest reading since Q4 2009. This was the third consecutive quarter in which banks tightened C&I lending standards, a troubling development. As the below chart from our Deutsche Bank colleague Jim Reid illustrates, tightening C&I lending standards are a leading indicator of high-yield default rates.

With respect to the other aforementioned categories, the net percentage of banks tightening lending standards for commercial real estate loans showed an even sharper increase in Q2 (+24.2% vs. +13.6% previously). This was the highest level since Q1 2010 (+27.3%). The only positives in the Q2 SLOS were consumer and residential mortgage lending standards, where, on balance, banks continued to ease in Q2. This should prove to be a mild tailwind for consumer spending and the housing market in the near term." - source Deutsche Bank
Since February we have highlighted the Commercial Real Estate Market (CRE) and particularly through CMBX series 6, the most exposed to retail, the latest survey does indeed confirm the debilitating trend of the underlying. In our recent conversation "Through the Looking-Glass" in May we indicated the following:
" When it comes to the CRE cycle being less advanced than the C&I cycle, we do think that the price action in both US retail CDS and CMBX shows that the CRE cycle will catch up fairly quickly with the C&I cycle. It is yet another indication that should worry "Humpty Dumpty" aka Janet Yellen and clearly shows that indeed, as we posited, the Fed is in a bind of its own making. We remember clearly that Charles Plosser, the head of Philadelphia Federal Reserve Bank, argued that the Fed should have increased short-term interest rates to 2.5% in 2011 during QE2." - source Macronomics, May 2016
We do think you need to track both the CRE and its derivatives CMBX series, as well as the US Senior Loan Officer Survey in the near future.

In our final point we will revisit what represents to us yet again a manifestation of Gibson paradox.

  • Final charts:  the Gold rush into gold funds is feeding on Bondzilla, the NIRP monster
While we won't bother going into much the details of Alfred Herbert Gibson's 1923 theory of the negative correlation between gold prices and real interest rates. We believe that the real interest rate is the most important macro factor for gold prices. When it comes to the deflationary forces of our very potent "bondzilla monster", this can be assessed by the below chart from Bank of America Merrill Lynch displaying the relationship between negative yielding assets and gold fund flows from their Credit Derivatives Strategist note from the 14th of July entitled "Deflationary flows, the Central Banks' put and yield hunting":

- source Bank of America Merrill Lynch
This relationship was as well confirmed in another note from Bank of America Merrill Lynch in their Follow the Flow note entitled "Deflationary flows into gold, IG and govies":
Deflationary flows into gold, IG and govies
The size of negative yielding assets has reached new highs. Amid rising
deflationary pressure investors are moving into gold and “ECB-eligible” assets like
government and high-grade bonds. A clear theme so far this year has been assets
that are backed by CBs’ policies and “deflationary” plays like gold are in vogue. On
the other hand, assets like equities have been suffering record outflows amid
concerns that the global recovery is losing steam." - source Bank of America Merrill Lynch
 Obviously the more our NIRP monster grows, the more inflows gold funds will get given Gibson 's paradox. What we are monitoring from a tactically more bearish approach is that very recently surprises, real rates and breakevens are on the rise as displayed in this final chart from Bank of America Merrill Lynch's latest Securitization note from the 15th of July:
"Since Brexit, economic numbers have increasingly surprised to the upside; last week’s June employment report was especially surprising. In “Navigating the summer doldrums (June 3),” we noted that in recent years, the Citigroup economic surprise index has tended to be weak in the first half of the year, bottom in June, and rise in the second half of the year. In Chart 1, we show the seasonal pattern of the average for 2011-2015, along with the 2016 performance. The rise in the index over the past two weeks suggests the “normal” H2 scenario of relatively good economic performance and fundamental data is off to a good start.
If so, it could mean the June plunge in interest rates that pushed the 10yr treasury yield to as low as 1.32% created a near term low for rates. Note that the official BofAML call is for the 10yr yield to end Q3 at 1.25%, and then rise to 1.50% by the end of 2016 (the nominal 10yr is at 1.58% as of writing). If rates and fundamentals have in fact bottomed, at least locally, it’s good news for securitized products, as prepayment risk for agency MBS and credit risk for the credit sectors are reduced. Given the possibility of the worst for rates and fundamentals being seen in June, we have moved to an overweight across most securitized products sectors. 
Chart 2 gives some sense of what rising economic surprises mean for the real 10yr rate, comparing it with the economic surprise index over the past two years. We observe common directionality from 2014 through early 2016, although the coincidence of the timing of the moves is loose at best. 2016 shows a somewhat sustained break in the pattern, however. The surprise index has been trending higher since the low in February. Meanwhile, the real rate has steadily moved lower since the Fed hiked rates last December, as the market has steadily faded the Fed’s ability to hike rates further; for example, the recent bottoming of the real rate on July 6 coincided with the peaking of the no hike probability by December 2016 at 93%.
The bottom line here is that if the economic numbers continue to surprise to the upside, which may have improved chances because real rates got so low, due in part to exogenous global factors, Fed hike probabilities will likely rise, as will the real 10yr rate. For now, though, we think the divergence seen in 2016 between economic surprises and the real rate is a big positive for risky assets: the real rate is probably far too low, and stimulative, relative to fundamentals.
The other side of the coin for nominal rates is breakeven inflation rates, which due to observed correlations over the past year, is the central component of our crosssector valuation framework for securitized products. Chart 3 shows the history of the 10yr breakeven rate in recent years; it remains in the downward trend channel that started around the time of taper talk in 2013.

Chart 4 shows the seasonal view of the breakeven rate in 2016 versus the 2011-2015 average."

- source Bank of America Merrill Lynch
So overall, tactically we think that indeed "risk-on" can further continue and that we could have seen the lows for now on Government bond yields which, would entice further short term weakness on both bond prices as well as gold in true "Gibson's paradox fashion.

Given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact.

"Memories are the key not to the past, but to the future." Corrie Ten Boom, Dutch author
Stay tuned!

Tuesday, 5 July 2016

Macro and Credit - Who's Afraid of the Noise of Art?

"Nations have their ego, just like individuals." -  James Joyce, Irish novelist
Back in September 2013 in our conversation "The Cantillon Effects" we described increasing asset prices (asset bubbles) coinciding with an increasing "exogenous" (central bank) money supply. We pointed out a very interesting study by Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":
"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.
In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.
Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

Nota bene: Classical equation of exchange, MV = PQ, also known as the quantity theory of money. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.
-Endogenous money, PQ => MV (Hume, Wicksell, Marx)
-Exogenous money, MV => PQ (Keynes, Monetarist)

In our on-going "Cantillon Effects", we get: Δ M  => Δ Asset Prices or the famous "wealth effect" dear to our "Generous gamblers" aka central bankers.

The most interesting part of using the art market as a "proxy" for asset bubbles is indeed that money changes (namely the monetary base) leads to the creation of "asset bubbles".

So you might be wondering why our chosen title on this specific topic? Well, (Who's Afraid Of?) The Art of Noise! was Art of Noise's debut full-length album, released in 1984, a called it a "techno-pop classic" and had a clear influence from German band "Kraftwerk". Given our fondness for electronic music from the 80s, we thought it be interesting to use this reference as in this particular conversation we would like to focus on the potential changing trends in the art market we are seeing. This additional indicators such as prices for classic cars as well, could be additional pointers to the lateness of this credit cycle we think.

In this conversation we will look at the trends in the art markets as well as classic cars which could portend a reversal in financial markets hence the importance, we think to regularly monitor this different yet important alternative "asset class" from a "macro" perspective and ask ourselves if indeed we should be afraid of the "Noise of Art" and its consequences.

