"Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things." - Isaac Newton
"My goal isn't to defend science from the barbarian hordes of lit crit (we'll survive just fine, thank you), but to defend the Left from a trendy segment of itself. ... There are hundreds of important political and economic issues surrounding science and technology. Sociology of science, at its best, has done much to clarify these issues. But sloppy sociology, like sloppy science, is useless, or even counterproductive."
"I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant"
"Wozzle is a much more specific and descriptive term. It was revealed recently that the entire decades-long crusade against saturated fat was based on a Wozzle and has no basis in fact. I also now see economists make claims that are entirely contrary to the basic principles of economics. When will we see scientists make claims that are entirely contrary to the laws of physics? (Actually that has already begun - don't get me started!) It seems that the principles of logic and mathematics (statistics) that apply to basic research have become irrelevant relics of another time and social paradigm. Scientific method in our culture is badly in need of a Renaissance."
"I think once again economists have jumped to the same mistaken cause/effect conclusions with the idea of "Aging Nations Like Low Prices Over High Incomes" as they did with the Phillips Curve. They go on to link the phenomenon to a decreased demand for durable goods and property. I have seen no evidence of this in countries with an aging population. In fact the opposite appears to be the case. First, it is premature to conclude that demographics is the culprit. It is more likely that economic development drives demographic trends and the accumulation of capital assets, as every nation that has achieved a high level of economic development develops almost the exact same trends. Perhaps when economists stop seeing the economy as some rigid machine where moving a lever causes a knob to turn, and turning the knob causes said lever to move, they will start paying attention to cause and effect, and asymmetric, non-reversable functions. As I've said before, it's a field were logical and scientific rigor is sadly lacking."
- Macro and Credit - Trump told you so folks
- Final charts - Deglobalize me
- Macro and Credit - Trump told you so folks
"He told us so
What if Trump does what he has said on trade policies? The so-called Trump trades, and particularly the USD, have seen a correction this year, as President Trump’s rhetoric has shifted toward trade protection. Our baseline assumes the US will avoid such policies, but we also see risks and markets could get more concerned in any case. This is consistent with a volatile but still upward USD trend. However, it is worth discussing the possible market reaction to potential US trade protection and how to hedge. This is just a first look, as a lot would depend on policy details and the potential reaction of the rest of the world.
We recommend hedges that could do well even in our baseline scenario of no trade protection. We consider three main scenarios of de-globalization: higher US trade protection; a global trade war; and a major repatriation of flows. Our analysis suggests that JPY, USD, and NOK would benefit in most cases, particularly against AUD, CAD, MXN and KRW—USD/JPY would weaken. However, for investors who do not expect such extreme scenarios but would still like to hedge their long Trump trades, our analysis supports being long the USD against AUD and CAD in G10, and against KRW in EM.
Trade protection and the Trump trades
The so called Trump trades, and particularly the long USD trade, have seen a correction this year. This is to a large extent because President Trump has gone back to his tough pre-election rhetoric against free trade. In one of his numerous recent tweets on the subject, he warned that “car companies and others, if they want to do business in our country, have to start making things here again. WIN!” In his inaugural speech, he said "we will follow two simple rules: buy America and hire America," adding "protection will lead to great prosperity and strength." This week, Trump and members of his administration accused Germany and Japan of manipulating their currencies to keep them weak. Indeed, the market correction started after President Trump’s first press conference after the elections, on 11 January, where he used strong rhetoric against US companies that invest abroad and then export to the US. This contrasts with his speech after he won the November elections, when he focused on fiscal stimulus and other market-friendly policies.
Our view is that the market is still pricing a benign scenario, in which the new US administration delivers fiscal stimulus and deregulation, but does not go ahead with trade protection. The market remains long the USD, despite the recent adjustment. The VIX index is at historically low levels, despite its latest increase. Global equities remain at historical highs, even after its correction this week. EM FX has been somewhat volatile, but without a clear trend this year. If anything, our flows reflect some buying in EM FX.
This is consistent with our baseline as well, but we do see risks. We have been arguing that the balance between fiscal stimulus and trade protection in the first 100 days of the Trump administration will determine the outlook of the Trump trades and of the USD. We remain constructive on the USD, as we expect President Trump to deliver on fiscal policy and not turn to trade protection. However, even in this scenario, we do not expect a substantial further USD rally, as the USD is already strong and the US government would also push against an excessively strong USD. Moreover, we have been flagging high uncertainties, as we are increasingly concerned about the strong rhetoric against free trade and free FDI coming from the US. Our baseline expects a volatile USD path upward. USD bulls should be more tactical, in our view.
