Tuesday, 25 April 2017

Macro and Credit - A Pyrrhic victory

“You were given the choice between war and dishonour. You chose dishonour, and you will have war.' - To Neville Chamberlain” - Winston S. Churchill

Looking at the results of the French presidential elections with keen interest given our involvement in the process, us being French, we reminded ourselves, for the title analogy of the definition of Pyrrhic victory, where the heavy toll negates any sense of achievement or profit. King Pyrrhus of Epirus suffered irreplaceable casualties in defeating the Romans at the Battle of Heraclea in 280 BC and the Battle of Asculum in 279 BC during the Pyrrhic War. In both victories, while the Romans suffered greater casualties but they had a much larger pool of replacements, so the casualties had less impact on the Roman war effort than the losses of King Pyrrhus. While financial markets are going through yet another relief rally thanks to the victory of the Media darling Macron, we would point out that, no matter what some pundits think, Marine Le Pen and her party are, to use a financial term and analogy "positive carry" (inequality and unemployment, immigration, terrorism, etc.). Let us explain ourselves. Most of the beneficiaries of what "populists" would label "crony capitalism" and the "elites" have been behind Macron's candidacy, so all in all they are today sighing with relief. Yet, we believe his upcoming victory would amount to a Pyrrhic victory, in the sense that, unless they are very important structural reforms implemented which have been postponed in France for the last 20 years (under Chirac, Sarkozy and Hollande), there is a high probability of another 5 years wasted under Macron. While the quotation we have used above from Winston S. Churchill sounds a little bit off the mark from a historical perspective, we do feel, to paraphrase Mark Twain, that history for France is not repeating itself, yet it rhymes with the troubled 30s. We could even rephrase Winston S. Churchill quote as follows when it comes to France: "You were given the choice between status quo to avoid bankruptcy and dishonour.  You chose status quo and you will have bankruptcy and dishonour. Unless we see some very bold structural changes in France, not only in order to reform inefficient and inept systems in place but with significant tax reforms and supply side policies as well, we do believe there is a very high probability that Macron's victory will be a Pyrrhic one down the line but we ramble again.

In this week's conversation we would like to look at what to expect in terms of the continuation and sustainability of the rally which climbed the most recent "wall of worry" of the French elections. 

Synopsis:
  • Macro and Credit - Paris in Spring?
  • Final chart - Bank of Japan, the ETFs whale

  • Macro and Credit - Paris in Spring?
While this bullet point could as well be a title analogy on its own and a reference to 1935 black and white musical comedy film directed by Lewis Milestone for Paramount Pictures, the relief rally seen so far, from our perspective has been mostly a beta play, particular in the light of the performances on the Monday following the elections on French bank stocks. As we have pointed out in numerous recent conversations, we continue to remain short term "Keynesian" when it comes to us being "risk-on", yet we remain medium term "Austrian" when it comes to tracking the weakness in credit growth, surging delinquencies and the credit cycle being long in the tooth. From an equities allocation perspective, we do think that Europe and other markets offer better prospects than US markets given the most recent macro data. Yet, with the slowdown in US hard data, we think at current levels US credit offers still better prospects than European credit both for Investment Grade and High Yield for which oil prices matter a lot.

For now the market wants to rally and will rally, as we often see significant rally in late stages in the credit cycle. For the time being the allocation tool DecisionScreen for High Yield is still in the buying zone for the aggregate signal which comprises the following trading rules: BB Financial Conditions Index US (3M Z-Score), US Budget Balance (Level), G10 Economic Surprise (5Y Z-Score), US GOV 10 Year Yield (1Y Z-Score).
- source DecisionScreen


It remains to be seen how long US High Yield will continue its upward trajectory. This of course to a large part as we discussed recently 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 remains very strong as per the below chart from MacroCharts.pro we also used in several conversations:
Correlation 0.938, R2 0.881 - source MacroCharts.pro

Same goes for the correlation between the S&P500 and the synthetic CDS High Yield US index CDX:
Correlation 0.987, R2 0.973 - source MacroCharts.pro

Of course when it comes to Bayesian learning history shows the final phases of rallies have provided some of the biggest gains. But we are driveling again given in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent), then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."
So all in all, you can probably see we are not part of the "permabear" camp, though we are acutely aware of the lateness stage we are in the credit cycle. It might be "Paris in the Spring" and "risk-on" for the time being, but, we do feel more cautious as we stated about the second part of 2017.

Given we have climbed the "French wall" of worry for the time being, while European investors had already been front running their Japanese peers, we do expect higher overseas demand for US Investment Grade credit thanks to improved cross-currency basis. On this subject we read with interest JP Morgan's Credit Outlook and Strategy note from the 20th of April 2017: 
"The US election results were followed by strong market optimism that US growth and corporate results would benefit. UST yields went from 1.83% on November 7 (the day before the election) to a peak of 2.61% on March 13th. The S&P rallied 12% from pre-election to its recent peak, and JULI spreads tightened by 24bp as well, to their recent low. Currently the UST 10yr yield is at 2.23%, unwinding 37bp or 50% of its post-election move. In contrast, the JULI is just 7bp wider so has unwound 30% from the post election tightest level, and the S&P is just 2% off of its recent peak, still up 11% post election, so it has given up 15% of its post election rally.
These developments suggest that markets have become less optimistic on growth and inflation picking up, while maintaining most of the optimism that drove equities up and credit spreads down on the election results. The move lower in UST yields reflects, in part, a flight to quality with the French election and increased geopolitical tension, but this "flight" didn't meaningfully hurt risk markets. There are several factors that can explain at least part of the strength of credit and equity markets even with rates markets suggesting rising risks to growth. These include:

