Thursday, 24 August 2017

Macro and Credit - The Dead Parrot sketch

"Fake is as old as the Eden tree." - Orson Welles

We read with interest the latest minutes from the FOMC and in continuation with our previous themes of revivals of defunct model, obviously once again their "beloved" Phillips curve model came to the forefront of their discussions, not only at the Fed but at the ECB as well. Therefore, when it came to selecting this week's title analogy, we could not resist but use a reference to Monty Python's flying Circus Dead Parrot Sketch which first aired on the 7th of December 1969. The sketch portrays a conflict between disgruntled customer Mr Praline (played by Cleese) and a shopkeeper (Michael Palin), who argues whether or not a "Norwegian Blue" parrot is dead. It pokes fun at the many euphemisms for death used in British culture. Obviously, one could be disgruntled at our central bankers and the lack of inflation within their inflation mandate. In the meantime some sell-side pundits and most recently central bankers have continued to discuss if the Phillips curve is "dead" or simply "resting" like a "Norwegian Blue" parrot. We rest our case. We find it amusing that a joke dated c. CE 400, recently translated from Greek, shows similarities to the Parrot sketch. It was written by Hierocles and Philagrius and was included in a compilation of 265 jokes titled Philogelos: The Laugh Addict. Probably yet another case of "barbaric relic" given the affection for gold from our central bankers but we ramble again...

In this week's conversation, we would like to look at the ongoing 2007 party like in credit that keeps going while there is indeed the need to be more discerning (beta wise that is) we think at this stage but first we will take another potshot at the Phillips curve cult members.

  • Macro - The Norwegian Blue parrot really DID exist but not anymore...
  • Credit - Smarten your beta
  • Final chart - Credit Mad Men

  • Macro and Credit - The Norwegian Blue parrot really DID exist but not anymore...
The latest FOMC notes from the July minutes do indicate how puzzled our central bankers have become on the validity and efficiency of their Phillips curve framework. Back in May this year in our conversation "Wirth's law" we discussed the wage conundrum in the US, pointing out that real wage growth had so far eluded the Bank of Japan and are still eluding the United States, hence the dismal prospects for inflation expectations given high qualification jobs in many instances have been replaced by low qualification jobs (yes training matters...). Also, back in our January conversation "The Ultimatum game" we looked at jobs, wages and the difference between Japan and the United States in relation to the "reflation" story or "Trumpflation". We argued that what had been plaguing Japan in its attempt in breaking its deflationary spiral had been the outlook for wages. Without wages rising there is no way the Bank of Japan can create sufficient inflation (apart from asset prices thanks to its ETF buying spree) on its own.

Following our recent musings our friend Kevin Muir, the author of the excellent and very entertaining blog the Macro Tourist reached out and asked several questions relating to the Norwegian Blue parrot aka the Phillips curve:
"Hey Martin.  I just your latest two pieces.  I really enjoyed them.  
What is your belief about the Phillips curve?   Is it dead?  Shifted down?  
I know you discussed your views about the mismatch in skills, but the curve does indeed seem to be obsolete.
I know to some extent it doesn't matter what we think- the Fed's reaction function is what matters.  But I am curious about your personal thoughts.  
I am beginning to think that Yellen's training as a labour economist is making her more hawkish than she should be.  As you point out, they think inflation is coming.  So they are tightening.  
I realize you are probably more bearish on the economy than me, so it is easier to say the Phillips curve is not kicking in, and the economy is rolling over, so the point is moot.
But if we get a global economic upswing that drags the US along, will we see real wage growth?  
Thanks, Kev." - source Kevin Muir, author of the Macro Tourist
Of course real wages are that's the most important point for inflation expectations, real wage growth matters and matters a lot. We pointed out a few things to Kevin such as the fact that a business owner is always a "deflationista", in the sense that 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. No offense to our central planners of the world but true capitalism is inherently "deflationist" when it comes to prices. For the simplicity of our reasoning, we are not taking into account oligopolies, cartels and other shenanigans being played these days in many instances (ZIRP, NIRP, etc.). Real prices always fall and inflation is simply organized theft which is willingly pursued and supported by our central bankers, at 2% or even 4% (should they decide to try and fail in tweaking their sacrosanct target).

As well, we pointed out to Kevin the excellent work of (unfortunately little known to so many) French economist Jean Fourastié relating to real wages, real prices and productivity. One particular book comes to mind "Pourquoi les prix baissent - Why prices fall". published in 1984. We do not know if this book is available in English, but, in our humble opinion it is a must read book and should be on the required reading list of any serious central banker or aspiring economist.

For Fourastié, real prices could only be observed by dividing the prices of any product by hourly wages (link in French). The inverse of real prices calculation measures purchasing power parity. What is the most important economic fact in the last 300 years? Most probably the fall in "real" prices for wheat prices with hourly wages on the Y axis:
- source Jean Fourastié

