“Praise out of season, or tactlessly bestowed, can freeze the heart as much as blame.” –  Pearl S. Buck

Watching with interest the weakening tone in February in credit markets following the stellar month of January, in conjunction with confirmation of a global slowdown, and with no resolution in sight between China and the United States in relation to their trade spat, and also with the weaker tone for financial conditions coming out of the quarterly Fed Senior Loan Officer Opinion Survey (SLOOs), when it came to selecting our title analogy, given the lower than usual temperature experienced in various part of the world including ours, we decided to go for “Cryoseism”. “Cryoseism” also known as an ice quake or a frost quake, is a seismic event that may be caused by a sudden cracking action in frozen soil or rock saturated with water or ice. As water drains into the ground (liquidity in asset markets), it may eventually freeze and expand under colder temperatures (global growth and trade deceleration), putting stress on its surroundings. This stress builds up until relieved explosively in the form of a cryoseism. Cryoseisms are often mistaken for minor intraplate earthquakes.  Initial indications may appear similar to those of an earthquake with tremors, vibrations, ground cracking and related noises such as thundering or booming sounds. Cryoseisms can, however, be distinguished from earthquakes through meteorological and geological conditions. Cryoseisms can have an intensity of up to VI on the Modified Mercalli Scale. Furthermore, cryoseisms often exhibit high intensity in a very localized area (such as leveraged loans) in the immediate proximity of the epicenter, as compared to the widespread effects of an earthquake. Due to lower-frequency vibrations of cryoseisms, some seismic monitoring stations may not record their occurrence. Although cryoseisms release less energy than most tectonic events, they can still cause damage or significant changes to an affected area. There are four main precursors for a frost quake cryoseism event to occur: (1) a region must be susceptible to cold air masses, (2) the ground must undergo saturation from thaw or liquid precipitation prior to an intruding cold air mass, (3) most frost quakes are associated with minor snow cover on the ground without a significant amount of snow to insulate the ground (i.e., less than 6 inches), and (4) a rapid temperature drop (global trade) from approximately freezing to near or below zero degrees Fahrenheit, which ordinarily occurred on a timescale of 16 to 48 hours.

In this week’s conversation, we would like to look at what the latest Fed’s quarterly Senior Loan Officer Opinion survey means for credit in general and high yield/high beta in particular. 


  • Macro and Credit – This recent rally is not on solid ground
  • Final chart – Credit pinball – Same player shoots again?
  • Macro and Credit – This recent rally is not on solid ground

In our most recent conversation, we pointed out to the cautious tone from investors, urging CFOs in the US to take the “deleveraging” route given the continuous rise of the cost of capital, which appears to be somewhat validated by the latest Fed Senior Loan Officer Opinion Survey (SLOOs). The Fed’s latest SLOOs points towards tightening financial conditions: “demand for loans to businesses reportedly weakened.”  But, we think we will probably have to wait until April/May for the next SLOOS to confirm (or not) the clear tightening of financial conditions. If confirmed, that would not bode well for the 2020 U.S. economic outlook so think about reducing high beta cyclicals. Also, the deterioration of financial conditions are indicative of a future rise in the default rate and will therefore weight on significantly on high beta and evidently US High Yield.

In our early January conversation “Respite“, we pointed out to our 2018 call, namely that analyst estimates were way too optimistic when it comes to earnings for 2019. If indeed Europe is a clear case of Cryoseism, with so much liquidity injected and not very much to show for macro wise in terms of growth outlook making it a very bad grade for the confidence tricksters at the helm of the ECB vaunting in recent days the great success of QE, the savage earnings revision pace we have seen so far clearly show the recent rally is not on solid ground. On the subject of earnings revision we read with interest Morgan Stanley’s take from their US Equity Strategy Weekly Warm Up from the 11th of February entitled “Earnings Recession Is Here”:

Earnings expectations for 2019 have fallen sharply, but consensus still embeds a material reacceleration in 2H19. History tells us to expect further downward revisions, higher volatility and a drag on prices. We lower our base case 2019 S&P 500 EPS growth forecast to 1%.

Our earnings recession call is playing out even faster than we expected. When we made our call for a greater than 50% chance of an earnings recession this year, we thought it might take a bit longer for the evidence to build. On the back of a large downward revisions cycle during 4Q earnings season, it’s becoming more clear. Consensus numbers have already baked in no growth for 1H19 (1Q projected growth is actually negative) with a hockey stick assumed in 2H19 that brings the full year growth estimate to ~5%.