1) Solid earnings expectations:
Consensus equity analysts estimates are for 7.4% revenue growth and 8.9% EPS growth in 1Q17 vs 1Q16, for the S&P500. Excluding Energy revenue and earnings growth forecasts are 5.3% and 5.1%. The weaker USD so far in 2017, down 4% in trade weighted terms, is a contributing factor to better earnings, as is the recovery in Energy prices and higher interest rates helping bank earnings. These earnings forecasts are much stronger than nominal GDP growth in 1Q17, which is likely to come in at just 4.1% higher than 1Q16. This is the most straightforward driver of the outperformance of credit and equities vs. US rates. That said, if low US rates are correctly predicting a slowdown in US growth, then earnings optimism will fade as well.

2) The regulatory reforms and pro-business agenda of the new administration as a driver of better corporate earnings, separate from the macroeconomic drivers of growth. It will be difficult to quantify the earnings impact of actual and potential regulatory relief, but it is hard to argue that it is not positive for corporate earnings over time. Related to this, potential changes to Dodd-Frank and new appointments at the Fed are fueling optimism in the Financial sector for some types of regulatory relief. As the legislative path of reform continues to be challenging for the new administration it is logical to assume there will be increasing focus on reforms and appointments that the executive branch can institute without congressional approval. M&A has been quiet recently but there is a lot of M&A discussion, particularly in the TMT sector. The assumption is that the new administration will be more likely to approve transactions that might have been blocked by the prior administration. This may or not be positive for credit markets, but it is usually positive for stocks.
3) The Fed rate hiking cycle is directly supportive of US bank earnings.Net interest margin rose for most banks in 1Q17. The most recent Fed hike was on March 15 so only a small portion of its impact was reflected in higher earnings in 1Q, while 2Q will reflect the full impact of this hike, and perhaps the beginning of the next Fed hike, which we continue to expect on June 14.
4) Lower sovereign yields in Europe have increased the need to diversify and are contributing for overseas demand for US HG credit. The 10yr bund is now at 33bp, down from a 2017 peak of 48bp on January 26th. The percent of JPM’s global sovereign bond index offering a negative yield was at a recent low of 17.6% on March 13, and has since ticked up to 21%. In the first part of 2016 low global bond yields contributed to overseas demand for US credit. This impact faded in the 2nd part of 2016 and in early 2017, but has increased once again. Some of the recent move lower in European sovereign yields is tied to the risks seen around the French election so may dissipate (or get worse) after Sunday’s vote.
The FX-hedged pickup of USD credit vs European and Yen credit has narrowed recently.
For Euro based investors USD credit, hedged with a 3m FX swap, now offers a pickup of 31bp. This is on the low end of the 31-68bp three month range.

For Yen based investors this pickup is now 63bp, also near the bottom of the 58- 93bp range. Still, with sovereign bond yields so low the need for diversification remains. The decreases in spread pickup for European and Japanese investors buying USD HG corporates is primarily due to a decrease in US HG corporate yields. The annualized cost of the USD/EUR and USD/JPY 3m FX hedges has remained relatively stable recently while the absolute unhedged yield differences have decreased.


Even taking account of these factors, the extent of the difference between UST and equity/credit spread movements over the past few weeks seems extreme.
The drivers of the equity rally and credit spread rally post the election were then described as tax reform (including overseas cash tax repatriation relief), infrastructure spending and fiscal stimulus. All of these are, at a minimum, delayed, and there is growing skepticism that the magnitude of corporate tax relief and infrastructure spending will match the Administration’s goals.
Some of the macro data would support higher UST yields as well, with consumer and business confidence near multi-year peaks and PMIs also very strong. 
Global Economic Activity Surprise indices reached multi year peaks in March but have receded since then. The Fed has raised rates in 2016 and a couple of weeks ago signaled that it would change its balance sheet reinvestment policy later in 2017. These factors might have been expected to keep UST yields high, but instead they have declined.
There are countervailing factors in the macro data, which are getting the focus of the Treasury market, however. Bank lending slowed in the later part of 2016 and this trend has continued, despite the strong consumer and business confidence figures, which might have been expected to lead to more loan demand.

Auto sales have also slowed, and retail sales growth overall has been modest.