Also in our previous conversation from September 2012 "Pareto Efficiency" we indicated the following when it comes to "wheat prices" and "revolutions":
"Historically the highest prices touched by wheat prior to the French Revolution were in 1789. Between 1780 and 1788, the average price for  a "setier" of wheat (setier was an old French units of capacity equating to 156 liters), was stable between 19 pounds and 13 shillings and 25 pounds and 2 shillings. Between 1786 and 1787 the price was stable at 22 pounds a setier. In 1788 it rose by 15% but in 1789 it rose by 36% in one year, touching 34 pounds and 2 shillings. The harvest for 1788 was one third lower and this impact was sufficient enough to trigger the doubling of prices in the period 1788-1789. Just before "Bastille Day" on the 14th of July, there was a tremendous storm on the 13th of July 1789 which caused massive destructions to crops.
  Wheat prices in "pounds per setier" units on the 24 of June every year from 1728 until 1789, source - "Le prix du blé à Pontoise en 1789" by Dr Florin Aftalion.
When it comes to volatility in wheat prices and the ultimate effect of manipulating prices or when "real" prices become "fake" prices or "manipulated" prices, we reminded ourselves with our May 2016 conversation "When Doves Cry" and the fascinating account on the "assignat" which was a type of a monetary instrument used during the time of the French Revolution (money printing on a grand scale with dire consequences...), in a book written by French economist Florin Aftalion in 1987 entitled "The French Revolution - An Economic Interpretation":
At the time of the French Revolution, Pierre Samuel du Pont de Nemours observed that by issuing "assignats", the French nation was not really paying its debts:
"In forcing your creditors to exchange an interest-bearing proof of debt for another which bears no interest, you will have borrowed, as M. Mirabeau has said, at sword-point". 
The issue with the assignats was that in no way it was capable of facilitating the sale of public lands, that ones does not buy with a currency, which is merely an instrument for the settlement of a transaction, but with accumulated capital. With QE becoming a global phenomenon with South Korea's president indicating that the country needs to look at possible 'selective' QE and Negative Interest Rate Policy becoming rapidly the "norm", one might wonder how on earth "capital" is going to continue to be "accumulated", particularly when one looks at negative yielding assets.
To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB. And when it comes to the "ultimate value" of the "assignat" (and the end result with NIRP...), a simple picture clearly display the trajectory of their final value:
  -source Macronomics, May 2016 

Hence the importance of using observable "real prices" and the impact monetary inflation can have on hourly wages and purchasing power when you want to assess the levels of inflation (Venezuela comes to mind...). We also reminded ourselves of Adam Smith's quote in relation to real "price" formation:
"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased." - Adam Smith

But moving back on the subject of the Norwegian Blue parrot, we read with interest Barclays Global Economics note from the 18th of August entitled "Questioning the reliability of the Phillips curve:
"Inflation discussion dominates July minutes
  • The FOMC deliberated at length the risks to the inflation outlook, including the effectiveness of its current Philips curve framework in forecasting inflation.
  • Although the minutes reveal increased concern about the inflation outlook, we did not sense that the committee is ready to pause rate hikes at this point.
  • The committee sounded confident about labor market progress, but financial stability and further easing in financial conditions were a concern.
Three broad themes that stood out from the July FOMC minutes, in our view, are the increased concern among committee members about the inflation outlook; strong consensus that labor market progress has been significant; and worries about financial stability, given easy financial conditions despite monetary policy tightening. Even if the committee may have wanted to strike a balanced tone between its concerns about inflation (which would argue for a more cautious tightening path) and those about financial stability (which would argue for continuing on its path), markets seemed to read the minutes as dovish and lowered the probability of a December hike significantly, from 44% to 36%.
Also notable in these minutes was the change in tone with regards to federal government policy. Earlier in the year, committee members viewed fiscal policy as a potential upside risk to the growth and inflation outlook, but in the July minutes, those expectations were toned down or reversed. A few in the committee pointed out that “the likelihood of near-term enactment of a fiscal stimulus program had declined further or that the fiscal stimulus likely would be smaller than they previously expected,” while several others commented that policy uncertainty (including fiscal policy, trade, and health care) “was tending to weigh down firms’ spending and hiring plans.” This downgrade on the policy front was balanced to some extent by an upgrade of the external sector, as a brighter international economic outlook was seen as boosting prospects for US exports.
We maintain our call for a December hike, but see recent inflation data and the discussion in the FOMC minutes as having lowered the likelihood of its happening. In our view, continued misses on the inflation front would not make it tenable for the FOMC to hike in December. Further disappointment in this front could pause the path for the federal funds rates until the FOMC feels confident that its price stability mandate is within reach.
Some in the FOMC question the validity of its current inflation framework
The committee recognised continued misses on its inflation forecast and suggested that it would likely remain low over the second half of the year. But it also continued to assign much of the recent decline to idiosyncratic factors. While the discussion about the near-term outlook seemed broadly unanimous, there was more disagreement about the medium run. “Many” participants saw risks that inflation would remain below 2% for longer than they currently expected, and “several” saw risks to inflation as tilted to the downside. Similarly, while the committee agreed on the importance of long-term inflation expectations, not all agreed that they remained stable, and “a few argued that continuing low inflation expectations may have been a factor putting downward pressure on inflation”.
But perhaps a bigger surprise came when a number of participants challenged the way in which the Fed analyzes and forecasts inflation. They argued that “much of the analysis of inflation used in policymaking rested on a framework in which, for a given rate of expected inflation, the degree of upward pressures on prices and wages rose as […] employment of resources increased above long-run sustainable levels” – basically, a description of a Phillips Curve (PC) type of framework. A few participants argued that it was not particularly useful in forecasting inflation, while most said it remained valid despite its recent flatness. While we would agree with the latter group, we find the very opening of this discussion as evidence that concerns about the persistent misses on the inflation mandate are starting to weigh on the committee. While many have criticised the PC before, no clear candidate has emerged as a way to analyze inflation in a monetary policy setting, a fact that will, in our view, limit how far this discussion can go within the committee.
Instead, a common theme among policymakers in recent years has been to find exceptions that could have led to a temporary and transitory flattening in the PC. These minutes were no exception, as they listed a number of reasons for the coexistence of low inflation and low unemployment, including less responsiveness of prices to resource pressures (stickier prices), a lower natural rate of unemployment, more slack in the labor markets that may not be captured by the unemployment rate, nominal wage growth and inflation reacting with a lag to labor market tightening, and a loss of firm pricing power from global developments and from technology.

