By Martin T., Macronomics
“War is not an independent phenomenon, but the continuation of politics by different means.” – Carl von Clausewitz
Looking with interest the rise in noncooperation around the world, with increasing trade war rhetoric between the United States and China, Turkish spiraling woes, Saudi diplomatic spat with Canada, Iranian sanctions building up against a reticent yet divided Europe and the push for additional Russian sanctions making rounds, in continuation to our war analogy used in July in our conversation “Attrition warfare“, we decided to go for another one, namely “Maneuver warfare”. “Maneuver warfare”, or manoeuvre warfare, is a military strategy that advocates attempting to defeat the enemy by incapacitating their decision-making through shock and disruption. Given the shock and awe tactics used so far by the Trump administration with North Korea and now with Iran, not to mention the tensions rising between the US and their European allies, one can clearly make sense of the use of our chosen analogy. In “Maneuver warfare”, tempo and initiative are critical to the success of the operation. According to the United States Marine Corps, one key concept of maneuver warfare is that maneuver is traditionally thought of as a spatial concept, the use of maneuver to gain positional advantage. The US Marine concept of maneuver, however, is a “warfighting philosophy” that seeks to shatter the enemy’s cohesion through a variety of rapid, focused, and unexpected actions which create a turbulent and rapidly deteriorating situation with which the enemy cannot cope. The U.S. Marine manual goes on to say:
“This is not to imply that firepower is unimportant. On the contrary, firepower is central to maneuver warfare. Nor do we mean to imply that we will pass up the opportunity to physically destroy the enemy. We will concentrate fires and forces at decisive points to destroy enemy elements when the opportunity presents itself and when it fits our larger purposes.”
One can argue that in recent years the United States have decided to “weaponize” the US dollar. The continuation of the surge of the US dollar thanks to QT and a hawkish Fed on the back of the US economy heating up, with the surge of inflationary pressures is indeed wreaking havoc on over-exposed and over-leveraged Emerging Markets economies such as Turkey. We do not see any respite yet for some ailing Emerging Markets which are over-exposed to US dollar funding and rollover risk.
In this week’s conversation, we would like to look at the continuation of the demand in high beta and the summer rally which is continuing for US equities mostly and ask ourselves how long it can go on as we move towards fall.
- Macro and Credit – Asset prices – Still short term “Keynesian” but starting to feel “Austrian” again
- Final charts – This isn’t your grandfather’s market
- Macro and Credit – Asset prices – Still short term “Keynesian” but starting to feel “Austrian” again
Given the strong tone of recent earnings in the United States corporate world, we continue to advocate being overweight US versus the rest of the world. To repeat ourselves, riding the EM wave was great in 2017, and we confided bailing out in late January this year, but, 2018 is proving to validate our most recent title “Dissymmetry of lift“, in the sense that the United States is powering ahead in both macro and equities, whereas so far, the rest of the world is struggling to keep up with the pace (check out MSCI World versus the S&P500, we rest our case). But, what is today’s news in terms of macro data, is already yesterday. Sure earnings were strong though there are already signs, even in the US of a weaker tone in the macro data (US housing and Mortgage applications for example). The US 10 year Treasury notes yield continues to flirt with the 3% threshold. With inflationary pressures building up on global scale, if you want “real yield”, even if US inflation seems to become stronger, you probably want US dollar fixed income exposure from a carry and roll-down perspective. We mentioned that 2018 marked the return of US dollar cash in the asset allocation toolbox.
When it comes to credit and asset allocation US credit and in particular the high beta space continues to benefit from the summer rally on the back of a technical bid thanks to reduced issuance. This is put forward by Bank of America Merrill Lynch in their High Yield Strategy note from the 3rd of August entitled “A Good Combination”:
“HY caught in between strong earnings and weak issuance
The HY bond market performed well over the past few weeks, with spreads tightening to 340bps down from 380bps around early July. This move nearly fully offsets the earlier widening that the index has experienced in late June. A notable change that has taken place during this period of time is that IG and EM assets have rebounded, allowing HY to rally along with them. In July, our USD IG and EM IG indexes have tightened by 15bps band 17bps respectively. Modestly higher rates contributed to this backdrop, with the 10yr Treasury yield currently at 3.0%, up from 2.80-2.90 range it established earlier in the month.
