Monday, 3 April 2017

Macro and Credit - Mexican divorce

"Friendship is the marriage of the soul, and this marriage is liable to divorce." - Voltaire

Watching with interest Theresa May the Prime Minister of the United Kingdom triggering the article 50, therefore putting in motion BREXIT, when it comes to our title analogy we reminded ourselves of the Mexican divorce. In the 1960s, some New-Yorkers used to travel to Mexico to obtain a "Mexican divorce". At the time, a divorce in Mexico was easier, quicker, and less expensive than a divorce in much US States. It is also mentioned in Jack Kerouac's famous book "On the Road" and often referred to as a "quickie Mexican divorce". Mexico doesn't require spouses to be present at a divorce hearing as they can send a lawyer to represent them. This "fast-track" process differed very much with the American divorce procedure which can be cumbersome to say the least. In the 1970s though, in accordance to Mexican Federal law recommendation, many courts stopped accepting divorce petitions from non-residents. With the advent of no-fault divorce in the United States, obviously Mexican divorces became much less popular as a result. On a side note, "No-fault divorce" is a divorce in which the dissolution of a marriage does not require a showing of wrongdoing by either party and without requiring the petitioner to provide evidence that the defendant has committed a breach of their marital contract. What is of historical intellectual curiosity to us is that the first modern no-fault divorce law was enacted in December 1917 during the Bolshevik Revolution given marriage was perceived as a "bourgeois institution". Also, the state of New-York in August 2010 was the last state to pass no-fault divorce law. It remains to be seen if BREXIT will entail down the line the implementation of additional "no-fault divorce" for additional European countries seeking their exit from a much flawed currency union but we ramble again...

In this week's conversation we would like to look at the prospects and risks for credit in Q2 2017. 

  • Macro and Credit - That late 2006 feeling for credit
  • Final charts - Get ready for the Boomer slowdown

  • Macro and Credit - That late 2006 feeling for credit
Q1 was clearly a continuation of "risk-on" thanks to the Trumpflation trade initiated in November, with Emerging Markets (EM) racing ahead when it comes to equities. Clearly the big loser was the long US dollar crowded traded and we saw gold making a comeback as of late. In the credit space, EM and High Yield continued their race ahead, moving closer to being priced to perfection. Yet, it feels that we are indeed moving closer towards the highs in the current tight spread environment from a credit perspective, hence our late 2006 feeling towards the asset class as a whole. As we posited in a previous conversation we continue to feel that 2017 could play out as a reverse of 2016, namely that the disappointment could come in the second part of the year, contrary to what played out in 2016 with a spectacular rally in US High Yield in the second part of the year. One thing for certain, is although this credit cycle appears to be somewhat longer than usual, technically, credit continues to be well bid thanks to a strong demand for yield products in conjunction with plentiful of supply. For instance, inflows, in Investment Grade credit continue to be strong, while in High Yield, the recent weakness manifesting itself with outflows has somewhat waned, As we argued in our conversation last week, given April is the new fiscal year in Japan, thanks to a better cross-currency basis, we could see a return of the Japanese Lifers in the foreign bonds market, at the time where core inflation is receding, making yet another compelling support argument for US Investment Grade credit, providing higher yields relative to Europe. While there might be hopes for a Mexican divorce when it comes with European politicians' woes relating to BREXIT and much uncertainties building up in the face of upcoming French elections, there is still room for some additional compression à la 2006, but not much left for the global yield hunters. On the subject of the on-going bull market for credit we read with interest Bank of America Merrill Lynch's take in their Credit Market Strategist note from the 31st of March entitled "Lower foreign core inflation=better sleep":
"Lower foreign core inflation=better sleep.
Our view continues to be that the biggest longer term risk for the bull market in high grade credit spreads is upside to foreign core inflation as that would re-price foreign central bank accommodation – particularly the ECB and BOJ. Such scenario could lead to significant compression between US and foreign yields, which would threaten the foreign inflows - that buy close to 100% of net supply in our market - and lead to a rates shock domestically and large outflows. However, this risk no longer keeps us up at night as there is not a trace of acceleration in core inflation to be found in Europe or Japan.

