Friday, 10 November 2017

Macro and Credit - Paraprosdokian

"He was at his best when the going was good." - Alistair Cooke on the Duke of Windsor

Watching with interest the continuation of the "carry play" thanks to low rates volatility, with equities making new record highs while credit continues to tighten on the back of favorable financial conditions as displayed in the latest quarterly Fed Senior Loan Officer Opinion survey (SLOOs), when it came to selecting our title analogy, we reminder ourselves of a figure of speech called "Paraprosdokian". A "Paraprosdokian" is a figure of speech in which the latter part of a sentence or phrase is surprising or unexpected in a way that causes the reader or listener to reframe or reinterpret the first part. It is frequently used by comedians or satirists, and even central bankers, as it enables a humorous or dramatic effect, producing somewhat an anticlimax. "Paraprosdokian" comes from the Greek "παρά", meaning "against" and "προσδοκία", meaning "expectation". The continuation of the most hated bull market in history is somewhat an illustration of "Paraprosdokian" we think. We could rephrase slightly our above "Paraprosdokian" quote by saying that markets are at their best when confidence is at the highest. Another interesting illustration is as follows:
"Always borrow money from a pessimist. He won't expect it back."
As well one could argue that our dear central bankers, when it comes to fulfulling their inflation mandates have been apt users of some form of Paraprosdokian such as this one:
"To be sure of hitting the target, shoot first and call whatever you hit the target."
Or more recently this one:
"In the year since the global financial crisis ended, our economy has made substantial progress to full recovery. By many measures, we’re close to full employment, and inflation has gradually moved up toward our target," Jerome Powell, new head of the Fed.
Today many pundits, including the Fed’s policy makers, are divided about how close the economy is to full employment. There is a well a continuation of a "Paraprosdokian" effect with the Phillips curve cult members behaving against expectations. Given the many potshots we have taken this year against the Phillips Curve cult members, on a side note, we will simply refer to the latest post from David Goldman in Asia Times entitled "You canna fool me – there ain’t-a no Phillipy-Curve":
"Structural factors — demographics, technology, and the organization of retail distribution — turn out to be more influential than demand management. Quantitative easing has been neither a success nor a failure. It’s been largely irrelevant." - David Goldman, Asia Times
We hope that once again, we have put to rest for the time being the Norwegian Blue parrot aka the Phillips curve but we ramble again...

In this week's conversation, we would like to look again at the critical support provided by foreign investors to US corporate credit as well and why we favor equities over credit in this ongoing melt-up.

  • Macro - One should favor Equities over Credit in true Paraprosdokian fashion
  • Credit - Foreign flows are critical for US corporate credit
  • Final charts - A hawkish Fed doesn't necessarily means a strong USD

  • Macro - One should favor Equities over Credit in true Paraprosdokian fashion
Sure many pundits will point out that valuations are stretched and it's getting late in the game. Of course it is. But, as per our previous musing, when it comes to valuation, we will go towards the 11 level on the valuation amplifier in true Spinal Tap fashion even for credit as we move into the "euphoria" phase with the additional melt-up in asset prices overall:
- source Bank of America Merrill Lynch - Month to Date until end of October 2017

We remain "short term Keynesian" but long-term wise we confess to have a more "Austrian" stance. If we would use a "Paraprosdokian" construction to define ourselves we would opine that we don't belong to a specified economic school of thoughts, but that we are "Wicksellian". 

The most recent quarterly Fed Senior Loan Officer and Opinion Survey (SLOOs) points towards loose financial conditions though credit standards for consumer loans continued to tighten amid steady demand. Loan standards have overall remained unchanged on net for commercial real estate (CRE) except for multifamily loans, which saw 22.2% of tightening according to the report. Also, banks reported weaker demand across a range of CRE loan types while net percentages of banks reported easing standards on most residential mortgage loan types as demand weakened. As we posited in recent conversations, we continue to monitor very closely US consumer credit. On that subject we noticed in the latest report that a net 9% of Senior Loan Officers said they tightened standards on credit cards, and 9.8% said they tightened standards on auto loans. It isn't yet a cause for concern but another sign that we are moving in the last inning of the credit cycle. For Commercial Industrial loans (C&I), more aggressive competition from other bank or nonbank lenders was by far the most emphasized reason for easing in this report. Another sign comes from the relentless flattening of the US yield curve with 10s and 2s touching 68 bps. 

If markets are at their best when confidence is at the highest, and given we belief that we are continuing into a melt-up phase akin to "euphoria", then it would make sense from an allocation perspective to favor equities over credit from a "beta" play perspective. In that regards, we read with interest Morgan Stanley's Cross-Asset Dispatches from the 3rd of November entitled "Why We Prefer Equities Over Credit":
"We are underweight credit vs. equities, given bigger late-cycle challenges in the former and relatively worse bottom-up exposure of credit indices vs. the S&P 500.
Top-down, equities typically outperform late in a cycle: While equity investors typically benefit from late-cycle dynamics like increased M&A and rising corporate confidence, credit investors are more exposed to the deterioration in balance sheet quality that often comes from these 'animal spirits', with capped upside, by definition. Historically, credit tends to underperform first into a cycle turn; this time around, CCC spreads have already begun widening, which may be the better leading indicator.

Bottom-up differences are underappreciated: The S&P has a higher proportion of companies with better fundamental metrics and better growth prospects relative to the credit indices. On the other hand, credit markets are more exposed to sectors with long-term operational challenges, particularly HY, with just under 30% of par (ex-energy) experiencing negative revenue growth over the past five years. Nearly a quarter of the S&P 500 market cap falls into tech. IG is most exposed to financials while HY is most overweight commodities, consumer discretionary and telecom.
Investment implications: We find that credit investors are not compensated appropriately for late-cycle risks. We like positioning for equity outperformance by going long SPX versus CDX HY (1:2 ratio) or by selling ATM puts in the SPX to buy 2x ATM puts in CDX HY, given the elevated ratio between equity vol and credit vol. The risk to both trades is equity underperformance versus credit. In addition, in credit, we prefer up-in-quality exposure, whereas in equities we prefer more cyclically geared sectors."  - source Morgan Stanley
Where we agree with Morgan Stanley is relating to the high beta part of the US High Yield market namely our CCC credit canary, which recently has indeed displayed some weakness as per the below Bank of America Merrill Lynch chart displaying US CCCs vs Bs:
- source Bank of America Merrill Lynch

Are cracks already showing in the credit markets? We believe we are seeing some cracks starting to show up particularly with increased dispersion in the credit markets universe. The higher the dispersion, the higher can be the performance of a long/short strategy. We won't delve too much into the subject of the attractiveness of long/short equities strategies, but during the 2008 melt-down, higher dispersion between stocks ensured a significant performance of these strategies overall (not the stuff a perma-bear would highlight...).