GDP growth in 1Q is coming in weak, though there has been an historical pattern of weak 1Q initial prints, which are then revised higher. CPI last month came in very weak, though again the magnitude of the drop seems overdone and may be revised in subsequent updates. This more cautious data, if truly predicting weaker growth, would be expected to impact stocks and corporate spreads, as well as Treasury yields, but this has not been the case so far." - source JP Morgan
As John Maynard Keynes aptly said:
 “The market can stay irrational longer than you can stay solvent.”
While it is indeed "Spring in Paris" with new records being broken in the equities space as we type, and pundits including us are watching with interest the divergence between hard data and soft data including retail woes, rising delinquencies and weaker credit growth in the US that portend most likely towards a weak US Q1 GDP print on Friday, you might rightly ask yourselves if indeed, when it comes to chasing this really fundamentals matter anymore. Earnings wise, no doubt the picture seems to be better, when it comes to US equities and the continuing surge. Yet, as we pointed out on numerous occasions and particularly for Fixed Income allocations, flows matter and they matter more and more particularly when you think that "Bondzilla" the NIRP monster is "made in Japan". We keep hammering this, but the Japanese investment crowd and their allocations should never be underestimated. These guys mean business when it comes to flows as we pointed out in our conversation "Drums Along the Mohawk" in early April:
"The February sell-off in French government bonds was significantly large and amounted to all Japanese purchases for Q3 2016 as per the table below. 
 - source Bank of America Merrill Lynch
 - source Bank of America Merrill Lynch
Indeed, if the French elections delivers yet another sucker punch à la BREXIT, this "exogenous" factor could precipitate additional pressure on French government yields given Japanese investors have been the largest purchasers of French debt since 2012 and hold 13% of it. When it comes to flows for foreign bonds, "Bondzilla" the NIRP monster is indeed Japanese and you would be wise to track is appetite when it comes to country allocation." - source Macronomics, April 2017
So yes, Macron's Pyrrhic victory in the first round of the French elections in conjunction with the recent start of Japan's new fiscal year might explain the recent rally in French debt but it is could be coming from a renewed appetite from foreign investors in particular "Bondzilla". He had offloaded a sizable chunk of French bonds in February as indicated in the table above we used in our previous post.

When it comes to Japan and their appetite for risky assets, if indeed Japan is Bondzilla when it comes to foreign bonds, for domestic ETFs it is indeed a whale.


  • Final chart - Bank of Japan, the ETFs whale
Whereas it is very important to track Japan flows, regardless of the fundamentals narrative when it comes to valuation when it comes to Fixed Income, it is interesting to focus as well to Bank of Japan who has indeed become a "Tokyo Whale" in the domestic ETFs market. On that subject, our final chart comes from Société Générale Cross Asset note from the 21st of April entitled "Where is the Tokyo Whale - Analysing the impact of equity ETF purchases by the Bank of Japan":

"The “Tokyo Whale” in the ETF market...
The term “whale” is frequently used to qualify big money participants in the market. The Bank of Japan has often been qualified as the “Tokyo Whale” since it became a major participant and holder in the Japanese government bond (JGB) market. Recently, this situation was replicated in the ETF market. At end-March 2017, BoJ’s cumulative ETF purchases were ¥13.1tn, with Japanese equity ETFs subject to BoJ purchases totalling ¥21.3tn assets. Based on the price performance of the Nikkei 225 and Topix indices and as dividends are not reinvested in Japanese equity ETFs but distributed, we can estimate the mark-to-market value of historical purchases. We assume the BoJ’s current ETF holdings stand around ¥15.7tn ($144bn), i.e. approximately 75% of the total assets in Japanese equity ETFs (orange line on below chart).
Eligible ETFs are physically replicated, which implies the ETF providers hold the underlying index constituents. From the estimated BoJ ETF holdings and index constituents list, we can deduce how much of the Japanese equity market is indirectly held by the BoJ through these ETFs.
... but also, indirectly, in the Japanese stock market
BoJ implicit holdings are quite small at the index level but significant on some specific
stocks
Comparing the BoJ’s ETF holding amounts per benchmark to each index’s market capitalisation is not relevant as many companies are common to the three (or two) indices. We have totalled the estimated amounts held for each stock through the three benchmark exposures and concluded that the BoJ may indirectly hold around 3.2% of the Nikkei 225 market capitalisation, 2.0% of the TOPIX and 3.1% of the Nikkei 400. These figures may seem quite low compared to the respective 75% and 40% estimated BoJ ownership of the Japanese ETF and government bonds markets. The impact at the stock level, however, can vary greatly from one stock to another." - source Société Générale
So you might ask yourselves, how long can this rally in equities continue? Well if indeed Central Banks such as the Bank of Japan, the SNB and others are now in the "investment business", the sky's the limit but we ramble again...

On a final note we think Macron's potential victory will be a Pyrrhic one given the growing divisions in France à la 30s and he would be wise to remember the latin words "Arx tarpeia Capitoli proxima", (“the Tarpeian Rock is close to the Capitol”) which some have interpreted to mean that "one's fall from grace can come swiftly". As a reminder to be hurled off the Tarpeian Rock was, from a certain perspective, a fate worse than mere death, because it carried with it the stigma of shame. The standard method of execution in ancient Rome was by strangulation in the Tullianum. The rock was reserved for the most notorious traitors, and as a place of unofficial, extra-legal executions such as the near-execution of then-Senator Gaius Marcius Coriolanus by a mob whipped into frenzy by a tribune of the plebs.

"History repeats itself, first as tragedy, second as farce." -  Karl Marx

Stay tuned!

