Monday, 20 March 2017

Macro and Credit - The Swiss Wall

"When things are steep, remember to stay level-headed." - Horace

Looking at the consequences of a finally Dovish Fed leading to a significant rise in gold and gold miners, with a continuation of the rally in risky assets, given we have been vacationing in the French Alps, it reminded us, this time around for our title analogy about a steep and difficult piste in the Portes du Soleil ski area, on the border between France and Switzerland called Le Pas de Chavanette, also called the Swiss Wall. 

This particular slope is classified in the Swiss/French difficulty rating as orange, which means that it is rated as too difficult to fit in the standard classification of green (very easy), blue (easy), red (intermediate) and black (difficult). It has a length of 1 kilometre and a vertical drop of 331 metres, starting at 2,151 metres above sea level. In similar fashion, if indeed the Atlanta Fed's Q1 US GDP estimate is estimated at 0.9% and the Fed continues with its "normalization" process, while there are some early signs of credit slowing, then in similar fashion to those who have experienced skiing on the much dreaded Swiss Wall (like ourselves) will know that this particular "slope" or normalization process, can quickly become hazardous, to say the least. The scary Swiss Wall starts in a narrow pass on the mountain top with an inclination of 40 degrees. The initial 50 metres have to be skied or boarded by everyone taking Le Pas de Chavanette. Especially without fresh snow, the slope gets icy quickly, turning the area between moguls into ice sheets. Not making a turn in these situations means that you miss the next mogul, and pick up too much speed to make the next one after that, starting off a tumble that ends a couple of hundred metres down the slope, while hitting a few dozen icy bumps in the course. By having kept interest rates, too low for too long, and given the Fed's propensity of being often behind the curve (or the slope), means, when it comes to our chosen analogy that markets could potentially tumble, hence the defensive outflows seen as of late from High Yield where the punters (or skiers) are aware of the difficulties that lie ahead of them. In similar fashion, on the Swiss Wall, after the initial very steep stretch, the choice can be made, up until the rocky passage in the direct path, to escape to the less steep left hand side of the slope, where a stumble is less dangerous. The direct path down Le Pas de Chavanette, to the right hand side and down the rocky passage, should only be taken by very experienced skiers and riders who know how to handle moguls, as it is effectively a continuation of the first 50 metres. As the slope eases out, it is easier to negotiate the moguls and make a single run down to the end, although the inclination and bumps still call for significant dexterity and physical strength. It remains to be seen, which path the Fed will decided to take and how experienced skiers they are when it comes to take the very slippery slope of the interest rate normalization process. In similar fashion to skiers venturing on the Swiss Wall, wearing protective gear like a helmet and a back protector is highly recommended. Same things goes in these "inflated" markets we think.

In this week's conversation we would like to look at how global financial risks can be driving spreads, in conjunction with near term political risks.

  • Macro and Credit - Taking the Investment Grade path where a stumble is less dangerous
  • Final chart - USD likely to weaken given current position in historical tightening cycle

  • Macro and Credit - Taking the Investment Grade path where a stumble is less dangerous
While there has been a continuation in the performance of risky assets and in particular equities on the back of the Fed's rate hike and a somewhat more dovish tone, in terms of outflows, there has been a continuation of a defensive stance building up in credit, leading to a rotation from High Yield towards Investment Grade. We do remain short term "Keynesian" when it comes to credit and in particular Investment Grade, yet we are cautious on a longer time frame due to the leverage accumulated thanks to cheap credit which funded buybacks on a grand scale, weakening in the process corporates' balance sheets. In similar fashion to skiers on the Swiss Wall, as of late investors have chosen to take the less steep left hand side of the slope, where a stumble is less dangerous. This can be seen in fund flows as reported by Bank of America Merrill Lynch from their Follow the Flow note from the 17th of March 2017 entitled "Quality yield inflows as political risks near":
"Cautious flows 
Heading to the Dutch elections, investors preferred to look for quality yield. Inflows into high grade bonds strengthened considerably, while outflows hit HY funds particularly hard. Equity funds suffered light outflows, as equity investors wanted to be light heading to the Dutch elections. However, we feel that post the strong risk-on moves yesterday, part of these flows should reverse back to high yield and equity portfolios. 
Over the past week… 
High grade funds continued on the same positive trend of late for the eighth week in a row; and recorded an inflow as strong as the one a week ago. Monthly data reveal that February flows were the strongest in 6 months. High yield funds flow dipped into negative territory; making last week’s outflow the largest in 32 weeks. Looking into the domicile breakdown, among the European HY domiciled funds the ones that focus on US and European HY were the ones that recorded the vast majority of the outflows, while outflows from globally-focused funds were marginal. HY monthly flows remained positive for a third month in a row. 
Government bond funds flows remained on negative territory for another week, recording a sizable outflow, the largest in 12 weeks. Money market funds weekly flows remained positive for a second week. Overall, fixed income funds flows flipped back to negative after 11 weeks of inflows. However February data reveal that FI funds recorded the strongest inflow in six months. European equity funds flows flipped back to negative territory, recording relatively mild weekly outflows. Monthly flows remained relatively muted in February for a third month in a row for the asset class.

Global EM debt fund flows continued on a positive trend for a 7th week. The asset class has seen ~$14bn of inflows YTD. Commodities funds flows flipped back to positive. On the duration front, strong inflows continued in short-term IG funds for the 13th week in a row. Mid-term funds posted a small outflow, while flows in long-term funds flipped to a marginal positive figure after three weeks of notable outflows. " - source Bank of America Merrill Lynch
There has been definitely a scare in The Swiss Wall of investing when it comes to High Yield as reported by Bank of America Merrill Lynch in their High Yield Flow Report entitled "The outflows continue":
"Largest outflows from HY since Ukraine; 3rd largest ever 
US HY recorded a $4.06bn (-1.7%) net outflow last week, the largest since August 2014 and 3rd largest of all time. This brought the YTD total back into negative territory at - $3.3bn (-0.9%) through Wednesday. Whereas last week’s $2.8bn in redemptions were driven mostly by HY ETFs, open-ended funds bore the brunt of this session’s outflows with a $3.1bn (-1.6%) net loss. Similar to the aggregate high yield figure, this was the largest outflow from open-ended funds since the Ukrainian plane crash in the summer of 2014.