From a technical perspective credit should continue to grind tighter, given the global search for yields runs unabated thanks to a growing slice of negative yielding bonds as displayed in the below chart from Bank of America Merrill Lynch:
- source Bank of America Merrill Lynch

With financial repression still running hot on the back of repressed/suppressed rates volatility, while credit players "carry on" from a beta perspective, in the ongoing "goldilocks" environment perspective we would rather allocate more to equities for the time being particularly in Europe where the risk reward on Europe High Yield with yields below 2% is not enticing to say the least. Morgan Stanley in their very interesting note make the following points:
"Why we prefer equities over credit
Since the start of the year, risk-adjusted total returns of the S&P 500 have outperformed the Bloomberg IG corporate excess returns index by ~5%. This is in line with one of our key calls from our year-ahead outlook. And we think that this relative outperformance can continue.
Our asset allocation preference is driven both by top-down and bottom-up considerations. From a top-down perspective, we find that the current stage in the business cycle is a larger boon for equities as opposed to credit simply due to the nature of the asset classes themselves. In addition, credit troughs tend to lead S&P 500 peaks historically. Various valuation and fundamental trends are also currently more favorable for equities than for credit.
Our preference also makes sense bottom up, a fact that we think is less appreciated by investors: owning the IG and HY indices creates exposure to sectors with inferior growth, ratings and leverage profiles relative to the S&P 500.
Investment implications: In credit, we prefer up-in-quality exposure, whereas in equities we prefer more cyclically geared sectors. We also recommend going long one unit of S&P 500 versus two units of CDX HY (adjusted for the beta differences between the indices), a trade we think could work in a bullish and bearish scenario, though less so if markets move sideways. For a more gradual divergence in credit and equities, we also like selling at-the-money S&P 500 put options and buying (2x) CDX HY puts, given the historically high ratio between equity and credit implied volatility.
Top down
1) Business cycle expansion is better for equities than for credit: Our Morgan Stanley proprietary business cycle indicator points to a US cycle in the expansion phase (Exhibit 3).

Strong macro readings within our model, particularly in employment and consumer  confidence, have driven recent strength in our cycle indicator's reading. This is the eighth year of expansion, one of the longest on record.
An expansion by its nature is more beneficial for equity than credit returns: During late-cycle expansions, increased demand helps to fuel capacity tightness, leading to a temporary accrual of economic rents to equity holders. While equity investors are able to earn the uncapped residual profits as that growth takes place, credit investors are more exposed to the deterioration in balance sheet quality that often comes from these rising 'animal spirits', with capped upside, by definition. Given the asymmetric risk/reward especially at tight spread levels, it is no surprise that credit has historically underperformed in this stage of the cycle.

2) Credit troughs tend to lead S&P 500 peaks: Towards the end of the cycle, credit and equity performance tends to diverge, with credit typically selling off in advance of equities. The asymmetric risk/reward profile of credit tends to make it more sensitive to weaker balance sheet quality and rising risks late in a cycle (see Bonding with Stocks, June 1, 2015). Since 1929, a trough in BBB credit spreads led a S&P 500 peak in 11 instances of 16 bear markets (a hit rate of almost 70%), with credit troughs leading S&P peaks by a median ~7 months (see The Credit Bear Market Almanac, February 19, 2016). Admittedly, prior to the 1990s, credit markets were much smaller in size and very different from today, so we hesitate to draw strong conclusions based on credit cycles far back in time. Looking specifically at the two most recent examples (2000 and 2007), credit spreads started widening in anticipation of a recession about 8-9 months before stocks ultimately peaked (Exhibit 5 and Exhibit 6).

However, we caveat that only two cycles' worth of data is far from a robust sample set.
To the extent that we are near the end of the cycle, we would expect credit markets to sell off in advance of equities. However, it is possible that the two markets may peak closer together (in time) compared to past cycles, given the strength of the 'yield seeking' flows into US credit. This year broad credit and equity indices have generally moved in the same direction, with total returns YTD of US equities at +17%, IG at +5% and HY at +7% (Exhibit 7).

But looking below the surface tells a more nuanced story. Lower-quality HY has outright diverged from equities (Exhibit 8), with the HY CCC index 103bp wider in spread since early March, as equities continue to make new highs.

The recent underperformance of CCCs makes intuitive sense, as credits most exposed to actual fundamental risks (as opposed to daily inflows and outflows) can show heightened sensitivity to rising risks near the end of a cycle (see A Tail of Dispersion, September 15, 2017). We saw a similar underperformance of CCC spreads in 1999 before an outright credit bear market began in 2000. In our view, this widening of CCC spreads could be how the late-cycle credit/equity divergence plays out this time around, and is something that investors should watch closely. Should cracks continue to emerge as we expect, we would expect the divergence in lower-quality credit to continue, a reason why we have recommended BBs over CCCs for most of the year.
3) Valuations: On the equities side, our equity strategists' preferred measure of equity risk premium (forward earnings yield minus the 10Y UST) still suggests that the S&P 500 is undervalued. With S&P 500 P/12M forward earnings trading at 18x versus our target of 19x, we still see equity upside. In contrast, a simple credit valuation metric that we like to track (credit spreads adjusted for leverage) is near 20-year tights, implying very poor long-term risk/reward.
4) Fundamentals: Company fundamentals ultimately drive both equities and credit. However, we would point out that credit and equity investors prioritize metrics differently. For example, leverage is an important consideration for both, especially  given equity holders' residual claims on a company. However, given that credit has capped upside and potentially large losses in the event of defaults/downgrades, corporate leverage is likely a more important indicator to a credit investor. Corporate earnings are also obviously important for both, as profit growth gives companies the ability to lower leverage and service debt. However, the uncapped potential of equities suggests that strong earnings growth may matter more for equity investors, but these benefits will not accrue to the same extent for credit investors and are therefore less relevant. To this point, we find that US earnings and leverage trends look very different: in the US, corporate earnings have been strong this year, with significant upside surprises. In contrast, leverage for our credit universes has remained elevated, sitting at or near the highest level in decades, as debt growth keeps pace with this robust earnings growth (especially for IG).
5) Fund flows: IG credit in particular has seen massive fund inflows in 2017, whereas equities have seen very muted flows/outflows. And the demand story for US credit goes beyond retail flows, as central banks have incentivized many different types of fixed income investors to reach for yield for years in this cycle. While not outright bearish for credit in itself, the flows picture presents risks, given how much credit investors may be relying on the technicals to remain supportive. For example, given the substantial support provided to credit markets as the Fed expanded its balance sheet in this cycle, we see scope for a weaker supply/demand picture as the Fed begins shrinking its balance sheet (see US Fixed Income Strategy: Trading the Fed's Balance Sheet, May 10, 2017). Equity flows do not present this risk to the same extent and instead show that the market has not yet reached the excesses often seen near the very end of a cycle.
- source Morgan Stanley

We do agree with Morgan Stanley that the recent underperformance of CCCs makes intuitive sense, as these credits are most exposed to actual fundamental risks and also clearly shows heightened sensitivity to rising risks near the end of this very long cycle. The widening of the CCC credit canary and its spreads indicates indeed how the late-cycle credit/equity divergence is again playing out this time around. We do agree with Morgan Stanley, the CCC bucket should be watched closely by investors.