While we do not think the Fed reached the conclusion that its inflation framework was invalidated by the recent softness in inflation, having this discussion at all raises the risk of a shift in the reaction function away from a focus on resource utilization and the PC. But it could also drive the FOMC to look for areas where it may have mis-measured the amount of spare capacity in the economy, for instance in the recent increase in the labor force participation rate of prime age women (see Rising participation among prime age workers, August 11, 2017). As discussed in Wage growth is not as weak as it seems, August 4, 2017, we share the committee’s view that the rate of increase in nominal wages is not low in relation to the rate of productivity growth and the modest rate of inflation. Overall, this shift in emphasis could likely imply fewer rate increases over the forecast horizon, given the weakness in incoming inflation data since earlier this year. We continue to expect an announcement on balance sheet normalization at the September meeting and a third rate increase this year in December, but we have reduced our subjective probability about a rate increase later this year to about 50% (down from 60% previously)." - source Barclays
To be fair to the Phillips curve cult members and also to Monty Python, the Norwegian Blue parrot did really exist as pointed out by a Daily Mail article in may 2008:
"Adding to the absurdity was the fact that parrots - being tropical birds - don't come from Scandinavia.
Or do they? For now, in a development putting the sketch in a completely different light, it turns out that the Norwegian Blue did exist.
Dr David Waterhouse, a fossil expert and Python fan, has found that parrots not only lived in Scandinavia 55million years ago, but probably evolved there before spreading into the southern hemisphere.
His discovery was based on a preserved wing bone of a previously unknown species, given the scientific name Mopsitta Tanta - and now nicknamed the Norwegian Blue.
The dead parrot script, voted Britain's favourite alternative comedy sketch by Radio Times readers in 2004, was written by Cleese and Graham Chapman and first broadcast in 1969.
As he returns the ex-parrot to Palin's pet shop, Cleese is assured it is just resting or stunned, being "tired following a prolonged squawk" and "pining for the fjords".
Cleese bangs it on the counter, trying to wake it up, screaming: "Hello, Mister Polly Parrot! I've got a lovely fresh cuttlefish for you!" But it is definitely expired.
Dr Waterhouse, 29, said of Mopsitta Tanta: "Obviously, we were dealing with a bird that is bereft of life, but the tricky bit was establishing it was a parrot."
He was studying for a PhD at the University of Dublin in 2005 when he visited a museum in Jutland and spotted a fossilised 2in-long humerus - appropriately enough, the funny bone - among bird remains which had been found near an open-cast mine.
Research has now confirmed the bone was part of an upper wing from a bird in the parrot family. Although the mine was in Denmark, the birds would also have lived in what is now Norway."
[ ...]

"However, the Pythons were wrong about one thing...the Blue could hardly have pined for the fjords.
"This parrot shuffled off its mortal coil around 55million years ago, but the fjords in Norway were formed during the last Ice Age and are less than a million years old," said Dr Waterhouse." - source Daily Mail
So dear Kevin, to answer your question we think that the Phillips curve, in similar fashion to the Norwegian Blue parrot did exist but is now simply "resting" in a Monty Python way. Same goes for the ECB's view on the Phillips curve as per Barclays recent note:
"The ECB’s accounts focused on a flat Phillips Curve and financial stability
The ECB’s accounts of the August meeting explored the Phillips Curve relationship in detail. Given the latest data, the accounts “acknowledged the strengthening of the economic expansion and confirmed that the risks to the growth outlook were broadly balanced”. At the same time, the accounts contain a very detailed discussion of the flattening Phillips Curve relationship, including due to labour market reform, hysteresis effects from prolonged high unemployment, the backward looking nature of wages, as well as the deleveraging process in the euro area. Nevertheless, the GC argued that the Phillips Curve relationship likely remained intact, but that “patience, persistence and prudence” were needed as this process would likely take time and be contingent on “very substantial degree of monetary accommodation”. While the statement explicitly mentions firm survey evidence of emerging labour shortages, a decomposition of the euro area wide European Commission survey (Figure 1) suggests that this is mainly driven by Germany (Figure 2), where, despite a 3.8% unemployment rate, wage pressures remain to be seen. Overall, the discussion is in line with underlying inflation on a moderate recovery trend and is unlikely to accelerate in the near term (Euro area inflation: Core improves but doesn't shift gear, 31 July 2017)."
All in all, with "patience, persistence and prudence" like the shopkeeper in Monty Python's sketch, we might see the Phillips Curve come back to life, but for the moment it is pretty much as the Norwegian Blue parrots, they really DID exist - but now they are all 'stiff, bereft of life and ex-parrots'.

This ends our numerous potshots we have taken in 2017 relative to the Dead Parrot aka the Phillips curve. In our credit point below, we have in recent months suggesting rotation towards higher quality credit and also recommended playing more defensively at this stage of the credit cycle while we continue monitoring the trend in credit conditions in particular consumer credit.

  • Macro and Credit - Smarten your beta
Back in June in our conversation "Potemkin village", we posited that as the Trumpflation narrative was fading, so was the beta narrative. In fact our tool DecisionScreen told us the same at the time when it came to its signal switching to slightly negative for US High Yield. The aggregated rule we use is made up of the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score) and US GOV 10 year yield (1Y Z-Score). The beta trade is also a function of investors’ perception about the pace of QE. Our central planners might be using a dead parrot for guidance, but, anyone is trying to guess the change of the rhetoric, should the doves finally become hawks in the near term given financial stability matters and matters a lot for this crowd. We continue to remain slightly negative on US High Yield and we monitor closely the shape of the CDX High Yield curve, particularly the front-end, to see whether the curve is starting to flatten or not.