Although there has not been one cataclysmic event to cause the recent burst of outflows, they have likely been driven by a combination of higher rates, renewed fears over another dip in oil prices, and a fatigued rally that pointed towards a reluctance to continue investing in high yield. These withdrawals have pulled down returns in March, which currently stand at -1.4% through the 15th. Non-US HY also recorded a sizeable outflow totaling -$1.64bn (-0.6%) last week, their first period of net redemptions since November." - source Bank of America Merrill Lynch
If indeed investors (or skiers) have been on the cautious side prior to the FOMC rate hike decision, hence their rotation towards a more defensive position, we are awaiting to see if the Japanese investors crowd such as the gigantic GPIF and Lifers will come back to play with their foreign bonds allocations as they should be enticed by higher yielding US investment grade once more. What we also find of interest relating to our analogy is that investors and skiers alike, given the Fed's dovish tone, are encouraged by some sell-side pundits to take the right hand side and down the rocky passage of the Swiss Wall of investing namely in "equities". So far this year as indicated by Bank of America Merrill Lynch in their Fixed Income Weekly Strategy note from the 17th of March, this strategy has been vindicated:

 - source Bank of America Merill Lynch

Yet, from a valuation perspective and given current US valuation levels reached, from a skiing perspective and thanks to the Fed's dovish tone as of late, we would therefore rather go for EM equities if we had to make this choice down the slope of the Swiss Wall of investing. The bullish "skiing" stance down the Swiss Wall of investing is as well put forward by Bank of America Merrill Lynch in their Relative Value Strategist note from the 13th of March entitled "In the realm of diminishing returns":
"Don’t be a hero 
Despite the wobble in risk assets over the last week, credit indices are close to their post-crisis tights. And after the strong jobs report, we think the near-term path of spreads is likely to lead them further towards these lows, post-FOMC and the March CDX roll. That said, in our view credit as an asset class is now past its prime; at these valuations, we believe we are entering a realm of diminishing returns. In fact, as our analysis shows, returns in either direction aren’t likely to be large enough to warrant significant, outsized positions. In our view, if there ever was a time to step back, clip coupon, accumulate small gains and focus more on avoiding blow-ups, it is now. 
Great or not, the rotation is here 
If you’re bullish, we think the risk-return payoff in equities is far more compelling than in credit. In particular, we like being long S&P 500 vs. short in a HY cash index product (hedged for rates). Over the last 7y, in excess return terms, corporate bonds have failed to consistently generate returns that would overcome the losses during bad times. The upside vs. downside payoff looks far better in equities and CDX than in corporate bonds. Going forward, if the economy remains on this trajectory, the equity market is likely to continue outperforming credit. The prospect of higher rates is more favourable to equities, while in HY, negative convexity will likely cap any significant capital appreciation here on. On the downside, certain tax policy proposals which aren’t being priced in, namely borderadjustment tax and the elimination of interest-rate deductibility, are likely to have a significant negative impact on both equities and credit if implemented. Within credit, we think high yield companies are more susceptible than HG names and a short in HY cash is likely to provide a good offset to a SPX long from a policy risk perspective. 
Upside, downside, and in between 
For those looking for a credit long, medium/long term, we think CDX HY is a good candidate. While this may seem non-intuitive at first glance, we think technical issues with the index will continue to mean that it is often less volatile than either IG or its cash counterpart. Over the last 7y it has provided better risk-adjusted returns than either. For those bearish credit in the near-term (3-6m), we think it best to wait to set CDX shorts (IG or HY), at wider levels, just as the sell-off begins to gain momentum. Historically, shorts at current levels haven’t had a significant pay-off over 3m, despite wider spreads. Finally, we reiterate our preference for positive basis positions i.e. long CDX or synthetics over cash indices/bonds." - source Bank of America Merrill Lynch
We do agree with Bank of America Merrill Lynch, that, for bolder skiers, going for the synthetic option for playing High Yield makes sense first because of the liquidity factor provided by the index, second because of the lower duration factor compared to cash.

Of course, like any difficult slope, it can always get trickier on the ever changing Swiss Wall of investing. The rally can continue thanks to a dovish tone from the Fed which would be supportive of EM asset classes and put pressure on the crowded long US dollar positions. When it comes to credit, we do agree with Bank of America Merrill Lynch's take, that we are getting closer to the lower bounds of credit spread, even with the technical support of lower supply in the primary markets:
"In the realm of diminishing returns 
Credit spreads, unlike stock prices, have a lower bound (notwithstanding the recent spurt of negative spread bonds in Europe). We’re aware that we trot this statement out every now and then, as credit benchmarks approach previous tights, but it is a point worth bearing- the payoff in credit becomes more asymmetrical at tighter spread levels. Despite the wobble in risk assets over the last week, credit indices are close to their post-crisis tights, reached in June of 2014. And after the strong jobs report for February, the near-term path of spreads is likely to lead them further towards these lows. Over the coming weeks, we think there is potential for spread compression, post-FOMC and also into the March CDX roll. 
In last week’s HY Wire, we noted the similarities between now and the first half of 2014. Of course, back then geopolitics and oil prices poured cold water on the rally by the third quarter and that set the stage for high volatility and poor returns for the next two years. For this year too we think the second half has the potential to turn sour as disappointment with legislative progress in Congress starts weighing on the market. As we wrote last month, it seems as if all the good has already been priced in, with little to account for the bad. That said, it is difficult to pinpoint what will eventually make the market turn and more importantly, when. There’s also the possibility, that the underlying strength in the economy and confidence keeps risk assets buoyed for much longer
In our view what is perhaps more certain, is that credit is now past its prime; at these valuations, we think we are entering a realm of diminishing returns. In fact, as our analysis shows, returns in either direction aren’t likely to be large enough to warrant significant, outsized positions. This is well reflected in our HY returns forecast for the year – around 6% - and even better in our year ahead title – ‘Don’t be a hero’. If there ever was a time to step back, clip coupon, accumulate small gains and focus more on avoiding blow-ups, we think it is now. 
  • If you’re bullish, we think the risk-return payoff in equities is far more compelling than in credit – consider long S&P 500 vs. short in HY cash.
  • For those looking for a credit long, medium/long term, we think CDX HY is a good candidate. While this may seem non-intuitive at first glance, we think technical issues with the index will continue to mean that it is often less volatile than either IG or its cash counterpart. Over the last 7y it has provided better risk-adjusted returns than either.
  • For those bearish credit in the near-term (3-6m), we think it best to wait to set CDX shorts (IG or HY), at wider levels, just as the sell-off begins to gain momentum. Historically, shorts at current levels haven’t had a significant pay-off over 3m, despite wider spreads.
  • Finally, we reiterate our preference for positive basis positions i.e. long CDX or synthetics over cash indices/bonds." - source Bank of America Merrill Lynch
In our Swiss Wall of investing, when there is plenty of snow, the path downhill is easier on both side of the slope. But, as conditions changes and when the snow melts away at the end of the season, leading to some icy parts forming, not only it gets trickier even for the experienced skier like ourselves, but you need to chose your path more wisely according to the weather conditions. At this stage of the credit cycle, it becomes easier we think to stumble, no matter how experienced you think you are. What we have learned from both our investing experience and skiing the Swiss Wall is the need to stay humble and avoid being overconfident. From one day to the next, the Swiss Wall is never the same slope, this is why it makes it very challenging at this stage of the credit cycle. Even if Emerging Markets (EM) looks currently more enticing from an allocation perspective compared to Developed Markets (DM), as put forward by Bank of America Merrill Lynch in their EM Corporate Weekly note from the 14th of March 2017 entitled "Beware of fat tails", "Global financial risk" is the most important short term driver of spreads (icy patches):
"Global financial risk most important ST driver of spreads 
Ahead of the upcoming risk events (FOMC, Dutch & French Elections), we analyze past short-term drivers of EM credit spreads. Using a simple econometric model, we find that changes in UST yields, commodity prices, and global financial stress are able to explain more than half of the variation in credit spreads. Changes in BofAML’s Global Financial Stress Index (GFSI) are the most important driver (a one standard deviation increase in the GFSI is associated with +6 bps wider EMCB OAS). The second most important factor is changes in UST yields, followed by commodities. Our analysis also finds that these three factors can only explain 84 bps of spread tightening for our EMCB index since July 1st, compared to an actual tightening of 111 bps. This residual can likely be explained by technical factors which we do not explicitly include in our model. 
In Focus: quantifying the drivers behind spreads 
EM corporates are facing two different currents: on the one hand, technicals remain strong and credit fundamentals are improving on the back of higher commodities and GDP growth. On the other hand, valuations look expensive and a rise in external risks could lead to a re-pricing of credit spreads. In an attempt to quantify the historical impact of external factors on spreads, we run a simple multivariate linear regression model. We gathered weekly data from Jan 2012-Mar 2017 for our EM corporate indices as well as several external factors. Our baseline specification is the following:
Where UST5Y is the weekly bp change in 5Y UST yields, Commodities is the weekly percentage change in the S&P GSCI index, and GFSI is the weekly unit change in BofAML’s Global Financial Stress Index which is a measure of global cross-asset risk. 
Global financial risk biggest driver of spreads 
Results from our model suggest that BofAML’s GFSI index has the biggest impact on spreads: a three standard deviation weekly increase in the GFSI index is associated with spreads widening by 18 bps. EM HY is more correlated with changes in the GFSI than EM IG: a 3SD increase is associated with +36 bps of widening for EM HY vs. +12 bps for EM IG. LatAm is more correlated with the GFSI than other regions (Chart 3) with an est. spread widening of 25 bps given a 3SD move compared to +11 bps for Asia.

