"Harmony makes small things grow, lack of it makes great things decay." - Sallust
Looking at the sudden violent dump in CDS protection for some issuers within the Itraxx Subordinated Financials CDS index due to HIS Markit revising index rules which will include in next roll UK and Swiss banks in the new index Series at HoldCo Level for the Senior and Subordinated Financial Indices, we reminded ourselves for our title analogy of the Goldilocks principle.
The Goldilocks principle is the idea that there is an ideal amount of some measurable substance, an amount in the middle or mean of a continuum of amounts, and that this amount is "just right" for a life-supporting condition to exist. The analogy is based on the children's story, The Three Bears, in which a little girl named Goldilocks tastes three different bowls of porridge (ZIRP, QE, NIRP?), and she finds that she prefers porridge which is neither too hot nor too cold but has just the right temperature.
What we find of interest is that in cognitive science and developmental psychology, the Goldilocks effect or principle refers to an infant's preference to attend to events which are neither too simple nor too complex according to their current representation of the world, same goes with central bankers. This effect was observed in infants, who are less likely to look away from a visual sequence when the current event is moderately probable, as measured by an idealized learning model (Phillips curve). In the case of central bankers, they are less likely to look away from their idealized outdated models, hence our recent discussion surrounding the failing of their much vaunted Phillips curve they have tried to exploit. There is as well another interesting application of the Goldilocks principle in medicine where it refers to a drug that can hold both antagonist (inhibitory) and agonist (excitatory) properties. QE and NIRP come to mind when thinking about the medical application of the Goldilocks principle, but we ramble again. In economics, a Goldilocks economy sustains moderate economic growth and low inflation, which allows a market-friendly monetary policy. A Goldilocks market occurs when the price of commodities sits between a bear market and a bull market.
Funnily enough, when it comes to our title analogy and the Goldilocks principle, we missed this weekend San Francisco Federal Reserve President John Williams speech in Australia, which was surprisingly hawkish as indicated by our friend Kevin Muir in his latest excellent musing on The Macro Tourist:
"Today, the U.S. unemployment rate is 4.3 percent - meaning that we've not only reached the full employment mark, we've exceeded it by a fair amount. Given the strong job growth we've been seeing in the United States, I expect the unemployment rate to edge down a bit further and remain a little above 4 percent through next year.
Meanwhile, inflation has been running somewhat below the Fed's goal of 2 percent for the past few years. In the past, this low rate of inflation was the product of a number of factors-the recession and the strength of the U.S. dollar being the two main ones. Recently, some special transitory factors have been pulling inflation down. But with some of these factors now waning and with the economy doing well, I expect we'll reach our 2 percent goal sometime next year.
Now, I'd love to be able to tell you that the news is all rosy and that our work here is done. Unfortunately, they don't call economics "the dismal science" for nothing. I'm paid to consider what potholes may be dotting the road ahead.
For starters, the very strong labor market actually carries with it the risk of the economy exceeding its safe speed limit and overheating, which could eventually undermine the sustainability of the expansion.
When you're docking a boat in Sydney Harbour, the San Francisco Bay, or elsewhere, you don't run it in fast towards shore and hope you can reverse the engine hard later on. That looks cool in a James Bond movie, but in the real world it relies on everything going perfectly and can easily run afoul. Instead, the cardinal rule of docking is: Never approach a dock any faster than you're willing to hit it. Similarly, in achieving sustainable growth, it is better to close in on the target carefully and avoid substantial overshooting.
What this means is that we do not want our economy to run too hot or too cold. Like Goldilocks, we want our porridge to be just right.
During the recession and recovery, jump-starting and speeding the recovery required historically low interest rates. Today, interest rates in the United States remain low - and this is even true after the most recent Fed action, which I'll get to in a moment.
I'm sometimes asked why we don't just leave things as they are and not raise interest rates. After all, if things are going well, why change? The answer is that gradually raising interest rates to bring monetary policy back to normal helps us keep the economy growing at a rate that can be sustained for a longer time.
If we delay too long, the economy will eventually overheat, causing inflation or some other problem. At some point, that would put us in the position of having to quickly reverse course to slow the economy. That risks stalling the expansion and setting us back into recession.
My goal is to keep the economic expansion on a sound footing that can be sustained for as long as possible. The last thing any of us want is to undermine the hard-won gains we've made since the dark days of 2008 and 2009, when it seemed like the U.S. and world economies were on the verge of collapse.
Therefore, we're in the process of normalization. At our June meeting, the FOMC undertook the second ¼ percentage point increase in our main policy interest rate this year. And we announced that we expect that economic conditions will warrant further gradual increases in the future." - San Francisco Federal Reserve President John Williams
"Re-read the paragraph about docking in a harbour. These are not the words of a Fed President willing to let growth run. He is on the same page as Dudley.