On the subject of smartening your beta we read with interest Barclays US High Yield note from the 18th of August entitled "Choose your Beta Wisely":
"Some of the fear that gripped risk markets due to geopolitical events just a week ago looks to have subsided. But the pick-up in volatility during that episode, has many investors more closely considering the tie between credit and equity markets. On the surface, there appears to be a dislocation between SPX and high yield valuations, but we expect the relationship to revert to its historical beta once the earnings-related volatility subsides.
US HY Still Looks Dislocated Versus S&P 500; Less So Versus Russell 2000
To start in Figures 1 and 2, we simply plot US HY Index spreads versus the S&P 500 ("S&P") and Russell 2000 ("RTY").

While not perfect comparisons, we believe asset allocators and specialists alike often look to the two broader indices to help formulate a first cut opinion on cross-asset performance and relative value. In terms of a short-term signal worth further dissection, we find that US HY spreads look modestly dislocated (wide) relative to its relationship with the S&P since the beginning of 2016. The relationship looks more in line when comparing US HY to the RTY. These findings are consistent with the broader narrative of small-cap equities and other higher-beta risk assets underperforming in August.
What could further explain the divide? Constituents differences and relative sector weightings provide a clue. Among the set of issuers in the High Yield Index, 62 are also in the S&P and 224 are also in RTY, with each group accounting for roughly 18% of par outstanding in the High Yield Index. Not surprisingly, the quality breakdown shown in Figure 3 suggests that the S&P cohort is higher in quality relative to the RTY constituents.

While neither cohort is exactly comparable to the High Yield Index, the quality weights of the High Yield Index align slightly better with the RTY than the S&P, which may help to explain the dislocation seen in Figure 1. That said, higher-quality credits have actually underperformed on a beta-adjusted basis recently, as noted in this week's Tuesday credit call. As a result, we find the magnitude of high yield's underperformance with respect to the S&P somewhat surprising considering that high yield is underweight higher quality.
Figure 4 shows the differences in sector exposures relative to the High Yield Index for both equity index's matched cohorts.

With the exception of energy, the S&P cohort is actually more closely aligned with respect to index weights than the RTY cohort. That said, the S&P's relative underweight with respect to energy has been a key driver of its outperformance relative to both the RTY and US HY in 2Q17, when E&P companies were faced with a litany of issues. However, adjusting for the differences in sector exposures using the weightings of the S&P cohort, we find that the High Yield Index would still have widened by the same 31bp in the aftermath of the recent sell-off despite its outsized energy exposure.
Quantifying How Sensitive Credit Returns Are To Equity Returns Now
While optically, high yield may appear modestly disconnected with respect to the S&P 500, it's worth noting that this relationship is somewhat fickle. In Figure 5, we track the trailing 6-month betas of daily total returns of the US High Yield Index versus the S&P and RTY.

As shown, both have gyrated significantly over time, suggesting that there is not a single best fit to explain the relative performance of credit and equities beyond short periods of time. At the moment, the betas are all generally towards the lower end of their two-year range, though slightly higher for the S&P than the RTY. This likely reflects the relatively more benign macro and volatility backdrop that has persisted for most of the last 12 months now that many of the stresses around weak commodity prices in 2015 and 2016 have become better understood and digested.
While it is true that the credit/equity relationship has been far from stable, it is interesting to note that the High Yield Index has consistently displayed higher sensitivity with respect to the S&P than the RTY. In other words, in order to design a "true" delta neutral portfolio, one would theoretically have to short more units of the S&P than the RTY against a long High Yield Index exposure. Of course, determining the "correct" market neutral hedge ratio is complicated by the changing face of the equity/credit relationship. Nonetheless, using the rolling 1-year historical total return beta to equities as the hedge ratio, we find that the return of the hedged portfolio is closer to zero using the SPX (Figure 6). 
A simple regression of weekly returns of the SPX and RTY against HY returns over the past five years would suggest that high yield displays a marginally better fit with respect to the S&P (R-squared of 36%) than the RTY (33%). Over the past month, however, high yield performance has more or less tracked its beta to the RTY month-to-date total returns through Wednesday's close (0.16x) has been closer to its historical beta to RTY (0.21x). Meanwhile, the ratio of high yield to SPX returns (-6x) suggests that its relationship to SPX (characterized by a total return beta of 0.32x to S&P) has recently broken down. For the reasons stated above, this divergence has less to do with its outsized commodity exposure, and has more to do with idiosyncratic stories and earnings-related volatility. But looking forward, we believe that high yield will perform more in line with its historical beta to the SPX once these concerns subside" - Barclays
Of course it should perform in line with its historical beta to the SPX. It remains to be seen how long US High Yield and the S&P 500 maintain their "elevated" valuation level. This of course, partially depending on the trajectory that will be taken by oil prices in the second part of the year.

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 the past (data up to the end of July):
Correlation 0.966, R2 0.933, 139 months in sample - source

In case you are asking, it shows you that High Yield, isn't that much of an "alternative" asset class, as put forward by some pundits.

When it comes to credit, defaults and leverage matters but pointing out the "low default rate" in Europe or elsewhere like some pundits do, it is we think "oversimplistic". Leverage matters more and so does earnings when it comes to High Yield. Looking at default rates is like looking at the rear view mirror. It tells you what has happened, not what is going to happen and maybe indeed looking at the iTraxx CDS credit indices is a cleaner way to look at the pure credit risk, given the greater liquidity in these synthetic contracts versus cash we think should you want to play the "hedging" beta game. Just a thought. When it comes to the maddening crowd our final chart displays WPP cds prices move following their profit warning and the warning it delivered for both credit and equity players.