By sector Basic Materials and Real Estate are most correlated with the GFSI while Capital Goods are the least (Chart 4).
The last time the GFSI index rose by 3SD was February 12th 2016 (China and commodity selloff). Note that the GFSI has a correlation of 0.67 with the VIX. The latter did not show as much explanatory power in our regressions, which is why we prefer the GFSI. It is also a broader measure of risk appetite. 
Higher commodities associated with tighter spreads 
As expected, a 10% (4 SD) increase in commodity prices is associated with spreads tightening by 10 bps, holding other factors constant. EM HY is more sensitive to changes in commodities than EM IG, while LatAm is more sensitive than other regions given the larger share of commodity issuers (47%). On a sector basis, Energy, Basic Materials, and Transportation are most negatively correlated with commodity prices. 
EM HY has most negative correlation with UST yields 
In contrast to the positive correlation between the GFSI and spreads, changes in UST yields are negatively correlated with changes in spreads. A 50 bps (4.7 SD) weekly increase in 5Y UST yields is associated with OAS spreads tightening by 16 bps (beta of - 0.33), holding other factors constant (Chart 3). This implies that average yields would rise by 34 bps if 5Y UST yields rise by 50 bps. We also tested to see whether is a difference in the estimated beta depending on whether UST yields are rising or falling, but didn’t find any statistical significance. EM HY has a more negative beta than EM IG (-0.6 vs. -0.3) while Asia has the least negative beta across the regions (-0.2 vs. -0.4 for LatAm and EEMEA). On a sector basis, energy and consumer goods have the most negative beta, meaning spreads stand to tighten the most in a rising UST environment. 
Spreads have tightened more than predicted since July 
This regression also allows us to check whether the 111 bps tightening in EMCB spreads since July 1st 2016 is justified based on the actual changes in UST yields, commodity prices, and global financial stress. We find that the 103 bps increase in UST yields can explain 30 bps of the tightening in spreads, the 5% rise in commodities can explain 8 bps of tighter spreads, and lower financial stress can explain 46 bps of spread tightening. In total, our model calculates that EM spreads should have tightened by 84 bps since July 1st, implying that spreads overshot by 27 bps. However, the three variables in our model explain only 53% of the total variation in spreads, so it is possible that other factors which we don’t account for, such as technical factors or EM specific news account for the remaining spread tightening. High frequency data on technical factors are difficult to come across but we will explore this topic in future research." - source Bank of America Merrill Lynch
Now, if you remember our February 2016 conversation "The disappearance of MS München", we quoted Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis, when it comes to assessing warning signals that could weight on spreads:
"Depending on the type of crisis, there are different warning signals, such as significant current account imbalances (foreign debt crisis), inefficient currency pegs (currency crisis), excessive lending behavior (banking crisis), and a combination of excessive risk taking and asset price inflation (systemic financial crisis). A financial crisis is costly, as they are fiscal costs to restructure the financial system. There is also a tremendous loss from asset devaluation, and there can be a misallocation of resources, which in the end, depresses growth. A banking crisis is considered to be very costly compared with, for example, a currency crisis.We classify a credit crisis as something between a banking crisis and a systematic financial crisis. A credit crisis affects the banking system or arises in the financial system; the huge importance of credit risk for the functioning of the financial system as a whole bears also a systematic component. The trigger event is often an exogenous shock, while the pre-credit crisis situation is characterized by excessive lending, excessive leverage, excessive risk taking, and lax lending standardsSuch crises emerge in periods of very high expectations on economic development, which in turns boosts loan demand and leverage in the systemWhen an exogenous shock hits the market, it triggers an immediate repricing of the whole spectrum of credit-risky assets, increasing the funding costs of borrowers while causing an immense drop in the asset value of credit portfolios." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis - Macronomics, February 2016
In world where positive correlations have been rising as discussed in last year's conversation and where global economies are much more intertwined, we have noticed in recent years much larger standard deviation moves, which have had significant large impacts on a very short period of time in various asset classes. In fact what is of interest from the quoted EM report from Bank of America Merrill Lynch comes from the volatility of spreads and kurtosis:
- source Bank of America Merrill Lynch

In similar fashion to the Swiss Wall of investing, as we move towards the end of the credit cycle, kurtosis is showing up, meaning that bursts of volatility can be faster and shorter in terms of time frame as we saw in the first part of last year with the Energy sector and spreads blowing out initially, and outperforming in the second part of the year. We continue to be very wary of the second part of 2017 which could play out as the reverse of 2016, namely we could move from "good performance" to "bad performance". The rally so far this year for many asset classes has been significant.

One thing appears clear to us is that the dovish tone of the Fed might indeed be linked to the recent weakness we mentioned last week in Commercial & Industrial (C&I) lending:
"Given C&I loans are strongly related to what the "real" economy does, this warrants we think close monitoring in the coming months, to assess if it is only a short blip or if there is indeed something more sinister going on (slowing credit growth)." - source Macronomics, March 2017 
This "dovish" respite most likely explains the rebound in the Euro versus the crowded long US dollar and is providing an additional boost for EM asset classes in the process. Yet, we think the trend in C&I lending is worth following very closely. This is as well highlighted by Bank of America Merrill Lynch Credit Market Strategist note from the 17th of March entitled "HG sector outlook: long beta, leverage and inflows":
"Soft data is hard, hard data soft 
The Fed’s patience makes sense as hard economic data outside the labor market has been relatively soft. As we have highlighted (see: Situation Room: In wait and see mode 07 February 2017), loan demand has been soft recently – C&I lending for example has been flat since October while consumer loans on bank balance sheets have risen just 4% (Figure 36, Figure 37).

Clearly everybody is in wait and see mode pending details of actual fiscal policy expansion from the new administration – including especially tax reform. Until they deliver – and that is not a small task – it would be counterintuitive to see a marked hawkish shift at the Fed. In the meantime we remain bullish on high grade credit spreads." - source Bank of America Merrill Lynch.
We agree with the above, namely that before taking the more difficult path of the the Swiss Wall of investing with its normalization process, the Fed is clearly awaiting for more clarity from the new US administration. On a side note, we were quite surprised by the strong rally in gold/gold miners following the FOMC as we were expecting a more hawkish tone from the Fed on the back of ADP/NFP data releases.