Also, in various musings of ours we have indicated that US credit investors should start rotating towards quality and favor style over substance, namely Investment Grade Credit versus High Yield. Since August, in terms of performances, US Investment Grade has been outperforming US High Yield on a vol adjusted basis. Even though US HY issuer weighted default rate continued to decline in October, to reach a nearly 2 year low of 3.33%, this is akin to looking in the rear view mirror we think. Credit availability is essential and a good predictor of upcoming defaults as far as we are concerned.

Another interesting part of Morgan Stanley's note relate to their overall "bearishness" on credit:
"Why we are bearish on credit
Our cautious view on credit is based on three key points: 
First, the Fed has now started to tighten policy in an unprecedented way: We think that credit investors may have underestimated the tailwind from QE in this bull market, and they are similarly now underestimating the headwind from reverse QE – especially when that headwind is coming as the Fed is also hiking rates, and as global central banks will be slowly adding less liquidity as well. It is important to remember that central bank stimulus in this cycle has been massive in size, and has been hugely supportive of credit markets.

We are not expecting a seamless process as central banks pull back in this largely untested way. At the very least, the volume of fixed income supply that needs to be absorbed by price-sensitive fixed income buyers is going to rise substantially in 2018. US credit will no longer be the only game in town. In our view, it is perfectly reasonable to assume the opposite of what happened when the Fed was expanding its balance sheet in this cycle (one-way flows into US credit) as the Fed begins shrinking its balance sheet, at least at the margin. And this means that the ‘liquidity buffer’ will no longer be there to the same extent, magnifying any negative catalyst that pops up along the way. In our view, it is not a coincidence that weaker-quality high yield credits are underperforming, as the shrinking of the Fed balance sheet is now being set in motion
Second, markets are late cycle: And while these late-cycle phases often coincide with the best returns in stocks, they usually do not coincide with the best returns in credit. In fact, this is when credit and equities often start moving in different directions, as discussed above. More specifically, we note that credit quality has weakened over the course of this cycle most ways we measure it. For example, corporate leverage is at levels rarely seen outside of recessionary environments while the average ratings of the IG credit index has fallen meaningfully. In addition, we think that ‘excesses’ are all over the place. For example, credit markets have doubled in size since 2007, given a  relentless reach for yield for the better part of the last decade, the percentage of LBOs levered over 6x is now at 2007 levels, covenant quality has never been weaker and low quality IG issuance (BBB rated) is up 31% y/y, to name a few. And as is always the case late in a cycle, the ‘stress points’ go underappreciated, until the cycle turns, and then all of a sudden the problems become obvious (i.e., how did I miss that?). We think that this time is no different. Lastly, as a result of the build-up in ‘excesses' over this nine-year bull market, problems are now starting to pop up, so far under the radar. For example, consumer delinquencies are rising slowly. Lending standards have tightened in places – i.e., autos, credit cards and CRE. And despite broadly tightening spreads, as mentioned above, the ‘tail’ in credit is growing. In our view, this is how it works – late-cycle 101. Problems pop up early on in the areas that experienced the most severe deterioration in fundamentals in the bull market. Investors initially treat those issues as one-off and ‘idiosyncratic’. They then spread out when credit conditions tighten more broadly.

Third, valuations are very rich in credit any way we slice the data, and in fact even richer than the headline indices suggest, when adjusting for the deterioration in quality of the markets over time. Very simply, in Exhibit 29 we show that IG spread per leverage is now lower than it was at the tights in 2007. Of course, valuations do not tell us much about where markets are going in the short term, but they do tell that long-term risk/reward in credit is very poor.
Our ultimate investment conclusions are as follows. For multi-asset investors looking to capture the upside in markets in the final phase of this cycle, look to asset classes with a less asymmetric risk/reward profile than credit, such as equities. For investors who only focus on credit markets, prioritize higher-quality, more liquid credits, even if that means giving up some yield, until markets compensate you to do otherwise.
Given all these considerations, we recommend a relative value equities versus credit trade. We prefer to go long one unit of S&P 500 (at 2570) versus short two units of HY CDX (at US$108.2/314bp) as we adjust for beta differentials (Exhibit 30). There are a number of considerations for our trade. We choose to use HY, given that many of the credit headwinds that we discussed are larger for high yield than for IG, both from a top-down and bottom-up perspective. HY tends to do worse than IG in expansions and has a larger concentration in smaller, highly levered and generally lower-quality companies. We also believe that current underperformance in CCCs will spread to the rest of the HY universe over time. And finally, we prefer CDX as opposed to cash instruments, given the liquidity advantage (although we would note that, in a bigger drawdown in credit with meaningful outflows, TRS may be a better hedge). Moreover, in this context, we prefer the S&P 500 for the equity leg (as opposed to the Russell 2000) as it is less sensitive to any tax-reform outcome, with more high-quality stocks, less exposure to sectors in decline and it has had smaller drawdowns. In our view, this trade should work well in either tail scenario. In the bull case, stocks have more upside than credit, even risk-adjusted. In the bear case, where markets worry about a cycle turn, credit markets have more downside on a risk-adjusted basis, at least initially, given current valuations and the tendency of credit spreads to trough before stocks peak.
The trade may work less well in a scenario where stocks move higher slowly and credit spreads grind wider over a long period of time: The S&P/CDX trade discussed above has a significant carry cost on the credit leg, with steep curves in the CDX market driving a 1Y carry + roll-down in CDX HY near 5%. To highlight this point, we look at the historical performance over 2H14. In short, credit spreads hit their tights in June 2014, before grinding wider into year-end, whereas stocks kept moving higher. Through 2H14, the CDX HY22 index price fell by US$2.3. However, after accounting for the coupon, the net P&L of shorting CDX HY was modestly negative over this period. At the same time, the S&P 500 returned ~5.3%. Even though the S&P 500 versus CDX HY trade did well, it did so mainly because of the equity index going up, whereas the credit short was hard to monetize, given the carry cost. In other words, if credit markets trade sideways or grind wider slowly, stocks would need to rise a fair amount based on earnings growth/multiple expansion to offset the carry cost on the 2x CDX HY leg.
One alternative way to position for a divergence is in the options market: In the options space, the downside 'tail' is already priced for our view: i.e., the put skew in credit is at the steepest historical level. Instead, we think that using close to ATM options works better. Given current levels of implied volatility, we think there is value in selling close to ATM puts in S&P 500 versus buying them (2x) in CDX HY. The implied volatility ratio between equities and credit has been inching higher this year and is currently close to 3x, much higher than the realized beta and realized volatility ratio of the two markets; in other words, the credit vol is cheap to the equity vol. For example, buying 50-delta puts in CDX HY to March costs 1.2% of notional, whereas 50-delta puts on the S&P 500 are roughly 2.7% of notional. On a beta-adjusted basis, this trade would pay investors an upfront of 0.3% of the equity options notional. The key risk to this trade is that equities underperform credit materially in a move lower.
- source Morgan Stanley