  • Final chart - Credit Mad Men
 Our final chart comes from DataGrapple's latest blog entry entitled "Do as I say, not as I do" and displays WPP CDS 5 year price evolution. The comments they made are very interesting from the point of view of credit investors but as well in the light of  WPP's "forward guidance" and the very challenging situation for retail. One might wonder if the situation will be contained...
"WPP blames “Uncertainty and short-termism reducing investment in favor of buybacks/dividends, although market levels lowering attraction” as a reason for the lack of dynamism of the advertising market. Companies are cutting costs to keep dividends & buy-backs very close to 100% of operating profits. At the same time WPP intends “Use of our substantial cash flow to enhance EPS through acquisitions, share buy-backs and debt reduction”. This was not enough to avoid the 10% drop in WPP’s share price today. WPP credit default swap did not react as much. The CDS is only 3 bps wider at 63 bps. Looking at the attached grapple, we see that the credit market is much more cautious on WPP for some time. The CDS is 40% wider than its lows mid-June. The company intends to use cheap debt to increase its net debt to twice its EBIDTA. The uncertainty of WPP’s EBITDA is a new challenge for credit investors. However, today was more an equity story with an interesting analyst presentation with a lot of data. WPP confirmed for instance the stress on the retail sector which is cutting on ads, -3% yoy.
Meanwhile, the credit index market was quiet. The credit index index option market was busier with some investors looking at options rather than outright hedges for the months to come." - source DataGrapple
As we pointed out recently, credit options are still a cheaper way in hedging your credit bets than going outright long the CDS index from a negative carry perspective. Volatility might indeed return in September thanks to additional US political uncertainties and other exogenous factors. It remains to be seen if contrary to the Phillips curve, volatility is not a dead Norwegian Blue parrot after all, we don't think it is but we ramble again...

"What the eyes see and the ears hear, the mind believes." - Harry Houdini

Stay tuned!

Wednesday, 16 August 2017

Macro and Credit - Experiments in the Revival of Organisms

"Life is obstinate and clings closest where it is most hated." -  Mary Shelley

Looking at the latest gyrations in risky markets including credit markets following our timely musing relating to "Gullibility", while thinking of our next post title we found it amusing the numerous attempts by various financial pundits in "reviving" the Phillips curve which we have been so critical of in recent conversations. For our title analogy we decided to steer towards the creepy given our title analogy refers to a 1940 Soviet motion picture which document Soviet research into the resuscitation of clinically dead organisms. It is available from the Prelinger Archives and is in the public domain. The creepy operations depicted are credited to Doctor Sergei Brukhonenko and Boris Levinskovsky who were demonstrating a special heart-lung apparatus called the autojektor (or autojector), also referred to as the heart-lung machine, to the Second Congress of Russian Pathologists in Moscow. Their modern "Frankenstein" experiments (involving decapitations) were related to the heart-lung machine. It was designed and constructed by Brukhonenko, whose work in the video is said to have led to the first operations on heart valves. The autojektor device demonstrated in the film is similar to modern ECMO machines, as well as the systems commonly used for renal dialysis in modern nephrology. The film depicts and discusses a series of medical experiments. It begins with British scientist J. B. S. Haldane appearing and discussing how he has personally seen the procedures carried out in the film and have saved lives during the war. The experiments start with a heart of canine, which is shown being isolated from a body; four tubes connected are then connected to the organ. 

You are probably asking yourselves already where we going with this creepy analogy of ours (after all being outright "scary" drives traffic for some blog pundits...), but in these Frankenstein markets to say the least, we found it amusing the attempts by so many including the PhDs are the Fed to cling on outdated models that were fit to purpose in their own time but not anymore. As pointed out by our friend Ilya Kislitskiy (@sayfuji on Twitter), resurrection is a complicated business, same thing goes with "Experiments in the Revival of Organisms":
"What can cause global anxiety? Maybe the fact that Phillips curve somewhere is "complicated" and "partially resurrecting" elsewhere? I definitely feel uncomfortable." - Ilya Kislitskiy (@sayfuji on Twitter)
Rest assured we do too, when it comes with macro old-school Phillips-curve-fans. Life is indeed obstinate, to paraphrase Mary Shelley, the author of Frankenstein. This is particularly the case with the Fed and the financial community when it comes to clinging to outdated models. It doesn't necessarily mean that these pundits' Phillips curve "autojektor device" will not eventually lead to a better model. In our book, for the time being, experiments in the revival of macroeconomic models such as the Phillips curve, defeat the purpose but we ramble again...

Also, when it comes to our analogy, Frankenstein markets comes to mind given Bondzilla, the NIRP monster has indeed become insatiable for anything with a yield. In similar fashion to Dr Frankenstein, our generous gamblers aka central bankers have become increasingly nervous with the "creatures" (or bubbles) they have spawned with their various resuscitation experiments and this is even without the exogenous geopolitical turmoil as of late. In recent years they have been doing various experiments in the revival of organisms, some European banks come to mind when we think about "zombies" in homage to recently departed horror film maverick director George A Romero

In this week's conversation, we would like to look at the need to continue building up your defenses in the credit space, meaning further rotation into higher quality in this overextended beta game given the accumulation of late cycle signs we are seeing.

  • Macro and Credit - Frankenstein markets thanks to our Modern Prometheus
  • Final charts - Fun in Funds

  • Macro and Credit - Frankenstein markets thanks to our Modern Prometheus
When one looks at a 70% rise in the VIX index over just three days, a 2% drop in global equities in conjunction with widening credit spreads including of course High Yield and the beta crowd, a young investor would have caught fright. But, in retrospect, this was merely a blip given our Dr Frankensteins are still busy with their central banking experiments. Obviously the big question is surrounding Bondzilla the NIRP monster, given the massive creature has been in growing in size since the start of our central bankers various iterations.