From our continued contrarian position and Swiss Wall of investing perspective, we believe that the US dollar is likely to weaken further, contrary to the herd mentality, which has been taking a different path on this slope and a significant long position on the "greenback" as per our final chart below.

  • Final chart - USD likely to weaken given current position in historical tightening cycle
While the trade war rethoric seems to be still in play following the most recent G20 meeting, we still believe as per our early 2017 conversations that the path on the Swiss Wall of investing is lower, not higher in the current environment. This is as well highlighted in our final chart from Barclays note Thoughts for the Week Ahead entitled "The Fed says carry on":
"We expect further near-term USD weakness, concentrated primarily against high-yielding currencies. History suggests that this point in the Fed’s tightening cycle is typically followed by further near-term USD weakness, stable equity prices and lower 10y UST yields (Figure 1). 

Although low-yielding G10 and EM currencies will likely struggle to materially strengthen further against the USD, the drop in cross-asset volatility (Figure 2) will likely support high yielders, particularly the ones with positive idiosyncratic stories (RUB, INR, IDR and BRL), in our view.

Additional USD consolidation is also likely, amid still elevated long USD and short UST positioning, according to CFTC data (Figure 3). 
- source Barclays

One could argue that, if everyone is thinking the same, no one is really thinking, because, if indeed the Fed's recent caution on the Swill Wall of investing appears to be warranted in the light of the recent Atlanta Fed 1st quarter GDP projection and slowing credit growth, there is indeed a possibility for our "bold skiers" to "tumble" if one takes into account their current stretched positioning but, we ramble again...

"Tis one thing to be tempted, another thing to fall." - William Shakespeare

Stay tuned!

Saturday, 11 March 2017

Macro and Credit - The Endless Summer

"The fact that logic cannot satisfy us awakens an almost insatiable hunger for the irrational." - A. N. Wilson, English writer

Watching with interest the continuation in the "Trumpflation" trade with equities pushing higher, credit going tighter and USD suddenly going stronger with real rates (pushing us to significantly curtail our gold mining exposure), we reminded ourselves for our title analogy of the 1966 worldwide release of surf movie "The Endless Summer". Its title comes from the idea, expressed at both the beginning and end of the film, that if one had enough time and money it would be possible to follow the summer up and down the world, making it endless (like the perfect asset allocator...). In similar fashion, the global reflationary trend witnessed so far thanks to central banks support, like the tide, has lifted all boats overall. From real estate to stock markets reaching in the US for some instance "lofty" valuations levels, given the recent strong macro data from PMIs to the latest ADP/NFP release in the US, we are indeed wondering if this credit cycle, while being long in the tooth, doesn't amount to "The Endless Summer". So if surfing the "wealth effect" seems so far appropriate for our title and markets analogy, we are wondering where the next big wave could be coming, given we recently pointed out that in many instances High Yield had been "priced" to perfection and the rally had been significant.

In this week's conversation we would like to look at the ebb and flow in the credit markets which could determine departure times from various asset classes as we move towards the Fed's hike decision.

  • Macro and Credit - Caesar, beware the ides of March
  • Final charts - Are Boomers "Bust" ?

  • Macro and Credit - Caesar, beware the ides of March
In modern times, the Ides of March is best known as the date on which Julius Caesar was assassinated in 44 BC which corresponds, dear readers to the 15th of March and equating to the next FOMC meeting of the US Federal Reserve bank. As we pointed out on numerous occasions we tend to look not only like any good pundits in the positioning of the players (such as the overstretched position in oil longs for instance...), but we do also look at the flows which could also be indicative in the changes in allocations.  As we pointed out in our most recent musing, so far this year High Yield fund inflows have remained strong in conjunction with the performance, making it look like an "Endless Summer" given the very significant performance of the asset class since the second part of 2016. Yet, it seems that as of late, it looks like some players have been trimming their sails. While next rate hike seems to be "baked in the cake", it remains to be seen how hawkish the tone will be at the next FOMC meeting. Many analysts are pointing out that the Fed is behind the curve, we have on numerous occasions joked with other macro rates pundits that the curve is behind the Fed. In relation to the risk of a more hawkish bias, we read with interest Bank of America Merrill Lynch's take from their Securitized Products Strategy weekly note from the 10th of March:
"Turning negative
Fed rate hike odds for next week are now almost 100%, up from the mid-30s just two weeks ago. The hawkish shift by the Fed has already been reflected in corporate credit spreads and real interest rates: IG and HY CDX spreads were as much as 5 bps and 30 bps wider in the past week, respectively, while the real 10yr yield is up by over 25 bps in the last two weeks. As usual, securitized products spreads have lagged the corporate and rate market action for the most part, as technical support for securitized products, especially credit, remains very strong.
What we’ve seen over the past two weeks is a mini-version of what we expect for 2017 overall. There is still plenty of time left in the year, so no doubt there will be continued swings in both directions on rates and spreads. But the big development in the past two weeks is the rapid hawkish shift in Fed rhetoric. We see potential for additional hawkish shifts in rhetoric going forward, including discussion of normalizing the balance sheet quicker than the market anticipates, and are in the camp that thinks the Fed is behind the curve on tightening monetary policy. If economic/inflation data forces the Fed to start tightening policy more aggressively, we think the market will eventually re-price equilibrium spread levels wider.
In short, the securitized products view is turning more and more into a view on how hawkish this tightening cycle will be for the Fed. Fed accommodation, and QE in particular, has unequivocally benefitted what we think of as the benchmark sector for securitized products, agency MBS. If the Fed is finally embarking on a sustained, hawkish tightening cycle, where their ownership of agency MBS is “normalized,” the path of least resistance for securitized products spreads is likely to be wider. Meanwhile, spread tightening potential, or at least justification for it, has become limited in our
view. Asymmetry on spreads is not a good thing.
Below, we examine the data connecting the Fed's MBS portfolio size to housing inventory, and rent and home price inflation. We believe the case can be made that reducing the portfolio sooner rather than later is warranted due to inflationary pressures in the housing market, although we recognize that this is probably a deep out-of-the money view at this point. Meanwhile, for the near term, the inflationary pressures in housing are a positive for residential mortgage credit.
We retain our neutral view on securitized products credit. There are positives on the technical and even fundamental front for the sector, except perhaps for CMBS, but our concerns about a looming hawkish shift by the Fed make us wary about chasing spreads tighter. Neutral balances it out for us. We turn underweight agency MBS, where we see enough negatives to outweigh the positives on the technical side. Specifically, we see seasonal supply pressures picking up and recognize that agency MBS are likely to be the first sector adversely impacted by any talk of accelerated balance sheet normalization.
Two indicators of why the Fed is/may be (way) behind on tightening 
We look at data that shows that the Fed is or may be way behind on tightening monetary policy, both in terms of raising rates and reducing its MBS portfolio. We are well aware that to date, both the Fed and the market have shown little concern over, or perhaps even awareness, of the analysis we present. As a result, it’s probably too early to think about it having a market impact. However, at a minimum, we think the data highlight the risk that the Fed somewhat abruptly shifts to a much more hawkish policy position.
In particular, unless mortgage rates are increased, by signaling accelerated MBS portfolio reduction, we think excessive home price and rent inflation looms on the horizon. Some have asked whether losses on portfolio sales would deter the Fed from selling. Losses might be a deterrent, but if rent and home price inflation spiral out of control, the Fed may not have a choice. Before considering the balance sheet, we focus on rate hikes as a policy tool.
1. Fed Funds and the Taylor Rule
Stanford’s John Taylor of Taylor Rule fame will be the featured speaker at the BofAML 2017 Residential & Housing Finance Conference this coming Tuesday, March 14, 2017. We'll wait for that session for guidance on the appropriateness of the Taylor Rule Fed Funds level versus the current Fed Funds level. Here, we simply present the historical data in Chart 1 (the two time series) and Chart 2 (Fed Funds – Taylor Rule) and leave it to the reader to decide if he or she thinks the Fed is possibly behind the curve. Currently, Fed Funds is roughly 300 basis points (twelve 25 basis point hikes!) below the Taylor Rule level.
The last time a disparity this large was seen was in 1974-1975, during a period of extraordinary rate volatility, when Fed Funds went from 13% to 5.5% in a matter of months. In a period of such high volatility, short term dislocation between an actual value and a model value can be expected. Now, with Fed Funds barely budging in eight years, the volatility explanation of the discrepancy does not apply. Rather, it appears as if the “Rule” is simply being ignored. As a result, after 40 years of roughly moving together, with the Taylor Rule level exhibiting less volatility than actual Fed Funds, they have decoupled.
Two possibilities emerge:
1. The Rule no longer applies and the decoupling will be permanent.
2. The Rule still applies and, as has been the case in the past, economic data inevitably force the humans setting the Fed Funds level to follow the Rule.
As a simple observation on the historical data, possibility #2 seems more reasonable to us, suggesting the Fed is way behind on tightening. Others can choose possibility #1.
2. The Fed balance sheet and home price and rent inflation
Here we consider the histories of existing home sales, housing inventory (measured as months supply, the number of homes for sale relative to the annual sales rate), Case Shiller home price appreciation (HPA), rent inflation and the Fed’s MBS portfolio size. We suggest that the Fed’s MBS ownership is creating home price and rent inflation, and that may not necessarily be a good thing.
Chart 3 starts with a look at existing home sales. January’s 5.69 million rate was the highest level since early 2007. That is also the level of early 2002, just before the housing bubble period commenced. Sales are seen on a steady uptrend since the end of 2008, when the Fed began buying MBS.
Chart 4 shows existing home sales versus Case Shiller HPA. Not surprisingly, the two series tend to move together. Policymakers and homeowners may be pleased that YOY HPA is reasonably strong, 5.85% for 2016. But what if it trends higher, along with existing home sales, as it did in the early 2000s? Is there a level of home price inflation that makes policymakers uncomfortable? What about the 36% of the population that do not own homes? Are they priced out of homeownership? Does strong HPA get passed through to rents?
Chart 5 suggests the answer on rents is yes. 5%-10% HPA may be great for homeowners but do policymakers really want to see rent inflation continue the steady rise that began in 2010, a year and a half after the Fed began purchasing MBS? Chart 6 shows that, two years after the Fed stopped increasing its MBS portfolio size, rent inflation appears to be accelerating. Similar to existing home sales, rent inflation is at the highest level since 2007.

