Monday, 23 October 2017

Macro and Credit - Who's Afraid of the Big Bad Wolf?

"If you live among wolves you have to act like a wolf." - Nikita Khrushchev

While still being mesmerized by the "goldilocks" environment for credit thanks to low interest rates volatility, in conjunction with new records being broken in the equities sphere, when thinking about what our title analogy should be, we reminded ourselves of the popular song  "Who's Afraid of the Big Bad Wolf?" written by Frank Churchill originally featured in the 1933 Disney cartoon Three Little Pigs. It was sung by Fiddler Pig and Fifer Pig as they arrogantly believe their houses of straw and twigs would protect them from the Big Bad Wolf. With the continuation of the beta game played by the "yield hogs", obviously the Big Bad Wolf would be a sudden burst of inflation, which would no doubt take down their "credit" houses of straw and twigs. This would clearly change the central banking narrative and put an end to the "goldilocks" environment we are seeing. We do not think we are there yet, but as we pointed out in our recent musings, for a "bear market" to materialize, you would indeed need a return of the Big Bad Wolf aka "inflation". In the Disney cartoon, an angry Practical pig did warn his two brothers though:
"You can play and laugh and fiddle. Don't think you can make me sore. I'll be safe and you'll be sorry when the Wolf comes through your door!"
Overall, we'd rather be seen as "Practical yield pigs" than "perma bears". As such we do think that a surprised return of inflation could indeed be a catalyst for a "repricing" of the bond "bubble". 

In this week's conversation, we would like to look at if indeed it's not the Fed which is responsible for its lackluster record in reaching its 2% inflation target. In terms of asset prices "inflation", one could argue that the Fed's record is "untarnished". 

  • Macro - Low inflation? Blame the Fed 
  • Credit - Credit cycles die because too much debt has been raised
  • Final chart - Senior officer loan survey leads default rates
  • Macro - Low inflation? Blame the Fed 
In our most recent musing, we mentioned that inflation in the US was suffering from an autocorrelation problem. What we have long posited is that while wanting to induce inflation, QE induces deflation and that's exactly what the Fed has been doing. This is what we discussed in March 2015 in our conversation "The China Syndrome". At the time, we quoted CITI's Matt King's 27th of February note entitled "Is QE Deflationary":
"It’s that linkage between investment (or the lack of it) and all the stimulus which we find so disturbing. If the first $5tn of global QE, which saw corporate bond yields in both $ and € fall to all-time lows, didn’t prompt a wave of investment, what do we think a sixth trillion is going to do?
Another client put it more strongly still. “By lowering the cost of borrowing, QE has lowered the risk of default. This has led to overcapacity (see highly leveraged shale companies). Overcapacity leads to deflation. With QE, are central banks manufacturing what they are trying to defeat?”
Clearly this is not what’s supposed to happen. QE, and stimulus generally, is supposed to create new demand, improving capacity utilization, not reducing it. But as we pointed out in our liquidity wars conference call this week, it feels ever moreas though central bank easing is just shifting demand from one place to another, not augmenting it.
The same goes for the drop in oil prices. In principle, this ought to be hugely stimulative, at least for net oil consumers. And the argument that it stems solely from the surge in US supply, not from any dearth of global demand, seems persuasive as far as it goes.
But in practice, the wave of capex cuts and associated job losses in anything even vaguely energy-related feels much more immediate than the promise of future job gains following higher consumption. The drop in oil prices, while abrupt, in fact follows a three-year decline in commodity prices more broadly. It’s not just oil where we seem to have built up excess capacity: it’s the entire commodities complex." - source CITI
Also, stronger USD leads to higher deflationary risk leading to lower long-term bond yields. Even though exports are only 13% of the US economy, remember that 40% of S&P 500’s earnings now come from outside the US. But when it comes to "anchoring" inflation expectations and the threat of the Big Bad Wolf, it seems that the Fed has failed as pointed out by BNP Paribas in their note from the 12th of October entitled "US: Blame the Fed for low US inflation":
  • Too hawkish rhetoric too early and too little attention to inflation expectations are the main reasons why core inflation is nearer to 1% than 2%. It’s the Fed’s fault.
  • The taper tantrum lowered inflation expectations a lot, and the 2015 and 2016 rate hikes both came when data were signalling a rise was inappropriate.
  • Inflation expectations are not at a level that is consistent with hitting 2% inflation – we reckon break-evens would need to be 2.5% to be consistent with that; we’re well short.
  • The Fed is a poor inflation forecaster and its reaction function is foggy, hence the need to heavily flag its moves. Bond rallies after rate hikes question the wisdom of the hikes.
Over-inflation of asset prices but too low inflation
Fed policy has achieved full employment – in fact, it has gone a bit beyond it. But after more than eleven years since its first cut in 2007, core inflation is 1.3%; at the same time it has overinflated asset prices. The Fed has not managed this alone – the “everything bubble” owes much to fellow central bankers who have helped pump up the liquidity that inflated financial assets.
What flattened the Phillips curve? The Fed.
However, we believe it is the Fed’s fault that US inflation is too low. Despite only four hikes in just under two years the Fed has subdued inflation expectations and therefore inflation. The Fed’s rhetoric has constantly been about raising rates, from way too early in the cycle and its rate hikes have too often been path dependent rather than state dependent.
Not enough attention given to inflation
The FOMC has too often ignored inflation when hiking. When Bernanke started the taper tantrum, core PCE inflation had descended from 2% in early 2012 to 1.4% – no wonder the market took fright. In the six months preceding the first hike, core inflation averaged only 1.3%.
Too ready to talk about hikes too early
Before the taper tantrum, the Fed had often signalled a desire to raise rates. By December 2012, it was saying that it would not hike until the unemployment rate was below 6.5%, well before full employment was reached. The same statement suggested an asymmetric inflation target: “The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective”.
The Fed has hurt inflation expectations
Inflation expectations are central to the inflationary process. The rate of increase of both wages and prices has decelerated this year– at least before hurricane effects gave them a boost. The Fed puts the inflation deceleration down to “idiosyncratic factors”. But the shocks have been so widespread and long-lasting that something else seems to be at play, especially when the deceleration also affected wages. Inflation expectations have generally declined since 2013 and we believe this has played a role in 2017’s disappointments. The end of 2013 is when the Fed started its tapering process. We don’t see this as a coincidence.
Fed driving expectations
Chart 1 shows the ASTIX measure of inflation expectations from the Philadelphia Fed.

Prior to the recession, real rate expectations and inflation expectations were positively correlated: as inflation expectations rose, so the Fed would tend to raise real rates. Since the crisis, spells of negative correlation have increased, suggesting that monetary policy is driving expectations, rather than being driven by them. We can see that QE1 and, especially, QE2 reduced real rate expectations and raised inflation expectations. Chart 2 shows this happened in markets too.

Taper tantrum drove down price expectations
The taper tantrum accompanied a big fall in inflation expectations and a rise in the expected real rate (Charts 1 and 2). We would be very critical of the Fed ignoring the much tighter monetary conditions caused by the taper tantrum when deciding to taper later that year. Not for the last time, once the Fed has been set on a course in this cycle, it has put its data blinkers on.
Fed failed to grasp import of taper tantrum
Since everyone knew that rate hikes could not start until tapering had finished, the act of tapering had a strong signalling effect. That was one of the reasons for the 2013 taper tantrum, sparked by two Ben Bernanke speeches in May and June, when unemployment was still 7½% or three points above full employment. The one-year one year (1y1y) forward rate rose almost immediately – from 0.25% to 0.50%. Bernanke had signalled that rate hikes were coming.
Fed paid too little heed to 2015 financial conditions
The reaction to Bernanke’s speeches suggests the market saw a move as premature. Before QE ended, the 1y1y had advanced, topping 1%. Rate policy had been tightened even though the policy rate was unchanged. Policy also tightened through other dimensions; the dollar appreciated and by December 2014 was up 9.2% y/y on the broad index. As rate hike expectations mounted and expectations of ECB QE built, by December 2015 there had been a further rise of 10.3%. This had a major effect on growth, inflation dynamics, including through growth, commodity prices and on expectations, we would argue. We don’t think the Fed paid enough attention to financial conditions, interpreting monetary policy too narrowly as the short rate, otherwise the December 2015 hike might not have happened.
First hike too date driven – hence no more for a year
The run-up to the first hike in December 2015 hardly suggested monetary conditions needed tightening. GDP growth in Q4 was only 0.5% aar; the ISM was sub-50 and core inflation was 1.3%. A data-dependent Fed probably would not have hiked in December, but the Fed appeared cornered by credibility concerns and delivered the first hike. Almost immediately, FOMC rhetoric switched and became much more data dependent, with the Fed backing off its hiking stance. By August, 2016 the 1y1y had declined by about 70bp from the December 2015 high. Bond yields rallied, with expected real rates falling and break-evens rising.
Fed had to press market to price in Dec 2016 hike
Things changed in mid-2016, with the ISM rallying. The Fed increasingly talked up the possibility of hikes, with Dudley saying in August that a September hike was possible. That didn’t happen, but when Dudley said on 19 October that he expected a 2016 hike, the market’s probability of a December hike rose to 75% on 26 October versus 47% on 26 September.
Hikes caused inflation expectations to fall further
The result was a sharp rise in bond yields, again largely driven by the expected real yield. The delivery of the December 2016 hike, as with the first hike, was a trigger for real rates to start to decline, after an abbreviated period. By spring, break-evens followed. The March and June 2017 rate hikes each saw bond yields and break-evens decline, along with ASTIX inflation expectations, which would suggest the market judged these hikes unnecessary.
 Difficult to see what can stop a December 2017 hike
The FOMC on 20 September gave a clear signal of a desire to hike in December. The September drop in the unemployment rate and the 0.5% m/m rise in average hourly earnings will probably have reinforced that. Despite core inflation at only 1.3% and inflation expectations seemingly too low to hit the 2% target for core PCE, it looks increasingly likely that the Fed will hike in December, short of another downward surprise to inflation.
Too late to avoid a policy mistake?
We doubt the wisdom of this and have sympathy for St. Louis Fed President James Bullard’s view that we are heading for a policy mistake. We also see support for Minneapolis Fed President Neel Kashkari’s point that the reason the Fed is undershooting its targets is the Fed itself. It has tightened too early and has dampened inflation expectations. This now leaves it in a quandary, we believe. To lift inflation to target, it will have to keep rates soft and risk even further asset overvaluation, while taking unemployment to too low levels risks a bust and a rise in unemployment that delivers recession and ends with the economy close to deflation. However, if the Fed were to raise rates with inflation so low, it would run the risk of further suppressing inflation expectations. This is a bind that has been caused by too many mistakes in the past and it appears difficult to thread a satisfactory way through." - source BNP Paribas
What the Fed has effectively been doing is playing the hand of aging populations by creating inflation in asset prices and in particular bond prices. Aging savers buy future goods (securities) rather than present goods. As we wrote previously, the issue we are seeing in both Japan and the rest of the world is that the older generations is averse to inflation eating away their assets while the young generations are more comfortable with relatively high wages and the resulting inflation. Unfortunately rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions and so far the money has been flowing downhill where all the fun is namely the bond market and particularly beta (the carry game) which can be illustrated by the outperformance in the CCC bucket in High Yield so far this year but also in terms of cumulative flows in bond mutual funds and ETFs as displayed in the below chart from Deutsche Bank from their Global Market Strategy note from the 20th of October untitled "Jumping equilibrium?":

- source Deutsche Bank

But is the game turning? Should we switch camp from the "deflationista" towards the "inflationista" camp? We wonder.