Monday, 17 April 2017

Macro and Credit - Narrative paradigm

"The first step towards philosophy is incredulity." - Denis Diderot, French philosopher

Watching with interest hard data becoming softer with the latest weak US CPI (-0.3%) and disappointing retail sales falling by 0.2% (0.1% fall expected), when it came to choosing our title analogy we reminded ourselves of the Narrative paradigm, a theory proposed by 20th century scholar Walter Fisher. It stipulates that all meaningful communication is a form of storytelling or reporting of events. It promotes the belief that humans are story tellers and listeners and are more persuaded by a good story than by good argument. Because of this, human beings experience and comprehend life and financial markets as a series of ongoing narratives, each with its own conflicts, characters, beginning, middle, and end. In his theory Walter Fisher believed that all forms of communication that appears to our reason are best viewed as stories shaped by history, culture, and character. The ways in which financial pundits and the Fed have been selling us the "Trumpflation" and "recovery" story justifying the hikes in interest rates have more to do with telling a credible story than it does in producing evidence or constructing a logical argument we would argue, hence our chosen title. These pundits, like the Fed are essentially storytellers and each individual chooses the ones that match his or her values and beliefs. Obviously, the test of the narrative rationality is based on the probability, coherence, and fidelity of the stories that underpin the immediate investment decisions to be made. Unfortunately, these "Jedi tricks" do not function well with us. We must confess that we never bought the strong dollar narrative story that everyone piled into. As of late, the latest raft of hard US macro data has pushed us to revisit a US long duration exposure. It seems to us that US GDP for Q1 2017 is going to be most likely more disappointing than Q1 2016, therefore we have gone with the narrative rationality of MDGA (Make Duration Great Again) from a tactical perspective but we ramble again...

In this week's conversation we would like to look at 


Synopsis:
  • Macro and Credit - Foreign bonds allocation - Are the Japanese back in town?
  • Final charts - Credit, the only easy day was yesterday...

  • Macro and Credit - Foreign bonds allocation - Are the Japanese back in town?
At the end of March in our conversation "Outflow boundary", we argued that it was important to focus on what our Japanese friends such as GPIF, Lifers and Mrs Watanabe were doing in terms of foreign bonds allocations.  At the time we also added:
"The weakness seen since the beginning of the year has reduced the cost of dollar funding, and with US policy in turmoil in conjunction with prospects for slower US growth than anticipated, there is a chance to "make duration great again" we think in the current "Outflow boundary" environment" - source Macronomics, March 2017
We also note that our tactical bullish US long bonds allocation since our recent post was validated:
"Now, if US long bonds yields such as 30 years continue receding, then indeed our contrarian stance of once again dipping our toes in long duration exposure (ETF ZROZ - TLT) and adding to Investment Grade credit with higher duration as well could be tactically enticing. We are watching closely the 3% level on the 30 year." - source Macronomics, March 2017
With the 30 year US bonds now at a yield of 2.89% supported mostly by geopolitical woes in conjunction with recent weaknesses in hard data such as CPI and retail sales. As we pointed out in our recent musings including our most recent one, we were eagerly anticipating a return of the Japanese investment crowd in US Treasuries and US credit thanks to an improving cross-currency basis. We also highlighted last week that European domiciled accounts had been front-running the Japanese investment crowd, which has now entered its new fiscal year. The big question one might ask in the current "Narrative paradigm" is as follows: are the Japanese back in town when it comes to their foreign bonds purchases?

One clear trend seen in recent years has been Bank of Japan's QE programme between December 2012 and June 2016 which has enticed large inflows into the US bond markets as displayed in Nomura FX Insights note from the 10th of April entitled "Where has the ECB QE Money gone":
- source Nomura

Is this time going to be different? We wonder. There is currently a clear avoidance in terms of allocation by the Japanese investment crowd for French Government bonds given the looming French elections. There is as well prevailing uncertainties from the new US administration when it comes to fiscal policies. What appears to be the case is that the current level of uncertainties is clearly slowing the return of the Japanese crowd this time around.

Also, the recent bout or "risk-off" with USD/JPY trading through the significant 110 level is somewhat probably dampening the velocity in the return of this specific investment crowd. On this subject we read with interest Bank of America Merrill Lynch Liquid Insight note from the 13th of April entitled "New fiscal year, new flow":
"New fiscal year, new flow
Japan entered the new fiscal year this month. Last week, we argued JPY strength may be overdone and that the USD/JPY’s medium-term uptrend has not ended despite a near-term possibility of further technical sell off through 110 where we stop out (Is JPY strength justified? 105 first or 117? 07 April 2017). In our view, global risk events may not fully explain the extent of JPY strength, and flow dynamics could have been behind the JPY strength. With new data from the balance of payment statistics, we argue the demand/supply balance of USD/JPY should be improving especially after an eventful April.
Japanese money in the new fiscal year
We have seen a notable slowdown in foreign securities purchases by Japanese investors since the US election in November (Chart of the day).

The slowdown probably reflects position unwinding among bank accounts and a wait-and-see stance among the Japanese real money community amid a volatile Treasury market in the final months of the Japanese fiscal year (Chart 1-Chart 2).


Banks could continue to unwind Treasuries, but it would involve little FX impact as they usually fund these investments in the USD, unlike real money accounts we discuss below.
Lifers – more USD buying
There is a seasonality of increased foreign bond purchases by insurance accounts during the early part of Japanese fiscal year. This year, we observe (1) rising yields in the JGB’s super long sector, but still at a relatively low level; (2) lower FX hedge cost; and (3) higher US yields, and (4) a lower USD/JPY (Chart 4).

True, it is unlikely they would be very aggressive in unhedged foreign bond investments as investors would balance across JGBs, hedged foreign bonds, and unhedged foreign bonds. For now, the USD/JPY at 110 may not attract strong demand, but we believe the USD demand will increase in the next few months once we go through April full of risk events or if we get renewed optimism for the US tax reform.
Trust accounts – market stabilizer
Trust accounts continued to sell rising assets and buy falling assets last quarter as the GPIF portfolio has presumably been close to its target for some time (Chart 5).