Quite the contrary was today’s disappointing 0.7% YoY reading on Eurozone core CPI inflation for March, down from 0.9% the prior month. For context the all-time low was 0.6% in 2015, a reading eerily similar to where we are today.
Happy New (fiscal) Year.
April is the start of the new fiscal year in Japan. It is also the time of the year where Japanese insurance companies significantly increase their purchases of foreign bonds, including corporate bonds. Most Japanese investors hedge FX risk using rolling 3-month forwards. Adjusted for these hedging costs, USD credit continues to offer higher yields relative to their EUR denominated counterparts - although less so than a year ago. Combined with bigger size, stronger liquidity and less political risk this suggests that the USD corporate bond market should continue to attract the majority of the Japanese demand for foreign bonds.

1Q=Excess demand.
Much focus this year has been on the record high grade new issue supply volumes –$401bn in 1Q, or $38bn (10%) higher than in the same quarter last year. However, arguably the bigger story is the surge in demand, as we forecast a record $80bn inflow to high grade bond/ETFs in 1Q, or an even bigger $66bn increase over the same period last year.

Excess demand for corporate bonds is the main reason why credit spreads have tightened 8bps this year to 122bps. Going forward we expect strong demand and a slowdown in supply – i.e. continued excess demand – and another 17bps of spread tightening to 105bps by year-end.
See it twice and it’s a pattern.
Much attention this week was devoted to the lack of buying and even selling of 30-year corporate bonds in the overnight market. However, since we saw the exact same pattern during the same week last year this could be a repatriation-related seasonal associated with the March 31st end of the Japanese fiscal year. That is our best guess. It could also be exhaustion in Taiwan after the insurance companies have bought $19.7bn of mostly 30-year paper in the in USD Formosa market - a 54% increase over the same period last year. If overnight buying of the back-end does not resume on Monday it was probably the latter story as Taiwanese markets are closed Monday and Tuesday next week." - source Bank of America Merrill Lynch
Overall in the credit space it's difficult to be "bearish" in an environment very similar to what we experienced first end in late 2006. There is continuous pressure on yields, thanks largely to strong demand and inflows. While we do remain for the time being "Keynesian" as the "animal spirits" continue to chase yield, we remain over the medium term more "Austrian" and very wary of the slowly but surely turning credit cycle as the Fed turns up the pressure to financial conditions with its on-going tightening bias. Relating to our reminiscence of 2006, we read with interest JP Morgan's Global Strategy note from the 30th of March:
"A look back at 1Q17 - what were the biggest surprises; a look forward to 2Q17 - what are the risks
Back in 4Q16 when thoughts first turned toward the outlook for the coming year, the mental playbook for 2017 was for something like 2005 through 2006. That is, a relatively low volatility environment where credit spreads mostly moved sideways-to-ground-tighter; where there was some compression; and where the synthetic structured credit bid of the 2005-06 period substituted for today’s central bank purchases.
To-date, this thesis seems to have been largely well-founded. Even when stocks recently traded lower and there was much talk of a more meaningful correction and the end of the reflation trade, credit spreads proved to be relatively resilient, with the possible exception of North American High Yield. Perhaps this reflects that calling the end of the reflation trade has been relatively consensual ever since the election of the New Administration in the US, such that positioning in global credit markets has never really been over-extended. Everyone’s been looking for the proverbial bogeyman for some time.
Back to our original 2017 investment thesis: if we really think 2005-2006 is the parallel period for today’s credit market environment, then it matters whether we think we're in 2005 or have migrated into 2006. 2005 was followed by 2006, i.e. more of the same. 2006 was, of course, followed by 2007 and we all remember what happened then!
Indeed, there are some interesting parallels, explicit and implicit, which can be drawn between the credit market environment today and the run-in to 2007. Firstly, in High Yield: Attack of the Loans, 22 March, Daniel Lamy highlighted how first-lien leverage in the loan market has risen to new highs, though a differentiating factor between today and late 2006 through early 2007 is a much lower level of end-investor leverage.