Back in our October 2012 conversation "QE - To infinity...and beyond" we quoted Richard Koo, chief economist at the Nomura Research Institute regarding the challenges of moving from QE to QT:
"Perceived limits on fiscal policy increase pressure on monetary policy
In spite of these experiences, the baseless view that fiscal policy has reached its limits has come to dominate the debate in many countries, including Japan. That, in turn, has placed a great deal of pressure on central banks and led them to inject a sea of liquidity into the market when there is no reason why more liquidity should have any effect. This liquidity will create no problems as long as there is no private demand for loans, since the funds essentially sit in the financial system. The problems come when private demand for loans returns to normal levels and those funds resume circulating. 
Central banks must tighten aggressively when loan demand picks up 
As soon as private loan demand recovers the central bank will have to mop up the excess liquidity, which is currently running at two to three times the normal level. Otherwise prices could double or triple. But to do so the central bank must sell the bonds it bought, putting upward pressure on interest rates just when the private sector is ready to borrow money again. The Fed, for example, will have to sell $1.4trn in bonds when conditions in the private sector return to normal, at a time when the economy is recovering and businesses and households are becoming sensitive to interest rates. And if the market decides that the central bank is not mopping up excess liquidity fast enough, that alone could lift private inflation expectations and send bond yields sharply higher. In short, the central bank finds itself in a difficult position whether it sells the securities or not. Either way a major ordeal awaits both the central bank and the bond market. Once this point is reached, the central bank will probably attempt to reduce the “real value” of liquidity in the market by sharply raising the statutory reserve ratio for commercial banks, a tactic frequently employed by the People’s Bank of China. But all these measures will have significant negative implications for the economic recovery. While QE will do little damage at a time when private loan demand is weak or nonexistent, like today, it requires the central bank to engage in aggressive tightening just when the private sector is beginning to recover." - source Nomura - Richard Koo.
Given China's most recent uptick in its PPI to 6.9%, we are indeed wondering if this is not a sign that we should change allegiance slightly towards the "inflationista" camp and start fearing somewhat the possibility of the return of the Big Bad Wolf aka inflation. We will be monitoring closely this latest Chines "inflation impulse". China's rising costs via exports could boosts inflation expectations in the US. These higher inflation expectations in the US would mean a steeper yield curve with a rise in long-duration yields ovcrall and it would lead to higher rates volatility down the line. A bear market needs a wolf and this wolf would materialize in a return of inflation we think.

Obviously the return of the Big Bad Wolf aka inflation would trigger a return of bond volatility. On this subject we read with great interest Christopher R. Cole, CFA from Artemis Capital Management latest note entitled "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987". It was very interesting in Christopher Cole's must read note to see his reference to the Ouroboros, the ancient symbol of a snake consuming its own body. We have used a similar reference as a title analogy recently in our September musings also called "Ouroboros". For us the Ouroboros represents the eternal return or cyclicality especially in the sense of something constantly re-creating itself like credit cycles. For Christopher Cole at Artemis the Ouroboros represents the dangerous feedback low between ultra-low interest rates, debt expansion, asset volatility, and financial engineering that allocates risk based on volatility. What is of interest to us, when it comes to the Big Bad Wolf and the Ouroboros mythical snake is the points made by Christopher Cole from Artemis relating to volatility always coming from debt markets:
"The death of the snake...
Volatility fires almost begin in the debt markets. Let's start with what volatility really is. Volatility is the brother of credit... and volatility regime shifts are driven by the credit cycle.

Volatility is derived from an option on the shareholder equity, but equity itself can be thought as a perpetual option on the future success of a company. When times are good and credit is easy, a company can rely on the extension of cheap debt to support its operations. Cheap credit makes the value of equity less volatile, hence a tightening of credit conditions will lead to higher equity volatility. When credit is easily available and rates are low, volatility remains suppressed, but as credit contracts, volatility rises.

In the short term we do not see the credit stress required for a sustained expansion of volatility, but this can change very quickly. Storm clouds are gathering around 2018-2020, as rising interest rates, rich valuations, and corporate debt roll-overs all converge as potential triggers for higher stress and volatility. The IMF warned that 22% of US corporations are at risk of default if interest rates rise. Median net debt across the S&P500 firms is close to a historic high at over 1.5x earnings, and interest coverage ratios have fallen sharply. Between 2018-2019 an estimated $134 billion of high yield debt must be rolled-over, presenting a catalyst for higher volatility in the form of credit stress.
Reflexivity in the Shadow of Black Monday 1987
Thirty years ago, to the day, financial markets, around the world crashed with volatility never seen before or equaled again in history. On October 19th, 1987 the Dow Jones Industrial Average fell more than -22%, doubling the worst day from the 1929 crash. $500 billion in market share vaporized overnight.

Entire brokerage firms went bankrupt on margin calls as liquidity vanished. It was not a matter of prices falling, there were no prices. You couldn't exit a position. Trading desks refused to pick up the phone. Black Monday appeared to come out of nowhere as it occurred in the middle of a multi-year bull-market. There was no rational reason for the crash. In retrospect, financial historians blame portfolio insurance, ignoring the role of interest rates, inflation, and the Federal Reserve. The demon of that day still haunts markets, and 30 years later the crash is still not well understood. Black Monday 1987 was the first post-modern hyper crash driven by machine feedback loops, but it all started in a very traditional way.
Be careful what you wish for... Today every central bank in the world is trying to engineer inflation, but inflation was the hidden source of the 1987 financial crash. At the start of 1987 inflation was at 1.5%, which is lower than it is today! From 1985 and 1986 the Federal Reserve cut interest rates over 300 basis points to off-set a slowdown in growth. That didn't last for long. Between January and October 1987 inflation violently rose 300 basis points. Nominal rates jumped even higher, as the 10-year US treasury rose 325 basis points from 6.98% in January 1987 to 10.23% by October 1987.

The Fed tried to keep pace by raising rates throughout the year but it was not fast enough. The quick increase in inflation was blamed on the weak dollar, falling current account balance, and rising US debt-to-GDP levels. None of this hurt equity markets, as the stock market rose +37% through August 25th, 1987. Then the wheels fell off." - source Christopher R. Cole, CFA - Artemis Capital - "Volatility and the Alchemy of Risk - Reflexivity in the Shadows of Black Monday 1987"
As pointed out by Christopher Cole in his must read note, the rise of the Big Bad Wolf aka inflation was what started a liquidity fire in credit that spread to equities before the 1987 volatility explosion described. The only issue is once the "Inflation Genie" is "Out of the Bottle" as warned by Fed's Bullard in 2012, it is hard to get it back under control:
“There’s some risk that you lock in this policy for too long a period,” he stated.  ”Once inflation gets out of control, it takes a long, long time to fix it”
Also, in addition to Christopher Cole's points, credit investors have a very weak predictive power on future default rates. Credit investors are collectively subject to an extrapolation bias. When default rates are high, credit investors behave as if default rates were going to stay high for the next 5-10 years. They liquidate their portfolios in panic (or because they are forced to do so). This snowball effect leads to spread levels that have no economic rationale. Inversely, when default rates are low, credit investors believe that stability is the norm, and start piling up on leverage, inventing new instruments to do so (CLOs, CDOs, CPDOs etc.). This recklessness leads to malinvestment, and sows the seeds of the next credit crisis.  Even for a rolling investor (whose returns are also driven by mark-to-market spread moves), initial spreads explain nearly half of 5yr forward returns, that simple as pointed out by our good friend Paul Buigues:
"For us, credit is spread, not yield. A high-yield bond is a bet on the issuer’s creditworthiness combined with a bet on risk-free interest rates. Consequently, people who rely mostly on the low yield argument to justify their bearishness on high yield bonds should concentrate their hostility against Treasuries."
Or in Europe, given the levels reached on some European Sovereign bonds, they should concentrate their hostility against them, given the ECB is the most important buyer in town, for now...

As we have repeatedly pointed out, the money is flowing "uphill" where all the "fun" is namely the bond market, not "downhill" to the "real economy". As we pointed out in our conversation "Thermidor" in August 2016, this of course leading to a "pre-revolutionary" mindset setting in, leading to the rise of "populism" and the deafening sound of "helicopter money" and fiscal profligacy as the "elites" and their central bankers are starting in earnest to "panic" somewhat. Could the rotation from "deflation" to "inflation" trigger indeed a surge in commodities? We wonder... After all the recent surge in the Chinese PPI could indeed be somewhat pointing towards some inflation surprises down the line.