Chart 7 shows the history of housing inventory. At 3.6 months, supply is back down to the record lows seen at the height of the housing bubble in 2005. Many will say that the low inventory is because builders are not building new homes. That may be true, but does that preclude the possibility that Fed MBS purchases may also be a factor, by artificially setting mortgage rates too low? The answer, in our view, is no, Fed balance sheet holdings cannot be ruled out as a driving force. Moreover, even if the Fed is responsible for low housing inventory, why is that a problem? Well, as we will see, it leads to home price inflation, which, as noted above, leads to rent inflation, which we think is a problem.
To help show these connections, we do a mathematical trick and invert the housing inventory and compare the inverted level to the Fed MBS holdings (Chart 8) and to HPA (Chart 9).

Similar to rent inflation, Chart 8 shows that the inverted housing inventory number bottomed in 2010, about a year and a half after the Fed started buying MBS, and has been trending higher ever since, meaning that inventories have been moving steadily lower. Chart 9 shows that this inverted inventory number tends to move in synch with or in advance of HPA, ie as a leading indicator. For anyone long housing, or residential mortgage credit, this looks like very good news for 2017. The data suggest that, due to record low inventories, the risk for HPA in 2017 is to the upside. The comparison of inverted inventory levels and rent inflation in Chart 10 shows a similar story for rent inflation: upside risk in 2017.
For a policymaker whose job is to maintain price stability, escalating rent inflation is not good news. There is a simple policy “cure” for this situation: raise mortgage rates by reducing the Fed MBS portfolio. Is the Fed anywhere near reaching this conclusion? Maybe not, but it probably should be, and if there is a rapid policy shift on this issue, we will not be surprised." - source Bank of America Merrill Lynch
There you go. While the Fed has been behind most of the "Endless Summer", one could argue that the Fed is not behind the curve, but, the curve is behind the Fed. Put it more simply, the Fed is the credit cycle, so, as the Fed starts to tighten in earnest financial conditions, the credit cycle will turn and rest assured it will entail some significant repricing at some point.

To that effect we agree with Jeff Gundlach from Double Line's recent take, namely that the Fed will hike until something breaks. It is bound to happen as the Fed has once again maintained rates too low for too long, which has led to some complacency in various asset classes and lofty valuations in many instances. This is as well the feeling in credit land as per recent investors' survey where there is a feeling of overvaluation.

This has been leading to some flow rotation with a more pronounced defensive stance leading to a reduction in both credit risk (from High Yield to Investment Grade) and a reduction in duration risk. This is clearly indicated in Bank of America Merrill Lynch latest Follow The Flow note from the 10th of March entitled "Shunning duration, adding yield":
"Reaching for yield, but cutting on duration
Higher yields and tighter spreads continue to benefit IG bond funds in Europe, recording a very strong inflow last week. Equities flows are back to positive with a $1bn inflow last week as economics data are strengthening. Duration is still under attack as IG investors are cutting back with rates moving higher. The reach for yield trade is in vogue with inflows into EM debt funds doubling w-o-w.
Over the past week…
High grade funds continued on a positive trend for the seventh week in a row; and recorded the highest inflow in 18 weeks. High yield funds inflows slowed down significantly last week, but still posted their 14th consecutive week of positive flows. Looking into the domicile breakdown, European-focused funds were the ones that recorded inflows, while outflows hit US and globally-focused funds.
Government bond funds flows remained on negative territory as rates moved higher. Money market funds weekly flows are back to positive after three weeks of outflows. Overall, fixed income funds flows remained strong and positive for the eleventh consecutive week; with more than $33bn of inflows over that period.
European equity funds flows flipped back to positive territory. So far this year the asset class has recorded inflows in seven out of ten weeks. Note that in 2016 the asset class recorded only eight weeks of inflows during the entire year.
Global EM debt fund flows continued on a positive trend for a sixth week, while flows more than doubled w-o-w. Almost $13bn of AUM has been added in the asset class YTD. Commodities funds flows flipped back to negative after seven weeks of consecutive inflows as oil prices dipped lower.
On the duration front, strong inflows continued in short-term IG funds for the 12th week in a row. Mid-term funds also posted a strong week of inflows; the second in the row. Flows into long-term funds remained negative for a third week in a row." - source Bank of America Merrill Lynch
Now if indeed there is added caution and a "Great Rotation" to quality (Investment Grade), one might wonder if indeed this time around credit will be leading equities and mark an end or a pause to the "Endless Summer". We looked at the below chart from Lawrence McDonald on our twitter feed and wondered:
- source Lawrence McDonald - Bloomberg/Twitter feed