In this context, we discuss which of the G10 and major EM currencies could be at risk in a scenario where we are wrong and President Trump does what he has said on trade policy and increases protection. Of course, a lot would depend on the details and on how the rest of the world reacts in this case. This is a first and very basic approximation but one that can provide insights even for a scenario in which the US does not increase trade protection but markets get more concerned about such a risk.
“What-if” scenarios of trade protection
Global trade is already on a declining trend. Following an almost smooth upward trend in recent decades, the share of global trade to GDP is now below what it was 10 years ago (Chart 1). After a V-shaped move following the global crisis, it has been falling recently.
This is a concern, as empirical evidence suggests international trade and economic growth reinforce each other. A move toward trade protection in the US could lead to a further decline in global trade, making everyone worse off.
Focusing on US trade policies, trade protection would hurt Mexico and Canada the most. China and the Eurozone export more to the US (Chart 2).
However, as a share of their GDP, Mexico and Canada stand out (Chart 3).
We believe MXN already reflects Trump policy risks, but we have been arguing that CAD underestimates such risks.
If we consider a very adverse scenario, in which protectionist trade policies in the US potentially trigger a global trade war, KRW, MXN and CAD could be affected the most.
• Looking at openness to trade as defined by the share of total exports and imports to GDP, the countries most vulnerable to a potential pull-back of global trade include Hungary, Czech Republic, Switzerland, Korea, Poland, Sweden and the Euro zone (Chart 4).
However, most of the European trade is intra-regional and it is safe to assume that protection within Europe will not increase—the region could still suffer if global supply chains get significantly disrupted. Excluding Europe, Mexico and Canada also stand out.
• Looking at the FDI net inflows as a share to GDP, the countries that will be affected the most by a pull-back include Switzerland, the Euro zone, Hungary, Brazil, Australia, Canada and the Czech Republic (Chart 5).
• Combining these two measures, this analysis will suggest negative risks for CAD, MXN and KRW, particularly against USD and JPY (Chart 6).
HUF, CZK, CHF, PLN, and EUR could also be at risk if global protectionism affects European exporters—our CEE baseline is bullish, as these currencies are undervalued and will benefit from a hiking cycle.
Considering an even worse scenario, in which trade protection triggers a repatriation of flows, Norway, Switzerland and Japan would receive most of it as a share of their GDP (Chart 7).
These are the economies with the largest net international investment positions relative to GDP by far. We would therefore expect NOK, CHF and JPY to appreciate in such a scenario, particularly against NZD, AUD, MXN and TRY.
Putting everything together, our analysis suggests investors who would like to hedge a tail risk scenario of a move away from globalization and toward trade protection should be long JPY, USD, and NOK against AUD, CAD, MXN and KRW. USD/JPY would also weaken in this case.
As the scenarios we have considered are extreme and mostly tail risks, we would prefer to focus on hedges that can do well even if these risks do not materialize and the USD rally continues. In this context, we would be long the USD against AUD and CAD in G10 and against KRW in EM. We remain constructive in CEE and we would avoid shorting MXN, as it could do well in a free-trade scenario." - source Bank of America Merrill Lynch
"If indeed the current account balance in the US deteriorates, then the US dollar should weaken as it generally happens in the late stage of a 10 year credit cycle, hence our contrarian stance versus the bullish US dollar crowd. The credit cycle is therefore deterministic we think" - source Macronomics, January 2017.
Moving on to "credit", as we pointed out in last week's final chart, it seems to us that currently High Yield is indeed "priced for perfection". As we indicated, we will be tracking very closely what credit spreads will do in the coming weeks. Yet, flows remain supportive for now and so does the shape of the CDX High Yield CDS index, a proxy for High Yield in the derivatives space. As pointed out by Bank of America Merrill Lynch in their Follow The Flow note from the 3rd of January entitled "So far so good...inflows across the board", investors have continued playing the "beta" game:
"YTD flows – inflows across the board
So far this year, amid a rising rates environment, investors have favoured higher yielding pockets of the fixed income world. Both EM debt and HY funds recorded strong inflows YTD. However, the ECB QE backdrop remains positive for IG and government bond funds; at least for now. Equities have started on the positive territory, but the pace is still slow (Chart 1).