What is already starting to show credit weakness, we think is indeed coming initially from US Commercial Real Estate (CRE). Of course as we pointed out in our most recent conversation, consumer credit is another piece of the credit puzzle we watch carefully as this credit cycle unfolds and is indicative of the lateness of it.  Back in February in our conversation "Pareidolia" we pointed out the following:
"At this stage of the cycle, there is a tendency for excesses (real estate prices, subprime auto loans, etc.) to build up meaningfully. For instance, we have been monitoring the weakening demand for credit but in particular Commercial Real Estate given the latest Federal Reserve Senior Loan Officer Survey has shown that financial conditions have already started to tighten meaningfully in that space" - source Macronomics, February 2017
CRE (Commercial Real Estate) is considered to be a good proxy for the state of the economy. And, if indeed investors are pondering the likelihood that the US economic growth is slowing and that CRE valuations have gone way ahead of fundamentals, then it makes sense to track what is going on in that space for various reasons, particularly when it comes to assessing lending growth and the state of the credit cycle we think. By tracking the quarterly Senior Loan Officers Surveys (SLOOs) published by the Fed you can have a good view into credit conditions. Credit conditions for CRE have already started to tighten since a couple of quarters and from a valuation point of view, it does feel that we are close in many instances to "peak valuation". From a valuation perspective we read with interest Wells Fargo's note from the 14th of August entitled "CRE Deal Volume Shows Late-cycle behavior Q2 Chartbook" particularly the part linked to the Hotel segment of CRE:
  • "Still reflecting the previous headwind of weak corporate profits and a stronger dollar, the seasonally adjusted real revenue per available room (RevPAR), which is the product of occupancy and the real average daily rate (ADR), fell to just 0.2 percent in Q2, year-over-year. That said, corporate profits were up more than 3 percent in Q1, and the dollar is softer suggesting there are some upside risks.

  • Real RevPAR for higher-end hotels (luxury, upper upscale and upscale) posted its fifth straight year-over-year negative reading in six quarters in Q2, while the pace for lower-end hotels (mid- and economy-scale), has slowed significantly from its cycle peak of 8.0 percent in late-2014 to just 0.8 percent.
- Source: STR, U.S. Department of Labor, FRB and Wells Fargo Securities

Are we at "Peak Occupancy" in this rate cycles? It certainly looks this way to us. Also the negative trend in Real RevPAR growth is yet another sign that the credit cycle is slowly but surely turning we think.

It is fairly clear to us that when it comes to credit availability and lending, the CRE space indicates things are indeed slowing as per Wells Fargo's remarks from their report:
  • "Senior loan officers reported that CRE lending standards tightened across the three categories while demand cooled during Q2. A net share of around 17 percent of banks, which is classified as “moderate,” reported tightening standards for construction and land development loans and multifamily.

  • According to the Mortgage Bankers Association (MBA), total commercial/multifamily debt outstanding broke the $3 trillion mark in Q1. At 41 percent, commercial banks and thrifts still comprise the largest share of debt outstanding.
  • Consistent with lending standards, loan growth in multifamily and construction and land development has slowed from its cycle high. Growth in income properties is also moderating.
- Source: STR, U.S. Department of Labor, FRB and Wells Fargo Securities

There are more signs from the CRE market alone that the credit cycle is slowly but surely turning and it is of course showing up in this market first.

When it comes to "Experiments in the Revival of Organisms", clearly the CRE market has reached record valuation levels as pointed out by Wells Fargo. Our Dr Frankensteins at the Fed should clearly be nervous about these lofty valuations levels we think:
"Elevated pricing (Figure 2) has also been a concern for investors, and we suspect the disconnect in pricing and transaction volume is also due to still-elevated levels of cross-border transactions.

Indeed, the low global rate environment and reach for yield, and in some cases, safe-haven plays made U.S. CRE a preferred asset class in many markets by foreign investors. With global economic conditions stabilizing, the risk of global deflation less of a concern, and hence, some major central banks expected to begin tightening monetary policy next year; investors are bracing for higher cap rates in the U.S. and abroad, and in turn, lower valuations. That said, the short and long-end of the curve are largely driven by different determinants. Moreover, cap rates don’t necessarily move in lock-step with the 10-year U.S. Treasury yield. On a global scale, the average cap rate in the U.S. in Q2 was the highest among the 11 countries tracked by RCA (e.g. France, Australia, etc.), with the risk premium still favorable at more than 400 basis points.
- Source: FDIC, Mortgage Bankers Association and Wells Fargo Securities

Sure valuation wise, as we pointed out in our most recent conversation "The Barnum effect", in these Frankenstein markets thanks to the modern Prometheus, already expensive asset classes such as European High Yield can become even more expensive thanks to central banking "Barnum effect". No doubt their Marshall amplifier can reach "11", as in the famous movie Spinal Tap. After all, as long as the Dr Frankensteins are in the game, you got to keep dancing right?

You are probably asking when the tide will be turning when it comes to the "Macro and Credit" picture. On this very subject we read with interest Barclays note from the 11th of August entitled "Macro Credit Framework: Let's be reasonable" where they update their framework for credit returns:
"With credit valuations near post-recession tights, we believe this is a good time to update our macroeconomic framework for credit returns. The core of our framework is that:
  • For the purposes of forecasting credit performance, we can reduce the business cycle into two regimes: a steady state in which the economy is growing consistently and a transitional state that includes recessions plus de 12 months before and after. Macroeconomic indicators can signal which state the economy is in.
  • Spreads evolve differently in the transitional state than in the steady state.
  • Valuations are the key driver of returns for both steady and transitional states, but the distributions shape of those returns varies across regimes. 
- In the steady state, returns are more normal for a given valuation, and treating returns as normal should be adequate for rough estimates of returns and loss probabilities.
- Transitional state distributions are more skewed, making the distribution of expected returns rely more heavily on starting valuations.
Applying the framework to the current environment suggests a 70% chance of positive excess returns for BBB credits, with an expected return near carry (Figure 1 ). 
The macro framework suggests that we should expect 60-70bp of Six-Month Excess Returns for Corporate BBBs