Going forward, a traditional risk-off market, as we currently observe, would likely be met by selling of domestic bonds (and potentially foreign bonds) and buying of domestic and foreign equities by pension funds. Reflation trade would be met by selling of foreign and domestic equities and buying of foreign bonds (and potentially domestic bonds) by pension funds.
Exporters’ hedging
Another source of the earlier USD/JPY weakness may have to do with Japanese exporters’ hedging activity into the fiscal year-end. Japan’s trade balance has been rising in light of stable oil prices and rising real exports (Chart 7).

There is a possibility the final months of the fiscal year generated additional USD selling.
As FY17 starts, we think corporate hedging should be more orderly, unlike last year. According to the BoJ’s tankan survey, large manufacturers had assumed an average USD/JPY rate of 117.5 heading into FY16, while the year actually opened at 112s, which led to a severe USD selling pressure last April, in our view (Revisiting the dollar’s 100 yen scenario 07 April 2016). This year, corporates assume an average USD/JPY rate of 108.4 (Chart 8).

Though this may suggest some near-term pressure, the assumption itself seems conservative, in our view. While the improving trade balance may support the JPY over the medium-term at margin, we believe corporate USD selling will be spread out and less intense this year." - source Bank of America Merrill Lynch
Whereas the Narrative paradigm has been so far seen in renewed optimism for US tax reform, the latest raft of hard data makes us wonder how many weeks before we seen again "Bondzilla" the Japanese NIRP monster's appetite return. Our current stance, given the weaker tone in both geopolitical rising tensions in conjunction with a much softer tone in hard data, has pushed us, was we indicated earlier on in our conversation to play the duration game again, in effect front-running the Japanese investment crowd before they are back in town, yet this time around in 2017 with a delay we think. On that point we agree with Bank of America Merrill Lynch's conclusions:
"Flow in the new fiscal year will likely put widening pressure on JPYUSD basis but the magnitude will be less this time
As highlighted above (and here), lifers are expected to start investing in foreign bond markets after the French election, but in the early part of the Japanese fiscal year. Lifers’ outward flow usually pushes JPYUSD basis wider as they try to hedge FX risk. This will likely be no different this time, but we expect the widening pressure will be less and it would be difficult to see JPYUSD basis go wider to last year’s level. At the current level of USDJPY, lifers will be more open to keep their foreign bonds unhedged and some of the contributing factors to the tightening of USDJPY basis since the start of the year are structural." - source Bank of America Merrill Lynch
No doubt the Lifers will come into play in terms of their foreign bonds allocations, and this will also have some impact in the already volatile USDJPY currency pair. What is of interest of course, when it comes to the "Narrative paradigm" is that there are already early signs of the Japanese investment crowd dipping their toes back into foreign bonds as indicated by UBS in the Global Rates Strategy note from the 10th of April entitled "What Japanese Investors Are Buying":
"French bonds overtake US Treasuries as main force behind Japanese selling Japanese investors' post-US presidential election trend of considerable net selling of overseas bonds continues. Weekly flow data underscores how Japanese investors sold ~¥5.4 trillion of foreign bonds from the time of the election to the end of Mar-17.
Today's more granular data release of which individual sovereign bond markets were bought and sold in Feb-17 highlights that French bonds have overtaken US Treasuries as the main force behind the overall selling pressure. This suggests that political risks as of February overshadowed the increasingly attractive currency-hedged pick-up over JGBs offered by French bonds. Separately, we note that the last week of Mar-17 saw the largest net purchases of overseas bonds in six months. However, as this follows the typical pattern around Japan fiscal year-end (.Figure 4), we would caution interpreting this as a sign of a sustainable rebound in Japanese demand for overseas bonds.
 - source UBS

While, yes it might be seen as too early to embrace yet the "Narrative paradigm", in the light of the recent weakness in both the US dollar and hard macro data, we would rather be a little bit early and start tactically adding at least on the long end of US Treasuries, rather than wait for additional signs from the Japanese investor crowd. Some says fortune favors the brave, we would posit that in most occasions it favors the bold contrarian but we ramble again here.

Finally, for our final charts below, as we posited in previous conversations, when it comes to the situation in credit and in particular in 2017, we would rather go for US credit, given it seems to us that Euro High Yield is "priced to perfection" and when it comes to US High Yield we closely follow what oil prices are doing and much less sanguine than we were back at the end of 2015. Yes, the credit cycle seems to be turning, but, it is slowly turning.

  • Final charts - Credit, the only easy day was yesterday...
Whereas the second part of 2016 saw a very significant rally in general for US High Yield and in particular for the US energy sector, the rally so far this year has been significant as well, making us wonder if there is any "juice" left given the performance so far. Yet something we would agree with Barclays from their Global Strategy Chart book from the 10th of April is that when it comes to credit we would favor US Investment Grade over Euro Investment Grade. On top of that agreement we also think that, when it comes to credit overall, the only easy day was yesterday:
"Credit was strong in 2016n but easy gains likely behind us" - source Barclays
As we pointed out, foreign demand remains key to not only US credit but as well for US Treasuries, so overall, let's see if indeed the Japanese Investment crowd and Bondzilla the NIRP monster find again their appetite while the "Narrative paradigm" surrounding the "Trumpflation" story fades away.