Over the past week…
High grade funds continued on a positive trend for the second week in a row. However the flows trend remains below what we have seen before tapering fears emerged. High yield funds saw inflows for the ninth consecutive week, and the asset class has accumulated more than $4bn of inflows since the start of the year. However, looking into the domicile breakdown, as Chart 13 shows, the inflow last week came only from US domiciled and globally-focused funds, while the European-focused funds inflows were very marginal.
Government bond funds had their second week of outflows amid rising rates; albeit very small. Money market funds weekly flows were negative for the third week in a row, while the outflow trend is strengthening. Overall, fixed income funds recorded a strong week of inflows, the highest in 27 weeks and the sixth positive in a row.
European equity funds flows were positive for a second week showing signs of moderate strengthening. Last week’s inflow was the highest in 11 weeks. However note that this pace is much slower than the inflows strength seen during 2015.
Global EM debt fund flows flipped back to positive territory after a brief week of outflows. Last week’s inflow was also the strongest in four weeks. Dollar weakness has been beneficial for the sector. Commodities funds flow remained positive for a third week in a row, but the inflow pace has slowed down.
On the duration front, inflows continued in short-term IG funds for the seventh week in a row. However the pace of the inflows has slowed down notably over the past weeks. Mid-term funds’ large outflow couple of weeks ago was partially reversed recording the biggest inflow in 13 weeks. On the other hand, flows into long-term funds remained downbeat recording an outflow for a second week." - source Bank of America Merrill LynchIt is no surprise to see, credit investors playing "defense" and rotating into shorter duration funds given that last year, during the second part they had increased both credit risk and duration risk as well. As we mentioned earlier, we are very wary about Japanese flows and appetite for foreign bonds which have been dwindling as of late following a record 2016 take up. Data from Japan’s Ministry of Finance confirmed this week that Japanese investors sold around ¥1.3 trillion ($11.54 billion) in foreign bonds between Jan. 21 and Jan. 28, taking net sales for the last 12 weeks to over ¥3.7 trillion, the largest amount since April 2014 according to the Wall Street Journal. This is as well confirmed by the latest Nomura JPY Flow Monitor note from the 2nd of February 2017:
"MOF international weekly capital flow data (22 - 28 Jan)
Japanese investors were net sellers of foreign bonds again last week for the second week in a row. The net selling accelerated to JPY1359bn ($11.9bn) from the previous week (JPY538bn), recording the biggest net selling since March 2016.
Uncertainty on the US policy stance remains high, while US yields have been rising again since mid- January, which has likely discouraged Japanese investors from increasing their foreign bond investment for now. Seasonally, foreign bond investment by insurance companies tends to slow in Q1 too, as the fiscal year-end approaches. January foreign portfolio investment by investor type data are scheduled next Wednesday, which will show the major contributors to the relatively large net selling of foreign bonds last week.
Japanese investors resumed their purchases of foreign equities for the first time in two weeks. They bought JPY125bn ($1.1bn) of foreign equities last week. This suggests the underlying Japanese appetite for foreign assets remains strong, although they had been large net sellers of foreign bonds over the past two weeks.
Foreign investors continued selling Japanese equities for the second week in a row (JPY144bn or $1.3bn), although the pace slowed from the previous week (JPY376bn). Their fixed income investment was mixed, purchasing long-term Japanese bonds (JPY446bn or $3.9bn) while selling short-term bonds (JPY586bn or $5.1bn)." - source NomuraThis could have serious implications should this trend continue. It represents not only a headwind for immediate further compression on US Treasuries yield, but, as well, it is adding pressure on the US dollar and could as well generate, contrary to what is expected by many, a rebound in the Euro in short order.
Furthermore, when rates move up, while it can be even more supportive for Euro High Yield, it represents a significant headwind for already expensive European Investment Grade thanks to the convexity factor credit wise. In conjunction with rising inflation, it is in short a bad recipe. This is clearly explained by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 1st of February entitled "When rates move up":
"Rising rates are supportive for high yield credit
Fixed income investors embrace higher yielding (with same quality/rating) instruments when rates decline. This has been the case over the past decade as flows into high grade funds were accelerating vs flows into govies. We find that there is a strong correlation between the rates trajectory vs. the flows differential between high-grade and government bond funds. We also find that flows tend to exhibit a “barbelling” trend, when rates advance, and vice-versa. Amid a rising rates backdrop, we see that the balance of flows in the fixed income market will likely favour high yield and govies more than flows into high grade funds.