History says be skeptical of the inflection forecast. The projected y/y EPS growth in 4Q19 is ~9.5%. This compares to an average projected rate of growth of 1% over 1Q – 3Q19, an inflection of ~8.5%. Since the early 00s, we have seen this kind of inflection happen a few times, but these inflections were all related to 1) comping against negative or slower EPS growth or 2) tax cuts mechanically lifting the growth rate. Neither of those forces are at play this year. In fact, it’s the opposite making the achievability of these estimates even more unlikely.

When consensus is embedding an inflection further out, downward revisions, some drag on price returns and higher volatility are all to be expected. We examined what tends to happen when consensus embeds a big jump in growth 4 quarters out compared to the next three quarters. We found that the numbers for all 4 quarters ahead tend to fall but the growth quarter tends to fall the most. If current estimates move in line with history, we could see a full year decline of ~3.5% in S&P earnings. There is a wide range of potential outcomes though, so today we only take our base case forecast down to 1% y/y growth. We also found that equity returns can still be positive in this environment, but they will likely be weaker than they otherwise would have been and the odds of outright price declines are substantially elevated. Whether prices move higher or lower, volatility tends to rise meaningfully., with average year ahead price volatility realizing ~5% more than the full period average.

Lowering our earnings forecast. On the back of this work, we lower our Base Case 2019 S&P 500 EPS growth forecast to 1% from 4.3%. While our earnings numbers are coming down, our bull, base, and bear case year end price targets remain unchanged as a lower rate environment provides support for year end target multiples. The bottom line–our base case year end target of 2750 is a lot less exciting than it was a month ago.” – source Morgan Stanley

In their executive summary of their interesting note Morgan Stanley indicates the velocity in the earnings revisions as of late. This rapid move clearly shows that the euphoria seen in January where anything high beta rallied hard is not on solid ground. Debt-financed buybacks after all fell to 14% of the total among US companies at the end of last year, the lowest level since 2009 according to JP Morgan data. Buybacks since 2012 has been an important “pillar” in terms of support to US equities in recent years thanks to multiple expansion rest assured.

On top of that there are an increasing percentage of companies with negative earnings: S&P 500 – 7%; Nasdaq – 47%; Russell 3000 – 28%; Russell 2000 – 37%. For us, “high beta” is very “junky”. If fundamentals are deteriorating such as global trade and global growth and earnings revisions are “savage” then regardless of central banks’ u-turn, it isn’t enough we think to provide the same support we saw in recent years and quarters. The cavalry was indeed late after the December massacre, but the overall macro picture ain’t rosy.

Given the velocity in earnings revision/recession Morgan Stanley have drastically revised their outlook according to their note:

Earnings Recession Is Here; Adjusted EPS Forecast Lower

With 4Q18 results season nearing completion we have been taking a closer look at 2019 guidance. Downward revisions have come even faster and steeper than we expected and the full year earnings growth number now sits just above 5% with a material upward acceleration projected in the 4th quarter of the year. At the start of a downward revisions cycle, history tells us not to count on that kind of upward inflection.

On the back of the recent downward revisions, we lower our earnings forecasts for 2019 as we think it is becoming increasingly clear we are in the midst of the earnings recession we called for in our year ahead outlook. Specifically, we are adjusting our 2019 EPS growth number down to 1% (from 4.25%) while noting that despite support from buyback accretion and a weaker dollar by year end, risks skew to the downside. We make minor changes to our 2020 growth assumptions and bull/bear case earnings estimates as well. Our revised forecasts are shown in Exhibit 1.

While our earnings numbers are coming down, our bull, base, and bear case price targets remain unchanged as a lower rate environment provides modest support for year end target multiples. With a more dovish Fed and our Interest Rate Strategy colleagues now projecting a year end 10Y UST yield of 2.45%, we revisit our Equity Risk Premium / 10Y yield matrix (Exhibit 2).

We highlight our target range of ~15 – 16.5x forward PE for the S&P. Our range below has a diagonal tilt as we believe lower yields will be accompanied by higher uncertainty on growth leading to a higher ERP while higher yields may reflect a more optimistic outlook on growth, allowing for ERP compression.

Don’t Count on a 4Q19 Inflection in EPS Growth

We are increasingly convinced that consensus earnings expectations for 2019 have further to fall and that the optimistic uptick currently baked into 4Q19 estimates is unlikely to happen. A modest further decline in earnings will deliver the earnings recession we called for. Equity returns can still be positive in this environment, but they will likely be weaker than they otherwise would have been and the odds of outright price declines are substantially elevated. Whether prices move higher or lower, volatility will likely rise meaningfully. So in essence, we are still looking at a bumpy, range bound market at the index level and think investors should continue to try and take advantage of the swings in price in both directions.