Also on our Twitter feed which caught our attention was Bloomberg Lisa Abramowicz comments relating to the outflows in the ETF HYG on the 8th of March:
"Yesterday saw the biggest one-day outflow from the biggest junk-bond ETF since the U.S. election." - source Lisa Abramowicz - Bloomberg
As pointed out by a credit market pundit on Twitter as well (H/T Fil Zucchi) $5 billion worth of new issues were bought in the cash markets. One has to remember that, when it comes to keeping it's cool under pressure, the retail crowd is much more feeble than the institutional crowd. Where we slightly disagree with Fil Zucchi is that there has been a very significant growth in passive management and in particular bonds ETFs. So while tracking bonds ETFs is of interest, it is of course not the best great gauge of real health in credit markets. Yet, in the European High Yield complex, this week has seen some heavy trading in the cash space thanks to growing redemptions in High Yield credit ETFs. So all in all, tracking flows in ETFs is necessary but, not always enough to gauge the state of the market. But, from a short term perspective, it might indicate some weakness in the near term.

Another cause for concern has been the recent sucker punch delivered in very short order to the very crowded long oil community, which once again is going to weight on credit spreads and in particular the Energy sector which have been on a tear in the second part of 2016, leading to a significant outperformance of the sector. This, we think is worth monitoring, given the correlation between oil prices and High Yield as displayed in the below chart from Tom McClellan on his twitter feed:
- source Tom McClellan - Twitter feed

So if it is indeed you are wondering when "The Endless Summer"  will end and if you are a "big wave surfer" like Bohdi in Point Break meaning you are waiting for the "50-Year Storm" and "big waves" à la Nazaré in Portugal you need to start asking yourself how will this credit cycle end. On that specific point we read with interest Société Générale's take from their Credit Market Wrap-up from the 6th of March entitled "How will this credit cycle end":
"Market thoughts
For the past two years (and most recently in “The big hangover, Part II”), we have argued that the credit cycle has become shorter since the global financial crisis. Based on data going back to the 1920s, we have noted that the typical credit cycle lasts eight years, with a bear phase, a bull phase, and a phase of broad stability. But as Chart 1 shows, in the past eight years this traditional stability phase has disappeared. The average life of a credit cycle has shrunk to three years, and we have had three full credit cycles.

Chart 2 shows that there is a historical precedent for this type of rapid cycling credit market. While the cycles of the 1980s and 1990s (and a fortiori the 1940s to mid-1960s) were relatively long, the late 1960s to late 1970s saw three cycles in the space of a decade.
Beards and flares may be back in fashion, but the current disinflationary world seems very different from the high inflation of the 1970s. Yet there is one similarity: real bond yields. Chart three shows credit spreads and US 10yr bond yields minus average CPI over the previous three years. In both the 1970s and the past ten years, US real yields were low, often negative, and always volatile. By contrast, real yields in the long 1980s and 1990s cycles were positive and well behaved. Negative real yields do seem to make credit cycles faster.

So if real rates rise as quantitative easing ends, credit cycles should lengthen again. But how would this rapid cycle phase end? The 1970s example is worrying, for the biggest spike in yields took place at the end of the period. Moreover, it’s worth noting that balance sheet leverage has been much stickier through this cycle than in the 1970s. Chart 4 shows the nonfinancial debt/assets ratio from two series from the Federal Reserve of Saint Louis, plotted against spreads.
The correlation between spreads and balance sheet leverage looks weak, as leverage was falling during the rapid cycles of the 1970s, rose during the long cycles of the 1980s (as academics convinced corporates of the value of tax shields), fell after the telecoms crisis and has risen again since nominal and real yields started to fall after the financial crisis. But the more important and worrying point is that balance sheet leverage is high now compared to history, and this may end up amplifying the impact of a crisis if one is triggered by the end of low real yields.
So to sum up, the history of the 1970s is worrying for two reasons. First, it shows that the switch from a negative real yield regime to a more normal, positive real yield regime might spark a big non-financial credit crisis. Second, this crisis could be amplified by the fact that there has been no real balance sheet deleveraging during this period of spread volatility (unlike the 1970s). The end of this credit cycle may be far off in the future – indeed further off than we might have thought at the start of this year. When it comes, however, it may be very messy indeed." - source Société Générale
Until then you might enjoy the summer lull and complacency of the credit markets, but one thing for certain is that the end of this particularly long credit cycle will see much lower recovery rates, for us that's a given.

If indeed corporate leverage is higher than in the previous cycle as pointed out by Société Générale, there also a phenomenon that needs to be taken into account and it is that the current Boomers are more leveraged than previous generations were ahead of retirement as per the final points below

  • Final charts - Are Boomers "Bust" ?
While the developed world in many parts is clearly in a state of over indebtedness, what is of interest as well is that the Baby Boomers generations that benefited from many golden years and the generosity from both governments and central banks in recent years do face some challenges as per our final charts from Wells Fargo Economics Group note from the 9th of March entitled "Till Debt Do Us Part: How Leveraged Is the Typical Boomer?":
"The Boomers are more leveraged than previous generations were ahead of retirement.
We examine the liabilities side of the balance sheet for this group and explore some of the challenges they may face.
The Borrowing Boomers
Unsurprisingly, the Baby Boomers have less debt than younger generations who are currently in their prime working years and still climbing the ladder of life. However, the typical Boomer has more debt at this point in their life relative to previous generations. As of 2013, 79 percent of households age 55-64 and 66 percent of those age 65-74 had debt of some kind (top chart).

The long-run trend in the top chart signals a rising share of each successive generation approaches the traditional retirement age with debt of some sort. In addition, not only do more Boomers hold debt, the typical value in real dollars has also risen. The Great Recession pushed debt holdings for this age bracket even higher in 2010 than the bubbly 2007 period. Real debt holdings for the typical boomer receded markedly in 2013, although this in part reflects a decline in homeownership.
Like the asset side of the balance sheet, housing comprises the bulk of debt for the average Boomer. A bit under half of Boomers hold debt secured by their primary residence (middle chart), with the median value for Boomers age 55-64 amounting to about $100,000. Credit card balances and installment loans (for vehicles for example) are also common, but median balances are a relatively manageable $3,000 and $12,000, respectively. Mean debt holdings are more than double the median, however, suggesting that some Boomers are significantly more leveraged than their peers.

Old School Not So Funny for the Boomers
Student loan debt has emerged as a hot button issue for some Boomers. A recent report by the Government Accountability Office (GAO) drew attention to this issue, highlighting the number of people whose Social Security checks are being reduced to pay off delinquent student debt.* The report found that there were 114,000 people age 50 or older in fiscal year 2015 who had their benefits reduced by about $140 a month for unpaid student loans. As the bottom chart illustrates, student loan debt has increased in size and prevalence for older individuals.