  • Macro and Credit - Sotheby's woes are only beginning as the art market and the economy are entering a soft patch
  • Macro and Credit  - Classic cars? Downshifting...
  • Final chart: Classic cars have been "turbocharged" 

  • Macro and Credit - Sotheby's woes are only beginning as the art market and the economy are entering a soft patch
Looking at the fall in Sotheby's stock and volumes in sales, is always of interest as in the past, the art market has always been an interesting indicator. The only major listed auction house Sotheby's (ticker BID) has on numerous occasions proved a timely indicator of potential global stock markets reversal by three to six months. While one year return for the stock has been dismal at -38.98%, Year to date so far the stock is up 5.82%. yet we believe that given that the art market, as well as the US economy is about to enter a soft patch and we think this is already confirmed by lower US government bond yields and a flatter yield curve and also we expect weaker Nonfarm payrolls going forward to that respect. If indeed we are correct in our assumption, then we think you are better off sticking with Sotheby's bonds rather than its stock, us of course having somewhat a credit bias. To that effect, we were in agreement with interest Bank of America Merrill Lynch's note on Sotheby's 5.25% bonds which date from the 6th of April 2016 entitled "5.25s are a masterpiece; Initiate at Overweight":
"Cyclical industry entering soft spot
The art market is entering a soft spot as a result of unfavorable changes in global exchange rates, a slowing economy and decelerated asset appreciation. Based upon lower art industry volumes, we believe that Sotheby’s Adjusted EBITDA will decline in FY16. However, the company has substantial liquidity to weather a more difficult environment.
Much to like
We believe that there are many attractive attributes of Sotheby’s business, including: (1) a strong brand name and positioning within the art auction industry; (2) the predominantly duopolistic nature of the art auction industry; (3) limited risk of substantially-levering acquisitions; (4) significant liquidity; (5) minimal maintenance capex; and (6) no near-term maturities. Sotheby’s has been engaged in the art auction industry since 1744 and over this tenure, has built a brand that would be challenging to replicate. Additionally, the duopolistic nature of the industry provides the company with the ability to increase price, as evidenced by a February 2015 increase. Despite small acquisitions over recent history, we believe that the company will not be a major participant in M&A activity in the future, limiting the risk of leveraging transactions. Financially, we estimate that maintenance capex is ~$10 million, which contributes to strong free cash flow and the company has no near-term maturities with which to contend.
FY16 EBITDA to decline, but free cash flow positive We estimate that Sotheby’s Adjusted EBITDA will decline 24% to $236 million in FY16.
However, we estimate that free cash flow will total $88 million, leaving net leverage only 0.4x higher at the end of FY16 (vs FY15).
Initiate at OverweightWe recognize that financial results could be soft in the immediate future. However, we believe that the rough period will be brief and that the company has adequate liquidity to operate through an extended downturn. Trading at a yield-to-worst of 7.3%, we believe that current trading levels are attractive, and initiate coverage on the BID 5.25% Sr Notes with an Overweight rating." - source Bank of America Merryll Lynch.
Whereas tactically this recommendation paid handsomely given the bonds are trading back close to par, when it comes to assessing the viability of Sotheby's business in the long run as well as most recent fall in art trading volumes, we must confide that we do not share Bank of America Merrill Lynch's views on Sotheby's ability to survive in the long run.

First of all as per Bank of America Merrill Lynch's note, inventories are up, leverage is up but, thanks to "cheap credit", the loan portfolio balance is still increasing, meaning that from our perspective, Sotheby's is resorting increasingly to "vendor financing" thanks to "Cantillon effects" and the "generosity" of our central banking deities:
"Inventory sales increased 23% to $36 million with $3 million of losses on inventory sales. Finance revenues totaled $17 million, a $2 million increase from 4Q14. The loan portfolio balance was $682 million at the end of 4Q15 (an increase from $644 million at 4Q14).
From an operating cost perspective, marketing expenses increased $1 million to $7 million. Salaries and related costs decreased $14 million to $75 million. G&A expenses decreased $4 million to $42 million. 4Q15 Adjusted EBITDA totaled $145 million vs $152 million in 4Q14. Based upon outstanding debt of $1.2 billion, total leverage was 3.8x at quarter end." - source Bank of America Merrill Lynch
Secondly, we do not believe no matter how "dominant" Sotheby's position is, that its business as well as its financial position are secure. On that note, we read with interest Artemundi's note from the 10th of June entitled "Sotheby's with one step closer to the grave":
"It has been a disastrous year for Sotheby’s, but the writing has been on the wall for a while. A series of unfortunate events has driven Sotheby’s to walk a tightrope, beginning with Bill Ruprecht stepping downin November 2014 -amid criticism- as CEO after being with the company for 34 years. His rookie successor, Tad Smith, and the new amateur directing board committee have exhibited their lack of experience within the art market, refocusing company ideals to make Sotheby’s a marketing brand that favors advertising and technology for online retail. The new management, forgetting that art remains a business where knowledge really matter, has adopted a new strategy limiting PR expenses. This has led to an unprecedented exodus of the company’s best asset: knowledgeable staffers with strong client relationships and more than 300 years of experience. Vicepresidents, Specialists, Worldwide Heads, Chairmen, and even CFOs have abandoned the sinking ship. The resulting feeling of an uncertainty and instability now pervades the glittering glass-and-granite-fronted building on Manhattan’s Upper East Side. Personally visiting the venue on Sunday, left us with the distressing feeling of a rundown business, just like a ghost with spiritual emptiness, or a phantasmagoric carcass of what once was one of the world’s largest brokers of fine art.
In a desperate effort to compensate for the auction house’s emptiness, the board of directors decided to overpay the private firm, Art Agency Partners, around $85 million on January 11th, 2016 to boost private sales. Thus, this auction season, all art market analysts’ eyes were on Sotheby’s expecting a miracle with Amy Cappellazzo as Sotheby’s triumphant savior. As expected, Post-War and Contemporary auctions developed smoothly with an astonishing 95% sell-through rate. It was a solid $242 million sale made extraordinary if we consider the context within which it was developed but a small sale nonetheless. Clearly the resulting revenue from this sector is not enough to cover the entire auction house’s expenses and debts. The failing 66% BI-rate for the Modern and Impressionist catalogue was a big downturn for Sotheby’s confidence. Excluding Post-War and Contemporary, the lack of talent on the other business sectors has deeply affected the quality and quantity of artistic offer.
 - source Artnet
To summarize, Sotheby’s total sales volume dropped almost by half: last year the house generated $748 million in sales, compared to this year’s $386 million. Furthermore, it seems that Sotheby’s own team tries to boycott its own selling process. The Latin American auction held on May 24th, suffered from serious technical problems for the morning online bidding, when the firm was unable to stream the live auction or place the selling results. The Latin American department surely worked very hard for six months, only to find themselves victims of the IT department’s inefficiencies.
As a result, the insufficient cashflow forces the company heavily depends on its credit facility. In fact, Sotheby’s has just announced that total sales revenue dropped 8%, suffering a $73M loss in 2015, which incremented $11M from last year’s forfeiture of $66M. In 2015, Sotheby’s gross margins narrowed from 47.25% to 43.72% compared to the same period last year, operating (EBITDA) margins now 27.19% from 30.75%.2 Narrowing of operating margins contributed to decline in earnings. As of today, Sotheby’s EBITDA margin keep falling, since on Friday 10th, the company’s EBITDA was of 14.58. This position had seriously affected Sotheby’s BID stock, which has crashed 54% over the past twelve months. Consequently, Sotheby’s current credit rating is at risk. That is to say, if Sotheby’s corporate credit rating from Standard & Poor Rating Services is downgraded to “BB-”, “B” or “B+”, the revolving credit line might be recalled and the auction house may be facing insolvency problems too frightening to even mention.
In addition to the current long-term debt of $603 million, Sotheby’s 25-year-mortgage originally had an initial annual rate of 5.6% has now increased to 10.6%. In fact, the possibility of relocating the business’ headquarters was presented at the New York Times in June of 2013. According to the New York Post, Sotheby's has retained Peter Riguardi of commercial real estate company JLL to help it search for a new location, possibly in the Hudson Yards development on Manhattan's far west side.
In what may be a "coup d’grace", a private, Singapore-based investment group called Shanda has just announced its ownership stake in Sotheby’s. Shanda originated as an online gaming company and is run by co-founders Tianqiao Chen and Chrissy Qian Qian Luo. They currently own two percent of Sotheby’s shares and could increase their stake to as much as 10 percent, raising the possibility that Sotheby’s could be acquired or taken private. According to Forbes, Chen, a self-made millionaire was a pioneer in China’s online game industry a decade ago and holds a Bachelor of Arts from Fudan University. As a collector himself, Tianqiao Chen might be acquiring prestige through the auction house’s purchase. In case you have not recalled this situation, the name Alfred Taubman might sound as a déjà vu. That is to say, Alfred Taubman took over the auction house in 1983, after he was object of ill treatment at Sotheby’s before he bought the business.8Would Chen’s money be just a tantrum or a fuel of fresh energy that Sotheby’s urgently needs? Let us hope that China’s 10th richest man truly understands the situation he is getting into." - source Artemundi - "Sotheby's with one step closer to the grave"
Maybe Bank of America Merrill Lynch analysts and their loan officers aren't afraid of the "Noise of Art" but, when it comes to our assesment of the situation, increasing leverage and "vendor financing" is not a long term "good recipe". The credit facility due in 2020 is $541.5 million. If indeed the credit facility get recalled, it might be "game over" for this business founded in 1744.