BBs continue to show notable resilience against this backdrop of higher rates coupled with their disadvantage to CCCs in spreads (an average BB OAS is 230bps vs 690bps in CCCs). Despite these headwinds, BBs performed exactly in line with CCCs in terms of spread changes and total returns over the past two weeks, and they are only marginally behind CCCs over the past month.
Year-to-date, the HY market is 17bps tighter in spread terms against a meaningful 55bps rise in 10yr yields. It has generated a total return of 1.2% and excess return of 2.2%, in both cases driven primarily by CCCs outperforming earlier in the year. Loans have posted a 3.0% YTD total return.
In technicals, this past week saw a moderate volume of coupons and calls/tenders in HY, around $2.5bn on each side. This was met with little issuance to speak of, at less than $1bn. Next week brings light calls ($1.2bn) and no coupons. The week after, ending Aug 17, promises a heavy $5.3bn call volume, complemented with $3.7bn in coupons. For the full month of August, we are forecasting $15bn in HY gross issuance against $13.6bn in calls/tenders and $1.6bn in maturities. We are also expecting $7.3bn in coupons, although as we have argued here, these should not be viewed as longer-term sources of investable cash.
Ok, so what do we think here? Two factors define the current HY corporate credit market backdrop more than others, in our opinion: strong earnings growth and weak issuance. Starting with earnings, our equity strategists are tracking 2Q bottom-up S&P500 EPS at $40.52 amid better-than-expected results across all 11 sectors (led by Tech and Health Care). This represents roughly a 15% increase from estimates going into the year, the outcome largely driven by the corporate tax reform. Overall, 58% of companies have beaten analysts’ expectations on the top- and bottom-line-the secondhighest proportion of beats in their data history.
Our own model of corporate earnings, initially introduced here, is currently pointing to an 18% growth in EPS over the next 12 months (Figure 1).
As a reminder, the model includes non-farm payrolls, consumer confidence, growth in corp debt and capex among key factors with leading relationships over earnings.
Credit cycles generally do not turn in the environment of double-digit earnings growth, and with earnings expectations outlined above we remain generally constructive on the longevity of this cycle.
Having said that, we must acknowledge that there is a number of ways a cycle could be cut short, and we are witnessing some of those ways being tried in recent weeks and months, including trade threats and otherwise generally irresponsible actions. We continue to think that little tangible long-term policy measures come of out of all this noise, and recommend heavily discounting most of it. Nevertheless, we remain cognizant of potentially being wrong at the end as second- and third-order effects begin to accumulate.
The other defining factor of the current environment is a slow pace of HY issuance. This has been the case throughout most of 2018, and it appears to have only gained further momentum in July: a month that is otherwise among the seasonally slowest has posted $8.4bn in primary volume, half of our seasonally adjusted estimate. We are also expecting a normally seasonally slow August, at $15bn (Figure 3).
YTD HY issuance is running at $117bn, or 24% below last year’s $155bn total over the same timeframe. Slow issuance is not happening in isolation, as we documented how both retail and institutional flows in HY have turned negative in recent months (Figure 7).
In addition, albeit less relevant, coupon flows are also going through a seasonally weak part of the year with both August and September among the slowest months (Figure 4).
The next key question in our discussion is whether weak demand for HY is causing financial conditions to tighten. Once/if such tightening occurs it generally leads to meaningful repricing of credit risk as investors begin to question the ability of weaker issuers to access market liquidity to satisfy their funding needs for investment and debt management activities.
To answer this question, we refer to Figure 5 (performance of recent new issues) and Figure 6 (performance of aged issuers with no market access in recent years).
We think that when underperformance is limited mostly to recent new issues, it is more reflective of their higher secondary market liquidity aspect, and not necessarily a wholesale repricing of credit risk. In this scenario, investors sell liquid assets in order to temporarily adjust portfolio risk without necessarily taking a long-term view on a credit/sector/market.
On other the hand, underperformance in aged issuers better reflects tightening financial conditions. In this scenario, investors get out of risk even if it means selling an illiquid instrument into otherwise weak market, often at prohibitively wide bid-asks. These actions require longer-term commitment to a trade and so could lead to meaningful tightening in financial conditions, particularly for the group of aged issuers who have been out of the market for a while.