We caution, however, about overstating the pervasiveness of the problem; according to Survey of Consumer Finances data, only 12 percent of 55-64 year olds have some form of student debt, with older Boomers having an even smaller share. In addition, the 114,000 individuals age 50+ from the GAO study represent less than 0.5 percent of Social Security beneficiaries. This suggests that most Boomers are not grappling with a crushing student loan burden as they enter their golden years. That said, the GAO report found that a sizable share of those who had their Social Security benefits reduced were either pushed below/pushed even further below the poverty line. Further, if the trend of growing educational debt continues, the problem will likely increase in scope over time and create further challenges for Boomers who are already struggling with retirement preparedness." - Source Wells Fargo
Although "The Endless Summer" has created a significant windfall for the holders of financial assets, it looks to us increasingly that in many ways the average US consumer is somewhat "maxed out". It remains to be seen how many hikes it will take before the Fed finally breaks something, but, we ramble again...

"Things as certain as death and taxes, can be more firmly believ’d." - Daniel Defoe, The Political History of the Devil, 1726.

 Stay tuned!

Sunday, 5 March 2017

Macro and Credit - Just Like Heaven

"The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of "private market value" as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism." -  Seth Klarman
Looking at the sudden jump in the Fed March hike probability concomitant with the "sucker punch" delivered in short order on Monday to the gold mining complex (making us reduce our exposure for the time being), while equities markets continuing their upward trajectory and credit their tightening bias, it made us wander this time around for our title analogy towards 1987 British band The Cure third single released and first American hit song "Just Like Heaven". Given the song is about hyperventilating and taking into account composer Robert Smith's childhood memories of mastering magic tricks, we are feeling impressed by the rapid move in markets from their hypomanic mood towards somewhat state of "euphoria" hence our chosen title. Whereas for the time being both flows and price action point towards a continuation of the rally, if indeed we are short term "Keynesian", we do remain, long term "Austrian" from a valuation perspective and that's just our "realistic bias".

In this week's conversation we would like to look at the sustainability of the rally particularly in credit from a flow perspective given in credit land since the beginning of the year and in particular High Yield, it feels "Just Like Heaven".

  • Macro and Credit - Tactically bullish, politically skittish
  • Final chart - Global expansion? This time it's different

  • Macro and Credit - Tactically bullish, politically skittish
When it comes to assessing credit, the ongoing rally in credit is supported by strong inflows into the asset class. What is questionable is the sustainable of the rally given its rapid advance. For instance, as displayed by Bank Of America Merrill Lynch from their most recent High Yield chart book for February, the year to date performance in credit and in particular US High Yield has been significant:
Cross-Asset Total Return Performance from 31st of December until 28th of February 2017 - Source Bank of America Merrill Lynch
What is of interest is that many sell-side pundits expect returns for US High Yield to be close to flat for the entire year. Yet, there has been a significant tightening in credit spreads on the back of strong inflows into the asset class as reported by Bank of America Merrill Lynch in their Follow The Flow note from the 3rd of March 2017 entitled "Reaching for yields continues":
"It’s all about rates
Lower front-end rates have been pivotal to support flows into credit to the detriment of flows into equities. Investors continue to favour short-duration high-grade paper to insulate against steepening of curves, while outflows continue from high duration pockets.
Over the past week…
High grade funds continued on a positive trend for the sixth week in a row; and recorded the highest inflow in three weeks. High yield funds inflows remained strong for another week, now counting 13 weeks of positive flows. Looking into the domicile breakdown, as charts 13 &14 show, even though European-focused funds recorded inflows, the majority of the inflow is concentrated in US and globally-focused funds.
Government bond funds flows went back to negative territory after a brief week of inflows. Money market funds weekly flows were negative for the third week in a row. Overall, fixed income funds flows remained strong and positive for the tenth consecutive week; with more than $30bn over that period.
European equity funds flows on the other hand moved back to negative territory after five weeks of inflows. The outflow from the asset class was the biggest in thirteen weeks.
Global EM debt fund flows continued on the positive trend for a fifth week, however we note a weakening of that trend recently. Commodities funds flow remained positive for a seventh week.
On the duration front, strong inflows continued in short-term IG funds for the 11thweek in a row. Mid-term funds’ flows turned slightly positive after three weeks of sizable outflows, while flows into long-term funds remained negative for a second week." - source Bank of America Merrill Lynch
So all in all, the technical support for credit in particular and risky assets in general, in this "risk-on" environment has clearly sounded "Just Like Heaven". But, according to Société Générale in their Credit Market Wrap-up from the 27th of February entitled "Why inflows into credit do not mean spreads will go tighter", they indicate that there is no guarantee this rally could continue and therefore the ongoing tightening of credit spreads is unsustainable:
"Market thoughts
We have been bearish about credit markets this year, and so far (despite a slight widening in spreads last week) we have been wrong. In The big hangover Part II, we outlined the reasons for concern. In The worst is yet to come, we reiterated why we thought rising government yields would eventually put pressure on credit markets. Yet it is clear that most market participants are a lot more bullish than we are.
Chart 1 shows the percentage moves in spreads since the US elections. Euro IG spreads are wider (though the move occurred in mid-November). Spreads are tighter in all other markets, with US high yield leading gains, EM (either high yield or investment grade) in second place, and Euro high yield tied with the US IG market over the whole period. Note that Euro HY gains have mostly taken place this year, while US IG gains principally happened in 2016.

One of the drivers of the good performance has surely been capital inflows. In their latest Mutual Fund & ETF watch, SG’s asset allocation team note a surprising shift in the flow of funds into credit. Between the end of January 2016 and October 2016, there was a startling 40 weeks of successive inflows into US investment grade credit funds, with inflows totaling some $77bn. Then came an equally consistent 11 weeks of outflows totaling more than $12bn. Since mid-January, inflows have returned; the $5bn inflows in early February were the highest since summer 2016 and indeed one of the highest weekly totals since the data began.
Are we back to a lasting period of inflows – and tightening spreads? Perhaps, but be careful, for the flow of funds into credit is not necessarily a good pointer for how credit spreads are going to evolve from here.
Chart 2 shows the three month total of inflows into USD IG credit (in blue) and the subsequent three-month change in spreads (in red). The correlation between the two is slightly negative; what’s more interesting, however, is to concentrate on the periods where flows sharply accelerated (which we have picked out in blue).
We note the following:
  • In two of the five periods (4Q14 to 1Q15; 1Q45) rising inflows subsequently led to higher spreads.
  • In three of the five periods (late 2013-early 2014; 2Q16; 3Q16) inflows led to tighter spreads but the tightening trend decelerated.
If the inflows into credit persist, then, this is not necessarily a good sign for the market: history would, indeed, tend to suggest the reverse, with inflows met by more supply, worsening credit metrics and eventually a widening in spreads rather than a tightening. Credit investors should be careful what they wish for from here on in."  - source Société Générale.
Yet, while credit is behaving "Just Like Heaven" thanks to the supportive background of strong technicals, as we mused out recently, early 2016 was very different in the sense that the first part of the year was plagued by "bad news" from the energy sector that spilled-over to other risky asset classes and ended up "good news" performance wise during the second part of the year. We believe that 2017 could be the reverse where "good news" (technicals and fundamentals), get impacted in the second part of the year by "bad news" (additional tightening financial conditions, credit cycle turning, rise of political risk, etc.). When it comes to US High Yield and "fundamentals", the picture in 2017 is completely different from 2016 as pointed out by Bank of America Merrill Lynch in their High Yield Strategy note entitled "Let's do the limbo" from the 2nd of March 2017:
"The HY rally continues
High yield spreads tightened another 26bps for a 1.21% excess return in February, the 8th consecutive month of spread tightening. Although all 18 sectors finished in the green, performance across industries varied with Health Care (+3.40%) and Telecom (+2.97%) leading all others. The former outperformed due to alleviated concerns surrounding changes to the ACA, while the latter delivered strong returns because of M&A speculation amongst two of the largest capital structures in the index (S and INTEL). On the opposite end of the spectrum, Energy was the worst performing industry with a +0.36% gain, just the 2nd time the sector has underperformed the overall index in the last year (Note: we lowered over view on Energy from overweight to market weight back in January). Although valuations have certainly become stretched across high yield as we are now just 39bps away from the post-crisis tights, we think this trend can continue (albeit more slowly) as it has come against a backdrop of improving fundamentals and a declining default rate, which we discuss below.
 Q4 fundamentals first take: sustained improvement
With roughly 70% of our HY universe having reported Q4 earnings, so far top and bottom line growth have continued to trend higher. Notably, HY revenue continued to improve for the 4th consecutive quarter; in fact, the current +5.0% growth represents the first YoY increase since Q4 2014. The same story holds true ex-Commodities, where revenue growth increased from +3.3% in Q3 2016 to +5.7% last quarter. And because EBITDA growth outpaced modestly higher debt levels, leverage continued to decline while coverage ratios increased.