Defining Business Cycle Regimes
For the purposes of making return forecasts, we believe that only two regimes really matter:
  • Steady state is the default, covering periods of consistently positive economic growth that are the “expansion phase” of traditional business cycles. These phases have periods of both slower and faster growth, but without the sustained deterioration that marks a recession.
  • Transitional states have been less frequent (especially in the past 30 years) and consist of recessions plus the 12 months preceding and following them.
There are number of reasons to condense the macro environment to only two regimes:
  • There are clear differences in how credit returns behave in the two regimes with credit more likely to widen, and more likely to linger at wider spreads during transitional states (Figure 2).
    But further subdivision do not seem to add much information - for example, for a given valuation, there is not much difference in returns from "early" in a recession to "late" - so it is sensible to use fewer states.
  • It makes it easier to define the conditions of being in each state, which makes it more likely that we will make the correct call. In general, we think it is relatively straightforward to understand when we are in a recession or its aftermath that means the only difficult call is whether we have moved from a steady to a transitional state.
Economic Indicators - Clue for Transitional Periods
The most challenging part of our framework is determining whether we have entered the transitional state, but we think there are useful indicators for when that happens. There are a number of layers to the process. First, the preconditions need to be in place. Then the timely indicators give us information about whether we are within the 12 months of a recession. Finally, a qualitative evaluation informs us whether our preferred signals are likely to have their usual reliability.
Preconditions for a Recession
Fed hiking cycles and tighter bank lending standards have historically been preconditions for recessions. The past six recessions have been preceded by Fed hiking cycles and leading up to the past two recessions, bank lending standards have tightened (Figures 3 and 4).

Intuitively, this makes sense - the economic benefits of looser Fed policy and accelerating lending conditions lean against the possibility of a recession.
While these indicators are necessary for a recession, they do not by themselves signal that a recession is imminent - both can be in place for multiple years before a recession begins. While these preconditions are currently being met, we must look at more timely measures that signal the economy is entering a transitional state.
Near-Term Indicators 
Jobless Claims
We believe that jobless claims are one of the best indicators of a regime shift, because they generally start to rise about a year before the economy enters a recession. This makes them particularly well timed for the move to a transitional state. Their usefulness as an indicator for credit is supported by the tendency of rising jobless claims to predict negative future returns for credit (Figure 5), consistent with our analysis that spreads generally widen from tights during the transitional state.

The decline in jobless claims has been impressive since 2009, and the measure is at all-time lows after adjusting for total jobs in the economy. With less slack in the series, the decline in claims has lost momentum, suggesting that further improvements could be limited (Figure 6).

However, claims have remained low or flat for multiple years in the past, so flattening alone is not sufficient to indicate a rise in claims. Consequently, we do not believe that jobless claims are currently signaling that we are entering a transitional period (although that assessment could change quickly).
Output Gap
The second timely indicator that we use for our macro credit framework is the output gap - a measure that Barclays Economics uses as a framework for the US business cycle (Figure 7).

The output gap uses a multivariable approach - with inputs such as working hours, output, employment, unemployment, and the labor force - to measure the actual output of the US economy versus the potential output.
We find that the output gap tends to follow the business cycle closely. The indicator typically peaks about three quarters prior to a recession, on average, and starts to roll over during the transitional state (Figure 8).

Coincidentally, spreads also tend to widen when the output gap is declining (Figure 9).

Currently, the output gap has closed and is near the 2005-2006 peak, meaning that the current business cycle is mature. However, the indicator does not seem to be rolling over and is not indicating that we are entering a transitional state yet.
Qualitative factors
In relation to position within the business cycle and whether the economy is entering a transitional period, it also makes sense to monitor qualitative factors that could pose risks to the current steady state of the economy.
Consumer Credit
Trends in consumer credit have become a cause for concern. Consumer debt outstanding has risen for credit cards, auto loans, and student loans, giving consumers less room to use debt to support spending. Delinquency rates have also begun to rise in all three cohorts (Figure 10), with the auto loan sector particularly worrisome.

Along with the significant growth in auto credits outstanding, auto loan quality has worsened, and auto sales have lost momentum. While these trends are somewhat troublesome, the size of the auto loan market pales in comparison with the mortgage market, a major issue in the last recession. And despite some deterioration in the quality of the ABS market, losses so far have been modest. Therefore, we do not believe that concerns in the auto sector will push the economy into a transitional state at the moment, but any further development should be closely monitored.
Retail sector
Weakness in retail has been a theme in 2017, with the sector facing revenue losses to e-commerce competitors and lower returns on assets because of overcapacity. Because the retail sector is such a large employer - up to 10% of American workers are in the sector in some capacity - there is a reasonable question about whether a sector restructuring could spill into the broader economy. We examined this question in greater depth in US Economics and Credit Strategy: Technology-based change leaves retail looking overextended, and our conclusion is that so far jobs are not being lost at a fast enough pace to create exogenous recession risk. For example, the number of retail workers affected by bankruptcies has increased quickly, rising above 200k over the past 18 months (Figure 11), but given that the US sees about 250k new jobless filings a week (a record low), that is not yet enough to cause broader problems.

Returns are more volatile during transitional states 
The next component of our framework is to understand what the most reasonable distribution of returns is likely to be within each state. The first thing we observe is that returns are related to starting valuations in both regimes (Figure 12).