In our conversation "The Trail of the Hawk" back in July we indicated that cheap gamma could be found in credit options and that in Investment Grade there were relatively cheap to own. From our point of view, playing it through options is a cheaper alternative than the cost of carry involved by the credit leg in Morgan Stanley's recommendation. The reason for credit volatility being cheap to equity is simply because there are more sellers than buyers. CDX options, unlike their counterparts in other asset classes, don’t enjoy a deep well of sponsorship among real money asset managers as a hedging tool.  Secondly, implied volatility is low because realised volatility has remained persistently low. Selling of volatility in the credit options market has been motivated by the same global reach for yield driving flows into US credit,  and has helped compress implied volatility to new cycle lows. You get the picture.

Credit, no offense to some investor pundits, is a low-beta asset class. As such it is inherently short volatility and tail-risk. At low yields and tight spread levels like today, the case for credit rests in part on attractive risk-adjusted returns. You don't have attractive risk-adjusted return on European High Yield. Low levels of volatility boost "carry" trades and of course make funds' "Sharpe ratios" look better. But, volatility, like the default rate, is backward looking. It is much less stable than a fundamental measure like leverage for instance. As we indicated earlier on, wacth dispersion in US credit. Why? Because it is actually higher today than it was at the tights of the cycle in 2014, making long/short strategies more and more enticing we think.

When it comes to US credit, as per our below point, overseas investors represent a critical support.

  • Credit - Foreign flows are critical for US corporate credit
We pointed out in various musings of ours how critical foreign flows have been for US credit and in particular Japan. No doubt to us that "Bondzilla" the NIRP monster is "Made in Japan" and represents a very important support from a flow perspective to the asset class as a whole. As a reminder, back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla"was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player.

We also indicated in our previous post that Bondzilla is "is a critical support of US credit markets. As we posited in our conversation "The Butterfly effect", during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk.

On the subject of foreign flows, we read with interest Wells Fargo Credit Strategy note from the 6th of November entitled "Overseas investors - From Buy-Buy to Bye-Bye? Not yet":
"Foreign Flows Have Slowed but Remain Strong
Investors came into 2017 expecting the frenetic pace of foreign inflows from 2016 to continue strengthening. With two months left in the year, we feel fairly confident in projecting that foreign flows will, in fact, be lower YoY. U.S. Treasury TIC data for the first eight months of the year show a pronounced slowdown in the first few months followed by reversal over the summer (Exhibit 1), with the YTD total running 35% lower than the same period in 2016.

On the other hand, flows into predominantly domestic mutual funds and ETFs are on track for a record year, with YTD flows of $277 billion already 70% ahead of the prior full year record of $164 billion back in 2012.
While foreign flows have slowed overall, by all accounts, they have remained quite positive this year, with holdings custodianed abroad increasing by $255 billion through the end of July. While we caution investors not to read too much into the U.S. Treasury TIC dataset as it is fraught with potential inaccuracies, we can surmise a few broad conclusions relative to our prior analysis:
- Broad geographic distribution has remained relatively constant, with Europe representing 82% of holdings, Asia 16%, Australia and Latin America 1% each. As a region, Latam is growing the fastest (+19% YoY), likely a direct result of several of the larger regional economies bouncing back from recent recessions. Australia is just behind as its large pension system seeks to diversify into non-AUD assets.
- Looking at holdings by country (Exhibit 2) shows that holdings decreased for only three countries YoY: Saudi Arabia, Singapore and Denmark.

- Within Asia, Thailand and South Korea surpassed Taiwan as the fastest-growing holders of U.S. corporates. We attribute this to Formosa issuance sapping Taiwanese demand3, while demand accelerates from South Korea as its insurance industry undergoes a similar regulatory transformation to Taiwan’s. Thailand’s exponential growth is likely a direct function of the rapid growth of its central bank FX reserves. The same argument holds true for some of the other smaller countries with rapidly growing holdings, such as Kuwait and Israel.
- Within Europe, Italy and Finland appear to be buying at an accelerating pace, albeit from a low base, while Germany and France have purchased significantly more on an absolute basis.
Tying together the TIC data with a number of other sources, we estimate that overseas buyers currently make up approximately 39% of the U.S. corporate debt market, down 1% from our prior estimation as a result of the record growth witnessed in the mutual fund and ETF segment. Within the Domestic Institutional part, the fastest growth has come from private pensions (+2% versus our prior estimation), likely a result of the upcoming PBGC premium increases pushing companies to top off their pension contributions (as well as fears around the impact of potential tax reform to the deductibility of these contributions).
- source Wells Fargo

As we pointed out, in similar fashion to the 2004-2006 Fed rate hiking cycle, currency risk will be sacrificed in favor of credit risk. This means that, credit could technically tighten much further and touch the famous 11 level on the credit amplifier in true Spinal Tap fashion.

"There is no alternative," is often abbreviated "TINA,". It is a phrase that originated with the Victorian philosopher Herbert Spencer and became a slogan of British Prime Minister Margaret Thatcher in the 1980s. Today it is often used by investors to explain a less-than-ideal portfolio allocation, usually to stocks, since other asset classes offer even worse returns. One could as well characterize US credit as TINA as pointed out by Wells Fargo in their note:
"The Unspoken Truth: Overseas Buyers Have Little Choice but to Buy USD Credit
We have thus far shown that overseas investors are still better buyers of USD credit despite increasing risks to the trade and expensive valuations. This begs the question of why these investors continue flocking to the asset class rather than buying their respective domestic credit markets. In our view, the simple truth is that within the world of IG credit, overseas investors do not have much of a choice. While the market has long been speculating over the demise of the USD as the only global reserve currency, in the world of IG credit, current issuance trends couldn’t be more contrary (Exhibit 10).

In fact, the proportion of USD issuance within global IG credit has been steadily rising for nearly a decade and is now back above 50% for the first time since 2003. On the other hand, the two main competitors are fading: EUR issuance, which was even with USD in 2008 is running at just 19% market share YTD, while CNY issuance has collapsed to its lowest share in four years at 14% of issuance. The catalyst for the drop in CNY issuance this year is a global M&A binge by Chinese companies which is forcing them to fund almost exclusively in USD. The Chinese government appears to be encouraging this trend with its recent USD sovereign issue, which lowered USD funding costs for Chinese companies. Thus, in the world of IG, global investors have less and less of a choice but to buy USD bonds if they want exposure to corporate spread product.
HY is a different story. While the proportion of USD issuance remains high at 70% in 2017, it has been steadily falling, mostly in favor of the EUR (Exhibit 11).