If as indicated by Christopher Cole, volatility is the brother of credit, then obviously assessing the longevity of the credit cycle is paramount. We do agree with Christopher that, for the time being, we do not see the credit stress required for a sustained expansion of volatility. Its only when the Big Bad Wolf will rear its ugly face that we will change our "Practical yield pigs" stance. But if indeed the credit cycle matters from an Ouroboros perspective, then obviously one as to wonder how the death of the credit snake comes about as per our next point below.

  • Credit - Credit cycles die because too much debt has been raised
When it comes to credit and in particular the credit cycle, the growth of private credit matters a lot. If indeed there are signs that the US consumer is getting "maxed out", then there is a chance the credit cycle will turn in earnest, because of too much debt being raised as well for the US consumer, but for now financial conditions are pretty loose. For the credit music to stop, a return of the Big Bad Wolf aka inflation would end the rally still going strong towards eleven in true Spinal Tap fashion. 

On the issue of how the credit cycle could end, we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note from the 13th of October entitled "The Evolution of the Credit Cycle":
"How it ends?
Our observations and model estimates so far have painted a relatively benign picture, suggesting that defaults could remain low for some time. Having adopted this as the base case, we now turn to discussion of factors that could potentially derail it and prove us wrong.
All cycles before this one have ended with a surprise event, a “black swan” of sorts, which, by definition, was unexpected by the consensus and meaningful in its impact. This one is probably not going to be unique in this respect. And while forecasting the exact event is a futile exercise, we can still think about the general set of circumstances that could potentially turn this credit cycle.
Broadly speaking we envision three kinds of developments that could play such a role:
1. Inflation returns. If low inflation and loose central bank policies have played a critical role in helping the markets get to this stage, it would be natural to expect them to play a certain role in reversing this move. At any given level of inflation, major central banks have proved time and again that they are more dovish than consensus expects them to be, and there are few signs to suggest that their behavior is about to change. With that it seems that only a genuine inflation surprise would wake them up and cause the kind of correlated policy tightening that few people currently expect to take place. So far, decent economic growth numbers in the US, Europe, and Asia have failed to spark any measurable inflation pressures. However, we are watching certain economic indicators closely, such as PMIs or Korean and Japanese exports (all at cyclical highs), which could prove to be early signs of an overheating. In the long run, we believe inflation will remain secularly squeezed by technology, but a temporary rise cannot be ruled out.
2. Distress in isolated sectors spreads. We have seen an example of this most recently in energy and commodities, where a 25% default wave nearly pushed the broad HY market into a full-blown default cycle. At the moment, there are few reasons to expect something like that to play out in the next year, with all known problematic segments, such as retail, wireline telecoms, and selected healthcare providers, representing tiny shares of the market (cumulative distress ratio is under 5% today). Again, we see few immediate reasons to believe that these known problems in narrow industries would spread elsewhere, but it’s usually helpful to think about broader vulnerabilities if things develop in some unexpected fashion. To that end, if we expanded the range of problematic sectors to broad retail, healthcare, wireline telecoms, and also brought energy/mining back into the fold, their combined size grows to 30% of the total HY market. An additional layer of risk is being created by extreme concentration of large IG issuers, where the top ten non-financial capital structures today represent 50% of the total size of the HY market, the second-highest on record except for 2002 (Figure 7).

A fallen angel of that magnitude would create a meaningful disruption on transition.
3. Geopolitics cause a trade contraction. The long list of unresolved global conflicts here is well known and does not require a recital here. Suffice to say that a flare up in any one of them could easily awaken the markets from their QE-induced hypnosis. And even outside the worst-case scenarios of an open military engagement, things could develop in a way such that the global economy suffers a shock. Consider the fact that S Korea is the single-largest source of Chinese imports, followed by the US and Japan. The same trio also appears on the other side of this trade superhighway, only as the largest destinations of Chinese exports. It is probably fair to say that some major global supply chains depend critically on these lanes staying wide open and unencumbered. One could draw a dotted line between where we are and a sharp contraction in this epicenter of global trade even if the world avoids the worst-case scenario on the Korean peninsula." - source Bank of America Merrill Lynch
Indeed, credit should be afraid of the Big Bad Wolf aka inflation. This would clearly generate renewed volatility in the rates space and obviously a reaction in the credit space. It seems for now the market doesn't seem much concerned by an inflation surprise, while the carry and beta game continue to be played significantly thanks to low volatility. We are part of the crowd that thinks that any small upside surprises in inflation could potentially affect markets materially. Such a surprise would trigger a surge in volatility. So who is afraid of the Big Bad Wolf? We are.

For our final chart, when it comes to predicting a move in the credit cycle and a surge in default rates as we pointed out in the past, you need to track the quarterly Fed's Senior Loan Officer Opinion Surveys (SLOOs).

  • Final chart - Senior officer loan survey leads default rates

The most predictive variable for default rates remains credit availability. The SLOOS report is that it does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. Our final chart comes from Bank of America Merrill Lynch Collateral Thinking note from the 20th of October and entitled "Deconstructing the default rate". It displays that SLOOs leads default rate in general:
"Being in one of the longest running credit cycles in history, the question we get asked most frequently is: when will we get the next default cycle? While we believe we are in the ninth inning, there is also evidence suggesting that the cycle has some more room to run in terms of accumulation of debt and generation of profits. As such we don’t think that default rates have quite bottomed out yet and believe next year to be characterized by even fewer default losses than this year. Our belief rests on both the macro and micro indicators that we use to predict the direction of default rates in Loans as well as HY.
Specifically for the loan universe, which we define as the loans in the LCD index, we gauge the state of the macro environment through the senior loan officer survey. This survey determines the ease with which medium to large sized companies (annual revenue>$50mn) are able get bilateral loans from banks, and thus is a good broad level indicator of on-ground credit conditions. On a micro level, we capture the change in the credit risk of the Loan universe through migration rates. A combination of these two factors is able to explain almost all of the variation in default rates since 2009 with about a 12 month lag. Today, both those factors are largely supportive of loans- the survey shows financial conditions have been easing for two quarters in a row (Chart 3), while credit migration rates have not materially deteriorated to flash warning signs. We think this firmly sets the stage for a lower default rate in 2018." - source Bank of America Merrill Lynch
Of course, should the Big Bad Wolf rear its ugly face again, then obviously, all credit bet for high yield would be off with the return of heightened volatility, the dear brother of credit as pointed at by Christopher Cole from Artemis Capital. For now Fiddler Pig and Fifer Pig continue to arrogantly sing while the volume is pumping up towards 11 that is in true Spinal Tap fashion but we ramble again it seems...

"It never troubles the wolf how many the sheep may be." -  Virgil
Stay tuned!

Thursday, 12 October 2017

Macro and Credit - Anatomy of Criticism

"Criticism may not be agreeable, but it is necessary. It fulfils the same function as pain in the human body. It calls attention to an unhealthy state of things." - Winston Churchill

Watching with keen interest, the continuation of the beta rally in both equities and credit, while looking at the weakening of the US duration trade on renewed discussions on tax reforms in the US as well as most recent macro data, when it came to electing this week's title analogy, given the growing change of narrative coming from our central bankers, we reminded ourselves of Canadian literary critic Northrop Frye's work entitled "Anatomy of Critiscim" from 1957. In Frye's Anatomy of Criticism, he deals extensively with what he calls myths of Spring, Summer, Fall, and Winter:
  • Spring myths are comedies, that is, stories that lead from bad situations to happy endings. Shakespeare's Twelfth Night is such a story and QE 1 as well in addition to the suspension of mark to market accounting rules. and other supports provided by our "Generous gamblers" aka our central bankers.
  • Summer myths are similarly utopian fantasies such as Dante's Paradiso or Universal Basic Income, or incredible valuation levels for Aramco's upcoming IPO.
  • Fall myths are tragedies that lead from ideal situations to disaster. Compare Hamlet, Othello, and King Lear and the movie Legends of the Fall, or the referendum in Catalonia, or the ongoing face-off with North Korea.
  • Winter myths are dystopias; for example, George Orwell's 1984, Aldous Huxley's Brave New World, and Ayn Rand's novella Anthem and the rise of the robots, including the spying of individuals through social networks and other means.
In similar fashion, all human narratives have certain universal, deep structural elements in common. Same things goes with credit and business cycle, no exception there. Our credit criticism in various musings have illustrated a rising unhealthy state of things to paraphrase Churchill. As we pointed out as well more recently, the beta rally is still going strong towards 11 that is, in true Spinal Tap fashion. After all records have to be broken on the way up as well as on the way down. But, contrary to the perma-bear crowd, we still think this rally has some more steam to go, given current financial loose conditions we are seeing, hence the outperformance of the beta play such as the CCC High Yield credit bucket this year. Of course there is always the exogenous risk factors at play, which could indeed spark some repricing in the on-going rally. We had the BREXIT, the Trump rally and now we have the on-going political tussle in Spain which we have decided to coin "FRACASTONIA" but we ramble again...Anyway, from a financial markets point of view in the coming weeks is the rising change of narrative from central bankers. Like in Disney's movie Fantasia, it's looks to us that our sorcerer's apprentice is starting to think it's liquidity injection via his magic broom is getting a little bit out of control, and for this little guy, financial stability matters, and matters a lot.

Dear readers, we would like to apologize for the lack of posting recently, but we have been travelling hence our difficulties in putting our thoughts down in our usual weekly fashion. In this week's conversation, we would like to look at if in credit, carry is still the trade du jour, or put it simply, is it still "beta max". Also from a macro perspective, we will look again at inflation from an autocorrelation problem perspective.