Secondly, how should we assess the market impact of any tapering by the ECB (and possibly the BoJ) if we regard this as the current day analogue of the structured credit bid going into reverse? J.P. Morgan's European Economics team expects the ECB to start tapering its asset purchases in 1Q18, with the likelihood that this is flagged at some point through 2H17. To the extent the announcement of CSPP last March impacted credit spreads globally, this could be significant." - source JP Morgan
From our perspective, we think, the current period is more akin to 2006, given how fast credit has tightened under the "Trumpflation" trade. While the recent weakness we have seen when it comes to US High Yield has been coming from the renewed pressure on oil prices since the beginning of the year. On this very subject we agree with JP Morgan's take when it comes to US High Yield:
"US High Yield
One of the key risks for high-yield investors in 2Q17 is the uncertainty surrounding Oil prices amid abundant supply and uncertainty ahead of a 5/25 OPEC decision to extend production cuts. Oil prices are off more than 10% versus the February high, and a key component for the high-yield outlook going forward is the forecast for tighter balances and higher prices into the summer months. While we are not worried about mid-$40 Oil prices, something much lower would likely prove disruptive. WTI Oil prices of $40 or below would likely not only disrupt the elevated level of complacency around credit risk, but probably more so, would translate into higher equity volatility and disrupt capital market activity.
The second risk for high-yield investors as we embark on 2Q17 is the current level of complacency around interest rates. At the March meeting, the Fed delivered a dovish hike when the Committee left its interest rate “dots” unchanged for 2017. 10-year US Treasury yields are now down 25bp since, which is providing a demand boost for higher quality credits. Should Treasury yields resume a climb above the prior recent high (10yr 2.65%) in response to a more hawkish central bank narrative, demand for high-yield credit would suffer. Recall, the bulk of the $7.1bn of retail outflows in March occurred alongside the rise in Treasury yields ahead of the Fed
Biggest surprise of 1Q17
The biggest surprise for us in 1Q17 was simply how well the market performed in January (+1.29%) and February (+1.42%) following a solid December (+2.20%). For context, the high-yield market had provided investors with gains in 12 of the past 13 months before March’s correction. And high-yield bonds yields had declined comfortably beyond our target by early March (5.95% actual versus 6.50% target) after residing above 7.00% in mid-November. Of course, driving these benign conditions were a number of factors. For one, Oil prices rose to a multi-year high by the end of February before sliding throughout March. Second, US Treasury yields defied consensus and declined throughout much of the quarter, despite optimism surrounding Trump’s pro-growth agenda. Third, stocks rose to a record high and volatility approached a record low. And lastly, overseas demand for $-based credit assets exceeded our expectation amid a continued dearth of alternatives. The byproduct of all of this: HY new-issue volume has positively surprised us, driven predominantly by a wave of refinancing activity." - source JP Morgan
Currently the aggregate signal we are getting from the tool DecisionScreen remains bullish US High Yield with a Sharpe Ratio of 2.11 since inception. This aggregate rule comprises the following input, BB Financial Conditions Index US (3M Z-Score), US Budget balance (Level), G10 Economic Surprise (5Y Z-Score) and finally US Government Bond 10 year yield (1Y Z-Score):

- source DecisionScreen

It remains to be seen how long US High Yield maintains its elevated valuation level. This of course, is depending on the trajectory that will be taken by oil prices in the second quarter. As far as US High Yield and the S&P 500 are concerned, correlation between both asset classes remain very strong as per the below chart from we also used in our last conversation:
- source MacroChart
Correlation 0.987, R2 0.974 on both asset classes. We shall see how the relationships evolve during the second quarter of this year. We do feel valuations for both US equities and European High Yield are stretched though. Probably from an allocation perspective, European equities versus US equities remain more favorable while US credit is still more enticing than European credit from a valuation perspective we think.