High yield credit tends to beta-outperform its high grade counterpart in a rising rates environment. We prefer to be long European high yield via synthetics more than via cash bonds, post the recent underperformance of Crossover.
Rising peripheral risks are under-priced in credit
European credit spreads have always been well correlated to peripheral risks (chart 1). The recent move higher in BTPs vs Bunds has not been unprecedented; it has been experienced before the PSPP-era, but also briefly in late November 2016. The common ground in both cases was that credit spreads were a lot wider. Even compared to last November levels, credit spreads were ~10bp wider, when Italian 10y yields were at the wides vs Germany. We feel that the move in rates is under-priced in credit spreads at these levels. This is also taking place as Greek government bond yields are rising again over the past couple of days.
Rising rates and credit performance
The world economy is in sync mode. Global QE across the Fed, ECB, BoJ and BoE, have resulted in a well synchronised rebound in economic data. Surprise indicators are also pointing to the strongest rebound globally. The reflation trade is strong across Europe and US with rates moving higher. The global QE is reaching “peak strength” this quarter. However, the reflation knock on effect is ultimately negative for credit, according to our analysis. Credit spreads tend to react negatively in periods of rising inflation. Fund flows are also pointing to the downside, as higher rates hit high-grade fund flows more than flows into government bond funds and high-yield debt. Barbelling your portfolio in risk-terms can be the solution. High yield credit tends to beta-outperform its high grade counterpart.
Can a policy mistake be the driver of a trend shift?
Inflation is picking up; but unfortunately it is not the core inflation trajectory that is trending higher. Headline inflation is picking up over the past months on the back of higher commodity, and more importantly oil prices. As our economics team has been highlighting this is the “bad” inflation that is decoupling and surprising to the upside. Low and sticky nominal wage growth means that purchasing of consumers suffers again very soon; and populism continues to rise.
The recent ECB meeting highlights the discrepancy between a very dovish message and a hawkish monetary policy (QE tapering from April), we think. Should headline inflation keep trending higher on the back of higher energy prices; we see higher risks of another policy mistake.
The credit market has historically been very well correlated to inflation trends.
• In chart 7, we find that the year-on-year changes in core inflation across Eurozone countries and the year-on-year changes in iTraxx Main non-fins 5y spreads are well synchronized. This has been the case especially in the period since the GFC were the central banks started unleashing their quantitative easing programmes.
• The same stands for headline inflation trends. However, should one look at the trend of headline inflation, there is a clear decoupling over the past year from that of credit spreads (chart 8).
It is notable that the credit market is still focusing on core rather than headline inflation. But at current levels, we fear that a policy mistake, like the one of the forthcoming April tapering decision, will ultimately be negatively received by credit investors.Credit is mispricing the current headline inflation pick upChart 8 is depicting the decoupling between inflation and credit spreads trajectories.
To normalise these moves we employ a z-score analysis, presented in chart 9.
We find that the current “richness” of credit spreads trend vs. that of headline inflation is the highest it has been in almost a decade.Looking back in times when this dislocation - between credit spreads and HICP - has been that strong, we find that the future credit market performance was not that positive. The previous peaks in “richness” have been in October-07, March-10 and March-11, as per chart 10. Remember that subsequently post reaching these peaks, credit spreads have always moved wider over the following months.
Downside risks on credit flows as rates move higherThe forthcoming “peak” of the QE positive backdrop is not our only source of concern. Fund flows into high-grade funds are negatively impacted amid a rising rates environment too. In our analysis we find that the higher the yield one can source from the government bond market - deemed as “risk free” - the lower the need to hunt for “quality yield” via the IG credit market.We compare cumulative flows trends in high-grade and government bond funds vs. the level of “risk-free” rates. For the fund flows we use EPFR data as per our weekly Follow the Flow publication, and we use the 5y bunds generic yield to track the trends in the European rates market.Historical evidence shows that:• Fixed income investors embrace higher yielding (with same quality/rating) instruments when rates decline. This has been the case over the past decade according to our analysis (chart 11).
Note that there is a strong leading indication (6 months) of the rates trajectory vs. the flows differential between high-grade and government bond funds (in relative terms, % of AUM).• There is a critical level in the rates market that prompts a shift into “quality yield” (i.e. high-grade credit) we think. This force kicks in when 5y bunds dip below the 1% handle (chart 12) it seems.