  • Macro - Inflation has an autocorrelation problem.
  • Credit - Beta max? Don't get "carried" away.
  • Final chart - A structural weakness in the labor market
  • Macro - Inflation has an autocorrelation problem.
While we recently took many potshots at the Phillips Curve "cult members" and discussed also the change in markets fundamentals such as globalization and demographics which have to some extent weighted on the efficiency of the Fed's model, we would like to look at additional reasons why the Fed continues to deviate from its 2% inflation mandate and what it entails. On that subject we read with interest Wells Fargo's take from their note from the 3rd of October entitled "Is There an “Invisible Hand” Behind the 2 Percent Inflation Target Rate?":
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” - Mark Twain
Executive Summary 
The Federal Open Market Committee’s (FOMC) 2 percent inflation goal is often targeted by adjusting the FOMC’s monetary policy stance. The implicit assumption (or the invisible hand) behind the 2 percent inflation target is that the inflation rate is mean-reverting at the 2 percent rate. However, this assumption requires further inspection and raises questions regarding the possibility that the inflation rate would deviate from the target rate. Moreover, what is the behavior of above-/below-target inflation? Are these deviations temporary or permanent in nature? 
An inflation target plays a critical role in the FOMC’s monetary policy decision making process. Therefore, testing, instead of assuming, to determine if the PCE inflation rate is mean-reverting is crucial for decision-makers.
Our statistical analysis suggests that the PCE inflation rate may be mean-reverting, although the evidence is tenuous. So, can we assume inflation is mean-reverting, and what level of confidence do we have? A mean-reverting series, by definition, can fluctuate from its mean but eventually returns to some average value. The next challenge is to estimate the pace of adjustment. That is, how long does it take the inflation rate to return to the target rate after deviating from it? And does the PCE inflation series have a persistence/autocorrelation problem? 
Why is persistence/autocorrelation of the inflation rate a concern for decision-makers? Inflation persistence has crucial policy implications as a consistently below-/above-target inflation rate would suggest an accommodative/restrictive monetary policy for an extended period of time, all else constant. Therefore, a very slow pace of monetary policy normalization would be a possible result if below-target inflation persists for an extended period of time. 
To Anticipate the Results 
Our analysis indicates that inflation has an autocorrelation problem. Put differently, when the inflation rate deviates from the target rate, inflation takes a long period to get back to the 2 percent target rate. One major reason is that the current inflation rates are highly correlated with the past values (coefficients are very high, close to one). Therefore, the inflation rate would take a longer time to get back to the target rate than if autocorrelation were not present. For example, during the period from November 2008 to August 2017, the inflation rate was below the 2 percent target for 86 out of 106 months. 
Furthermore, persistently low inflation may not only affect interest rates but also other variables. One of them is the unemployment rate, as the Phillips curve suggests an inverse relationship between the unemployment rate and inflation. The recent debate about the Phillips curve status is reflective of the characteristic that the original Phillips curve does not allow for an autocorrelation problem. Persistently low inflation may also explain part of the slower wage growth in recent years. Low inflation rates may reduce business production and their ability to raise prices, and, thereby, may affect profit margins in a low-productivity economy. The wage-price spiral may have lost its speed as well.
Source: U.S. Department of Labor and Wells Fargo Securities 
The 2 Percent Inflation Target Rate: Is Inflation Mean-Reverting? 
Statistically, if a series is mean-reverting then that series will move around its mean (the FOMC is assuming the 2 percent is the mean) and deviations from the mean (higher/lower inflation periods) are temporary in nature. As a policy model, the FOMC’s 2 percent target assumes, implicitly, the inflation rate is mean reverting. 
We live in a constantly changing world and need to test, instead of assume, that the PCE inflation rate is mean-reverting. We apply a unit root test (ADF test) to find out if the inflation rate is mean-reverting.1 The PCE deflator (year-over-year percent change) is the preferred inflation measure of the FOMC, and, thereby, we utilize that series in our analysis, Figure 1.
For the 1984-2017 period, we find the inflation rate is mean-reverting and the mean is 2.3 percent. In the next step, we apply the state space approach to test the possibility of a structural break in the inflation rate series. If we find a structural break in the inflation rate and the break coefficient is positive (negative), then that indicates the inflation rate has shifted upward (downward) since the break date. We found two breaks—one positive and the other negative. Both breaks represent the price swings during of the 2008-2009 financial crisis. Therefore, the inflation path temporarily shifted and then returned to the long run average—a typical behavior of a mean reverting series.
Autocorrelation: When Slow and Steady May Not Be Enough to Win the Race 
If a series is mean-reverting, the fluctuations from the mean are temporary—but fluctuations still exist. Thus, while inflation rates may deviate from the mean, it is crucial to find out the pace of adjustment. How long does it take inflation to get back to the mean? PCE inflation persistently above or below the 2 percent target rate is not ideal for the FOMC. Both of these scenarios would ask for an extended period of a particular monetary policy stance. One way to test if the inflation rate series has a persistence problem is to test for an autocorrelation. The inflation data having an autocorrelation problem would indicate that the farther the inflation rate deviates from the target rate, the longer the inflation rate would take to return to the 2 percent target rate.
We estimate autocorrelation functions (ACFs), and the estimated correlation coefficients are nonzero, statistically, for first 12 lagging months, Figure 2. Furthermore, if the estimated coefficients are non-zero then that indicates the underlying series has the autocorrelation problem. We found that the PCE inflation series is autocorrelated, which indicates current inflation rates are highly correlated with its past values (coefficients are very high, close to one). Therefore, the inflation rate would take a longer time to get back to the target rate. During the period from November 2008 to August 2017, the inflation rate was below the 2 percent target for 86 out of 106 months.
This gives reason for the market’s expectation that the pace of monetary policy adjustment would be gradual as well. 
Why is the persistence/autocorrelation of the inflation rate noteworthy for monetary policy decision-makers? Inflation persistently below the target would indicate an accommodative monetary policy for an extended period of time, all else constant. Therefore, a very slow pace of the monetary policy normalization is a possible result of persistently lower inflation
Final Thoughts: The Invisible-hand may need a Boost 
The mean-reverting along with lack of autocorrelation/persistence assumptions may be the ‘invisible hand’ behind the 2 percent target rate. However, our findings of autocorrelation suggest the invisible hand may need a boost. Moreover, the autocorrelation/persistence problem has broader implications for decision makers, as persistently lower inflation may not only affect interest rates but also other variables. One of them is the unemployment rate, as the original Phillips curve does not anticipate an autocorrelation problem, Figure 3.

A persistently low inflation rate may also explain part of the slower wage growth in recent years. The persistently low inflation rate may reduce business production and their ability to raise prices and thereby may affect profit margins in a low-productivity era. The wage-price spiral may have lost its speed as well. Therefore, the invisible hand behind the inflation rate may need a boost." - source Wells Fargo
So on top of structural headwinds mentioned while criticizing the Phillips Curve model aka the Norwegian Blue parrot, inflation does suffer from an autocorrelation problem as well it seems. Furthermore, there has been rising discussions surrounding a potential return of inflation in recent weeks, not only on the blogosphere, but, as well from the sell-side. Concerns of the tightness in certain labor markets in Developed Markets (DM), make some sell-side pundits wonder if inflation could not make an unexpected return. Despite the low inflation conundrum discussed in various musings of ours, we do think that the change of the narrative from our central bankers is more a case of loose financial conditions than anything else. Regardless of the undershoot of the Fed's inflation mandate, we do think that Financial Stability matters more, when it comes to their rising discomfort with valuation levels reached in many asset classes. This is an important point put forward by Bank of America Merrill Lynch in their Liquid Insight notes from the 6th of October entitled "Jobs and FX":
"When central banks ignore low inflation 
Since the latest USD rally started in mid-August, the only currencies that have done even better than the USD are GBP and CAD. In all three cases, the respective central banks surprised markets with a hawkish turn, either hiking, as in the case of the BoC, or effectively announcing that a hike was on the way, as in the case of the Fed and the BoE. In all three cases, the real reason was not inflation concerns: UK inflation is above the BoE’s target, but mostly because of the sharp GBP drop since the Brexit referendum. Concerns that the labor market was getting too tight was the main reason, in our view, possibly leading to inflation pressure in the future. 
This suggests to us that many G10 central banks may either believe inflation is temporarily low, or that available inflation measures are missing something important. In Don’t fight the central banks when they want to do the right thing we argued that the Fed and most likely other central banks are also concerned about asset price bubbles and that they would take advantage of the “good times” to normalize policies, despite low inflation. It may not be their job to call a bubble, but it would also be irresponsible to allow bubbles to form. Leaning against the wind may be a good compliment to macro prudential measures, which have proved to have a mixed record anyway. 
Inflation could still surprise to the upside. The Phillips curve has lost its appeal, but the gap between labor markets and inflation is the widest it has been in recent decades (Chart 1). 
Some indicators suggest US inflation is not that low, with an index including a larger basket of goods suggesting US inflation is high and rising (Chart 2). 
Global monetary policies remain very loose in any case. A simple Taylor rule suggests that global monetary policies have never been looser than today in recent decades, with all G10 central banks having loose policies (Chart 3 and Chart 4).

Monetary policies have a long way to tighten before they become tight.
At the same time, while in recent years G10 central banks were involved in a form of a currency war, this has changed more recently. We believe Fed tightening—hikes and unwinding of its balance sheet—creates more room for other central banks to adjust their policies to a stance more consistent with their domestic conditions, without being concerned that their currencies may overshoot. 
Labor markets and FX valuations 
We are trying to assess possible inflation pressures by looking at the extent to which G10 labor markets are tight. Even if the Phillips curve is flat, or at least more flat than it used to be, recent central bank focus on labor market constraints suggests to us that the answer on which central banks are likely to move next may be in the labor market.
To do so, we do not have to know the natural rate of unemployment, which is difficult to estimate in practice. Instead, we look at the difference between the latest unemployment rate from the lowest level since 1980. It is reasonable to assume the smaller this gap, the tighter the labor market, and the more likely the central bank may want to tighten policies.
We then compare labor market tightness with valuation of G10 currencies. We also take a simple approach in FX valuation, by considering the z-scores of real effective exchange rates from their 20-year averages. Currencies that deviate the most from their historical average are likely to be the most misaligned. The results could provide insights on which G10 FX crosses could perform well in the medium term because of central bank policies, keeping everything else constant.
The Chart of the Day shows the results from this analysis, as follows:

  • GBP/CHF has the most upside potential. The UK labor market is the tightest in G10, with the unemployment rate at an all-time low. At the same time, GBP is the most undervalued G10 currency. On the other hand, unemployment remains historically high in Switzerland, while the CHF is overvalued. Of course, Brexit uncertainty is what is keeping GBP weak. Still, our results suggest GBP/CHF has the most potential to appreciate in G10 if the BoE starts a hiking cycle, or if the UK and the EU agree on a Brexit transition. EUR/GBP will also weaken in this case, as the Eurozone has the highest unemployment rate compared with its own history.
  • CHF/JPY could weaken. The cross is overvalued, while the labor market in Japan is tighter than in Switzerland. This is consistent with our bearish CHF outlook.
  • The Scandies could do well against the Antipodeans. SEK and NOK are historically cheaper and with tighter labor markets than AUD and NZD. Our results also support buying CAD against AUD and NZD.
  • The outlook for EUR/USD is mixed based on this analysis. Although the Eurozone has much higher unemployment than the US, EUR/USD is somewhat undervalued. This is consistent with our projections, expecting EUR/USD to weaken slightly more, to 1.15, by end-2017, but appreciate back to 1.19 in 2018.
  • Similarly, our analysis suggests balanced risks for USD/JPY, with the US labor market tighter than in Japan, but USD/JPY overvalued.
  • EUR/JPY on the other hand could weaken, as Japan’s labor market is tighter than in the Eurozone, while EUR/JPY is historically strong. However, this analysis does not take into account the ECB constraints, which are likely to force early QE tapering next year. If the BoJ remains committed to its loose monetary policies, EUR/JPY could even appreciate more—for these reasons, long EUR/JPY was one of our high conviction year-ahead trades for 2017. 
Bottom FX line 
Our analysis suggests possible surprises from central banks in G10 as they focus more on labor market conditions, despite low inflation, could support GBP against CHF and EUR, with the caveat of downside risks from Brexit negotiations. They could also support the Scandies, CAD and JPY against the Antipodeans, and could also be bearish for CHF/JPY. 
Although our results are mixed for the USD, as the US labor market is tight but the USD is not historically weak, we would argue the Fed will continue leading the normalization process, which should keep the USD supported. In any case, the USD is not far from its historical average, suggesting it could appreciate more in the short term. We expect Fed tightening to create more room for other central banks to follow, without being concerned that their currencies could overshoot. This suggests to us that the trigger to position for monetary policy divergence in G10 FX could be provided by the December Fed hike, particularly if markets move closer to the Fed’s dot plot for next year. Progress in US tax reform could have a similar impact, although with a much stronger USD
appreciation, in our view. " - source Bank of America Merrill Lynch
While we agree with Bank of America Merrill Lynch's view that the Fed and other central banks are also concerned about asset price bubbles, when it comes to USD strength, we have already seen a significant rally in a short period of time. A cause for concern we think, from an "Anatomy of Criticism" perspective lies in the growing trade war rhetoric between several countries. This would not be supportive of the USD dollar, on the contrary. While everyone is focusing on the US tax reform, we do think that it will be essential to monitor possible growing tensions in global trade in the months ahead.

When it comes to asset price bubbles, we also think that we continue to be on a trajectory of going to 11 that is, in true Spinal Tap fashion when it comes to valuation levels. We might have been overly defensive credit wise when it comes to the performance of the beta space and in particular the CCC High Yield bucket. It remains to be seen how long this game is going to continue. In the meantime flows remain supportive and the change in the narrative from our central bankers is yet to be perceived  as a meaningful threat by the investors crowd.

  • Credit - Beta max? Don't get "carried" away.
Whereas we continue to witness a significant mountain of negative yielding assets globally, the credit mouse trap has been set by our central bankers. For investors starved of safe yield, anecdotally we even have seen Investment Grade investors with no choice but to reach out for more duration and more credit risk. No wonder they have gone for higher quality high yield, causing the BBs rating bucket to return a very decent 6.8% YTD. At the same time, low volatility and minimal credit losses, have led CCCs  credit canary to reward handsomely credit investors with a YTD of 9.8% according to Bank of America Merrill Lynch. The current low interest rates volatility is providing a "goldilocks" environment for credit. Unless there are some meaningful exogenous factors that come into play, it seems to many that the game of "carry" appears to be "bulletproof". 

As we pointed out in recent musings, no doubt to us that we will go to 11, valuation wise in true Spinal Tap fashion. On the subject of valuation for credit we read with interest Deutsche Bank's Credit Strategy note from the 20th of September entitled "Is Carry Still King?":
"Valuations even more stretchedThe performance seen through the summer has only served to make credit appear to be even more expensive as we head towards Q4. Figure 2 (left) updates our often used analysis highlighting where current spreads rank relative to their own histories for a broad selection of credit indices. As we stand all but two of the analysed indices are at a spread level tighter than the median. For EUR HY, spreads are at levels where they have been tighter less than about 15% of the time through history. It is not quite so extreme for IG but non-financial BBBs across all currencies are around the cusp of the tightest quartile. Looking at the right hand chart, which is focused on the rank history for EUR non-financials, we can see that we reached even tighter spreads in early August. 

In Figure 3 we look at EUR IG and HY non-financial spread histories to get a sense of where current spreads sit relative to levels going all the way back before the financial crisis. As can be seen, the current HY/IG spread ratio is near a record low and we continue to see HY valuations as stretched at an absolute level as well as relative to IG. Nevertheless, we are also cognizant of the fact that at the current stage of the economic cycle stretched valuations can persist for a while. Overall, we think HY would be more vulnerable in a sell-off following its recent outperformance.

Spreads supported by positive economic momentum 
In general, there's no doubting that across the credit spectrum valuations appear expensive. However continued performance has been supported by the solid macro backdrop. In particular European macro data have generally been strong in recent weeks/months. In Figure 4 we show our economists' SIREN monitors looking at indices summarising both economic growth momentum and macro surprises.

(For more information on these monitors, please see the relevant section in DB Focus Europe, available at The SIREN Momentum index has been in a new, higher range in the last six months, consistent with close to 2.5% annualised GDP growth. At the same time the SIREN Surprise index has also improved since the middle of the year, edging back into positive territory.
In addition to the supportive macro data we have also continued to operate against a backdrop of low volatility which tends to keep spreads tight. Measures of market volatility remain at the lower end of ranges and as such we couldn't entirely rule out some further spread compression. Updating our simple spread model looking at where implied equity, rates and FX volatility suggest that while HY spreads are broadly in line with the volatility-implied levels, for IG an argument can be made that spreads could get even tighter. But at the very least the charts suggest that if we don't see a meaningful move higher in volatility then spreads are likely to remain close to the current relatively tight levels. 

Will technicals provide some headwinds? 
Obviously, central banks remain a key driver of asset prices and in EUR credit, the ECB CSPP remains a powerful force keeping spreads in check. While we do expect the ECB to announce a further trimming of the overall QE programme on 26 October, we expect them to err on the side of caution given the absence of inflationary pressures. The ECB's exit from the bond market is likely to take place over an extended period of time even if the economy evolves according to their forecasts. While we do expect the negative technicals of a QE taper to lead to moderate widening of spreads, as long as economic fundamentals continue to be strong we would not expect a meaningful sell-off in credit." - source Deutsche Bank
Indeed, central banks remain the key driver of asset prices, hence the importance to track the change in their narrative. Both the Fed and the ECB will probably reduce the alcohol content of the credit punch bowl at a very slow pace.

While we advise for caution, the continuation of the rally in all things beta seems to be pointing towards the development of a state of euphoria. As long as the narrative of our generous gamblers doesn't meaningfully change or some exogenous factors comes into play (Catalonia aka "Fracastonia", North Korea and more...) it seems we are surely going to move towards the 11 level. After all records are meant to be broken. In this high stake poker games, it seems the margin for error is smaller by the day, we would rather tone down the enthusiasm and continue building some defenses. One could opine that given the on-going goldilocks period for credit thanks to low interest rates volatility, one should continue to play the "beta max" game as posited by Société Générale in their Credit Strategy Weekly note from the 29th of September entitled "Only a shock can shake credit":
"Only a shock can shake credit 
Into the last stretch of what has been another good year: The last quarter of the year is upon us, and so far the performance has been fairly healthy across the various credit asset classes. After surpassing all major political tests, there remains one hurdle in the form of the ECB meeting in late October. The risk is that the central bank announces a rapid withdrawal of QE support that disrupts the markets. Even a slow withdrawal is likely to be enough to push sovereign risks higher and put pressure on credit spreads, even if we believe that CSPP will be the last programme to be altered. At best, the ECB will simply announce an extension, and in that case it’s plain sailing until the end of the year. But a tapering announcement is not improbable, and in that sense we prefer to reduce duration, as we expect the credit curves to steepen. 
High beta sectors remain the place to be: Tapering or no tapering announcement, the higher beta sectors (AT1 CoCos, sub insurance, Tier 2 bonds and corporate hybrids) remain the better investment alternatives on both sides of the Atlantic, in our view. If there is no tapering, the high beta sectors, names and bonds will outperform given the higher carry and tightening potential. But if tapering does come and we see yields on a rising trend, then these sectors are likely to be the more volatile, but the higher breakevens will provide a better cushion and ultimately a better performance than low beta, low yielding, high rated and long maturity bonds." - source Société Générale
Whereas macro data continues to be supportive, from an "Anatomy of Criticism" perspective, only a change in the narrative from our "Generous Gamblers" constitute the largest threat to the investors crowd. The herd mentality continues to be strong in playing the beta game. When it comes to US Investment Grade Credit as shown by Bank of America Merril Lynch in their Situation Room report from the 11th of October entitled "New post-crisis tights" we are going to 11 in a Spinal Tap fashion:
"On Tuesday our benchmark US high grade index reached the tightest level at 103bps since the financial crisis. This follows the previous spread market peak over three years ago, when spreads bottomed out at 106bps on June 24, 2014 (Figure 1).

Here we update our analysis on where spreads stand currently relative the prior market peak in 2014 (see Vs. post-crisis tights). One factor contributing to tighter spreads currently are the large downgrades to high yield in 2015, mostly among EM credits. With many wider issuers out of the high grade index, EM spreads are now 40bps tighter than in June 2014, while DM issuer spreads are actually 3pbs wider." - source Bank of America Merrill Lynch
Thanks to low rate volatility, the carry game enables all sort of beta plays. Unfortunately, it is getting late in the game and central bankers have started to lower the volume in the credit binge party. You have been warned.