We also note that for a given valuation, they are more volatile, and more likely to be negative, in the transitional state.
We base this analysis on Moody's data on spreads for industrial BBB long bonds. The series starts in 1919, which allows us to calibrate spread performance around 17 recessions. This is a significant advantage over using the Bloomberg Barclays Indices, which cover only three recession cycles. The disadvantage is that the Moody's data do not provide carefully structured return calculations, so we need to estimate returns using carry, spread changes (assuming the same duration as the BBB long index), and historical default rates to account for losses.

Digging a little deeper into the steady state, both returns and volatility rise consistently with starting spreads, in a very orderly relationship (Figure 14).

We also note that they look fairly normally distributed, although with some extra downside tail risk (Figure 15).

By contrast, in the transitional state, returns are less clearly related to valuation (Figure 16).

This seems to be related to more pronounced skew during these periods. But the degree and direction of skew also appear to be a function of valuation.
  • When spreads have been in middle third (between 215 and 285bp), they have widened on average, but usually not enough to offset all returns from carry. As a result, the average estimated six-month return has been about 90bp. At the same time, the occurrences of large gains have been balanced fairly even against the number of large losses.
  • When spreads have been the widest third (widest than 285bp), they have usually tightened, generating an average estimated six-month return of more than 200bp. They have also had higher-than-normal probabilities of large gains or tightening events." - source Barclays.
This analysis in our opinion is very interesting from a Macro and Credit perspective, as posited by our Friend Paul Buigues in his 2013 post "Long-Term Corporate Credit Returns":
"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." - Paul Buigues, 2013
Returns are related to starting valuations in both regimes, this is a very important point for credit investors we think. Also, according to Barclays, in the transitional state, returns are less clearly related to valuation. As concluded as well in this previous 2013 by our friend Paul:
"Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates.
As a consequence, spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors."  - Paul Buigues, 2013
Do not focus solely on the current low default rates when assessing forward credit risk. Trying to estimate realistic future default rates matter particularly when there are more and more signs showing that the cycle is slowly but surely turning in both CRE and consumer credit. Peak jobless claims and peak hotel occupancy might after all show us that we are indeed moving towards a transitional state in these Frankenstein markets. One thing for certain, the energy sector credit woes in 2016 and outperformance in the second part of 2016 was a sign that returns can be clearly related to valuation or when credit spreads reached do not make economic sense that is when average high-yield spreads above 1000bp can be irrational.

Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: 
"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on
 We have always wondered in relation to the global rounds of quantitative easings the following:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"
Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

As a reminder, in our part 2 conversation "Availability heuristic" from September 2015, the liabilities structure of industrial countries is mainly made up of debt (they are “short debt”), in particular in Japan, the US and the UK. In contrast, the international balance sheet structure of emerging markets is typically composed of equity liabilities (“short equity”), which is the counterpart of strong FDI inflows that contributed to improve emerging markets’ external profile in the last decade. With a rising US dollar, what has been playing out is a reverse of these imbalances hence our "macro reverse osmosis" discussed in past conversations to explain violent rotations in flows from Emerging Markets. 

As we have seen on numerous occasions, and as we have remarked in our conversation  "Critical threshold", higher yields can lead to material fund outflows. As a reminder, more liquidity = greater economic instability once QE ends. As we move towards the transitional state described by Barclays in their note, one way of "mitigating" dwindling policy support would be to "embrace" a barbell strategy. 

For our final chart, no doubt to us than in these Frankenstein markets and experiments in the revival of organisms, it has been a "Goldilocks environment" for US credit.

  • Final charts - Fun in Funds
Bondzilla the NIRP monster has been created by our Dr Frankensteins in various central banks. Clearly the instigation of NIRP has put the demand for US credit from foreign investors into overdrive and it has been as we pointed out recently "Made in Japan". Our final charts come from Wells Fargo Credit Connections report entitled "Correction mode" from the 11th of August and displays fund flows relative to net share buyback:  

"Follow the Money
"Nearly $1.2 trillion of new money has flowed into U.S. Taxable Fixed Income mutual funds and ETFs since 2009. Much of that money came from Money Markets as central banks slashed cash rates and investors rotated from cash to bonds to enhance their yield. International investors jumped on the bandwagon in 2014 following the Fed’s taper tantrum, and accelerated their buying last year after European and Asian central banks cut cash rates to negative. Throughout the entire period, the lion’s share of money poured into U.S. IG credit funds. An upsurge in demand for corporate bonds allowed corporations to ramp up gross bond issuance to record levels of nearly $1.5 trillion per annum over the past six years. Much of that bond issuance was used to fund share buybacks, which helped buoy stock prices. All of this is shown in the charts above and below.

So, the $1.2 trillion question is, when does this virtuous cycle end? The short answer is, not yet as the world remains awash in excess savings and global central banks continue to pump about $200 billion of new cash into the system each month via their existing QE programs. But, we suspect the slow march back towards cash has begun. In the U.S., the Fed has raised the Fed Funds rate by 100 bps over the past 20 months to 1.25% (upper bound) and remains in tightening mode. The Wells Fargo Securities’ economists expect another hike this year, and three more next year. However, cash rates in Europe, Switzerland and Japan remain deeply negative. Until these rates are greater than zero, global excess cash will likely continue to hunt for yield enhanced investment opportunities around the world, a portion of which should flow into U.S. credit and serve as a backstop against spikes in volatility." - source Wells Fargo
As long as our Dr Frankensteins keep pumping into the system and NIRP stays firmly into play, there is no reason why asset prices cannot go even further towards the 11th mark on the Marshall amplifier of our central banks. The only creepy and scary thing with experiments in the revival of organisms is when our mad scientists will lose control of their Bondzilla, but we guess that's a story for another day while we keep monitoring the credit impulse globally and weakening signs from the US.

"Invention, it must be humbly admitted, does not consist in creating out of void, but out of chaos. " - Mary Shelley

Stay tuned ! 

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