Furthermore, there is an ongoing assymmetry in the art market particularly in contemporary art where only a few names are dominating sales as well as the auctions. This assummetry is well described in ArtAscent article from the 1st of February 2016 entitled "Market trends and reality: two examples":
"At a sale on March 7, 2014, Koons’ ceramic Balloon Dog (Red), number 131 of an edition of 2,300, sold for $22,500. This appears to be a good return on an investment held by the collector for 18 years. If one considers the transaction in a little more detail, the return on investment is not all that it might seem at first glance. The process of calculating a return on investment is a little complicated, but it is well worth understanding how it is done.
First the sale price must be discounted by the 25 percent buyer’s premium retained by the auction house. In this case of Koons’ Balloon Dog (Red), it was 25 percent of $22,500. So from the transaction, the seller’s account was credited with $18,000. From this was deducted the auction house seller’s premium or commission of 20 percent. Thus, the seller pocketed $14,400 from the sale. In calculating the return on investment we need to know the cost base or book value of the work. This is particularly difficult as commercial galleries are notoriously tight-lipped on sale prices. It is possible that the owner of the single piece from the large edition of Koons’ Balloon Dog (Red) acquired it for something in the range of $2,000. The return on the 18-year investment ($14,400 – $2,000) may have been around 34 percent per annum. But, there is another way of looking at this. If we put $14,400 actual return from the sale into a calculator at, we find that this sum equals $9,499 in 1996 dollars. Over 18 years, the real/uninflated annual rate of return for this investment, was about 26 percent. Koons’ Balloon Dog (Red) was a very good investment no matter how it is calculated, but not as stunning as it may first appear.
Only a few lucky investors had the foresight – or available cash – a couple of decades ago to invest in a work by Jeff Koons or one of his colleagues who now happen to top the art index. It is a question of predicting future demand for the works or a particular artist.
Currently, 68 percent of contemporary works sell at auction for under $7,000. They are not the works of so-called “market leaders.” Consider a single work, chosen more or less at random, as an example – a 10-inch X 96-inch oil on canvas, Lamay Bridge, (1987) by the American artist Woody Gwyn (b. 1944). In February 2010, it sold at auction in San Francisco from the collection of a law firm, fetching $4,575. Subtracting the 25 percent buyer’s premium, the return to the seller was $3,432. Because this work was part of a large consignment by the law firm, the auction house seller’s commission was probably discounted to around 10 percent. The law firm likely received in the vicinity of $3,089 from the sale of this work that was originally acquired in 1987 from a Santa Fe gallery. The price at the time might have been about $500. The difference between the book value of the artwork and the return from its sale ($3,089 – $500) shows a $2,589 capital gain. The annual rate of return on investment was in the range of 23 percent. But, when we put the $3,089 return from the sale of the work into an inflation calculator, this sum is equivalent to $1,609 in 1987 dollars. Subtract the cost of acquiring the work originally and the uninflated gains from the purchase are $1,109, or ($1,109/22 years) $50 per annum or 10 percent.
These two examples show the differences in return on investment. If a collector with a small budget is lucky – or clever enough – to acquire a work by an emerging artist who eventually rises to the top of the market, the rewards can be substantial. This applies equally to investment in works by skilled artists who do not achieve a mega-star status. In both cases, the risk must be considered in relation to a best guess at future demand and the potential rate of return.
The good news must be tempered with an important warning. All the statistics on which art market trends are calculated are based on actual public sales. No one reports on the huge number of works that are put up for auction and fail to find a buyer. Depending on the prevailing economic conditions it is not unknown, for as many as half the works in a sale to be bought in or remain unsold.
In the art market, statistical trends are an imperfect guide at best. They are not of much use in helping an art investor determine risk. In the case of the acquisition of art for investment purposes, the eye is invariably mightier than the math. Even if capital gains are not forthcoming, a well-chosen work will delight the owner. There is no way to put a monetary value on this, so it’s not subject to the vagaries of statistical analysis." - source ArtAscent, 1st of February 2016
Furthermore there is even more distortion in the auction process particularly with Sotheby's not only engaging in "vendor financing" but, as well paying some buyers to bid on its artwork as reported by Bloomberg by Katya Kazakina on the 10th of June in her article entitled "Sotheby’s Is Paying Buyers to Bid on Its Artwork":
"Sotheby’s was in a bind. The auction house had won several top consignments for its bellwether spring auction, including a Jean-Michel Basquiat that sold for $7.4 million four years ago, by guaranteeing the sellers minimum prices.
But as volatile financial markets sent jitters through the art world, Sotheby’s faced the prospect of owning the work if it failed to sell. In the weeks leading up to its May 11 auction, the company began pitching a new perk to potential buyers: a fixed fee to those who agree, before the auction even starts, to make at least a minimum bid. The new incentive helped Sotheby’s find buyers for guaranteed pieces.
Sotheby’s is joining Christie’s in offering the fees to buyers, whose private deals sometimes undercut the notion of a public auction market. Sotheby’s previously resisted the incentive on concerns it would reduce profit and price transparency. The auction house’s change of heart comes after new Chief Executive Officer Tad Smith reshuffled the ranks of managers and specialists and brought in a former top Christie’s executive. The company’s shares have lost about a third of their value in the past year.
Sotheby’s change “makes them more competitive on the financial side with Christie’s,” said Thomas C. Danziger, a partner in Danziger, Danziger & Muro LLP. “In the current climate, every advantage that you can have helps the bottom line. Stupid money is not flowing in the ways it might have 12 to 18 months ago.” Sotheby’s declined to comment for this story.