Whereas the latest job report was a miss, for our final chart, there is more to the low inflation story and its coming in the US from structural issues preventing an acceleration in wages increases and it has to do with the labor market.

  • Final chart - A structural weakness in the labor market
We won't go through again all the arguments we have put forward for the Fed's broken Phillips Curve model, hopefully we have put that Norwegian Blue parrot to rest, no offense to the cult members out there. What is we think more interesting from a US macro perspective is that there is a structural weakness in the US labor market which, as pointed out by Wells Fargo in their report from the 6th of October entitled "Taking the Long View Over the Short Run Dip". The Beveridge curve shows that the mean duration of unemployment remains stubbornly high:
"Structural Problems Persist: Drag on GrowthFor any given unemployment rate (labor supply), the vacancy rate (job openings) remains wider than in the previous expansion (bottom graph), however the slack is gradually tightening. 

This Beveridge Curve signals a structural weakness in the labor market which is confirmed by several labor market survey indicators. Compared to a year ago, the unemployment rate for those without a high school education and with a high school diploma remains higher than the unemployment rate for those with some college. The mean duration of unemployment rate remains at 24.4 weeks which is higher than any level since 1982. Finally, the prime age labor force participation rate has risen over the last year but remains far below the level of participation since 1990." - source Wells Fargo
If inflation remains low, is also due to the fact that the prime age labor force participation rate hasn't been repaired and is still pretty much impaired. Fed minutes show concern that low inflation is not transitory. Whereas the Fed finds it mysterious that inflation is still so low, we don't. Maybe the Fed should start their own "Anatomy of Criticism" after all, but we ramble again...

"The true mystery of the world is the visible, not the invisible." -  Oscar Wilde

Stay tuned!

Monday, 25 September 2017

Macro and Credit - Rescission

"Perfection of planned layout is achieved only by institutions on the point of collapse." -  C. Northcote Parkinson, British Historian

Looking with interest at the decisions taken by the Fed at its FOMC meeting to start unwinding its bloated balance sheet, when it came to selecting our title analogy, we reacquainted ourselves with the term "Rescission" from contract law, (not to be confused with "Recession" yet). In contract law, "Rescission" has been defined as the unmaking of a contract between parties. "Rescission" is the unwinding of a transaction. This is done to bring the parties, as far as possible, back to the position in which they were before they entered into a contract (the status quo ante). One could opine that "Rescission" is typically viewed as "an extreme remedy" which is rarely granted, but in the case of the Fed, it was a unanimous decision to hold the federal funds rate between 1.00% and 1.25% and begin the process of shrinking its balance sheet by October hence our chosen analogy for this week's conversation.

Before we go into more details of this week's conversation, we would like to make a support appeal on behalf of our surfing friends in Saint Martin. They lost everything when hurricane Irma levelled their island. While we do have a tip jar on the blog page, for those of you who enjoy our free weekly musings, we would be extremely grateful if you could be helping out in providing financial support for the reconstruction of Saint Martin's surf club facilities given they really need a new boat. These facilities have been effectively wiped out. Jean-Sebastien Lavocat, a great windsurfer and surfer, is running the place. In 23 years of existences the surfing club of Saint Martin has generated numerous young surfing champions including current top French number three Maud Le Car. He really needs your support to continue to do so. You can make donations at the following address: Solidarity with Windy Reef. Please give them a hand. As well, the natural reserve area where the surf club is located, needs financial support. You can also donate on the following page: "Réserve Naturelle St-Martin Vs IRMA". After Irma please participate in the restoration of the last natural sites of the island of Saint Martin! Thanks again.

In this week's conversation, we would like to look at the Fed's low inflation mystery, in relation to the fall of productivity in the US, yet another nail in their Norwegian Blue parrot aka the Phillips Curve. Another wise wizard from the BIS, namely Claudio Borio has delivered another blow to the outdated model used by the central banking "cult members".

  • Macro - Low inflation mystery? The Fed is gone fishing.
  • Credit - Beware of rapid credit expansion
  • Final chart - "Broken" asset investment in Developed Markets

  • Macro - Low inflation mystery? The Fed is gone fishing.
Given the colloquial meaning of "Gone Fishing" relates to a checkout from reality, as well as being unaware of what's going on, Janet Yellen's latest comment on the low inflation mystery is another indication of their lack of understanding of why their Phillips Curve model is clearly past its due date we think. 

While in various recent musings we have been pounding this Norwegian Blue Parrot, which is still resting for the Phillips Curve "cult members", we couldn't resist to bring back this subject following the support coming from Claudio Borio, Head of the BIS Monetary and Economic Department in his most recent discussion on the low inflation issues entitled "Through the looking glass" published on the 22nd of September 2017.  
"Central banks must feel like they have stepped through a mirror, and who can blame them? They used to struggle to bring inflation down or keep it under control; now they toil to push it up. They used to fear wage increases; now they urge them on. They used to dread fiscal expansion; now they sometimes invoke it. Fighting inflation defined a generation of postwar central bankers; encouraging it could define the current one.
What is going on in this topsy-turvy world? Could it be that inflation is like a compass with a broken needle? That would be a dreadful prospect – central bankers’ worst nightmare. And what would be the broader implications for central banking?
In my presentation today, I would like to address these troubling questions. I will do so recognising that “in order to make progress, one must leave the door to the unknown ajar”, as Richard Feynman once said. We should not take for granted even our strongest-held beliefs. That, of course, means that I will be intentionally provocative.
I will make three key points – putting forward two hypotheses and drawing one implication.
First, we may be underestimating the influence that real factors have on inflation, even over long horizons. Put differently, Friedman’s famous saying that “inflation is always and everywhere a monetary phenomenon” requires nuancing (Friedman (1970)). Looking back, I will focus mainly on the role of globalisation; but, looking forward, technology could have an even larger impact.
Second, we may be underestimating the influence that monetary policy has on real (inflation-adjusted) interest rates over long horizons. This, in fact, is the mirror image of the previous statement: at the limit, if inflation were entirely unresponsive to monetary policy, changes in nominal rates, over which central banks have a strong influence, would translate one-to-one into changes in real rates. And it raises questions about the idea that central banks passively follow some natural real interest rate determined exclusively by real factors, embodied in the familiar statement that interest rates are historically low because the natural rate has fallen a lot. Here, I will provide some new empirical evidence to support my hypothesis.
Finally, if these hypotheses are correct, we may need to adjust monetary policy frameworks accordingly. As I shall explain, that would mean putting less weight on inflation and more weight on the longer-term real effects of monetary policy through its impact on financial stability (financial cycles). Incidentally, the stronger focus on financial stability would bring central banking closer to its origins (Goodhart (1988), Borio (2014a))." - source Claudio Borio, BIS
Of course, we would argue that, if indeed, one is to make progress, one should be ready to reassess the validity of its framework such as the sacrosanct Phillips Curve. We were pleasantly surprised to read in the excellent speech from one of the BIS maverick economists, that globalization was put forward as one of the reasons for the lack of responsiveness of the Phillips Curve framework, which for some is simply resting like a "Norwegian Blue parrot":
"The one I find particularly attractive is that the globalisation of product, capital and labour markets has played a significant role. Is it reasonable to believe that the inflation process should have remained immune to the entry into the global economy of the former Soviet bloc and China and to the opening-up of other emerging market economies? This added something like 1.6 billion people to the effective labour force, drastically shrinking the share of advanced economies, and cut that share by about half by 2015. Similarly, could it have remained immune to the technological advances that allowed the de-location of the production of goods and services across the world? Surely we should expect the behaviour of both labour and firms to have become much more sensitive to global conditions. We know that workers are not just competing with fellow workers in the same country but also with those abroad. We know that, for a given nominal exchange rate, the prices of two tradable goods that are close substitutes should track each other pretty closely. And we know that exchange rates have not been fully flexible, as the authorities have been far from indifferent to exchange rate movements. In other words, we should expect globalisation to have made markets much more contestable, eroding the “pricing” power of both labour and firms. If so, it is quite possible that all this has made the wage-price spirals of the past much less likely.
More specifically, one can think of two types of effect of globalisation on inflation. The first is symmetrical: assuming something akin to a global Phillips curve, one would expect domestic slack to be an insufficient measure of inflationary or disinflationary pressures; global slack would matter too. The second is asymmetrical: one would expect the entry of lower-cost producers and of cheaper labour into the global economy to have put persistent downward pressure on inflation, especially in advanced economies and at least until costs converge." - source Claudio Borio, BIS
As we pointed out earlier in September in our conversation "Ouroboros", these are the reasons why the Phillips Curve is broken we think:
"For us, there are three main reasons why the Phillips curve is a Norwegian Blue parrot, simply resting in a Monty Pythonesque way:

  1. Demographics: as population ages, there are more pressure on aggregate demand and total consumption. 
  2. Globalization: real wages have come under pressure thanks to offshoring of labor in different parts of the world, leading to good solid wages jobs in the industrial sector being replaced by low qualification low paying jobs in the service and hospitality sectors.
  3. Technology: As per Henderson's work and recent progress in technology, pressure on prices as been appearing thanks to the Experience curve. The fight between Amazon and the retail sector comes to mind we think about it. Technology has been holding down costs overall and facilitated rapid price competition in some sector (internet on retail).
This is why we think the Phillips curve is obsolete, for structural reasons." - source Macronomics, September 2017

Obviously our hypotheses have been given some much appreciated boost from none other than the wise and respected Claudio Borio from the BIS. We will not delve into more details of Claudio Borio's speech, but, in our opinion, it is a must read, particularly for the Phillips Curve "cult members". As Richard Feynman once said, and as pointed out by BIS Head of Monetary and Economic Department, in order to make progress, one must leave the door to the unknown ajar. Unfortunately, for many it seems, the door is closed. For them, the Phillips Curve is simply "resting".