"Skepticism is a virtue in history as well as in philosophy." -  Napoleon Bonaparte

Stay tuned!

Monday, 10 April 2017

Macro and Credit - Drums Along the Mohawk

"The most persistent sound which reverberates through man's history is the beating of war drums." - Arthur Koestler, Hungarian novelist

Looking at the brief return of "exogenous" factors thanks to the escalations in Syria, leading to some interesting market gyrations in conjunction with a weaker Nonfarm payrolls number with, no surprise an Atlanta Fed revised GDPNow report for US 1st quarter GDP to a miserable 0.6%, made us remember for our title analogy of John Ford's 1939 historical technicolor film called Drums Along the Mohawk. The film was John Ford's first color feature movie and was a box office success. It tells the story of settlers on the New York frontier during the American Revolution suffering British, Tory and Indian attacks on their farm before the Revolution ends and peace is restored. The time of the story is July, 1776, and the spirit of revolution is in the air. The valley's settlers have formed a local militia in anticipation of an imminent war. The latest change in the rhetoric when it comes to the events in Syria, could no doubt spur some renewed volatility in the markets in conjunction with the upcoming French elections. It seems to us that along the Markets' Mohawk Valley, drums are indeed resonating and the eerily calm volatility akin to the one seen in the last months of 2006, as per our previous week's musing could face a significant regime change in the upcoming weeks, should "exogenous" factors return to the forefront. 

In these days and age of delusions and populism, beating the war drums have always been a short cut for politicians to garner support in very short order. Couples of examples come to our mind:
-The crumbling military government of Argentina with their Falklands adventure
-The response from Prime Minister Thatcher against Argentina's incursion solidifying her political base and garnering very large support.
-The second war in Chechnya which boosted the popularity of Russian president Putin
-The invasion of Iraq in 2003 by the Bush administration
-The Libya operation for French president Sarkozy
-The Mali operation for French president Hollande

 To name a few...

In this week's conversation we would like to look at Financial markets gyrations during "exogenous" factors such as "conflicts" and what Q2 entails in terms of potential surge in volatility. 


Synopsis:
  • Macro and Credit - Delusions and gyrations
  • Final chart - Fiscal stimulus, if you give it, earnings will come...

  • Macro and Credit - Delusions and gyrations
In somewhat a similar replay to Q1 2016, we expect US GDP for 1st quarter to disappoint. The recent weakness in the latest Nonfarm payroll report and our recent call to extend duration exposure has made us dip back slightly into long US treasuries. When it comes to our gold mining exposure, we are quite satisfied by the year to date performance overall and we will continue to add opportunistically. As our readers know by now, we didn't embrace the herd mentality spirit of the long US dollar crowd and so far the performance for the first quarter has validated our stance. We continue to prefer in terms of positioning other markets than the US when it comes to equities. 

As we await for the return of the Japanese investment crowd in US credit thanks to an improving cross-currency basis, it seems European domiciled accounts have been front running as of late the Japanese crowd which is now entering their new fiscal year as indicated by Bank of America Merrill Lynch in their Follow The Flow note from the 7th of April entitled "Blame it on the Basis":
"More into risk assets
Last week we recorded inflows across a broad range of risk assets. Inflows have been recorded across equities, EM debt, commodities and HY funds. Inflows into high grade bonds have also strengthened. This was mainly driven by inflows into dollar IG bond funds that over the past two weeks have accounted for almost half of the total flows into this space. This move into USD credit from European-domiciled accounts was probably motivated by the recent tightening in the EUR–USD cross-currency basis.
Over the past week…
High grade funds flows remain strongly on the positive side for the eleventh week in a row. Last week’s inflow was also the largest since August ‘16. The inflows came equally from USD and EUR focused funds to the tune of $1.3bn.

High yield fund flows switched to positive after three weeks of outflows. Looking into the domicile breakdown, as charts 13 & 14 show, the largest part of the inflow came mainly from Europe-focused funds, followed by US-focused HY funds.
Government bond funds flows remained positive for the second week but inflows were marginal. Money market funds weekly flows turned strongly positive after a brief week of outflows. Overall, fixed income funds recorded their third consecutive inflow, and the highest in 36 weeks, supported by strong credit inflows. 
European equity funds flows remained on positive territory for a second week.
Global EM debt fund flows continued on a positive trend for the tenth week in a row and the third consecutive one over the $2bn mark. Commodities funds saw their fourth week of inflows; nonetheless we note the recent weakening in the magnitude of the inflow.
On the duration front, inflows continued in short-term IG funds for the 16th week in a row. Mid-term funds posted another strong inflow and the highest in nine weeks. Flows in long-term funds were lower than the previous week but remained positive for the fourth week in a row." - source Bank of America Merrill Lynch
When it comes to the Japanese investment crowd and their appetite for foreign bonds, one clear picture worth mentioning has been their recent distaste for French government bonds which they have been shunning in anticipation of the French elections. On that specific point we read with interest Bank of America Merrill Lynch's take on Japan selling pressure on French debt from their Japan Rates and FX Watch note from the 10th of April entitled "Japan BoP: New fiscal year, new flow:
"Trump shock done for now; France and seasonality the themes in April
After a painful three consecutive months of sales in foreign bonds after Trump’s victory, Japanese investors finally stopped selling with a small net purchase of ¥39.0bn in March. The continued bleeding from banks is likely over with only small net sales of ¥367.8bn compared to the previous three months with monthly net-sales over ¥1tn. If US treasuries continue to trade in a range with no further progress in Washington, we would not expect another month of selling as a result of the impact caused by Trump’s victory. On the other hand, the French election will continue to one of the key determinants of Japan’s bond flow into April and may cause another round of de-leveraging with much depending on the evolution of the polls.
- source Bank of America Merrill Lynch