Based on what we see in Figure 5 and Figure 6 the evidence leans heavily towards the first scenario, where recent weakness is limited to newly issued and liquid instruments, and thus more likely to be temporary in its nature. It provides support to our argument that this credit cycle is not yet showing signs of cracks in its basement.
So then the next question is: if this is not yet a turn in the credit cycle, why is demand weak, both on institutional and retail sides (Figure 7)? We think the answer originates in tight valuations, both in absolute sense, and also against other major yield alternatives. At 340bps, HY spread is 18th percentile of its historical range over the past 25 years, and it has never delivered positive excess returns over a three-year horizon starting with sub 300-bps spread levels. We are not quite there yet in terms of extreme tights, but we are getting there.
And in a relative value sense, some major alternatives are now becoming available to investors, including a 4% yield on our USD IG index, 4.5% on EM IG, and a 3% yield on Italian 10yr, and 7.5% on Turkish 10yr USD bonds. As Figure 8 demonstrates, HY used to deliver more that 15% of Global Agg’s expected income two years ago, and now that share has dropped to less than 8%, returning to its normal historical range for the first time in four years.
For as long as valuations in HY remain tight in absolute and relative sense, we expect weak flows to persist, leading to soft demand for new issues.
And so we are to be dealing with to contemporaneous developments going forward: strong earnings and weak issuance, a good combination indeed. Between these two forces, the HY market should continue to experience deleveraging going forward. As Figure 9 shows, US corporate credit has been in the process of slow deleveraging for the past two years, and we expect it to persist and perhaps even accelerate going forward.
As we opined previously, high leverage in corporate credit is not an indication of the next cycle being around the corner but rather a consequence of the commodity bust of 2014-2015 showing all the hallmarks of being a credit cycle, albeit limited in scope/duration.
Figure 10 also goes on to show that US corporate issuers have slowed down their share repurchase activity in recent quarters.
Note that dividend payments plummeting to negative values are a function of foreign earnings repatriation, and thus temporary in its nature (we have previously witnessed this behavior in 2005-2006 during the previous foreign tax holiday). Regardless, these repatriated funds could be used to continue the deleveraging process if corporate managements chose to do so, a development we expect to take place.
As we mentioned previously, we find HY valuations to be on a tight side both in absolute value sense (340bps actual level vs 380bps target), and relative value sense. On the latter side, Figure 11 and Figure 12 provide some context behind this view, based on our previously introduced models described here.
Both charts are showing z-score signals of deviations in HY vs IG and CCCs vs BBs respectively. We thus find HY to be trading too tight against IG by 1 standard deviation event, or roughly 50-75bps. We also find CCCs to be modestly tight to BBs, by about 0.5x stdev event.
Note that HY vs IG relative value deviation is also consistent with our strategic targets on both asset classes, where Hans Mikkelsen maintains a 100bp target in IG (-16bps from here), and HY needs to go +40bps from current levels to reach at our target.
We view these valuation gaps as modest headwinds at this point, i.e. not extreme enough to substantiate a full-scale underweight in anticipation of outright negative returns. We think higher quality outperforms in beta-adjusted terms (2.0x for IG vs HY and 1.7x for BBs vs CCCs), but not yet in direct 1-to-1 terms. We will need to see a stronger valuation gaps to be willing to take an outright underweight in CCCs vs BBs and expect unadjusted 1-to-1 underperformance in lower quality.
Another way to think about the extent of this positioning would be to say that we a willing to take 1/3rd of the total possible extent of an underweight in lower quality vs higher quality here. We would be looking for even tighter valuation gaps to be willing to go further down that line, to 2/3rds of the full extent of an underweight. Signals that would get us to a full-scale underweight need to be as strong as those generated by our model in 2000, 2007, and 2014, all turning points in previous credit cycles (Figure 12).
Higher rates remain a key risk to this positioning, as they have been since February without much to show for their progress since then. We continue to believe that global rates should go on towards further normalization, while US rates are already approaching their peak levels for this cycle. As such we view US 10yr at 3.0% as good value, with an eye towards 3.25% as better value. We do not expect this benchmark to exceed 3.5% on a sustainable and meaningful basis.