While both the Fed and the ECB might continue with their Sokal hoaxes, it appears to us that the recent shift from investors towards shorter duration is clearly a manifestation of a defensive stance, which could be further validated by the weakness in the support from overseas investors such as Japanese investors. Where we slightly disagree with Bank of America Merrill Lynch's take is that, if indeed there is some short term correction in equities, it is hard for us to expect that a move wider in European High Yield could be avoided thanks to its inherent strong correlation to stock movements. Though, from a convexity perspective, High Yield should be less immune than Investment Grade with rising sovereign yields, should equities remain stable in the coming weeks.At the end of 2011, at the heights of the sovereign crisis, the lack of yield in the “risk-free” market (i.e. bunds) and the subsequent OMT moment, six months later, prompted a strong reach for “quality yield” and inflows accelerated into IG bond funds. We are still far from that level, but the trend is clear from here.The solution to higher rates = barbell your portfolioIn 2016 we saw the lowest in yields and spreads. We doubt that we will see these levels again, especially post the recent strengthening of economic data across the globe. We expect that as rates will continue higher from here in the years to come (more in the latest Global Rates weekly) this will have a strong effect on flows across fixed income pockets. We think that flows into govies and HY credit funds will fare better than flows into high-grade ones." - source Bank of America Merrill Lynch.
As a reminder from our August 2013 conversation "Alive and Kicking":
"Moving on to the subject of convexity and bonds, how does one go in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays
Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.
The downside protection offered by the CDS market as well as the better liquidity provided by the CDS market can indeed mitigate the damages.
Nota bene: Liquidity in the CDS market tends to be greatest at the 5 year point, making the 5 year single name CDS contract a more viable alternative than other CDS maturities.
With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger... " - source Macronomics, August 2013Therefore you now understand why Bank of America Merrill Lynch prefer to be long European high yield via synthetics more than via cash bonds, post the recent underperformance of Itraxx Crossover. We totally agree on this and it makes perfect sense.
Finally for our final chart, rising populism has gone hand in hand with protectionism (that 30s feeling we talked about...) hence renewed inflows into the "barbaric relic" aka gold which, we hinted, we had been adding since late December.
- Final charts - Deglobalize me
Protectionism has been the buzzword over the last few weeks, and much of the narrative has been emanating from the US. Since President Trump’s inauguration, executive orders have been signed to repeal free trade deals and to temporarily restrict certain forms of US immigration. Add to this the growing comments from the Republican administration around foreign countries’ weak currencies, and perhaps the post-Lehman vision of globalization has never felt more challenged. And as the rest of the world looks on, the risk of retaliatory protectionist rhetoric – or actions – grows.
While stocks and corporate bonds have rallied year-to-date, we see a very “incongruous” kind of calm in the markets at present. Note, that while equity volatility is still hovering around record lows, inflows into gold funds year-to-date in Europe have surged (chart 1).
In reality, the trends of protectionism – or “deglobalization” – have been bubbling for a while. Plenty of protectionist measures have in fact been put in place by countries around the world in the aftermath of the Global Financial Crisis – albeit ones not as dramatic as directly repealing free trade agreements. Rather than just tariffs and trade defense measures, governments appear to have become more imaginative in avoiding WTO disciplines. And over the last few years, more overt trade spats and protectionism have been seen (such as the EU’s and China’s issue over solar panels in 2013).
Chart 2 shows the countries that have implemented the most protectionist measures since 2005. Note that the US and the EU head the list. Moreover, the WTO’s trade monitor from June last year highlighted that for the 2015-2016 reporting period, trade restrictive measures had jumped to the highest monthly average on record.
Yet protectionism, in our view, is inherently inflationary in nature. As Chart 3 shows, just as globalization is being challenged by leaders, the world is more “connected” than ever at present.
Corporate supply chains have branched out across the globe over the last 10 years. And free movement of goods, services and labour have been an additional boon for corporate profit margins.
But if protectionism cuts back the tentacles of global supply chains – be it through higher tariffs, border checks or restricting worker migration – then corporates stand to be made less efficient via a rising cost base. Thus to preserve corporate margins, output prices will need to rise…" - source Bank of America Merrill Lynch
So, all in all, regardless of the Sokal monthly hoaxes from our central bankers, can you spell "stagflation"? Because we certainly can...
"Truth emerges more readily from error than from confusion." - Francis Bacon