Although these figures remain better than their historical averages during ‘normal’ times, the recent trends should act as a token of optimism for investors. Within sectors, these preliminary earnings results show the strongest YoY gains in Gaming, Capital Goods, and Retail. On the other hand, Food and Health Care have experienced the largest deterioration in EBITDA on a year over year basis.
Default rate sees largest 1 month decline since 2010 
The US HY default rate fell from 7.06% last month to 6.11% today; this 95bp reduction is the largest 1 month change since August 2010, when the rate fell from 4.25% to 2.97%. There was a noticeable lack of filings last month, where for the first time in over 2 years there were 0 first time defaulted issuers1. However, also driving the default rate lower was the removal of February 2016 from the trailing 12 month rate, where we saw 10 unique issuers default. Although the reduction in Energy defaults is responsible for most of the decline, on an ex-Commodity basis the default rate still ticked lower, from 3.3% to 2.9%. These drops are consistent with our view for a lower default rate in 2017, where we expect the rate to decline to just 4.0% for US HY issuers and remain at 2.9% ex-Commodities. With just 5 defaults YTD, this would imply an additional 31 defaults in 2017 (20 ex-Commodities)." - source Bank of America Merrill Lynch
While looking at the High Yield default rate is like looking at the rear view mirror, the most noticeable change in terms of fundamentals between 2016 and 2017 has been EBITDA YoY percentage change as per the below chart from Bank of America Merrill Lynch High Yield chart book:
- source Bank of America Merrill Lynch

Some would rightly ask if this "Just Like Heaven" picture would be distorted by the Energy sector, it isn't as per the chart below:
- source Bank of America Merrill Lynch

What matters for default rate going forward is the evolution of lending conditions. As we have mentioned recently the noose is already tightening for Commercial Real Estate (CRE), but we have to see a meaningful deterioration overall, spilling over to the default rate as per the chart below from Bank of America Merrill Lynch:
- source Bank of America Merrill Lynch

Yet, while the picture seems rosy, in fact "Just Like Heaven", given our fondness for monitoring credit conditions to assess the credit cycle, we have noticed that since the beginning of the year in the US Commercial and Industrial Loans (C&I) have turned "South". The chart below from Bank of America Merrill Lynch illustrates the latest trend:
- source Bank of America Merrill Lynch

Given C&I loans are strongly related to what the "real" economy does, this warrants we think close monitoring in the coming months, to assess if it is only a short blip or if there is indeed something more sinister going on (slowing credit growth).

While markets so far seems oblivious to political uncertainties building up and remain tactically bullish, political uncertainties particularly the mess in France could throw in short order a spanner in the works, hence our cautious "optimism" or short term "Keynesian" bias. In relation to French elections and us being French we would like to give you our opinion on the matter. After all, we got Trump and Brexit right in 2016, but, when it comes to having a clear view on the outcome, we must confess we do not have one. It is probably the first time since 1958, that French elections represent such a "known unknown". One would think pundits would have learned from making inaccurate predictions after an eventful 2016 which saw BREXIT, Trump's elections and the Italian referendum. The odds of Marine Le Pen upset in the second round has to be taken into account, particularly given that the second round occurs on Sunday 7th of May and the Monday is a holiday. People might decide they have other things to do than show up at the poll stations. Bear that in mind. Whoever gets elected on the 7th of May doesn't resolve the uncertainty for France given that a month later you get the parliamentary elections for the national assembly. All in all, France is a very big mess. 

As things stand, global expansion in this particular credit cycle has seen volatility subdued, but, given the gradual pull back from accommodation from central bankers, one would think there is a heightened probability in seeing a regime change in terms of volatility regime. We think the second part of the year could mark this change. In our final chart below, we will briefly discuss the relation between global expansion and lower volatilities.

  • Final chart - Global expansion? This time it's different
Though the macro data seems to be pointing towards an acceleration in global expansion, volatility continued to be subdued, yet political uncertainties keep rising on a daily basis. Our final charts comes from Nomura FX Insights note from the 3rd of March entitled Le Pen and the lessons learnt for FX Vol" and shows that global expansion has led to lower volatilities, yet this expansion, in the ongoing credit cycle has been very different from the past:
A global expansion has historically meant lower FX vols overall, but ending unconventional monetary policy could be the exception to the rule
Historically, when we have entered into a global expansion phase as we expect (see Catch-up expectations and Back to boom/bust?), we tend to see FX vols head below their long-term averages (see The Great Moderation of 2014).
While this is perhaps true for equity vols, it could be different this time for rates and therefore FX vols. The US expansion is entering its seventh year of growth, which is already the fourth-longest expansion we have seen since the late 1940s (Figure 1) and on some metrics is looking rather mature already.
Big questions remain on the outcome of the geopolitical risks, but also what impact on markets the years of unconventional monetary policy will have when it comes to an end. We studied the impact of the zero lower bound (ZLB) on fixed income and what happens at times of lift-off, where we found term premia in fixed income markets can increase in a non-linear fashion (see Lift-off, term premia and exchange rates). With the risk of a sudden non-linear increase in interest rates as the ECB and other central banks look to exit unconventional monetary policy the “post Trump” sell VIX / Buy MOVE trade still looks like it will remain at high levels (even though we already hit our target, see Top Trump Trades).
So while equity markets continue to exhibit strong optimism for global growth, in fixed income it may not be such a smooth ride, given the removal of monetary policy stimulus, which could also have a feed-through impact on FX vols on a general basis." - source Nomura
When it comes to changes in the volatility regime, for now it's "Just Like Heaven", but, maybe the road to hell is paved with European elections? Who knows...

"Fragility is the quality of things that are vulnerable to volatility." -  Nassim Nicholas Taleb
Stay tuned!

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