We also note that measures of implied vol are again very low across the board – equities, rates, FX, and credit. This backdrop helps spreads grind tighter while it persists, and yet we think the low vol environment should be used to gradually reduce portfolio risk, not increase it. The time to use this dry powder of available portfolio risk allocation will come when we hit the next volatility episode, whatever the cause of it might be.” – Bank of America Merrill Lynch
Given US Investment Grade so far has been lagging US High Yield, from a relative value perspective, if indeed we are looking at a “macro” deceleration thanks to the rise in “Maneuver warfare” then we could see the duration game coming back into play which would no doubt benefit more US Investment Grade versus the successful high beta game which has been performing well in 2018. We do agree with Bank of America Merrill Lynch in the sense that current low vol complacency should entice somewhat some risk reduction in less liquid high beta exposure as we move into the third quarter which is traditionally more jitterier it seems.
So what’s the risk for US credit markets one might rightly ask?
As we pointed out in previous conversations, the US credit markets benefit from a strong outside support thanks to the large appetite of foreign investors in particular Godzilla the NIRP monster which is “Made in Japan”. Both the ECB and the Bank of Japan are still failing there inflation mandate meaning that there is plenty of accommodation from their part. From our perspective, the biggest risk for US credit markets would indeed be a buyer strike emerging from Japan. On that point we read with interest UBS’s take in their Global Credit Strategy note from the 6th of August entitled “What if JGB yields keep rising?”:
“Last week’s BOJ decision to raise the 10year JGB ceiling to 20bps has attracted investor attention, particularly considering that JGB volatility has increased since their initial announcement. We believe the focus on Japan is warranted, given the sizeable outward portfolio flow generated by very low JGB yields. Japanese insurers have increased their allocation to corporate bonds steadily, from 8.7% in March 2010 to 13.6% in March 2018 (Figure 1).
Japanese pensions have been forced abroad to foreign fixed-income in size, as GPIF’s asset allocation demonstrates (Figure 2).
In a previous note, we estimated that Japan represented 25% of the total net flow, and 50% of the total non-US flow, into index-eligible IG credit over the past few years, easily surpassing Taiwan and Europe in importance.
Will the BOJ’s policy shift negatively impact credit?
As long as the BOJ credibly commits to defending the 20bps maximum on 10yr JGB yields, we believe credit flows will be relatively unaffected. The largest Japanese pension fund (GPIF) seeks a return target of 1.7% + the rate of increase in domestic wages (which has been roughly flat over the last several years). JPN insurers need 20-30yr JGB yields of around 1% to meet guaranteed interest rates on new insurance policies. At current JGB yields, there is still a strong incentive to invest abroad. In addition, both 7-10yr US IG and EU IG credit provide an attractive 50-100bp yield advantage over 30yr JGBs, even after paying funding costs to hedge back into yen (Figure 3).
Rising dollar hedging costs may shift demand from the US to Europe, but the flows to global credit in general should continue (Figure 4).
Lastly, nearly 40% of JPN life insurer portfolios are unhedged for currency risk; clearly this increases the appeal of holding US fixed income with Treasury yields near 3% and US IG corporate yields near 4%. Our conversations with local investors indicate unhedged dollar buying could increase this year, particularly with the marketing of dollar-based insurance policies to local clients. We would expect unhedged USD fixed income purchases to pick up most aggressively, after a strengthening in the yen to 100-105 vs the dollar, from 112 today, based on public reports.
What could materially derail the JPN flow into global credit? If 20-30yr JGB yields hit 1%+, we would become meaningfully more concerned (Figure 5).
This is not our base case in 2018, but it could occur with either 1) a formal change in the BOJ’s 10yr yield target (highly likely by July 2019) or 2) a bear steepening of the JGB yield curve, that the BOJ allows to aid a banking system squeezed by low rates at home and higher dollar funding costs, exacerbated by Fed hikes. Our conversations with local insurers and several public statements1 indicate that 1% long-end JGB yields would preclude the need to continue buying foreign fixed income. Importantly, even if US and EU yields increased to maintain their current yield advantage over JGBs, JPY lifers would still prefer to invest at home. 20-30yr JGBs reduce asset liability duration mismatches, better than global credit, given the long average duration of life insurer liabilities (19yrs). Investing in JGBs also clearly reduces portfolio volatility with respect to credit and FX risk; note that even insurer FX-hedged purchases of foreign bonds do not generally hedge the interest income that accrues, introducing another source of risk into future returns.