The new perk in Sotheby’s arsenal of incentives, disclosed in catalogs in April, sweetens the deal for investors who agree to step in as buyers of last resort. In the past, so-called irrevocable bidders were compensated with a part of the auction house’s sales commission only if another buyer purchased the artwork that they had backed. Now, by opting for a fixed fee, they are guaranteed a payout and can get the artwork effectively at discount.
‘Onion Gum’
The new approach reduces the risk that Sotheby’s ends up with too much artwork in its inventory -- a concern particularly in a slowing market. But as the May 11 auction showed, the company can still lose money.
“Onion Gum” was one of four works in that sale consigned by hedge fund manager Daniel Sundheim. Sotheby’s gave him undisclosed guaranteed prices for the paintings, and in the weeks before the auction, it lined up irrevocable bidders for the four pieces.
The Basquiat sold for $6.6 million, net of the fee paid to the mystery buyer, who was the only bidder. That was less than the guarantee to Sundheim, according to a person familiar with the matter, leaving Sotheby’s with a loss on the painting.
Transparency Concerns
Sotheby’s lists the price net of fees paid to such buyers, making it possible to estimate the fee that the company doesn’t disclose. The buyer of the Basquiat work received $258,000, based on Sotheby’s standard sales commission.
The company argues this form of disclosure is more transparent, because the fee paid to the irrevocable bidder works like a discount. Christie’s does not adjust for such fees in its reporting of final prices.
Christie’s declined to comment. The fees are “a separate transaction to the sale, reflecting the risk the third party has taken in relation to the minimum price guarantee,” the company says on its website.
Sotheby’s is offering the new incentive to investors after it took a loss on a $509 million guarantee on the collection of its former chairman A. Alfred Taubman and had to take possession of $33 million of unsold artworks last year.
Like ‘Steroids’
Auction guarantees have proliferated since the financial crisis, covering half of the $2.1 billion of art in November’s semi-annual auctions in New York. Since then, the number of guarantees at Sotheby’s and Christie’s has fallen as the market slowed. Art adviser Todd Levin says guarantees act like "steroids" in the market by presetting bids often at artificially high levels.
David Nash, a co-owner of Mitchell-Innes & Nash gallery in New York, says irrevocable bids are part of financial machinations that distort the art market. When highly valued works with prearranged bids come up for auction, in many cases there is no genuine bidding and they are bought by the guarantors, he said.
That’s what happened with Roy Lichtenstein’s "Nurse," which was purchased in November at Christie’s for $95.4 million -- an auction record for the artist that was 70 percent higher than the previous high two years earlier.
“It’s a sale agreed in private to take place in public and pretend it’s an auction,” said Nash." - source Bloomberg.
So if you think that only central banks are "manipulating" markets, think again. Having "auctions" rigged through this "new process" makes us indeed afraid of the "Noise of Art". We disagree with Bloomberg in the sense is that this new approach in no way reduces the risk that Sotheby’s ends up with too much artwork in its inventory - a concern particularly in a slowing market. On the contrary "rising leverage", "rising inventory levels", "rising vendor financing" in conjunction with this new process makes us even more worry of the consequences in a market where volumes have been falling significantly. Whereas it is difficult to "time" the consequences of "easy money" and "market manipulations" (even in the art market), we do not think it is different this time and the weaker credit rating of Sotheby's make us wonder if now the time is not right to start thinking again about shorting both the bond and the stock in the near future...

This brings us to the second point of our conversation, namely that not only the art market risk facing a "soft patch" but "classic cars" who have enjoyed "stellar returns" for the savy and wealthy investors are beginning to show sign of slow down and price revisions.

  • Macro and Credit  - Classic cars? Downshifting...
While active use of engine braking (shifting into a lower gear) is advantageous when it is necessary to control speed while driving down very steep and long slopes, the latest slope of the US economy in particular and the global economy in general makes us wonder if indeed the "down trend" is not your friend. 

For the last couple of months we have made an interesting, yet entertaining exercise of building up a "virtual garage" made up of "classic cars" of interest and monitored on an ongoing basis their valuation by using the website "". What we have noticed since we added a few cars since April in our "virtual garage" is some interesting price revisions taking place. For instance, one of the most recent car added to our garage was a Ferrari 250 GT Lusso which we parked on June 7th, to the price of: 1,712,000 EUR seeing the car's price today coming down to 1,689,000 EUR. Another interesting price revision on a downtrend was for an Aston Martin DB6 which we parked on April 17, 2016 at the price of 415,000 EUR and which is now being offered at 365,000 EUR. Some of the most striking price revisions were for some more recent Ferraris we must admit such as a restored Ferrari 330 GT 2+2 we parked on April 5 at the price of 339,000 EUR which is now being offered at 239,000 EUR. There was as well a 1971 Ferrari Dino GT4 246 GT SERIE M parked also on April 5, 2016 at a price of 490,000 EUR, now offered at a revised price of 399,000 EUR. Rarities such as 1955 Mercedes-Benz 300 SL Coupé Gullwing are still commanding an impressive 1,600,000 EUR price tag and are yet to show any price revisions at the moment.

While it is difficult to come to any clear conclusion from such a small sample, the website "Hagerty" enables us to have a broader and clearer picture of the downward trend for classic cars in the US. The Hagerty Market Rating uses a weighted algorithm to calculate the strength of the North American collector car market. The Hagerty Market Rating is expressed as a closed 0-100 number with a corresponding open ended index (like the DJIA or NASDAQ Composite). The Hagerty Market Rating measures the current status of the collector car market in terms of activity or “heat”; directional momentum; and the underlying strength of the market:
"How it Works:
Each individual component of the Hagerty Market Rating is comprised of a number of individual measures, with each measure being scored on a scale of 0-100. Each component’s individual measures are combined into a “weighted average” based on how indicative the measure is of market status, which results in the overall score for each component of the Hagerty Market Rating. Like the rating for the individual components, the overall Hagerty Market Rating is a weighted average of the eight components’ individual scores, with those measures that are a more correlative of the market’s status treated with more preference in the algorithm.
Therefore, in order to calculate the overall Hagerty Market Rating, each component’s score must be calculated, which in turn requires that each individual measure’s 0-100 score must first be determined. To do this, we calculate each measure’s current performance against its historic performance. Scores for any measures that are based on dollar amounts are calculated using inflation-adjusted values relative to 2014 dollars. The resulting scores are then combined according to their predetermined relative weights for a final number.
For all measures, components, and the overall Hagerty Market Rating, a “bell curve” type distribution is expected, with 0 falling on the far left, 100 falling on the far right, and 50 landing at the curve’s peak. Because of this, the rating is more fluid in 40-60 range, and much more difficult to move at the rating’s extremes." - source Hagerty
Right now the reading for June 2016 according to Hagerty is down to 69.01:

  • Following a very slight increase last month, the Hagerty Market Rating is down to 69.01 for June.
  • While last month marked the largest increase of 2016 in the auction channel, auction activity instead saw its largest decrease so far this year for June and is currently at a 33-month low.
  • Private sales activity fell for the third consecutive month. Over the last 12 months, the average private sale price has fallen 10 percent and the percent of vehicles selling for above their insured values has fallen 1.4 percent.
  • Requests for insured value increases for braod market vehicles declined for the ninth consecutive month.
  • Requests for insured value increases for high-end vehicles fell for the second consecutive month and are at a 15-month low.
  • Correlated instruments saw an increase for the second time this year, as the price of gold per ounce fell and the S&P 500 passed 2,100 forthe first time since November 2015.
  • May's reported rating was revised from 69.35 to 69.17 due to newly released inflation numbers." - source Hagerty
What we find of great interest is the "Cantillon effect" and the significant rise in price appreciation for classic cars which can be directly link we think to our central bankers generosity and their "dear wealth" effect and balance sheet expansion. In similar fashion it had an impact in art prices and equities indices we think:
"The Hagerty Market Index is an inflation adjusted open ended index (similar to the DJIA or NASDAQ Composite) based on change in dollars and volume of the market. 
- source Hagerty

The all-time high was reached in September 2015 whereas the Dow Jones Industrial Average reached an all time high of 18312.39 in May of 2015.

On a continuation to our "little" personal entertaining exercise we did notice on Hagerty that the hottest part of the market in the US namely classic Ferraris is experiencing a slowdown:
"The Hagerty Price Guide Index of Ferraris is a stock market style index that averages the values of 13 of the most sought after street Ferraris of the 1950s-70s. The graph below shows this index’s average value over the past five years. Values are for #2 condition, or “excellent” cars.

As the top of the market moves, so moves the Hagerty Ferrari Index. This group of cars performed similarly to the Blue Chip Index in that it recorded its first drop since September 2009 and in that the drop was also a nominal 1% slip. None of the index’s 13 component cars increased in value—the first time since May 2009 that this has happened—which is remarkable considering Ferrari has hands down been the hottest part of the market for half a decade.
In particular, softness was exhibited for some of the biggest movers of the past two years, as these models find new footing following a rapid run up. The Lusso dropped by 9%, the 275 GTB/4 fell by 8%, and the Daytona Spyder lost 9%. Over the past 12 months the 330 GTC is the loss leader with a 10% decline in value.
This may be bad news for anyone who bought a car in the last 6 months expecting to sell for a quick return, but will likely be of little concern to an end user. Looking through a longer lens, the most sluggish of the bunch over the past three years—the Dino—has still gained more than 50% in value and it is unlikely to retreat back to pre-2013 numbers. -Brian Rabold, May 2016" - source Hagerty
Could the Dino retreat back to pre-2013? Us not suffering from "Optimism bias" and being as you know by now "contrarians" would beg to differ. So overall, not only are we afraid of the "Noise of Art" but we are also very wary of what the "Ferrari index" has been doing as of late.