The February sell-off in French government bonds was significantly large and amounted to all Japanese purchases for Q3 2016 as per the table above. Indeed, if the French elections delivers yet another sucker punch à la BREXIT, this "exogenous" factor could precipitate additional pressure on French government yields given Japanese investors have been the largest purchasers of French debt since 2012 and hold 13% of it. When it comes to flows for foreign bonds, "Bondzilla" the NIRP monster is indeed Japanese and you would be wise to track is appetite when it comes to country allocation.

Whereas fund flows continue to be supportive for now, another factor to take into account other than "exogenous" factors such as geopolitical events has been the weakening in hard data as of late. As we mentioned in numerous previous conversations, we believe the credit cycle is ending slowly but surely ending. On this specific subject we mentioned we have been monitoring closely the trend in C&I Loans as they are more reflective of what is happening in the real economy. Given financial conditions have been both tightening for Commercial Real Estate (CRE) and for C&I Loans, it remains to be seen if we are going through a soft patch à la Q1 2016, or if there is indeed more to it with some recent rise in delinquencies in both mortgages and auto loans. The below chart from Bank of America Merrill Lynch displays US C&I Loans versus EU Corp Loans since 1985:
- source Bank of America Merrill Lynch

Last three months changes for C&I loans have been negative with January ending at -0.1%, February at -0.4% and March at -0.7%, clearly indicative of a deteriorating trend. The big question obviously is if this continued trend will prevent the Fed from hiking in June with odds currently above 60%. The latest patch of soft data does indeed make us wonder whether there is more clarity awaited in regards to US fiscal stimulus and reforms, or if there is more to it. On that subject we read with interest Bank of America Merrill Lynch analysis from their Credit Market Strategist note from the 7th of April entitled "Is soft the new hard data?":
"Is soft the new hard data?
This week saw some softness in hard data as auto sales and jobs growth declined sharply. While two observations do not make a trend, this occurrence nevertheless is noteworthy as on the one hand very positive sentiment indicators suggest activity should pick up (Figure 1), while on the other hand loan data suggests everybody is in wait-and-see mode pending details of fiscal stimulus (=tax reform) - which highlights the risk of softer hard economic data.

For example, weekly bank asset data shows that C&I lending has not increased since September 7 last year (Figure 2), the first period of no growth for at least six months since the 2008-2011 aftermath of the financial crisis, and prior to that after the early 2000s recession (Figure 3).

At the same time, consumer loan growth has slowed substantially - up just 1.4% since the US elections compared with 3.1% the same period the prior year (Figure 4). 

As tax reform by House Speaker Ryan's own account is not going to happen anytime soon, and likely will be watered down as the Border Adjustment Tax (BAT) is replaced by a Value Added Tax (VAT) and the elimination of net interest deductibility for corporations, the biggest near term risk to our bullish outlook for credit spreads we maintain is a correction in equities - most likely prompted by weak hard data." - source Bank of America Merrill Lynch
Is there something more ominous at play or are we going through a soft patch like in Q1 2016? We believe it will be essential to track the evolution of consumer credit in the coming weeks from a credit perspective. There is as well a possibility that the "Trumpflation" trade is continuing to fade and that investors were somewhat delusional in their expectations. For the continuation of the rally in equities, earnings will be key and so will be the guidance provided apart from "exogenous" factors that could trigger renewed bouts of volatility.