The good news? We find it difficult to fathom Japanese life insurers selling existing holdings of global credit; these bonds are needed to meet legacy insurance policy yield bogeys that are much higher than the current 1% rate. It would take a material increase in downgrade/credit risk to force outright selling.
But the lack of new flow would put pressure on US IG, and reduce a potential buyer for EU IG at a time when the ECB is ending CSPP. Any material period of issuance would likely lead to spread widening, as we experienced for much of 2018 until recently. And there is no obvious buyer to pick up the baton from Japan. Rising dollar funding costs have caused Taiwanese insurers to allocate less to 30yr US IG credit (Figure 6); this will be exacerbated by additional Fed hikes in 2018 & 2019.
In Europe, dollar funding costs of 2.8% are a problem and Solvency II prevents insurers from running unhedged positions to obtain extra yield. Lastly, while many investors have focused on US pension demand given an increase in funding ratios, we believe this overlooks the forest for the trees. Non-US investors purchased $1.4tn in US credit since 2013; US pensions purchased $350bn (Figure 7).
It seems unlikely that increased pension demand could make up for a reduction in foreign buying on its own; all US investors (including insurers and domestic funds) would need to increase their purchases, and likely in concert with a reduction in IG issuance and continued strong fundamentals, to keep IG spreads stable if the Japan bid fades.
1%+ back-end JGB yields would not only impact US IG credit. JPN pensions have also drastically reduced domestic holdings of JGB yields in order to buy foreign fixed-income (Figure 8).
But there is room to add if JGB yields rise, though the bar for pension reallocations is likely higher than for insurers. The more aggressive stance of JPN pensions this cycle would mean that high-yield would be at risk of a reduced inflow. In particular, EU HY has been the major beneficiary of separately managed account flows from JPY pensions (Figure 9).
While flows into other credit markets have been more limited, we would note that short duration US HY, a consensus favorite today, could also face negative side-effects.
Will US HY’s perfect technical storm last?
US HY spreads have effectively lapped the field in 2018. US HY spreads are -10bps tighter, far besting performance in US IG (+16bps) and EU HY (+61bps) and contrary to our expectations in Q2. In addition, lower-quality HY spreads have tightened considerably, with CCC spreads -63bps YTD. The easy answer to the above dynamic is that US growth is strong, which has led to improved earnings and healthier credit fundamentals. However, this does not appear to be the case. We are still awaiting full Q2’18 earnings releases, but B+CCC rated HY EBITDA growth through Q1’18 was a paltry 2% Y/Y, closer to an earnings recession than to the peaks of this cycle (Figure 10).
We believe lower-quality US HY remains most vulnerable, given weaker fundamentals and outsized performance this year relative to BB’s. We estimate 36% of CCC, 30% of B, and 25% of BB issuer debt is floating-rate in nature (Figure 11).
Clearly, as the Fed keeps hiking, HY earnings growth has to pick up from current levels to prevent a worsening of interest coverage ratios, which while not precarious, are fairly weak for lower-quality names. We believe an additional 3-5 Fed hikes, given current coverage ratios and earnings trends, would be enough to increase default risks from today’s low levels.
The real reason for US HY’s stellar performance is a significant technical imbalance, one of the strongest we have seen. As Figure 12 indicates, US HY supply has shrunk, which with the help of coupon payments, has offset notable fund outflows.
As previously discussed, many spec-grade rated firms are still borrowing debt, but they are migrating to the leveraged loan market where lending conditions are easier and demand is healthier for floating-rate instruments. We believe this technical backdrop will incrementally wane. We see little evidence that tax reform is impacting HY issuance; lower-quality firm supply is relatively higher even though the capping of interest tax deductibility post tax-reform is more painful for these firms. Higher LIBOR will also narrow the relative cost advantage of floating vs. fixed rate funding, which played out last cycle as HY issuance increased near the end of the Fed tightening cycle. We continue to expect gradual normalization in HY issuance to -12 to -15% for FY18.