This highlights the fact that most HY issuers tend to be more coupon sensitive than spread sensitive, making the EUR market an attractive market for some non-Eurozone issuers.
On the other hand, IG issuers have become increasingly sophisticated in their ability to fund at the most advantageous spread on a currency-agnostic basis. As such, the key driver pushing non-U.S. issuers towards the USD market over the past few years has been the widening basis swaps between some currencies and the USD (Exhibit 12).

While the dynamic driving cross currency basis swaps is an entire topic unto itself, the short message is that currencies where central banks are more heavily skewing respective asset markets have the most negative basis swaps (i.e., JPY and EUR), a boon for issuers that fund in USD and swap the proceeds back to their home currency. Thus, in 2017 just 58% of USD issuance was from U.S. companies, down from 76% in 2008 (Exhibit 13), back when central banks were not intervening in their respective markets and therefore cross-currency basis swap costs were close to zero.

If the current issuance trends persist, the sensitivity of USD IG credit to economic factors outside the U.S. is set to markedly increase.
Not surprisingly, the Eurozone and Japan have been responsible for between 10-15% of USD issuance every year for the last nine years in a row (Exhibit 13). In the case of Japan, this is directly contributing to the dramatic shrinkage of its own corporate market, down 50% in size since 2010 before accounting for the ¥3.2 trillion of corporates owned by the BoJ (Exhibit 14).

The EUR corporate market has fared better, as the ECB has been less intrusive than the BoJ. More importantly, large cap U.S. issuers have begun to increasingly rely on the EUR market as “Reverse Yankees” now make up 19% of the market, second only to France in the EUR index.

Ironically, one could argue that these U.S. issuers have been crowded out of the domestic market by the tidal wave of overseas money and issuance that has flowed into USD credit. In other words, the unintended consequences of central bank QE are far-reaching and extend well beyond their respective shores. " - source Wells Fargo
From a flow perspective, the lion share of the allocation from foreign investors has been US Investment Grade credit when it comes to TINA. In the last four weeks, there have been big Investment Grade debt inflows of $25.1 billion. This represents the 46 straight weeks of Investment Grade bond fund inflows. That's where all the "fun" is going, uphill to the US Investment Grade bond market.

While our "Euphonists" are still playing loud aka our central bankers, some of the alcohol content of their credit punch bowl has been removed yet some investors pundits are still dancing while the music is playing and the credit mouse trap has been set up. Some players have started cashing in it seems. We already told you that you have been warned and that the tune of our central bankers have been changing.

This is as well the conclusion of Wells Fargo's note:
"Musical Chairs Means Central Bank Flows in 2018 Are Critical
The impact of central bank QE on global credit markets should not be underestimated. It has profoundly shifted the technicals that underlie global credit, pushing investors to take risks far away from their own shores in remote corners of the credit markets. But a new era is upon us as central banks attempt to extricate themselves from this grand experiment. In Exhibit 16 below, we show the magnitude of global QE flows over the past several years and attempt to project them forward into next year based on stated plans (Fed, ECB, BoE) and implied average pace (BoJ, SNB, PBOC).

In our view, the takeaway is quite stark: The peak in foreign flows into USD credit in 2016 was largely coincident with the peak in global QE purchases.
Looking forward, if global central banks are able to stick to current policy paths, there is a good chance that net QE flows approach zero by year-end 2018. This could have serious ramifications for the pace and sustainability of foreign flows into USD credit if overseas central banks manage to catch up to the Fed’s quantitative tightening policies and a USD bear market ensues. That said, so long as USD remains the currency of choice for a majority of issuers globally, overseas investors will likely have no choice but to remain involved to some extent in the USD corporate credit market." - source Wells Fargo
Sure the fun has been fabulous "uphill", in the bond market that is, and foreign investors have been as well properly intoxicated, but it was and still is a case of TINA we think.

For our final charts below, we still believe in additional weakness in the USD.

  • Final charts - A hawkish Fed doesn't necessarily means a strong USD
Our bearishness on the USD was the correct stance we adopted in early 2017 in opposition to the investor crowd thanks to our propensity to be contrarian at times. We still believe that even with a hawkish Fed in the making, it doesn't entail a stronger USD. Our final charts come from the same Wells Fargo reports shows that foreign investors are willing to take on more credit risk in the current low yield environment:
"A Hawkish Fed Does Not Necessarily Translate to a Strong USD
The behavior we outlined above (investors increasingly taking unhedged FX risk in U.S. corporates) is, in our view, a direct result of investor complacency with regard to the direction of the USD (as proxied by DXY, Exhibit 8). Post the significant rally around the first Fed rate hike in H2 2014, the USD has been relatively range bound. Foreign investors putting cash to work in a low-yield, tight spread environment on an unhedged basis are implicitly taking the view that they believe the USD will remain within this broad range (and therefore is likely to rally from current levels given DXY currently sits at the bottom of this range).
Investors espousing this view seem to be relying on the notion that a hawkish Fed, and therefore a rising rate environment, is almost certain to lead to further USD strength. Our FX strategy colleagues disagree with this thesis and believe we are in the early stages of a period of long-term U.S. dollar depreciation over several quarters and years.7 Moreover, investors should not assume that rising rates and a rising currency are highly correlated. In Exhibit 9, we shade in gray all periods since 1967 where the USD fell over at least one quarter, while at the same time UST five-year yields rose. While this pattern has not appeared much in the recent past (perhaps the reason for the prevailing misconception), it occurred in 22% of quarters since 1967, with most of those concentrated towards the latter end of prior economic cycles. In our view, the distinct possibility of a simultaneous bear market for both bonds and the USD (i.e., yields up, dollar down) is the single largest risk to overseas flows into U.S. credit."  -source Wells Fargo
Of course, there is a strong possibility that "balanced funds" will get "unbalanced" and that the traditional allocation will not work like a charm this time around in true Paraprosdokian fashion but we ramble again...

"To steal ideas from one person is plagiarism. To steal from many is research."
Stay tuned ! 