The pace of wage inflation is influenced by productivity growth. In this environment of weak productivity growth, firms may be more hesitant to raise wages. Productivity growth has averaged 0.5 - 1.0% yoy over most of this recovery, which is a historically slow pace of growth. Without productivity growth, it becomes harder for companies to justify raising wages since the output per worker has failed to increase, that simple. We already discussed the issue of US productivity in June 2016 in our conversation "Optimism bias":
"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." - source Macronomics, June 2016
As we pointed out to Kevin Muir author of the Macro Tourist in our conversation "The Dead Parrot sketch", a business owner is a "deflationista" at heart because he fights day and night to compress his costs and find smart ways to do more and earn more with less in order to maximize his profits. Also it is worth mentioning French economist Jean Fourastié's work relating to real wages, real prices and in particular around productivity. In our last conversation we indicated that when it comes to the Phillips curve, the deflationary bias of capitalism and the Experience Curve should not be neglected in addition to the globalization factor:
"As we move towards the end of an economic expansion in the US, productivity has been falling, and jobs have been mostly created for lower skills workers, hence the lower wages conundrum weighting on inflation expectations." - source Macronomics, September 2017
When it comes to productivity issues, it seems to us that the Fed is unaware of what's going on, namely, that they've "gone fishing". On the issue of low productivity, we read with interest Bank of America Merrill Lynch's Economic Weekly note from the 22nd of September entitled "Productivity growth is a procrastinator":
  • "The US economy is currently in a low productivity regime, averaging just 0.6% growth since 2011.
  • The near-term outlook appears dim due to headwinds from unfavorable demographic factors and weak capital investment.
  • Broad adoption of new IT goods and services could generate better productivity growth. But a regime shift is likely a long-term story.
Productivity growth down in the dumps
Labor productivity growth has been abysmal. Since 2011, it has averaged less than 1% and the trend is pointing down, as it came in flat in 2016. As we wrote last week, low productivity growth is likely one of the factors holding down wage gains and one of the catalysts that led some FOMC participants to revise down their longer-run dot in the latest SEP projections. In this note, we break down productivity growth into its three major components—labor quality, capital deepening and multifactor productivity—and ponder the near-term outlook.
Not all hours are created equal
Labor quality measures the effect of shifts in the age, education, and gender composition of the workforce. One can imagine that total output will vary given a workforce with a certain set of education, skills, and experience. Contribution of labor quality to productivity growth has varied over time as the composition of the workforce has shifted (Chart 1).

Labor quality took a dip in the late 60s to the 70s as a surge of young inexperienced workers (Baby-Boomers) entered the job market, lowering the experience level of the overall workforce. But as those workers gained experience and entered their prime-working age (when they are likely to be the most productive), the labor quality of the workforce increased, leading to greater productivity gains. Additionally, we saw the skill level of the workforce rise as a greater share of workers obtained higher degrees, helping to usher in an era of high productivity growth.
Today, the forces affecting labor quality are mixed (Chart 2).

On one hand, the share of the prime-age workers is declining as Baby-Boomers begin to retire and the Bureau of Labor Statistics projects that the trend will remain flat over the next decade. On the other hand, a greater share of workers are obtaining college degrees or higher and the trend looks broadly positive. In the long run, a more-educated labor force should pay dividends for productivity growth. However, in the near term the “Silver-Tsunami” effect will likely be a bigger countervailing force, keeping the contribution of labor quality to productivity growth below levels experienced in the 90s and 2000s.
You got to spend money to make money
Capital deepening or capital intensity is the amount of capital investment in relation to labor input. More machinery or equipment should make a worker more efficient, which should translate to more output per hour. Prior to the Great Recession, capital deepening contributed on average 0.9pp to labor productivity growth. Moreover, we experienced a big surge in capital investment at the turn of the century as businesses invested more in information and communication technology during the IT revolution. Since then, the pace of capital investment has slowed. The Great Recession played a role in holding down business investment, but during the current recovery, the pace of net stock of capital investment growth has remained well below prior trends (Chart 3).

Recently, businesses have placed investments on hold, as they wait to see if Congress passes corporate tax reform. Moreover, in the industrial sector, capacity utilization remains well below pre-recession levels and overall capital formation is only modestly outpacing depreciation, lessening the need to invest heavily in new equipment and machinery. All told, given our expectations for nonresidential fixed investment to grow at a tepid pace over the next several years, we see little prospects of a strong pickup in capital deepening.
Multifactor productivity: the magic elixir for growth?
Multifactor productivity (MFP) measures the output per unit of capital and labor input. In essence, it measures the overall production efficiency of the economy. The driving force of MFP is hard to pinpoint. In fact, empirically MFP is usually estimated as the residual of the production function. But the right combination of labor and capital can lead to significant productivity growth similar to what we experienced during the IT boom.
Although productivity growth at the aggregate remains weak, certain sectors have benefited from adoption of new technologies (Table 1).

For example, the oil and gas industry experienced a surge in MFP growth due to new drilling methods such as “pad” drilling, which allows rig operators to drill groups of wells simultaneously. Additionally drillers have found further efficiencies by developing fracking methods, which reduce the amount sand and water needed to drill wells. The IT-producing and service industries such as “computer and electronic products” and “computer systems design and related services” industries continue to see productivity gains from faster processors and algorithms and the adoption of cloud computing technology. In the retail world, ecommerce has led to a surge in the share of retail activity at non-store retailers, while job growth has remained limited, boosting productivity growth in the sector. In fact, according to the BLS, labor productivity growth for non-store retailers has averaged 5.6% over the last five years, well above the aggregate pace.
Innovation in robotics and artificial intelligence, adoption of big data and machine learning analytics raise the prospects for productivity gains. However, broad diffusion of these technologies will likely take years if not decades, implying that the hoped for rebound is likely a long-term story. We could see some incremental increase in the meantime, but a full regime shift seems unlikely.
A word on mismeasurement
It’s possible that there are some mismeasurement issues in the data. The skeptics of low productivity growth usually argue that prices for IT products used to deflate nominal expenditures are too high given the quality improvements, implying more real output and greater productivity. The jury is still out, but the preponderance of evidence suggests that mismeasurement issues were around prior to the slowdown in productivity growth and there’s little evidence to suggest it has exacerbated. One area where we see potential measurement issues is profit shifting of US corporations abroad, distorting the way corporate income is reported, which leads to wider trade deficits than the official measure. According to Guvenen et. al., adjusting for this mismeasurement would add 0.1pp annually to productivity growth for 1994-2004 and 0.25pp for 2004-2008, mitigating some of the productivity slowdown.
Adding it all up
The prospects of returning to a high-productivity regime and seeing better potential growth in the near term seem limited. In fact, the risks are likely skewed to the downside to our already low estimate for potential growth of 1.7%. Demographic trends are unfavorable and businesses appear to be in a “wait and see” mode on capital spending. Multifactor productivity remains an unknown factor: the trend doesn’t look too promising, but broad diffusion of new IT products could lead to some modest productivity gains in the short run before seeing greater gains once potential is fully realized. Until then, we remain comfortable with our call for productivity growth to stay subdued and for growth to hover around 2% over the next several years." - source Bank of America Merrill Lynch
As we pointed out, productivity has been falling, and jobs have been mostly created for lower skills workers. On top of that, business owners have been more creative in keeping costs under control and not only due to "globalization". Overall, low inflation should not be a mystery for the Fed:

  • if they had read the work of French economist Jean Fourastié, 
  • if they had taken the globalization factor pointed out by Claudio Borio at the BIS 
  • if they had taken into account BCG's Experience curve impact (a company’s unit production costs fall by a predictable amount - typically 20 to 30 % in real terms - for each doubling of “experience,” or accumulated production volume). 

What we called recently in one of our musings the "Amazon factor" is effectively today' application of the Experience curve in the sense that it is the ability to produce existing products more cheaply and deliver them to an ever-wider audience (or what BCG calls "shaping demand with successive innovations").

That's about it for our "Macro" bullet point. For our credit point below, we would like to point out the brewing instability coming from rapid credit expansion, as it might be the case, that, from a Financial Stability perspective, at least the Fed is getting nervous on that front.

  • Credit - Beware of rapid credit expansion
As we pointed out in our previous conversation, the work of Claudio Borio from the BIS, has been very interesting when it comes to pointing out the risks for Financial Stability including rapid credit expansion. As a reminder, Claudio Borio and his colleague Philip Lowe wrote in 2002 a very interesting paper entitled “Asset prices, Financial and Monetary Stability: Exploring the Nexus”, BIS Working Papers, n. 114. In this paper the authors made some very important points that are worth reminding ourselves today:
"Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions […] Booms and busts in asset prices […] are just one of a richer set of symptoms […] Other common signs include rapid credit expansion, and, often, above-average capital accumulation" - source BIS 
A common sign of brewing instability has always been rapid credit expansion. The "controlled demolition" analogy we used in the past when discussing the threat of the Shadow Banking sector in the Chinese economy was a clear illustration that the Chinese authorities were clearly aware of the risks. So far they have managed to dampen the issues at hand. It is always critical to assess rapid credit expansion to gauge rising instability in our current credit world. On this subject we reminded ourselves of September 2016 paper by Matthew Baron and Wei Xiong, Quarterly Journal of Economics, entitled "Credit Expansion and Neglected Crash Risk":
"By analyzing 20 developed economies over 1920–2012, we find the following evidence of overoptimism and neglect of crash risk by bank equity investors during credit expansions: (i) bank credit expansion predicts increased bank equity crash risk, but despite the elevated crash risk, also predicts lower mean bank equity returns in subsequent one to three years; (ii) conditional on bank credit expansion of a country exceeding a 95th percentile threshold, the predicted excess return for the bank equity index in subsequent three years is -37.3%; and (iii) bank credit expansion is distinct from equity market sentiment captured by dividend yield and yet dividend yield and credit expansion interact with each other to make credit expansion a particularly strong predictor of lower bank equity returns when dividend yield is low." - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics
As pointed out by the BIS work, rapid credit expansion can have severe consequences on the real economy. The recent Great Financial Crisis (GFC) was an illustration of out of control credit expansion in the housing markets with global dire consequences:
"The recent financial crisis in 2007–2008 has renewed economists’ interest in the causes and consequences of credit expansions. There is now substantial evidence showing that credit expansions can have severe consequences on the real economy as reflected by subsequent banking crises, housing market crashes, and economic recessions, (e.g., Borio and Lowe 2002, Mian and Sufi 2009, Schularick and Taylor 2012, and L´opez-Salido, Stein, and Zakrajˇsek 2016). However, the causes of credit expansion remain elusive. An influential yet controversial view put forth by Minsky (1977) and Kindleberger (1978) emphasizes overoptimism as an important driver of credit expansion. According to this view, prolonged periods of economic booms tend to breed optimism, which in turn leads to credit expansions that can eventually destabilize the financial system and the economy. The recent literature has proposed various mechanisms that can lead to such optimism" - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics.
As we have discussed recently, in credit booms such as the ongoing one, credit quality is deteriorating, which is the case when it comes to US Investment Grade. The deterioration of credit quality forecasts not only lower future corporate bond returns but, will also have an impact on the recovery value. In their very interesting paper, Matthew Baron and Wei Xiong look if credit expansion predicts a significantly higher likelihood of bank equity crashes:
"We find that one to three years after bank credit expansions, despite the increased crash risk, the mean excess return of the bank equity index is significantly lower rather than higher. Specifically, a one standard deviation increase in credit expansion predicts an 11.4 percentage point decrease in subsequent three-year-ahead excess returns." - source Matthew Baron and Wei Xiong, Quarterly Journal of Economics.
Their analysis demonstrates the clear presence of overoptimism by bank shareholders during bank credit expansions, which of course not a surprise given this phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics. You might already be wondering where we are going with this but, we think that right now, loose financial conditions are leading to rapid credit expansion which is probably a concern for the Fed relating to Financial Stability. On this subject we read with interest Société Générale Market Wrap-up note from the 19th of September entitled "What the macro number tell us about borrowing" which indicates that leverage is rising now in Europe as well:
"Market thoughts
In “Leverage is rising in Europe too,” we used two bottom-up data series of leverage, built from the companies in the iBoxx euro-denominated IG and high yield indices, to show how European companies were getting more risky. Do the macro figures back these conclusions up?
The Banque de France published its latest update on the financing of the corporate sector on 12 September. The year-on-year growth rate of loans to non-financials remains just under 5%, more or less unchanged from where it has been since mid-2015 (as Chart 1 shows).