In addition, Figure 12 even understates the positive technical we have witnessed. At the same time that supply has shrunk, US HY managers have invested more aggressively into the market. According to eVestment, US HY cash balances of 2.3% are near the lows of this cycle (Figure 13).
It is difficult to know exactly when this perfect technical storm will end, but US HY is increasingly susceptible to any slowing of growth or large market shock that raises risk premia. A conceptually similar measure of cash balances from the ICI (Liquid Assets2 Ratio) indicates that US HY cash balances are at dangerously low levels (Figure 14).
At levels below 4%, the probability of spread widening over the next 6 months is 67%, with a 25th-75th percentile spread performance of -21bps to +152bps.
Institutional investors are souring on high-yield credit
In addition, our latest institutional flows update indicates that global investors are positioning for credit underperformance and a likely period of decompression between global high-yield and investment-grade spreads. Figure 15 provides Q2’18 nominal flows by global credit universe, while Figure 16 details investor flows by domicile, as a percentage of the total outstanding market size captured in eVestment3.
Put simply, the investor retreat from global high-yield rated credit continues. US HY and EU HY sustained -$20bn (-3.2% AUM) & -$2bn (-2.7% AUM) of outflows respectively, driven by both institutional separately managed accounts and retail fund. This continues a trend we have seen for the last 12-18 months.
The US leveraged-loan market did receive $5bn of inflows (1.4% AUM), but the attribution of buying is shifting. Loan demand has slipped from institutional investors; we believe the loan market is becoming increasingly reliant on CLO purchases (and to a lesser extent domestic retail buying). Indeed, CLO creation is up 32% YTD and CLOs own roughly 65-70% of US leveraged loans outstanding. While fundamental risks are building in the form of covenant-lite indentures, significantly elevated leverage, aggressive use of EBITDA add-backs, and a notable increase in loan-only capital structures, we believe duration fears continued Fed hikes and an absence of near-term credit risks should keep demand for this floating-rate asset class alive.” – source UBS
Regardless of the fundamentals put forward, when it comes to US High Yield, there is indeed a strong technical support coming from slower issuance. As well, the Bank of Japan most recent move clearly shows that they are ready to throw the proverbial kitchen sink to maintain stability in JGB yields for the time being, providing yet a compelling support to global credit in general and US credit markets in particular. Yet there is no denying that some institutional players have started climbing the quality ladder and shed some of their exposure in recent months to US High Yield and high beta. There might be an additional case to be made for an outperformance of US Investment Grade relative to US High Yield in the coming months should the duration trade reassert itself with a lack of strength in maintaining the US 10 year Treasury Notes yield clearly above the 3% threshold. When it comes to credit markets we therefore remain “tactically” for the time being “Keynesian” yet it appears to us that cracks are appearing in the narrative hence the more defensive move being taken by institutional investors in regards to US High Yield, making them becoming more “Austrian” to a certain extent.
We pointed out that rising dispersion in credit, with investors becoming more discerning when it comes to issuer profile would make active management “fun” again. We also pointed out in our most recent note that we were seeing more and more large standard deviation moves (such as the one seen by the Facebook stock price recently). In our final charts, though volatility has been very muted for both credit and equities as of late, rising dispersion is displaying we think markets’ fragility.
- Final charts – This isn’t your grandfather’s market
Rising dispersion in our book is a sign of rising instability brewing. The manifestation of it comes with large standard deviation moves and marks we think the return of the “macro” players to a certain extent after years of financial volatility repression by central banks. Our final charts come from Bank of America Merrill Lynch European Credit Strategist note from the 9th of August entitled “A world of populism” and shows that when it comes to European High Yield, 2018 marks a clear return of fragility at the forefront. No wonder some are already running for the exits and reducing their high beta exposure on illiquid names in that context:
“The summer rally is the gift that keeps on giving for credit markets. Since the start of July, corporate bond spreads have retraced just under half of their Italy-inspired sell-off. And we think the rally still has legs for now…judging by the very light investor positioning reflected in our latest credit investor survey.