  • Final chart: Classic cars have been "turbocharged" 
Our wariness of the latest trend in "classic cars" and the recent slowdown warrants close monitoring we think from an "alternative" macro perspective. The chart below comes from the latest Knight Frank Classic car special Luxury Investment Index review for Q1 2016 and clearly index the significant performance reached overall by classic cars:
Classic Car performances relative to other "tangible asset classes":

"Classic cars were once again the top performing luxury asset on an annual basis, according to the latest figures from the Knight Frank Luxury Investment Index (KFLII).
While the overall value of KFLII increased by just 5% in the 12 months to the end of March 2016 – the lowest annual increase since the first quarter of 2010 – cars outperformed with a 17% surge.
Wine saw the second strongest growth, up 9%, with coins in third position, rising 6%. Art and furniture were the biggest losers, dropping by 5% and 6%, respectively." - source Knight Frank
To quote one of the recurrent themes of our friends at Gavekal research, it has “never been so expensive to be rich” particularly if you want to snap up a classic Ferrari it seems. Kudos to our central bankers and their obsession with the "wealth effect":
"As most of our readers will know, modern art, fine wines, & horses, are assets that tend to peak just before the start of a pronounced downturn of the economic cycle. And interestingly, over the past couple of months, these assets have really been shooting up, breaking several records on the way" - source Gavekal, July 20th 2006.
History does indeed rhyme and we must confide that at this stage of the "credit cycle", we are afraid of the Noise of Art given back in 2006 our Gavekal friends indicated the following:
 "Usually, the last thing to go up in prices are rare automobiles" - source Gavekal Five corners, July 20th 2006.
This time it's different? We don't think so.

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

Monday, 27 June 2016

Macro and Credit - Optimism bias

"The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails." -  William Arthur Ward, American writer
While looking at the numerous "sucker punches" delivered on Friday due to the "Brexit" results, we reminded ourselves for our title analogy for a subject we already touched back in January 2012, namely the "Optimism bias" which we touched in our conversation "Bayesian thoughts". Following the dismay of so many of our friends relating to the outcome and as well to both markets and bookmakers being all wrong at the same time, we reminded our friends and ourselves the following on this occasion:
"Brexit analysis simply explained: « Optimism bias »: One of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics. Many tend to overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, many underrate our chances of getting divorced, being in a car accident, or suffering from disease and overestimate probability on extreme long-shots such as winning the lottery." - source Macronomics
Last week, when it came to assessing the potential outcome for the much dreaded referendum we also indicated the following:
"For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe..." - source Macronomics, June 2016
While assisting in Paris to the "Brexit conference" set up by our friends at Saxo Bank, one of the members of the audience during the Q&A session pointed out the "accuracy" of the bookmakers for the remain to "prevail". We could not resist but intervene to rebuke that statement by using as an illustration how bookmakers got it so wrong when offering 5000/1 odds at the beginning of the season for FC Leicester to clinch the British football Premier League and still having the odds at 500/1 around October. The biggest liabilities for the bookmakers were accrued at around 100-1 to 500-1. To quote Mike Tyson: "Everyone has a plan 'till they get punched in the mouth". Since that "FC Leicester punch" the longest odds that can now be placed on any event will be 1,000-1 to ensure that the betting company Ladbrokes is less exposed in future to 'black swan' events. We reminded also the Saxo crowd the Nash equilibrium concept, us playing on this occasion the "Devil's advocate". In fact not a single time did the bookmakers anticipated a victory for "Brexit" yet another display of the "Optimism bias" as displayed in the below chart from the following The Telegraph article "Why the 'experts' failed yet again to call which way Britons would vote" from the 25th of June:
- source The Telegraph

Parsing through the markets various "reactions" on Friday akin to a "deer caught in the headlights" kind of moment, us being contrarians, we were ready for the "sucker punch" on our "gold miners" exposure (which we have been advocating for a while for those who follow us...). It looks like indeed our "pessimism bias" was this time around the "lucky approach". But at this juncture dear readers before we go into the "nitty gritty" of this week's conversations, we think it is is important for us to "illustrate" our core philosophy which we have nurtured in recent years by asking a simple question: Why people get lured into making inaccurate conclusions?

What affect one’s judgment in today’s world markets one might rightly ask?

We think the below four points resume our core contrarian "philosophy":
  1. « Herd mentality »: People are influenced by their peers to adopt certain behaviors, follow trends, and/or purchase items. Examples of the herd mentality include stock market trends and fashion.
  2. « Information cascade »: One of the topics of behavioral economics often seen in financial markets where they can feed speculation and create cumulative and excessive price moves, either for the whole market (market bubble...) or a specific asset, like a stock that becomes overly popular among investors.
  3. « Dunning-Kruger effect »: a cognitive bias in which unskilled and inexperienced individuals suffer from illusory superiority, mistakenly rating their ability much higher than average. 
  4. « Optimism bias »: One of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics. Many tend to overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, many underrate our chances of getting divorced, being in a car accident, or suffering from disease and overestimate probability on extreme long-shots such as winning the lottery.
Of course Friday's shock result was clearly illustrated by the last point, hence our title analogy given we have already used as title analogies most of the above points in previous musings. Therefore, challenging  the “consensus” is like betting in a race horse on the outsider – the returns, if achieved, will be significantly higher.

For instance we have told you before that Government bonds were always correlated to nominal GDP growth, regardless if one looks at it using "old GDP data" or "new GDP data". So, if indeed GDP growth continues to be weak, then one should not expect yields to rise anytime soon. As a matter of fact in January 2014 we recommended and bought very long duration exposure on US Government bonds using PIMCO ETF ZROZ when nearly all « experts » were calling for higher US yields by the end of 2014. Very few such as us, Dr Lacy Hunt and Jeff Gundlach called it differently. The ETF ZROZ finished the year 2014 as the best performing ETF in the Fixed Income space, gaining more than 44% in US dollar terms but that's another story...

While everyone is still reeling on the "Black Swan" outcome from the Brexit vote, we watched with interested US Durable-Goods Orders cratering further by 2.2% in May (vs. -0.5% expected). Not only U.S. firms are already cutting back on their capital expenditures but we would also expect going forward weaker Nonfarm payrolls, neutering in effect the "recovery" story and stopping in its tracks the hiking process of the Fed which is reinforcing even more our appetite for US long duration exposure and of course validating our gold miners exposure.

In this week's conversation we will look focus on the productivity puzzle and its impact on economic growth leading to the on-going "secular stagnation", we will as well look at additional pointers on deterioration of credit metrics and why the trend in medium term is not your friend.