From a yield perspective, given the on-going financial repression still going on in both Europe and Japan, US Investment Grade remains still enticing thanks to strong technicals yet, it remains to be seen how the scenario for risky assets is going to play out during in the second quarter. For US High Grade, we read with interest JP Morgan's case given we expect Japanese to be attracted again to the asset class in the near future:
"US High Grade
Our current YE forecast is 140bp, just a few basis points tighter than the current level. When the forecast was developed in November 2016 spreads were at 160bps; the post-election rally brought them most of the way towards our YE17 target. While we are comfortable that the current level of UST yields, US growth and bond supply is consistent with our YE spread target, if growth accelerates and/or UST yields rise meaningfully, this is likely to support lower spreads.
A more bullish scenario of strong growth and higher UST and European yields would be positive for spreads for both Technical and Fundamental reasons. Note that JPM’s US 10yr YE17 yield forecast is 3.00% and Bund forecast is 0.90%. Higher UST yields would be bullish for both US and European Financial issuers as it would improve interest earnings. Financial issuers represent 30% of the USD HG credit market and a rally in this sector would be supportive of the index. It would also be supportive for technicals, as there is a strong negative correlation between UST yields and bond spreads in the long end of the curve. This is because higher 10yr and 30yr UST yields tend to attract more buying from pension funds, insurance companies and sovereign wealth funds. Under the bullish macro case described above, we see HG bond spreads reaching 125bp, close to the post crisis peak of 122bp reached in June 2014.
A more bearish economic outlook would have the opposite effect. A mildly bearish scenario with lower growth, lower UST yields and presumably lower oil prices as well (JPM’s YE Brent forecast is $48/bbl) would lead to wider spreads. Energy issuers represent 10% of the HG bond market and they would contribute to wider spreads. Also, Financial issuers and long end bonds would likely widen with lower UST yields. We would expect spreads to reach 160bp under the mildly bearish scenario. A recession scenario would lead to much wider spreads. Given the rise in leverage over the past few years for HG issuers, a recession would likely lead to more downgrades to HY. UST yields would fall further, contributing to wider spreads as well. In February 2016, when recession fears were high, the US HG bond market spread peaked near 250bp, and we would forecast a similar result when/if the next recession occurs." - source JP Morgan
No doubt those exogenous factors such as a different expected outcome at the end of April for the French presidential elections could put a spanner to the continuous grind tighter in credit spreads. Oil as well remains a dominating factor when it comes to assessing the potential for further weakness in US High Yield.

On a side note and in relation to the dangers of "exogenous" factors, back in February 2016 in our conversation "The disappearance of MS München", we mentioned "rogue waves" akin to exogenous factors, that sunk the MS München, a 261.4 m German LASH carrier in December 1978.

Last Friday a 266,000 ton South Korean bulk carrier called Stellar Daisy, a Very Large Ore Carrier (VLOC)  disappeared off the coast of Uruguay en route from Brazil to China, hours after issuing a distress signal. The Marshall Islands-flagged vessel measured 323.86 in length and had a beam of 58 meter. In this case we are talking about a huge ship. While in that specific case, it doesn't look a "Rogue Wave" was involved, it seems probably, the very large vessel had some structural damage with cracks in hull. Though when did those cracks or crack appear, is unknown, in similar fashion we do not know, what exogenous factors will trigger, cracks in the credit cycle, yet, normalization in the Fed's monetary policy is akin to tightening financial conditions.

In the case of Stellar Daisy, ensuing water ingress during voyage, which in itself, wasn’t deadly, most likely caused liquefying, cargo shift, developing 15 degrees list and finally, fatal disaster.  There are reports of iron ore sinter feed (or sinter feed) shipments from Brazilian ports, including Ponta da Madeira, Tubarao and Itaguai, liquefying en route. Liquefaction of mineral ores, resulting in cargo shift and loss of stability, has been a major cause of marine casualties for many decades. In cargoes loaded with a moisture content in excess of the Flow Moisture Point (FMP), liquefaction may occur unpredictably at any time during the voyage. Some cargoes have liquefied and caused catastrophic cargo shift almost immediately on departure from the load port. some only after several weeks of apparently uneventful sailing. While the risk of liquefaction is greater during heavy weather, in high seas, and while under full power, there are no safe sailing conditions for a cargo with unsafe moisture content. Liquefaction can occur unpredictably even in relatively calm conditions on a vessel at anchorage or proceeding at low speed.