Yet all around there are signs that this is anything but a run-of-the-mill summer grind. The most notable trend in markets is that of performance dispersion, and examples abound almost everywhere. Take Turkey vs. Russia debt for instance, or Apple vs. Facebook shares, or value vs. growth stocks, or even US Treasuries vs JGBs. Assets that were previously well correlated, are now witnessing a much more diverse performance of late. And in credit land it’s much of the same…note the significant outperformance of single-As relative to BBBs over the summer period (chart 1), or the number of bonds dropping conspicuously across the European high-yield market (chart 2).
The end of synchronised everything…
The temptation is put these moves down to just one-offs, and there have indeed been plenty of macro shocks in ’18. Yet, rising dispersion is the clearest reflection of how the investment backdrop has fundamentally changed, in our view. The synchronisation of global growth, central bank policies and corporate fundamentals of yesteryear has given way to a more challenging world of diverse politics, economies and liquidity support.
Much – although not all – of this sea change has been instigated by the rise of populism. In our view, this has helped reshape many of the hitherto market norms.
Take “globalization”, for instance. In 2018, this theme has been chipped away at. Chart 3 shows how cross-border capital flows have evolved over the last few years, a good proxy, in our view, for measuring how globalization is changing.
While not all measures are in retreat, what looks to be suffering more is Foreign Direct Investment, which has declined from 4% of GDP in 2015 to just 2.4% recently. And note how Foreign Direct Investment into the US has slowed down over the last few quarters despite the economy’s rebound (FDI into the US in Q1 ‘18 was 45% down YoY, see appendix chart).
But such secular changes have brought big market consequences. Chart 4 shows the conspicuous drop in world trade volumes over the last few months despite a global economy that continues to hum along fairly well.
As a result, the casualties have mounted: witness the recent plunge in German factors orders (-4% MoM), even though US GDP in Q2 (+4.1%) was the strongest since Q3 ’14.
A world of corrections in ‘18
More broadly, the divergence and dispersion theme is symptomatic of a rise in the amount of market “corrections” this year. Chart 5 shows the cumulative number of market corrections over time. We look across a large sample of government bonds, equity markets, currency pairs and credit indices, and count the number of times that 4
Standard Deviation moves are being observed (both up and down).
As can be seen, 2018 has witnessed a rise in the pace of market corrections, albeit more so in government bonds, equities and credit. Conversely, there has been less of a jump in corrections in the commodity and currency space this year.
Chart 6 shows the total number of market corrections on a yearly basis. Extrapolating this year’s number suggests that 2018 will see a lot more corrections than in 2017.
In fact, 2018’s corrections shouldn’t be far off from the pace seen in 2015/16 – a period when there was genuine stress across the global economy emanating from the slowing of China’s economy, plunging commodity prices and rising default rates. And as chart 18 in the appendix shows, perhaps not suprisingly, market corrections have been common in 2018 in regions where economic growth has been more vulnerable.
Note the high number of market corrections in emerging markets and Europe this year, for instance, relative to the US (where there has barely been a pickup).
Weak hands and the rush for the doors
A rise in dispersion across markets feels like a boon for active investing. Yet, with so many market divergences – and unpredictable ones at that – risk managing portfolios can also become incredibly challenging, weakening the market’s resolve for running large positions. In the end, too much dispersion can become self-defeating…ultimately motivating a broader derisking by the market.
It’s exactly this “rush for the exit” that the corporate bond market is starting to become fearful of, based on our credit survey. And note how quickly perceptions have changed: after investors’ citing “bubbles in credit” (i.e. too much liquidity) as their biggest concern in June ‘18, their primary worry has now flipped to “market liquidity evaporating”.” -source Bank of America Merrill Lynch
Rising dispersion leads to shock and disruption, hence the need for “maneuver warfare” when it comes to trading “tactically”, to paraphrase Tuco from the Good, the Bad and the Ugly:
“When you have to shoot, shoot. Don’t talk.”
Are we seeing a case of “Making Duration Great Again”? (MDGA). For sure it seems to us that the huge short positioning on the US 10 year Treasury Notes seems overstretched from a “military” perspective, but we ramble again…
“If everyone is thinking alike, then somebody isn’t thinking.” – General George S. Patton
Stay tuned !
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