  • Macro and Credit - Secular stagnation? It's the productivity stupid!
  • Macro and Credit  - Our "pessimism bias" make us continue to prefer the safety of US High Grade
  • Final chart: Global Non-Financial Corporate Debt to GDP is "off the charts"
  • Macro and Credit - Secular stagnation? It's the productivity stupid!
On numerous occasions on this very blog we have pointed out our lack of "optimism  bias" towards the much vaunted "recovery story" being sold mostly by pundits due to the lack of "wage growth" as indicated in our conversation  "Perpetual Motion" from July 2014. We argued that real wage growth was indeed the "most important" piece of the puzzle the Fed has so far been struggling to "generate":
"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014
But, there is more to it when it comes to the theory of "secular stagnation" and this has all to do with the lack of "productivity" it seems. On that very subject we read with interest Bank of America Merrill Lynch's take from their Global Economic Weekly note from the 3rd of June entitled "The global productivity puzzle":
"The global productivity puzzle 
Labor productivity growth has slowed significantly across developed markets over the past half-century; it currently is at record-low levels.
Weak total factor productivity (TFP) growth is the main reason; low capital investment or declining labor quality only account for a small portion of the slowdown on average.
There are many potential explanations for weak productivity but much of the decline remains a puzzle, with no clear policy offset.
Pronounced, and potentially persistent 
Growth in most developed markets (DM) has been disappointingly slow, while emerging markets have seen their growth rates decelerate each of the past five years. Many observers have gradually come to the conclusion that the supply side of the global economy appears to have been damaged — perhaps permanently. The clearest evidence of this phenomenon is the sharp reduction in labor productivity — total output divided by total hours of labor input — in most developed markets (and many emerging markets) over the past several years. In fact, DM labor productivity has converged to historically low, sub-1% growth rates (see Chart 1 and Chart 2 for G10 country data). More significantly, the decline appears to have begun  before the global financial crisis hit.
These two observations have important implications. First, it strongly suggests that common global factors may be responsible for the worldwide decline in productivity growth. Second, the global financial crisis is unlikely to be the main, let alone the only, explanation — although persistent spill-overs or hysteresis (cyclical shortfalls that become structural) from the crisis may be playing some role in holding back the supply side globally. Indeed, one of the troubling aspects of this analysis is that the causes of the productivity slowdown remain elusive, despite a myriad of potential interpretations.
Notably, some of these are much more persistent than others, and some are more amenable to policy fixes. Together, these imply the global economy isn’t doomed to low productivity forever, but it could drag on for quite some time.
Lower everywhere you look 
The simplest and most direct measure of productivity is output divided by hours worked. The more output that can be produced with a given amount of labor input, the more productive each hour of labor is. Conversely, if hours are growing faster than output, labor productivity must be slowing down. Such slowing has been a common occurrence over the past few decades among developed economies (and more recently among emerging markets). Chart 1 plots a smoothed measure of labor productivity growth (estimated by locally weighted regressions) for each of the G4 economies since 1951. All are appreciably lower during the last 5 to 10 years than at any time in the prior 55 to 60 years. Chart 2 is a similar plot for several other European economies. 
In the US, productivity growth slowed notably in the 1973-1995 period, then accelerated for about a decade before slowing down more significantly from around 2004 until today. Japan and Germany had notably higher labor productivity growth in the aftermath of the Second World War but recently have converged toward US levels. Britain started slower but its labor productivity surpassed the US pace from the late 1960s until around 2000, before diving below zero recently. Chart 2 shows a similar pattern for other DM economies, with labor productivity growth generally peaking at some point in the 1960s and declining ever since; Sweden and Switzerland experienced some stability in the 1990s and early 2000s before declining further. Like the UK, Italy’s measured labor productivity has turned negative on average recently.
Accounting for the growth slowdown 
A capital concern 
To understand the factors that have slowed productivity growth, economists often engage in “growth accounting.” One way to increase labor productivity is to give workers more or better capital (tools, equipment, computers, etc.) to work with — so called “capital deepening.” As investment spending has been weak in the post-crisis period, that seems like an obvious place to look for an explanation for the slowdown in labor productivity. Chart 3 illustrates how much a decline in capital deepening has impacted labor productivity growth across the eleven G10 DM economies. Note that due to data limitations, we analyze annual data from 1994 to 2014.

All eleven economies experienced a decline in productivity growth in the 2005-2014 period relative to the prior decade, by nearly 1.1pp on average. And, in most of them, the contribution from capital deepening (the sum of the orange and green bars) declined as well — but only by less than 0.3pp on average. Japan experienced the largest decline (60% of the fall in labor productivity growth can be attributed to less capital deepening), followed by the UK and the US (although only about 40% of the productivity slowdown); in Canada capital deepening actually grew slightly. All told, only a relatively small proportion — about 25% — of the slowdown across DM in labor productivity growth over the past two decades is due to slower growth in the amount of capital per worker.
A related hypothesis is that investment in information and communication technology (ICT) capital boosted labor productivity in the late 1990s and early 2000s, but that impact has since faded. Chart 3 also separates capital deepening into ICT (green) and non-ICT (orange) components. Some countries experienced measurable slowdowns in ICT capital deepening — most notably France, the Netherlands and the UK — while several others — Germany, Canada, Sweden and Belgium — actually saw a rise. Thus there is no systematic relationship between ICT investment and the decline in labor productivity among the G10 economies since the mid-1990s.
We don’t need no education? 
A second underlying factor that could change labor productivity would be changes in the quality of the labor force. A more skilled or educated labor force is likely to be more productive, all else equal. Chart 3 additionally contains estimates of “labor quality” from the Conference Board. Some analysts have speculated that more skilled workers are hired early in a recovery, and as it progresses the average skill level of newly hired workers goes down. That dynamic might help account for lower labor productivity recently versus a few years ago, but cannot readily explain the decadal differences in Chart 3. That said, with the exception of the UK, the decline over time has only shaved 0.1 to 0.2pp from labor productivity growth. Hence, changes in the composition of the labor force are not a significant factor for lower trend productivity." - source Bank of America Merrill Lynch.
What we find of interest on the above statement relating to "education" is clearly that the "student debt growing bubble" has not translated we think in an increase in the quality of the labor force. This can be seen on a monthly basis through the BLS data relating to employment components and education as per our below updated chart:
- source Macronomics / BLS - June 2016 update

So, you will excuse our "pessimism bias" because when it comes to "student loans debt", it's "much ado about nothing" in our book hence our lack of belief in education translating in "productivity labor growth". It hasn't happen and will not happen.

When it comes to explaining the "productivity" conundrum, in their note Bank of America Merrill Lynch try to put forward several possible explanations on the subject:
"Residual issues 
The part of labor productivity growth that cannot be explained by factor inputs (as above) is called “total factor productivity” (TFP). Conceptually, TFP can take a variety of forms, including technical innovations, gains in efficiency of operations, management style changes, etc. Practically, TFP is also known as the “Solow residual,” named after the prominent macroeconomist Robert Solow, the father of growth accounting. As the name implies, TFP is what is “left over” after other observable supply-side factors are accounted for. Significantly, the decline in measured TFP accounts for most of the decline in labor productivity for the DM countries in Chart 3. More generally, variation in TFP tends to account for most of the variation in labor productivity both over time and across countries. What has led to a decline in TFP is the key question.
There are a few big theories about why TFP growth has slowed over time across DM, listed in order from the most persistent — ie, the most likely to result in long-run low
TFP growth — to the least: 
No more “low-hanging fruit.” The big economic innovations have happened already according to this argument, and inventions today are simply not as significant as (say) electrification or penicillin or the internal combustion engine.
This is a structural story that has an “end of history” flavor to it: the internet is just a fancy telegraph; nothing transformative here. Growth will stay low in this view; better get used to it. 
Consumption over production. In this argument, innovation has shifted from supporting more efficient production to more intense consumption. Mobile phones, ubiquitous cellular service — these are used for casual gaming and sharing cat videos, rather than pushing out the production possibilities frontier. That doesn’t necessarily preclude a more productive use down the road. But to the extent this too is a structural shift, it likely means TFP growth remains lower for longer.
Diffusion dynamics. Important technological development is still happening; it just takes time for its effects to show up on the shop floor and in the data. Firms are still learning how to most effectively utilize mobile, cloud, sharing, etc, to raise TFP. Robotics, genetic engineering, the “internet of things” — these innovations will raise productivity (and with it trend growth) at some point in the future.  
Mismeasurement. Productivity growth  already is high, for all the reasons mentioned above — it just isn’t measured correctly. Output excludes many free services because they aren’t priced; significant quality improvements aren’t fully captured. In this view, the statistics will eventually catch up to reality. Meanwhile, in this view real output is higher and inflation lower than commonly reported. The future’s so bright, you’ve got to wear shades.
The first two more persistent slow growth stories may have some ring of truth, but history is littered with prior assertions that productivity growth had ended — only to be proven unduly pessimistic. However, if TFP is embedded in the capital stock and investment remains low, a self-reinforcing adverse feedback loop could arise: weak productivity creates few incentives to invest which perpetuates weak productivity. Indeed, there is a risk that such a feedback loop is already in place. The third explanation does have recent history on its side: the US (as well as some other DM economies) experienced a significant slowdown in TFP growth in the 1980s as the personal computer age began, but then saw more rapid growth from the mid-1990s until the mid-2000s as the returns to ICT investment were realized. Economic historians have found related evidence that the introduction of the steam engine into manufacturing did not materially improve productivity until the production processes were altered to better take advantage of this new invention. This diffusion process took several decades in that case. Something similar may be occurring with today’s latest technological innovations, such as mobile and cloud computing.
The mismeasurement story, on the other hand, has some optimistic appeal but is hard to reconcile with the data. A recent in-depth study finds evidence of mismeasurement of technological innovation, but this has not changed over the past few decades while,the share of such products in domestic production has declined thanks to offshoring. As a result, mismeasurement actually exacerbates the productivity slowdown rather than explains it. Meanwhile, the combination of low wage and price inflation suggests that weak demand is as much at play as weak supply. Strong productivity growth historically has produced strong real wage growth, yet real wages are generally depressed in DM." - source Bank of America Merrill Lynch
What we have seen with "the rise of the robots" and the very aggressive "cost cutting exercise since the Great Financial Crisis undertaken by many large corporations is that the productivity slowdown has indeed been exacerbated leading to non existing wage growth and depressed "real wages" à la Japan as discussed in our previous Macro and Credit conversation.