The Market Needs a 4Q19 Growth Inflection To Support Full Year EPS Growth

In our year ahead outlook we argued that 2019 had a greater than 50% probability of seeing an earnings recession defined very simply as two consecutive quarters of negative y/y earnings growth. Following a steep downward revisions cycle over the last few months, consensus forecasts are quickly getting there.From the end of November, earnings growth expectation on the S&P fell from ~9% to their current level of around 5%. With an expectation of negative y/y growth in 1Q19 and very marginal growth in 2Q19, the mid-single digit full year number embeds a heavy ramp up of earnings growth in the back half of the year, and in 4Q19 in particular (Exhibit 3).

Importantly, since consensus bottom-up numbers are really just a reflection of company guidance this earnings slowdown could have real knock-on effects to corporate behavior like spending and hiring which then puts further pressure on growth.

Furthermore, company managements tend to be an optimistic group. As such, we’re not surprised they are calling for a trough in 1Q. However, we would advise against taking too much comfort in these calls for a trough in 1Q19 of the down cycle from the same people who didn’t see it coming in the first place. In addition to a trough in 1Q, consensus estimates are now forecasting a big second half inflection in growth.
Anything is possible, but we have little confidence in such an inflection given sharply falling top line growth and disappointing margins in the face of very difficult comparisons for the rest of this year
. If we accept that an earnings recession is here, the key questions are how deep will it be and how long will it last? Again, it’s hard to know, but we can look to history for some context on how expectations for a large upward inflection in earnings usually play out.” – source Morgan Stanley

Again, analysts going into 2019 have been way too optimistic when it comes to earnings. A usual trend but given the amount of liquidity injected into the system by central banks no wonder we are seeing growing risks of “cryoseism” in 2019. Volatility is firmly back.

As we stated before, where oil prices goes, so does US High Yield and in particular the CCC ratings bucket given its exposure to the Energy sector. No wonder Energy rallied strongly over the month of January:

– graph source Bank of America Merrill Lynch (click to enlarge)

In its January 2019 Senior Loan Officer Survey, the Fed said that a net positive percentage of domestic banks reported increasing the premiums charged on loans to large and middle-market firms. Historically, this tends to be a reliable signal of a pending recession. Both the supply and demand for household and business credit is either slowing or contracting. This is yet another “Cryoseism” sign that the epic high beta rally seen during the month of January is not on solid ground. So sure the rally in US High Yield has been very significant but, if indeed financial conditions continue to deteriorate, it doesn’t bode well for the asset class down the line.

As we mentioned on numerous conversations, like any good behavioral psychologist we tend to focus more on flows than on stocks. We stated as well at the end of the year that for a rebound in credit markets, fund flows need to see some stabilization the latest dovish tilt from central banks globally have enabled such a bounce as indicated by Bank of America Merrill Lynch in their Follow The Flow report from the 8th of February entitled “Reaching for yield”:

Equities record first inflow, HY inflow surpass $1bn

Dovish central banks globally have instigated a risk assets rally. The reach for yield is back amid lower government bond yields. Inflows into high-yield funds have strengthened over the past weeks and equity funds recorded their first inflow in a while as light positioning has become a tailwind for the asset class.

Over the past week…

High grade funds flopped back to negative territory. Last week’s outflow reversed part of the inflow from week ago, ending a two week streak of inflows. However, the outflow was driven by one single fund and removing it would result into a $1.1bn inflow. High yield funds on the other hand continued to see stronger inflows w-o-w.
We note that last week’s inflow was the largest since September last year. Looking into the domicile breakdown, US-focused funds recorded the lion’s share of the inflow, while Europe-focused funds recorded a more moderate inflow. Note that the inflows into global-focused funds were marginal.
Government bond funds recorded a decent inflow this week; the third in a row. Money Market funds recorded a strong inflow last week. All in all, Fixed Income funds recorded another inflow, though the pace has slowed down w-o-w.
For a change European equity funds recorded their first inflow after 21 consecutive weeks of outflows. Note that during this period total outflows reached $45bn.

Global EM debt funds continued to record inflows, the fifth weekly one. Note that last week’s inflow was the strongest since July 2016. Dovish Fed and lower dollar has become a tailwind for the asset class recently. Commodity funds recorded another inflow, the ninth in a row.
On the duration front, we find that the belly underperformed recording the vast majority of the outflow last week. Long-term and shot-term IG funds also recorded outflows last week, but to a lesser extent.” – source Bank of America Merrill Lynch

A dovish Fed in conjunction with lower rate volatility have led to Emerging Markets benefiting from the return of the “carry” trade.