The growth rate is broadly in line with the levels seen in mid-2011, ahead of the euro crisis, but less than half the peaks in 2001 (ahead of the 2002 bear market) or 2007/8 just before the US-led global financial crisis. The level of borrowing is not striking, but the composition is more noteworthy. While borrowing for short-term needs is now stable year-on-year, and borrowing to finance property investment has dipped, the borrowing for other forms of capital investment is running at 7% per annum, well above the 2011 peaks.
This suggests that companies are borrowing to invest, and explains some of the rise in balance sheet leverage noted in our earlier study.
Seen at a pan-European level, however, the trend looks far less significant. Chart 3 shows the growth in borrowing from the ECB for corporates and households (with the latter split into consumer credit and house purchases).

Corporate borrowing is not only growing less quickly than household borrowing, but the year-on-year growth rates have decelerated recently.
On balance, then, the macro data is rather less alarming than the bottom-up figures, which do show that leverage is rising. As we noted in our earlier study, however, this could be because of the increase in high yield borrowing and issuance in euro-denominated debt from issuers outside the eurozone. The bank lending figures themselves are more likely to be biased towards domestic borrowers." - source Sociéte Générale.
While on balance the macro data seems less alarming, there is no doubt that leverage is creeping up and that covenants are being loosened, even in Europe, which seems to indicate rapid credit expansion in some instances. No surprise some central banks including the Bank of England are wary about these developments. As shown in a recent article by the Wall Street Journal, leverage loans are coming back at a rapid pace, as indicated in their article from the 24th of September entitled "Leveraged Loans Are Back and on Pace to Top Pre-Financial Crisis Records":
"Lending to the most highly indebted companies in the U.S. and Europe is surging, a development that investors worry could pressure financial markets if the global economic expansion starts to fade.
Volume for these leveraged loans is up 53% this year in the U.S., putting it on pace to surpass the 2007 record of $534 billion, according to S&P Global Market Intelligence’s LCD unit.
In Europe, recent loans offer fewer investor safeguards than in the past. This year, 70% of the region’s new leveraged loans are known as covenant-lite, according to LCD, more than triple the number four years ago. Covenants are the terms in a loan’s contract that offer investor protections, such as provisions on borrowers’ ability to take on more debt or invest in projects.
Toys ‘R’ Us offered a reminder of the risks of piling on debt when the company filed for bankruptcy protection on Monday. The toy seller’s chief executive said in court papers that Toys ‘R’ Us had been hampered by its “significant leverage.” Its $5.3 billion in debt included a large number of leveraged loans and high-yield bonds" - source Wall Street Journal
Given in the US a third of loans to private-equity backed companies this year are leveraged six times or more, according to LCD’s calculations of companies’ debt to earnings before interest, tax, depreciation and amortization and despite 2013 guidelines from U.S. regulators, including the Fed, on loan underwriting stating that leverage of more than six times "raises concerns for most industries", you probably understand why the Fed is envisaging "Rescission" from its generosity, and draining some of the alcohol out of the credit punch bowl. In similar fashion, credit expansion and loose covenants have become more aggressive in Europe as indicated in the Financial Times on the 20th of September in their article "Aggressive term in Stada bond sale causes outcry":
"Analysts and investors are crying foul at an aggressive term in the bond sale backing the €4.3bn buyout of Stada, which they say creates a new way for the drugmaker’s private equity owners to strip cash out of the business.
The €825m high-yield bond deal is being sold alongside a €1.95bn syndication of leveraged loans, in order to finance Bain Capital and Cinven’s acquisition of German generic drugmaker Stada. The acquisition is the largest leveraged buyout of a European-listed company in four years." - source Financial Times
European companies are indeed getting more risky. This another indication of the lateness of the credit cycle, even in Europe, although one could argue that US is ahead of Europe when it comes to its rapid credit expansion phase as pointed out by JP Morgan in their note from the 20th of September entitled "Age isn't everything -  Gauging the DM business cycle":
"The US looks modestly more vulnerable
On balance, most indicators suggest that the DM as a whole is not close to its next recession, despite having returned to full employment. While this case can be made for the DM as a whole, the picture is more mixed for the US—the economy farthest advanced in its cycle. Our US team’s recession risk tracker places the risks of a recession in the next twelve months at a relatively low at a 1-in-4 chance. However, the risk profile rises sharply to a 3-in-4 chance at the two to three year horizon.
Two factors appear to differentiate the US from other DM economies. First, falling productivity growth and weak pricing power has led to a significant decline in corporate profit margins from the highs. Some of this margin compression owed to the hit to the energy sector in recent years. With oil prices having bounced from the severely depressed levels in early 2016, and also with productivity growth having recovered, US corporate margins are staging a bit of a recovery. Still, with labor markets continuing to tighten, the pressure will be for some compression in US corporate margins.
Second, there has been a large increase in nonfinancial corporate credit with debt/asset leverage at the 85th percentile of its nearly four decade average. It is important to recognize that our US recession probability model does not account for the fact that rising corporate leverage and falling margins have usually been accompanied by other late cycle pressures that push interest rates up. With US interest rates low and the Fed unlikely to tighten policy significantly over the next year, forces magnifying problems due to tight labor markets and lower corporate margins do not look likely to intensify soon. Still, US shocks generate powerful reverberations through the rest of the world, and it is important to track the factors generating US vulnerabilities alongside our assessment of DM risks in the aggregate." - source JP Morgan
One thing for sure, the Fed might be in "Rescission" mood when it comes to its balance sheet and the credit punch bowl, the US Yield curve is still not buying their "Jedi tricks" as it is getting flatter even after the latest FOMC. So overall credit is becoming stretched and productivity is remaining low in the US. Meanwhile business investment remains very low as well in this unusual "recovery" cycle as per our final chart below.

  • Final chart - "Broken" asset investment in Developed Markets
Although the Fed is lost in "inflation" translation, and with the ongoing low productivity seen so far in this cycle, there has been as well a notable imbalance such as the downward trend in business investment. Our final chart comes from JP Morgan report quoted above and displays the trend in Fixed asset investment in Developed Markets (DM):
"With regard to imbalances, there are few signs of an overstretched durables spending cycle. Even accounting for a downward trend, the level of outlays for business investment remains relatively low by historical standards (Figure 18).

Similarly, DM spending on housing and motor vehicles remains low relative to GDP or to population growth. At the same time, household balance sheets are quite healthy even if corporate balances are beginning to look somewhat stretched. 
It is difficult to be precise about the timing of recessions,which are inherently coordination failures among millions of economic actors. The historical record on slack underscores a wide range of outturns once full employment is reached, and there is sufficient evidence to suggest that the typical vulnerabilities associated with recessions are not currently present. However, as vulnerabilities rise, they can be amplified by unforeseen shocks, often coming from financial or commodity prices. It is worth noting that every US recession (except one) was preceded by a material increase in oil prices and every oil market disruption (except one) was followed by an economic recession (“Historical Oil Shocks,” J. Hamilton, 2011). The fact that oil prices have witnessed a spectacular supply-led collapse since 2014 and continue to struggle is encouraging in this regard. While the direction of causation is widely debated, it is arguably the interaction between the various vulnerabilities noted above, along with tightened economic conditions, with financial and commodity prices that becomes the catalyst for recession." - source JP Morgan
As we pointed out last week, for a bear market to materialize, you would need a buildup of inflationary pressure that would reignite the volatility in bonds via the MOVE index. We also pointed out in a previous conversation in similar fashion to JP Morgan that past history has shown that what matters is the velocity of the increase in the oil prices. A price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years. No need to press the "panic" button yet, but it is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation. The Fed might be in "Rescission" mode when it comes to its bloated balance sheet, the US Yield curve remains oblivious to its Jedi tricks and continues to flatten. This does indicate that "Rescission" could eventually lead to "Recession" in 2018, but that's another story...

"Expansion means complexity and complexity decay." - C. Northcote Parkinson, British historian.
Stay tuned !

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