Moving back to the subject of "exogenous" factors and their impact on financial markets gyrations we read with interest Nomura's take on the subject from their Japan Compass note number 433 from the 8th of April entitled Financial market movements during US wars":
"Flows tend to be risk-on at outbreak; rates market and USD movements depend on Fed policy
Markets have become risk-off and bond yields have fallen in response to the US launching air strikes against Syria.
However, we do not recommend investors buy bonds aggressively; at least until the Fed suggests that it will address this new geopolitical risk by weakening its hawkish stance.
In the past, the outbreak of a war by the US has led to risk-on flows (i.e., reflecting the US’s military dominance). However, as Russia supports President Bashar al-Assad of Syria, we believe the US is unlikely to start a war and overthrow the president, as in past conflicts, but will likely seek another resolution (or the conflict would simply fade without escalating further). In these circumstances, we believe the equity market will remain under pressure for some time, until uncertainties are cleared.
We also note that the Trump administration’s move toward reorganizing the National Security Council in such a way as to weaken its pro-Russia, far-right proclivities. If this leads to a higher support rating for the Trump administration, markets may react with risk-on flows, in our view.
In previous cases of US wars (e.g., Gulf War, Iraq War), markets tended to: 1) become risk-off as the event that triggered a war occurred; and 2) become risk-on as the US or multi-national force took military action. However, these tendencies clearly took place only in equity markets, and the rates and currency (USD) markets tended to move more in line with central bank policies.
The previous two US wars occurred during the Fed’s easing cycles (i.e., when economic conditions were poor, which may have made encouraged the US government to seek military options).
The US’s military action against Syria was unexpected, and the context and pretexts are not as clear as in the Gulf War and Iraq War (Iraq’s invasion of Kuwait, 9-11 terrorist attacks and Iraq’s possession of WMD). Unless the conflict is resolved in one way or another, the equity market would likely remain under pressure. A resolution may not materialize as a full-scale war. Before the Iraq War, e.g., Iraq accepted UN nuclear weapons inspections.
In contrast with the Gulf War and Iraq War, the Fed is in its hiking cycle now, with macroeconomic conditions improving in the US. Considering the rates and currency markets moved more in line with Fed policy during these two wars, and were not affected much by investor concerns over military risks, we believe these market movements will depend on the resilience of the economy in view of the geopolitical risks.
When Iraq invaded Kuwait, the Fed was apparently more wary of a macroeconomic slowdown caused by higher crude oil prices than a rise in inflation expectations (the US economy actually entered a recession and the Fed began cutting rates)." - source Nomura
Obviously the asset class most susceptible to large variation thanks to "exogenous" factors linked to geopolitical tensions remain oil in the current situation. As highlighted by the Euchre on his twitter feed, Kuwait's invasion by Saddam Hussein in the early 90s was a good illustration of exogenous factors impacting significantly oil prices:

- source The Euchre - Twitter feed


And, as far as we are concerned when it comes to Drums Along the Mohawk, where oil goes, so does High Yield CCC as per our short term MacroCharts.pro graph below displaying the correlation between both asset classes:
- source MacroCharts.pro

This is not a surprise given the large weight in the CCC sector of the Energy sector, which has been issuing in drove in recent years.

While everyone, in many instances have been sounding the alarm, when it comes to valuations and in particular US High Yield, oil prices remain a key support for High Yield as indicated by the weak performance experienced in the first half of last month as highlighted by Bank of America Merrill Lynch in their High Yield Strategy note from the 4th of April entitled "1st half pain, 2nd half gains":
"Strong back half of March not enough to offset weak start
Driven by a combination of lower oil prices and uncertainty surrounding Healthcare and tax reform, the first half of March proved to be the worst two-week performance for high yield since the election slump that occurred last November. Not surprisingly given the reasons behind the pullback, the two worst performing sectors through March 14th were Health Care (-2.32%) and Energy (-2.97%). However, a mid-month 25bp hike from the Fed and respite from oil weakness provided markets with sufficient confidence around the growth and inflation trajectory that performance was able to turn around in the 2nd half of the month. Although high yield was unable to recoup the 180bps in losses accumulated during the first two weeks, a +0.7% return from the 14th to the 31st helped limit losses on the month to just -0.21%. This brought the YTD total return down slightly, though the figure remains at a respectable +2.7% (+11.4% annualized). With the first quarter of 2017 in the books, we take a moment to reassess the strategic outlook for high yield during the remaining 9 months of the year." - source Bank of America Merrill Lynch
Of course recent fund flows in conjunction with rising oil prices have validated once again a strong appetite for High Yield in recent weeks, hence the second half of March rally in the asset class. Does that mean we remain defensive? Once again we would like to re-iterate our short-term Keynesian somewhat "bullish" stance, yet we remain medium term Austrian from a credit cycle perspective and we will watch very carefully the evolution of credit conditions as well as oil prices. We continue to believe we are starting to notice some early signs in the deterioration of the credit cycle. As we posited recently, 2017 could indeed play the reverse of 2016, namely that the second part of the year could see a weaker tone in and upset this on-going "risk-on". 


  • Final chart - Fiscal stimulus, if you give it, earnings will come...
While Drums are beating Along the Mohawk, and given recent weakness with hard data becoming soft, the "Trumpflation" trade which has been running since the elections on renewed hope for Fiscal stimulus, makes us wonder if earnings as we enter earnings season will materialize on top of markets pundits hoping for a delivery. Our final chart comes from Nomura's Rates Weekly note from the 7th of April entitled "Risk markets, what's left in the easing tank" and displays the S&P 500 profitability metrics, showing clearly that easy money rather and multiple expansion rather than earnings have been in the driving seat of the rally since 2012:


"We think Figure 2 is self-explanatory from the standpoint that easy money drove asset valuations to lofty levels. However, just like Greenspan’s comments in the late 1990s, markets can remain irrational for longer too. Current stock market dynamics, relative to profitability metrics (and by extension P/Es) look eerily like the 1999-2001 experience.
Back then, the view was that earnings would eventually come as “the internet” would revolutionize the world; it did, but it took years to do so from an efficiency standpoint and profits never materialized for many because they seized to exist post the crash. Stimulus (and prospects of a new fiscal policy) has clearly driven markets, so wouldn’t the reverse be true if the economy does not accelerate and/or we do not get the full US fiscal plans?" - source Nomura
Markets since the US elections have no doubt been trading on hope some fiscal stimulus would materialize with the new US administration. Yet recent softening in hard data and disappointing earnings could potentially have an impact, not only Drums Along the Mohawk...If the US administration does give it, will earnings return? We wonder...

"Nothing is more sad than the death of an illusion." -  Arthur Koestler, Hungarian novelist

Stay tuned!

 
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