Wednesday, 1 November 2017

Macro and Credit - Euphonium

"Indeed, bull markets are fueled by successive waves of prior skeptics finally capitulating as their fears fade. Eventually, fear turns to euphoria, and that's the stuff of bubbles." - Kenneth Fisher

Listening to "Le Chiffre" aka Mario Draghi confirming lower QE for longer and watching a continuation of the rally with outperformance of beta, while thinking for this week's title analogy and given the start of a euphoric mood in financial markets, we decided to go for a musical reference "Euphonium". If one needs to keep dancing while the music is playing, it seems to us that the large conical-bore, baritone-voiced brass instrument deriving its name from the Ancient Greek word εὔφωνος euphōnos meaning "well sounding" or "sweet-voiced" is appropriate.  The euphonium is a valved instrument; nearly all current models are piston valved, though rotary valved models do exist.  A person or a central banker who plays the euphonium is sometimes called a euphonist. As a baritone-voiced brass instrument, the euphonium traces its ancestry to the ophicleide and ultimately back to the serpent. Our previous reference to "Ouroboros", the ancient symbol of a snake consuming its own body makes it even more interesting. On a side note, the most popular professional models of "Euphonium" in the United Kingdom are Besson Prestige and Sovereign models. It seems to us that the Sovereign models have been particularly popular with our "Generous gamblers" aka our dear central bankers, when it comes to playing the music everyone has been dancing to namely the QE tune. The euphonium has historically been exclusively a band instrument (rather than an orchestra or jazz instrument), whether of the wind or brass variety, where it is frequently featured as a solo instrument. Because of this, the "Euphonium" has been called the "king of band instruments" which fits perfectly the central banking narrative of these days. It has also been called the "cello of the band", because of its similarity in timbre and ensemble role to the stringed instrument. "Euphoniums" typically have extremely important parts in many marches (such as those by John Philip Sousa), and in brass band music of the British tradition. In many instances we think our "Generous gamblers" have been trumpeting their achievements with much fanfare and the wealth effect, this particularly loud music they have been playing with their various instruments, ZIRP, QE, NIRP and more but we ramble again...

In this week's conversation, we would like to look at consumer credit in particular and the US consumer in general given that no matter how loud our "Generous gamblers" are playing their "Euphonium", income growth is becoming a concern in the "land of the free" with rents eating a larger portion.

  • Macro - With the lack of "Income growth" is the Euphonium justified?
  • Credit - Revisiting previous record tights thanks to the Euphonium
  • Final charts - Keep up with the "melt-up" play the Euphonium via options

  • Macro - With the lack of "Income growth" is the Euphonium justified?
Back in May in our conversation "Orchidelirium", we asked ourselves if the US consumer was somewhat "maxed out":
"The "wealth effect" has globally lifted all boats but, in our book a credit cycle's length is around 10 years, so we do believe we are entering the last inning and that the final melt-up in asset prices could be significant before the usual "Bayesian" outcome. From our credit perspective, it appears to us that "cracks" in credit in the US are beginning to show up, particularly in the form of slowing loan demand. While we are not yet sounding the alarm bell, we think in the coming months it is going to be paramount to monitor credit demand and in particular consumer credit." - Macronomics, May 2017
From our credit and macro perspective, given we live in a credit world we indicated the importance of tracking loan demand as per the quarterly Fed Senior Loan Officer and Opinion Survey (SLOOs). We concluded at the time it was too early to envisage some clear headwinds for the US economy, but it is clear to us that we are late in the credit cycle. It remains to be seen how many hikes it will take before the Fed finally breaks something, but, clearly a December hike is on the cards. Yet there are growing signs that the credit cycle continues to slowly but surely turn as per the breakdown in the relationship between incomes and savings as indicated in Megan Greene, Chief Economist at Manulife Asset Management in Bloomberg's article from the 31st of October entitled "You Wanna See Something Really Scary? Try These Market Charts":
“The breakdown in the relationship between incomes and savings suggests that the consumer -- who drives every U.S. economic recovery -- may be near the end of the credit cycle.” - source Megan Greene, Chief Economist at Manulife Asset Management in Bloomberg.
We think it's too early to call it a day for the US consumer, although, no doubt, the tightening of lending standards appears to be slowly grinding tighter. Overall, financial conditions remain fairly loose. On the subject of the credit outlook for 2018 relating to consumer credit we read with interest Bank of America Merrill Lynch's take from their Consumer ABS Weekly note from the 27th of October. 
"The broader view – employment and debt service ratio are key
The level of economic activity should be supportive of credit performance of consumer debt, while the levels of consumer debt and interest rates may be less supportive. The positive trends in employment, net worth, saving, and income levels should be positive for credit performance. The level of spending and the willingness to borrow and lend remain primary factors driving consumer debt levels and credit performance.
In our view, the favorable economic environment should have positive impacts on the willingness to borrow, while weaker credit performance could have a negative impact on willingness to lend and/or lending standards in certain consumer loan segments. We believe the net impact will lead to higher levels of overall consumer debt. In other words, we still view the overall lending environment as favorable, despite some headwinds.
By loan segment, auto lenders may be willing to lend but they likely will leave lending standards unchanged to tighter, while credit card lenders likely will be willing to lend and loosen lending standards. Education loan and personal loan lenders likely will be willing to lend but will leave standards unchanged.
The growth rate for consumer debt seems to be stabilizing in the 6% to 7% range, while the rate for home mortgages has been steadily increasing since reaching a low of negative 4.6% YoY in December 2010. Some of the differences between the post-crisis growth rates can be explained by fewer opportunities, if any, for homeowners to monetize the equity in their homes.

Also, over the last few years, credit card lenders have begun to focus more on revolvers than rewards-driven convenience users. The growth in consumer debt has contributed to the increase seen in the related debt service ratio (DSR), although the ratio remains well below the peak seen in 2001.
Similar to prior periods, the willingness to borrow/lend has contributed to higher consumer debt levels (recall spending has been growing at a modest pace), which has contributed to a higher consumer DSR.

The higher consumer DSR, along with the employment situation, can have significant impacts on the level of charge-offs. We believe tighter standards are needed to slow growth in consumer debt, reduce the consumer DSR and, ultimately, lower charge-offs.

Auto loans should see lower growth as origination volume related to increasing sales of off-lease vehicles partially offsets volume lost to declining new vehicle sales and tighter lending standards. Credit card loans should see higher growth as the number of open accounts and credit limits have increased and lenders increasingly focus on revolvers. Education loans should see steady growth as expected increases in college enrollment and costs should offset expected increases in prepayments. Other or personal loans also should see steady growth as traditional lenders and relatively new “marketplace” lenders continue to offer loans and relative new products continue to gain traction (e.g., mobile device payment programs).
Consumer debt stood at record levels at the end of June 2017, after steadily increasing since June 2011 to reach $4.2tr. Among the various loan types, only auto loans and education loans have reached record levels, as relatively strong vehicle sales push auto loan origination volume to higher levels and needs-based lending standards push education loan origination volume to higher levels. The current outstandings for credit card loans is 91% of the peak seen at the end of December 2008, while the same for other loans is 78% of the peak at the end of June 2003.

Healthy economic environment but higher debt loads
The positive trends in employment, net worth, saving, and income levels should be positive for credit performance. Despite these trends, weaker standards have led to higher consumer debt balances, higher debt service ratios and, ultimately, weaker credit performance.
- source Bank of America Merrill Lynch

While overall, we cannot conclude that it's time to panic in true Halloween fashion. You would be wise to remember that the interest rate for most credit cards is floating with margins benchmarked to the related bank card issuer’s prime rate. Therefore the expectation for higher interest rates could place pressure on credit metrics.