Given that bad news has become good news again during the month of January, given the dovish tilt taken by most central banks, high beta has come back to the forefront thanks to the central banking cavalry. 2019 has clearly started on a very strong tone as indicated by Bank of America Merrill Lynch in their European Credit Strategist note from the 8th of February entitled “Play it again Sam”:

“As the expression goes…it’s always darkest before dawn. Year-to-date, high-grade spreads have rallied 18bp and high-yield has tightened by 72bp in Europe. These are impressive moves. For the investment-grade market, 2019 is shaping up to be one of the best ever starts to a year outside of 2012 – a time when the ECB’s life-saving LTROs energised a huge rally across the market.

An epic central bank “blink”

In 2018, only 13% of assets across the globe posted positive total returns…and only 9% of assets managed to outperform US 3m Libor. Jump to 2019 and the picture couldn’t be different. As Chart 1 shows, 98% of assets across the globe have positive total returns so far this year (the second best outcome since 1990).

The clearest instigator for such a bullish reversal, in our view, is that central banks are now undergoing one epic reversal in their monetary policy stance. In 2019, the Fed has already pivoted to being on-hold, the ECB has moved the balance of risks to the downside, Australia has stopped hiking and India has delivered a surprise rate cut.

When the most important central bank in the world changes tack, others must follow…or risk unwanted currency appreciation. True to form, as Chart 2 shows, the number of global central bank rate cuts over the last 6m is now greater than the number of central bank rate hikes (although the picture is less dramatic when excluding Argentina).

And when central banks flip-flop, so do markets. With interest rate vol at record lows now in Europe, this means a green light for carry trades and a return of the thirst for yield.

Cash spreads can still squeeze…but watch out for March indigestion

In credit land, the Street looks particularly offside in this tightening move, reflective of low inventory levels. And with earnings blackout still in place, cash bonds could still squeeze tighter in the short term (especially non-financials). We think the real challenge for the credit market will emerge in March, given that supply is seasonally highest then (14% of yearly issuance). A €50bn+ month of supply, for instance, could herald a return of big new issue premiums and widening pressure on secondary spreads.

Hubris 101– it never ends well

We’ve seen this central bank movie too many times in the past, though, to forget that markets always overshoot amid a yield grab. And that’s exactly what we worry about this time. After all, 30yr Bund yields at 72bp, 5y5y Euro inflation swaps at 1.48% (the lowest since Nov ’16) and rising BTP spreads signal the market’s doubt over the efficacy of another dose of monetary support, in our view.

Our concern is that Euro credit spreads are now increasingly dislocated from European economic data, and at best are pricing-in a Euro Area recovery that may take longer to materialise than the consensus thinks.

Chart 3 shows that European high-yield spreads have closely tracked the Eurozone manufacturing PMI New Orders index over the last 20yrs (72% correlation of levels, since mid-98).

New Order indices are a more forward-looking, and relevant, indicator in our view. But note that this index is still falling and is now far below the 50 recessionary threshold (47.8). Yet, with the market having rallied strongly year-to-date, our regressions point to Euro high-grade spreads being roughly 20bp too tight, and Euro high-yield spreads a more concerning ~200bp too tight.


Credit spreads are likely discounting a revival in the Eurozone cycle. Our economists expect Euro Area data to begin rebounding as we approach 2H ‘19. But the point is we’re not there yet…and the data flow thus far – especially industrial production – suggests that the Euro Area rebound may, if anything, take longer to materialize.

As an open economy, the Eurozone needs a thriving global economy to grow strongly. Germany, in particular, is exposed to non-European export markets. And given how Germany is integrated into other European countries’ supply chains, German weakness means a broader spill-over to Eurozone growth. But the external environment has been very unfriendly to Germany of late. Chart 4 shows how non-Euro Area trade has faded, with trade wars and China’s slowdown being culprits.

Weaker non-EZ trade means less of a buffer for the Eurozone to counter rising political uncertainties.

That means Euro credit markets need to see two things pretty soon to justify today’s spreads: firstly a US-China trade “agreement”, and secondly signs that China’s stimulatory efforts are finally paying dividends (and supporting broader Asian growth).

  • While a US-China trade compromise is our base case, it’s not yet clear whether the US administration has moved on from their concerns over European car imports. On this front, investors should keep an eye on the US Department of Commerce’s Section 232 report on the national security threat of motor vehicle and auto part imports. Bad news here would weigh further on global trade volumes to the detriment of the Eurozone.
  • While China has engaged in a number of stimulatory measures lately (RRR cuts, tax cuts for small businesses and a perpetual bond-for-bill swap), credit growth dynamics have yet to materially rise. Chart 5 shows that the ratio of China Total Social Financing to China M2 remains subdued, for instance.