To end our side note, we believe that liquefaction and "liquidation" in financial markets can occur unpredictably in relatively calm market conditions and during low economic growth periods like ours, particularly with the rising appetite in the retail space for passive investments such as ETFs.

Whereas "Trumpflation" and "reflation" have so far been the "trade du jour", there is we think still considerable deflationary forces at play is this low yield, low growth environment. One of these forces, is clearly the growing cohort of Boomers in the United States which in many ways represent additional headwinds as per our final chart below for US consumption, still a hefty part of US GDP.

  • Final charts - Get ready for the Boomer slowdown
The deflationary headwinds facing Developed Markets, while at bay thanks to the current "reflationary" trend have not disappeared. For instance, US GDP and its heavy reliance on consumption. Our final chart comes from Wells Fargo Economics Group note from the 24th of March entitled "Boomer Spending: Bracing for the Slowdown". This chart displays the spending by age bracket and illustrate the predictable pattern in consumption in again population over time, hence the deflationary headwinds it represents over time:
"Consumer Spending: Boomers Shift from Tailwind to Headwind
Spending follows a predictable pattern as consumers age. As earnings rise and families grow, household spending increases through middle-age before falling as the kids move out and the house (ideally) gets paid off. Over the past few decades, falling outlays among older households were
masked by the rising earning and spending power of the Boomers as they entered their prime working years. With adults age 65+ expected to rise from 20 percent of the adult population to 25 percent over the next 10 years, there is no offset to the slowdown in senior spending this time around.
More than three quarters of the Boomers are already over the age of 55, when household spending begins to decline (below chart).

With retirement age households spending 25 percent less than younger households, the aging of the Boomers stands to weigh on consumer spending, the powerhouse of the U.S. economy, in the years ahead. Spending could be hampered further in the near term if Boomer households try to shore up their retirement savings by putting more money away now, although this at least would limit the drag on spending further down the road.
What Areas of Spending Will Be Hit Hardest?
The degree to which businesses will need to brace for the spending slowdown as more Boomers reach retirement age varies by industry. Not surprisingly, one segment where spending rises with age is healthcare (out-of-pocket and government). In every other major category, however, spending among households over the age of 65 falls. Apparel, dining out and transportation (vehicles purchases, finance charges and gasoline) see the largest drop off, with average annual expenditures for households 65 and over falling by at least than one-third (below chart).

Discretionary Spending Pressured by Healthcare and Housing
But will Boomers spend the same way as older generations after turning 65? Healthcare looks set to account for a greater share of spending among Boomers than previous generations. Rising insurance premiums have more than offset out-of-pocket savings on prescription drugs due to Medicare Part D. Of course, a substantial share of healthcare spending is paid for by the government, and, with the rising number of beneficiaries, total healthcare spending is likely to remain one of the strongest segments of consumer spending in the years ahead.
Housing is also taking up a higher share of senior spending as more households reach age 65 without having paid off their home or are renting, leaving them exposed to future price increases (bottom chart).

In contrast, seniors are saving at grocery and clothing stores, helped by relatively low inflation in these categories the past two decades. This should limit the hit to discretionary spending, but won’t change the fact that Boomers will still be spending less overall, generating a drag on consumer spending." - source Wells Fargo
While the "Trumpflation" / "reflation" trade continues its course in both equities and credit as we enter the second quarter, it is clear to us that, structural issues such as the ability to spend by Boomers overall remains a clear long term headwind for the US economy as a whole but, as well for other similar Developed Markets (DM).
"The older you get the stronger the wind gets - and it's always in your face." - Pablo Picasso

Stay tuned!

No comments:

Post a Comment

View My Stats