As we stated above, how many hikes it will take before the Fed finally breaks something? This is the question Wells Fargo tried to answer this question in their Interest Weekly note from the 25th of October entitled "Is Consumer Credit a Concern with Rates on the Rise?":
"Is Consumer Credit a Concern with Rates on the Rise?

Consumer credit as a percent of disposable income is at an all-time high. With the Fed expected to continue hiking rates, readers may be concerned that an uptick in defaults could have an outsized impact in this cycle.
Dig a Little Deeper
At first blush, the below graph may raise concerns among those who correctly notice that the outstanding amount of consumer credit is at an all-time high as a percent of personal income.

This concern is perhaps more amplified against the backdrop of a Federal Reserve that is prepared to raise the fed funds rate in December and continue tightening policy through 2018. And although not all consumer credit is attached to a floating rate, delinquency rates may be expected to pick up as new credit becomes more expensive to pay back.
However, while the ratio in the top graph does has some interesting implications, it must first be acknowledged that this ratio includes a stock number (consumer credit) being divided by a flow number (disposable personal income). A stock refers to the value of a series at a point in time while a flow refers to the total value of the series over a period of time. Thus, stocks and flows are not easily comparable and therefore are not always useful in deriving conclusions.
Instead, we turn to the debt service ratio (below chart), which compares the flow of consumer credit to the flow of disposable personal income over the same period.

In this instance, the most recent data point is well below the all-time series high reached in late 2001. Despite the relatively subdued debt service ratio, the recent upward trend since 2013 is worth monitoring. The growing amount of auto and student loans being financed with credit is partially responsible for this trend as payments for these consumer debt categories continue to become due. Interestingly, the debt service ratio for mortgages has not seen an increase despite a modest rise in the federal funds rate. The fact that fixed-rate mortgages are much more common than adjustable-rates mortgages is perhaps partially responsible for the recent trend difference. Mortgage payments are consistent regardless of the interest rate environment, whereas credit card rates are largely floating.
Household debt delinquencies, largely, are still continuing their downward trend (bottom graph).

The exceptions to this are student loans, which have been essentially flat since 2013, and auto loans, which have slowly climbed for 12 consecutive quarters. As we have stated in past pieces, we do not think the auto loan market poses a threat to household finances, as auto loans comprise just 9.2 percent of total household debt. Additionally, as the Federal Reserve continues to tighten policy we would not be surprised to see delinquency rates modestly tick up and loans with floating rates become marginally more difficult to pay back. However, if the Fed continues to raise rates in the ‘slow and steady’ manner in which they have over the past year, then a sharp uptick in consumer debt delinquencies will likely not occur, all else equal, as Fed policy would likely lag income gains." - source Wells Fargo
When it comes to assessing credit, the distinction between stocks versus flows is paramount. We have made this point on numerous occasions. What matters is the rate of change of credit.

Yet, higher consumer debt balances and higher debt service ratios, make this cycle particular vulnerable to a sudden change in the narrative. As well with credit risk and duration risk extended thanks to the Euphonists at the Fed, there is a potential for heightened risk if, as we mused last week there is a sudden unexpected return of the "Big Bad Wolf" aka inflation. Put it this way, there is a very small margin for error or for a "policy mistake", the interest rate buffer is razor thin.

We are clearly not there yet. We have remained short-term "Keynesian" given the large inflows pouring into various asset classes, while longer term we do remain "Austrian". The "wealth effect" from the Euphonium has globally lifted all boats but, in our book a credit cycle's length is around 10 years. We still believe we are entering the last inning and that the final melt-up in asset prices could be significant before the usual "Bayesian" outcome.

While we have pointed out for the risk of an unexpected return of inflation which would trigger some acute repricing and renewed volatility as discussed last week, we also pointed out that Financial Stability matters for the various Euphorists. So far the investor crowd has been oblivious to the change of tune of their baritone-voiced brass instrument. When it comes to credit spreads, thanks to low rates volatility we are no doubt going to hit the level 11 on the amplifier in true Spinal Tap fashion.

  • Credit - Revisiting previous record tights thanks to the Euphonium
The beta rally has once again been very impressive since the market took a turn during the second semester of 2016 following a dismal first semester largely impacted by credit oil woes particularly in the High Yield sector. High beta returns so far this year have been impressive. Many are questions the hefty valuations levels reached in various asset classes. But thanks to the Euphonium tune, we do think records are made to be broken. The technical bid remain in place, particularly for the naysayer in European High Yield. This is due to the fact that there is a shrinking universe in the European junk bond market. This is the conjunction of several factors such as upgrades as well as a competition rateching up from the loan market. Bond-to-loan refinancings has the favor of private equity players coming back into play. Longer-dated fundings can be provided. This clearly shows that the table has turned at least in Europe thanks to the CLO market heating up creating a hefty demand for loans versus bonds. Structured credit is back into play.

On the subject of record being broken, while many eyes are watching the equity space march upwards, in similar fashion, things are heating up in the credit space hence our veiled analogy to a state of "Euphoria" developing in earnest. On this subject we read with interest Bank of America Merrill Lynch's take from their High Yield Strategy note entitled "Quantifying HY Risk Premiums"":
"Could we revisit previous record tights?
We do not take a sub-300bps HY spread forecast lightly. Many things need to go right for this projection to materialize and any one of them going wrong could upset it. And yet when we look at the macro environment as it exists today, we can’t help but think we are in this rare goldilocks scenario which could deliver such an unusual outcome. In a recent interview, Michael Milken described the current market environment as the “golden age for private equity”(See Bloomberg News, a story by Steve Dickenson, “Michael Milken Says Private Equity's ‘Golden Age’ Will Continue”, September 14, 2017). He went on to qualify this description by pointing out the ease at which issuers can presently get leverage in the market and borrow without covenants, allowing PE firms to achieve very unusual rates of return at times of low yields and tight spreads.
As we listened to that interview, we caught ourselves thinking how long it has been since we last heard someone in a similar position of authority and respect in our market describe it in these words. It has been about ten years or so, if memory serves us well. 
And so this is where we think the market finds itself today: as open and as supportive of credit risk, as it was in the last couple of years of the previous credit cycle. With many new deals coming as oversubscribed and priced at the tight end, we think the “golden age” description of today’s capital markets feels appropriate. Taken a step further, if one defines a default trigger not as a fundamental balance sheet issue but instead as mostly a liquidity event (in which a weak issuer is finally cut off from its ability to refinance or close a negative cash flow hole by issuing new debt), then in our opinion today’s environment presents little opportunity to see many defaults materialize. It is not that there are not enough overlevered balance sheets out there, but rather that the market is willing to provide leverage and do so on issuers’ terms.
A two-handle HY spread goes against our consciousness as long-term investors, and our best judgment of long-term value, and yet it appears appropriate in the context of the one year forecasting horizon. In fact, a question we have heard on a number of occasions recently is if the market is so accommodative, volatility remains low, and defaults continue to be rare, what is it going to take for us to retest all-time tights? It is going to take time.
This view has a precedent in the last cycle, where it took three-plus years after the volatility collapse in late 2003 for us to reach the tights in spreads in early 2007 (see the distance between grey and yellow vertical lines in Figure 7).