  • And importantly, while US and Euro credit markets have seen a material tightening in 2019, (high-grade) credit spreads in China remain elevated.

QE Infinity, and the real meaning of “pushing on a string”

The dovish leanings of policy makers this year have been manna for financial markets. For over a decade, central banks have been able to cajole asset prices higher with their repeated interventions. In fact, Chart 7 shows how effective the ECB has been since 2009 in propping up sentiment: growth in the ECB’s balance sheet has always been enough to counter spikes in European policy uncertainty.

But after ~$11tr. in central bank balance sheet growth since The Global Financial Crisis (GFC) (using the “big 4”), the limits of monetary policy are being reached. Central banks have much less capacity to effect economic change this time around. 

Chart 8, for instance, shows where interest rates would be if central banks repeated their post-Lehman easing cycle, from today.

Understandably, some of the numbers would be far out of the realms of possibility. Hungarian interest rates, for instance, would drop to -10%, Eurozone deposit rates would fall to -4% and US interest rates would be heavily in negative territory (-2.5%).

Moreover, as the expression “pushing on a string” reflects, successive rounds of stimulus over the last decade look to have produced incrementally less economic growth, we think.

In Chart 9, we show what has happened historically to (1) global GDP momentum; and (2) global debt-to-GDP levels, in periods when global central bank balance sheets have expanded notably. Since 2006, we find five such periods.

Since then, however, periods of central bank balance sheet expansion look to have produced a much weaker impulse to the global economy.

  • The second round of stimulus post-GFC (‘10/’11) was followed by a decline (-0.9%) in the OECD Lead Indicator, which was driven by strong deleveraging (-9pp in the global debt/GDP ratio),
  • And the short, but visible increase in global central bank balance sheets between late ’17 and early ’18 was not even enough to propel growth upwards: the OECD Global Lead Indicator fell by 0.3% over the following 12m.

In summary, we caution that markets should not get carried away by central banks’ newfound dovishness. After so much support already, and with $58tr. of global debt being added since the GFC, recreating the impact of past support now looks much tougher for central banks.” – source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch, “carry on” but do not get “carried away”. If financial conditions will gradually continue to tighten as per the latest SLOOs, there is more potential for “Cryoseism”. No matter how much liquidity has been injected by central banks, the massive issuance in credit markets in recent years have led to the illusion of “liquidity”. For this illusion, you just have to check the secondary market in credit markets to gauge its depth. The next quarterly SLOOs will be paramount as per our final chart below.

  • Final chart – Credit pinball – Same player shoots again?

Are we seeing yet another case à la second part of 2016 which saw a significant rally in credit markets and in particular in high beta US high yield thanks to the recovery in oil prices and a more dovish tone from central banks? One might wonder. Our final chart comes from Bank of America Merrill Lynch’s Credit Market Strategist note from the 8th of February entitled “Happy New Year, welcome back” and displays the SLOOs versus US Investment Grade corporate spread. Is this a similar situation to the early recession fears of 2016 or is this time different? We wonder:

Lather, rinse, repeat

Back in late 2015/early 2016 US recession fears were overblown as investors extrapolated from weak manufacturing data a high recession risk. This exact same scenario played out late 2018/very early 2019 as markets forgot that the manufacturing sector is only 17% of the US economy and the remainder is strong (see: Fool me once, fool me twice). Back then the Fed’s senior loan officer survey showed in response a shift toward tightening lending standards. The same thing is understandably happening this time as the survey period for the fresh Fed survey was the last half of December, which represented the height of recession fears (Figure 7). Like back in 2016, as recession fears are proven wrong, this will pass and banks will once again go through a period of loosening lending standards well before the next downturn. For banks the problem is a lack of loan demand, as the cost of debt has increased materially. Absent recession that means banks will soon be back to loosening standards and undercutting yields in the corporate bond market in order to gain business.” – source Bank of America Merrill Lynch

Earnings were decent but the outlook is deteriorating fast. Also financial conditions seems to be tightening, We have seen stabilization in fund flows but this rally is not on solid grounds particularly with weakening buy-backs as CFOs are urged to become more defensive by investors of their balance sheet. You have been warned. It is still capital preservation time. Carry on but don’t get carried away…

“Sometimes the early bird gets the worm, but sometimes the early bird gets frozen to death.” – Myron Scholes

Stay tuned ! 

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