So what are the implications for policymakers around the world given the continued rising of populism? Bank of America Merrill Lynch in their note give us some sobering indications:
Implications for policy 
Weak productivity growth translates into weaker long-run economic growth, which means it is harder to grow out of budgetary shortfalls or debt burdens. Coupled with slowing population growth and declining worker-to-retiree ratios, it means more stress on social safety nets. For monetary policy, slower productivity growth will tend to mean output gaps close more quickly for any given pace of recovery, which will force central banks to normalize policy sooner or risk overshooting on consumer and/or asset prices. It also means a slow, drawn out recovery cannot be remedied merely with low rates and large-scale asset purchases.
Fiscal policy may be able to help jumpstart faster productivity growth by encouraging innovation through product and/or labor market reforms, but these take time and tend to be politically divisive. Investment in public infrastructure also may be supportive. Evidence strongly supports the idea that global competition via open trade boosts productivity. Unfortunately, around the world both the volume of trade, and the political support for promoting it, appears to be waning. This, too, could be an avoidable factor that is helping to push down productivity growth across countries. But without a clear diagnosis of the reasons for the decline in productivity, it is difficult to suggest a set of feasible policies to counteract it." - source Bank of America Merrill Lynch
Furthermore, for the "Optimists" crowd, we think that the weak productivity situation should not be taken lightly. This is clearly re-iterated in the most recent BIS annual report published in June:
"Less comforting is the longer-term context – a “risky trinity” of conditions: productivity growth that is unusually low, global debt levels that are historically high, and room for policy manoeuvre that is remarkably narrow. A key sign of these discomforting conditions is the persistence of exceptionally low interest rates, which have actually fallen further since last year." - source BIS, 86th Annual Report

In our book, "secular stagnation" is not only due to the burden of high global debt levels but, as well by the evident slowdown in productivity labor growth, which is clearly impacted by the "rise of the robots". This does not bode well for the stability of the "social fabric" and with rising populism in many parts of the world.

Back in November 2014 in our conversation "Chekhov's gun" we argued the following:
"Our take on QE in Europe can be summarized as follows:Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 
“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend." - source Macronomics, November 2014
Obviously our "Hopeful equation" suffered from "Optimism bias" and as we argued at the time:
"Our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015) " - source Macronomics, November 2014
Increasingly it looks to us that we are moving towards the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). That's our take and our "pessimism bias" for now.

When it comes to "asset allocation" in the current "risk-off" environment, we continue to like long duration high quality credit such as US High Grade. It benefits from the rally in the "Greenback" (US dollar) as well as higher yields than its European peers. More on this in our next bullet point.

  • Macro and Credit  - Our "pessimism bias" make us continue to prefer the safety of US High Grade
While we have long advocated going for "quality" and indicated that US Investment Grade credit was the only "game in town" particularly for Japanese investors, the current "risk-off" environment is favoring the safety of the US Dollar Index given today as we write our latest musing, we have seen the largest 2-day increase since 1992, a "cool" 5-sigma event. This is what you get with central banks meddling with asset prices for too long: rising positive correlations leading to significantly large standard deviation moves. This was highlighted in our "lenghty" but nonetheless must read February post on risk and VaR (Value at Risk) conversation "The disappearance of MS München".

What is currently being priced in the US government bond market contrary to the Fed's recent stance is more "easing" rather than "hiking" we think hence the relative safety and comfort in US Investment Grade credit from an allocation perspective. On this subject we agree with Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 24th of June entitled "European divorce":
"More monetary policy easing 
Behind today's plunge in global yields lies - in addition to lower global growth – the expectation that Brexit will prompt more monetary policy easing from global central banks. Included in this is that we now expect the Bank of England (BOE) to lower rates and start engaging in QE this summer. Brexit is also expected to dampen the Fed’s rate hiking cycle – case in point right now the Fed funds futures market is pricing in equal probabilities of a rate hike and a rate cut at the next FOMC meeting in July (12%).
However, clearly since foreign countries lead the decline in economic growth the net result is incrementally more dovishness abroad than in the US.
That explain why US yields remain high relative to European yields, even though the absolute level of US yields is coming down (Figure 9), which should continue to attract European buying of US corporate bonds.

Moreover, on the Japanese side US corporate bonds are now more than ever the only game in town. Specifically Japanese corporate yields are now 0.13% and the situation is not much better in 30-year JGBs yielding 0.15%. However, the yield on a fully currency hedged basis for a Japanese investor buying a 10-year US senior bank bond is 0.80%, or 5-6 times as high (Figure 10)

Corporate yields can decline 
A defining aspect of the big sell-off in the beginning of the year was the stability of corporate yields – hence as Treasury yields plummeted spreads blew out almost in the relation of one-to-one. That happened as both domestic and foreign investors stepped to the sidelines with the simultaneous decline in US yields and yields relative to foreign fixed income (Figure 9). However, because the weakness this time around is driven more by expected European weakness, as explained above, our market is not becoming less attractive to foreign investors. This means that, even though yield sensitive domestic investors may now become very defensive we should continue to attract significant foreign demand. We think that the Brexit surprise means that US corporate yields can now decline further – which is what we saw in today’s post-Brexit reaction – both in the USD and EUR markets. 
Credit outperforming on Brexit 
Given the low Brexit probability priced by the market by the end of Thursday the reaction on Friday was severe across most markets. In high grade credit, on the other hand, the move wider in spreads was rather underwhelming. In particular banks and some industrial spreads are actually tighter today following the actual vote for the “leave” camp than the wides reached last week in response to just the risk of Brexit.
Moreover, highlighting the strength in credit and unlike February, Friday’s widening in high grade credit spreads was less than the decline in rates, pushing corporate yields lower in both in the US and in Europe.
On Friday, following the results of the UK EU referendum, the Sterling was down 8.2% (a 15 standard deviation move for the period Jan 2010 to the present), European stocks sold off 8.6% and iTraxx Main closed 18bps wider. Naturally the shock spilled into US markets as well, pushing the yield on the 10-year Treasury down 19bps to 1.57% and stocks down 3.6% on the S&P 500, including 5.4% for the financial sector (Figure 1).
- source Bank of America Merrill Lynch
Having exposure to US High Grade Credit in this on-going "Japanification" process can indeed dampen the volatility experienced in various asset classes, while US credit still boast more favorable carry thanks to higher yield and roll-down compared to European credit which has tightened even more dramatically thanks to ECB meddling with Corporate credit as of late. Furthermore US Investment Grade credit still benefit from favorable flows unlike equities and High Yield.