It has been almost two years since the last time we had a major spike in volatility in late 2015/early 2016; thus, we think time is still on our side." - source Bank of America Merrill Lynch
This "goldilocks" low rates volatility environment is exactly what is needed to have a "golden age for private equity". This could lead of course to a return of significant LBO transactions which would no doubt create anxiety for bond investors given their propensity in impacting significantly CDS spreads. Do you need to dust up the LBO screeners used in the heyday of the credit excesses of 2006-2007? Probably.

Although some sell-side pundits are pointing towards exhaustion in spread compression, we do believe that we can go further. Wells Fargo in their Global Macro Credit Outlook from the 25th of October points towards spread compression running out of steam:
- source Wells Fargo

With close to $11 trillion in negative-yielding bonds globally, you have a strong technical bid in place thanks to the mesmerizing tune from the "Euphonium". As we stated many times, the "wealth effect" is leading to flows going where all the "fun" is, namely the bond market, not really downhill, towards the "real economy", making the US recovery pretty tame in this cycle thanks to central banking meddling with asset prices. 

A lot of foreign flows into US credit are "Made in Japan". Back in July 2016 in our conversation "Eternal Sunshine of the Spotless Mind" we indicated that "Bondzilla" the NIRP monster was more and more made in Japan due to the important allocations to foreign bonds from the Government Pension Investment Fund (GPIF) as well as other Lifers in conjunction with Mrs Watanabe through Uridashi and Toshin funds (Double Deckers) being an important carry player. In the global reach for "yield" and in terms of "dollar" allocation, Japanese investors have been very significant hence the importance of monitoring the flows from an allocation perspective. Bondzilla the NIRP monster is "is a critical support of US credit markets. As we posited in our conversation "The Butterfly effect", during the 2004-2006 Fed rate hiking cycle, Japanese foreign investors lowered their ratio of currency hedged investments and sacrificed currency risk for credit risk. As pointed out by Wells Fargo in their report, demand for US Corporate Credit remains incredibly strong thanks to the Euphonium:
- source Wells Fargo

Strong demand, strong earnings, strong economic data, you have the recipe for a final melt-up. This bull market will continue to be the most hated bull market in history even though we agree that one can rightly question the fundamental basis of the rally thanks to a credit binge induced by the Euphorists. So, sorry for the perma-bear crowd, this hated rally, unfortunately, for the frustration of many, has more room to go as per our final charts. 

  • Final charts - Keep up with the "melt-up" play the Euphonium via options
The Euphorists are still keeping the dancing at the party with their loud music, although they have started to withdraw some of the alcohol within the credit punch, but at a very slow pace, still making the investor crowd properly inebriated. Thanks to the Euphonium and the central banking euphonists, as per our final charts, should you want to keep up with the "melt up" in equities, you might want to think about playing it through cheap options as indicated in our final charts from Bank of America Merrill Lynch from their Global Equity Volatility Insights from the 31st of October entitled "The equity melt-up may have already occurred given today's low vol":
"Sharpe Ratios near 80yr extremes suggests using cheap options to capture US equity upside
While US equity returns over the last 12 months have been far from historical highs, the Sharpe Ratios of US equities are in fact near 80-year highs for the Dow Jones Industrial Average and not far behind for the S&P 500 – a consequence of today’s near-record low volatility and low interest rates. With equity Sharpes in such “rare air” and option costs near all-time lows, we like using SPX call spreads to capture potential US equity upside into year-end with limited risk.
  • A melt-up in US equity Sharpe Ratios: Over the past 12 months, the Dow Jones Industrial Average has rallied nearly 29% (not including dividends) on 7% realized volatility, good for a Sharpe Ratio of 4 (Chart 7).

  • Since 1935, the 12M Sharpe Ratio of the Dow has been higher only 1% of the time. Similarly, the S&P 500 has recorded a Sharpe of 2.8 over the past 12 months (96th percentile; Chart 8) while generating a relatively pedestrian 12M return of 21% (77th percentile; Chart 8).

  • Moreover, with a 12M Sharpe of 2.5, the Nasdaq 100 is approaching Tech Bubble peaks in risk-adjusted returns despite nominal returns only ¼ as large.
 Ultra-low vol turning good equity returns into historically great Sharpes:
  • The common factors transforming today’s good equity returns into stellar Sharpe Ratios? Historically low equity volatility and interest rates. Chart 9 isolates all historical 12M periods since 1935 in which the S&P 500 recorded a Sharpe Ratio of at least 2.8 (= S&P Sharpe over the past 12M).

  • Among these “high Sharpe” periods for US equities, the most recent 12M period has witnessed the lowest S&P 500 price return and nearly the lowest realized volatility in history. The last historical period with higher S&P 500 Sharpe Ratios was the mid-1990s (Chart 9); while realized volatility was also in the single digits, this occurred against a different macro backdrop of flat to falling short-term interest rates (Chart 11).

  • One has to go back to the early-1960s to find a period with (i) Sharpe Ratios exceeding today’s levels, (ii) equity volatility as low or even lower on a sustained basis, and (iii) a gently rising rates cycle (Chart 10).
Extremes in Sharpe motivate using cheap options to capture further upside:
Interestingly, the mid-1990s and mid-1960s featured the three longest streaks on record of consecutive trading sessions without a 5% or more pull-back in the S&P 500 (the current streak of 339 days is fourth-longest). Curiously, the eventual 10% sell-off that ended the 387-day streak in June-1965 seemed largely driven by sentiment rather than fundamentals. Given today’s equity Sharpe Ratios are in “rarefied air”, we continue to advocate using historically cheap options to capture upside with less risk. For example, owing to low volatility and flat call skew, S&P 500 3M 40-delta / 10-delta call spreads (roughly 2600/2700 ref. 2573) cost 1%, near the lowest level recorded since Jan-2001 (Chart 12).
- source Bank of America Merrill Lynch

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. As a bonus chart to illustrate further our Euphonium analogy, the final chart below comes from Credit Suisse Gobal Cycle Notes from the 31st of October and is entitled "To Euphoria and Beyond":
"Our credit risk appetite index has moved into euphoria, and a further surge in global IP growth would, based on history, make a full-fledged global risk appetite euphoria much more likely. Of course, euphorias need not be driven by higher risky asset prices alone. Falling safe asset prices – that is, rising yields – can lead to the same place."  -source Crédit Suisse

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."
There you have it, the euphonists have been playing louder, the investor crowd is already intoxicated and even if they have been removing some of the alcohol content from the credit punch bowl, some drunk punters are still dancing to the loud music coming from the euphonium. Unfortunately they remain oblivious to the fact that some are already leaving the dance floor, but we ramble again...

"This world's a bubble." -  Saint Augustine
Stay tuned!
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