While we have been in recent months describing the slow deterioration in the credit cycle, "Brexit" or not being the catalyst for the recent bout of "sell-off", it was our belief in the US economy being weaker than expected that has enticed us again this year to play à la 2014 the long US duration play (partly once more via ETF ZROZ). We keep telling you that we are indeed in the last inning of the credit game and as per our last conversation we'd rather focus on the big picture being tighter financial conditions and deterioration in macro data rather than on the "political fallout" stemming from "Brexit". Once again like any behavioral psychologist, we tend to focus on the process rather than on the content. When it comes to advising you to reach for quality in 2016 credit wise, we also agree with Bank of America Merrill Lynch's High Yield team when it comes to assessing the credit picture. For instance, we read with interest their High Yield Wire note from the 20th of June entitled "Bifurcate or break: the investment conundrum of a rolling blackout":
"Laelaps and the Teumessian fox 
In Greek mythology the Teumessian fox’s great power was to always be able to escape its hunter. Laelaps the dog, on the other hand, charged with catching the fox, had an equally great power: to always catch its prey. And with such simplicity a great paradox was created: how can one who catches everything catch something that can never be caught? The answer? It can’t. In the case of Laelaps and the Teumessian fox, Zeus turned both into stone. We find great meaning in the story … what happens to an economy that can’t grow or generate inflation when it is met with a central bank that, although has made mistakes in the past, seems to always right the economy eventually? Like Zeus, who turned our main characters to stone, do the modern day fox and dog effectively become paralyzed in their current states of low growth and accommodation? And if so, what does this mean for markets?
We believe the credit cycle is currently in its latter innings as the growth process has arguably stalled if not begun to slip backwards. Although Draghi, Kuroda and Yellen are doing their best, monetary policy can only be as useful as fiscal policy allows. And although our belief is that eventually deteriorating corporate earnings will lead to layoffs, a collapse in consumer confidence and spending and ultimately a recession, we also believe that an increasingly compelling case can be made that in between bouts of volatility our rolling blackout scenario may become the norm for much longer than any of us can anticipate. Under such circumstances the most levered companies with the poorest earning potential, those disrupted by technological innovation, and issuers relying on constantly open capital markets would trade at distressed-type levels. Meanwhile, those companies with consistent capital market access, strong management structures and who are financially nimble effectively would trade at some liquidity premium and very little credit risk premium, likely becoming targets for IG M&A. Effectively, valuations in high yield could become even more binary than they are today: trading at distressed levels or like an investment grade credit with a bit of extra liquidity premium.
Under such a universe, we think the case can be made that bigger is not better. In fact, we would argue that smaller high yield, high quality corporates that are attractive M&A candidates for IG companies would be compelling vs. a large BB and high quality single B credit that has a massive balance sheet and is susceptible to shocks. For those who must play high yield, believe in our barbell strategy, and are looking for index-level yields and returns, own small-cap BBs (along with a cash position in treasuries) with smaller CCC risk in issuers that have “already realized” their event.
The bigger the tree the harder the fall 
With our view that bigger companies are susceptible to risks and shocks, and that default risk has the potential to be a constant presence — even if a subdued one — for a long period of time, we are often told that the market is safer today because it’s more a “real” market relative to pre-crisis. “Real”, often defined as a bigger universe of names, larger issuers, more recognizable brands and higher EBITDA is a term we would hesitate to use. And although there is no doubt that the high yield market today is not only larger than it has ever been (it has grown in size by 90% since 2008), we would challenge the assertion that the high yield market is any safer because of growth. We prefer to judge markets more on their “maturity” and would focus more on the increase in the base of investors, breadth of industries, as well as the degree of price transparency and liquidity than on size. Clearly the ability for capital markets to structure deals in difficult times is also crucial to defining credit market maturity and having investors up and down the capital structure is also important. When considering this definition, we find that today’s market is not significantly more “real” than it has been in the past. Although we do benefit from increased price transparency because of the documentation of TRACE activity, the high yield market today still shows a relatively small investor base and high concentration among the top 3 industries (table 2):
Mutual fund ownership peaked in 1998 and — absent a brief increase in 2012 — has been on a consistent decline ever since, allowing institutional funds to gain greater market share and concentrate ownership into the hands of a few large investors (Chart 2).
The same story holds true as it relates to sectors, where in today’s market Energy, Healthcare, and Telecom make up 37% of US HY by face value. This is not all that different from Telecom, Media, and Materials’ 42% representation in 2000 and suggests the lack of industry breadth present in today’s market. We do not deny that the development of TRACE in 2005 has led to significantly greater price transparency and was the harbinger of future technological developments, including our own Instinct® Loans e-platform that was recently launched. However, these financial innovations have been coupled with increased regulatory burdens and more balance sheet restrictions, and we have actually seen lower trading volumes (Chart 3) and little change in bid/ask spreads since 2008. In fact, some would argue TRACE has hurt liquidity, as the transparency into small transactions makes it difficult to execute larger transactions discreetly.
Additionally, we believe the ghosts of markets past coupled with indebtedness never before seen will likely cause financial burdens that are not fully appreciated. Our view is that central banks have effectively obfuscated the true health of the global corporate markets and absent a significant increase in growth — something we question accommodative policy’s ability to spark – this cycle is unlikely to look meaningfully different than past cycles when the business cycle ultimately turns. In fact, when coupled with the growth in commodity issuance in the post-crisis years, the lingering impact of 2006 and 2007’s LBOs and the lack of earnings power outside of just a few sectors, we argue that in real terms, the US high yield market today looks remarkably similar to how it looked like during the Clinton and Bush years.
This is in contrast to the view that more mature capital markets and larger companies will cushion the next cycle. In fact, we think we could make just the opposite case — that large serial issuers, fueled by cheap debt and poor organic earnings prospects will likely prove a problem when the cycle turns, as history suggests size is not a good determinant for defining credit or default risk. Additionally, the biggest high yield issuers are unlikely to spur any targeted M&A, sponsor or strategic deals just given their size and bloated balance sheets. To this end, high yield is no more a “real” market than it has ever been. Have some aspects matured? Yes. Do traditional size-based measures indicate a healthier investing landscape? No." - source Bank of America Merrill Lynch
While some might infer with their "Optimism bias" that eventually things will turn out alright, we beg to disagree, in this long credit cycle fueled boy over-zealous central bankers, we believe that when the cycle will turn in earnest with US slowly grinding towards recession, the default rate will be much larger and recoveries will of course be much lower. That's a given.

What makes us having this "Pessimism bias" you might rightly ask? How about our final chart below?

  • Final chart: Global Non-Financial Corporate Debt to GDP is "off the charts"
Our "Pessimism bias" stems from the very high leverage of the non-financial sector on a global scale and as pointed out before, a lot of Emerging Markets corporate debt has been issued is US dollar denominated, we believe this is a recipe for disaster as previously highlighted by the BIS as well as by our friends from Rcube. Our final chart comes from Deutsche Bank's Credit Bites note from the 8th of June entitled "A no excess cycle? Not true in corporates":
"Figure 1 looks at global non-financial corporate debt/GDP based on the BIS dataset and definitions. Whilst it’s not always easy to categorise debt into various buckets and whilst we have some issues with slightly different results across different data providers it’s fair to say that the BIS data is the best way of looking at the global debt picture. 

So non-financial debt has increased significantly in this cycle. On this measure the increase is of the magnitude of around $15 trillion since the lows after the financial crisis." - source Deutsche Bank

So in a world plagued by low productivity labor growth and high level of debt we wonder how some pundits can continue with their "Optimism bias". We'd rather stick to our "Pessimism bias and play the "minimax principle":
"A principle for decision-making by which, when presented with two various and conflicting strategies, one should, by the use of logic, determine and use the strategy that will minimize the maximum losses that could occur. This financial and business strategy strives to attain results that will cause the least amount of regret, should the strategy fail." - source
It is isn't a game of capital appreciation but it certainly becoming one of capital preservation we think...

"A pessimist is a man who tells the truth prematurely." -  Cyrano de Bergerac
Stay tuned!

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