It is stunning that markets are not taking these words more seriously. I don't know if it was too many times crying wolf, but we have hit a point where markets are ignoring extremely hawkish rhetoric from Fed officials. The Fed seems to have lost credibility, and I fear that when the market finally realizes the Fed might in fact follow words with deeds, an abrupt repricing of financial assets will be on deck." - source Kevin Muir - The Macro Tourist - The Third Mandate is Official
We do share our concerns with Kevin Muir, the Fed looks like it's getting serious about its "porridge" and the Goldilocks principle even though as of late US macro data such as the recently released May's preliminary durable goods orders tumbling 1.1% MoM has steered towards the weak side. As we pointed out last weekend, you have been warned, and the Fed could mean business.
In this week's conversation, we would like to reiterate our call to start playing defense credit-wise. Credit in some segments of the market has moved in earnest from expensive to very expensive.
Macro and Credit - In the current inning of the credit cycle stealing third base in High Yield isn't worth it
Final chart - US Corporate Pensions? Stuck in the Middle with You
Macro and Credit - In the current inning of the credit cycle stealing third base in High Yield isn't worth it
As we concluded back in early June in our conversation "Voltage spike", the MDGA trade (Make Duration Great Again) has made a very good comeback as indicated by the ETF ZROZ we follow, which delivered a 6% return over four weeks (not too shabby of a performance). We continue to favor style over substance, quality that is, over yield chasing from a tactical perspective.
The relentless flattening of the US yield curve shows that in the current inning of the credit cycle, and with a Fed determined in continuing with its hiking path, from a risk-reward perspective, we believe long duration Investment Grade still offers support to the asset class and not only from a fund flows perspective with retail joining late the credit party. On another note, the "Trumpflation" narrative has now truly faded to the extent that the deflation trade du jour, long US Treasuries (the long end that is) is back with a vengeance, while inflation expectations have been dwindling on the back of weaker oil prices (after all they still remain "expectations" from our central bankers perspective).
When it comes to us sticking our neck out and praising the Investment Grade long duration credit game, we were pleased to read that UBS in its recent Macro Keys note from the 21st of June entitled "Is the high-yield rally hitting a wall?" has joined our ranks:
"The mood from investors has certainly changed from earlier this year, when sweeping US tax reform and a significant uptick in US GDP were expected. Fast forward to today and investors are downplaying the likelihood of fiscal stimulus. Global credit impulses have fallen sharply. Consumer delinquencies are rising, raising doubts about the health of US consumer balance sheets. And further declines in oil are leading investors to question the state of global demand weakness, not only US shale oversupply.
Yet credit is holding in, admittedly better than we anticipated, given an uptick in macro data disappointments. Investors have settled on the view that growth is still good enough to keep credit spreads stable and earn carry. We still believe investors are more comfortable with credit risk than duration risk. But is this a prudent risk to hold? Remember, investments should be judged by what is priced into markets and by the distribution of outcomes around what is priced. Here, our view remains that US high-yield continues to price-in too much good news. Put simply, US high-yield spreads relative to US investment-grade spreads imply a stable mid-cycle environment, akin to 2004-2006 or 2013-2014. However, underlying credit signals we track remain moderately weaker than those in prior periods, in terms of higher credit-based recession probabilities, weak economy-wide corporate earnings, and initial signs of non-bank liquidity tightening.
There are perhaps nascent signs of fatigue already building. High-yield spreads are effectively unchanged since February. This is in contrast to an equity market that continues to register new highs. HY energy spreads have widened as lower oil prices increase default risks. And US CCC spreads have started to wobble as well (Figure 1), widening 50bps over the last 3 weeks.
What should investors do? We recommend investors take advantage of underpriced credit risk to rotate further into longer-duration US investment-grade over US high-yield. Absolute returns for US IG will not be as strong going forward, as declines in Treasury yields may have moved too far, too fast. But we expect relative outperformance vs. US high-yield. We also recommend buying put options on HY ETFs, as short-dated implied volatility has collapsed to near record-lows.
How could we be wrong? An increase in US tax reform odds could be an upside surprise, given a market underwhelmed with Washington politics. A Fed that lets inflation overshoot its 2% target could spark more risk-taking, but this seems unlikely in light of the Fed's hawkish stance last Wednesday. Lastly, a new source of demand from US insurance companies due to changes in capital requirements could boost high-yield further. This latter factor is significant enough to matter and has not received enough attention in our view. Hence we address this upside risk to credit specifically in the third section of our piece.
How expensive are current high-yield valuations?
US high-yield spreads are 392bps, a mere 280bps wider than US investment-grade spreads of 112bps (Figure 2).
This difference is near the tights of the post-crisis period, implying a lack of fear over credit risks. One can clearly see this dynamic in the relationship between BB rated US high-yield (average maturity of 7 years) and 10+yr BBB-rated US investment-grade credit (Figure 3).
Investors can now earn an extra 21bps in yield by moving up to long-duration US IG credit (BBBrated) over US HY (BB-rated). This is a rare occurrence in credit markets and reflects still excessive fears of duration risk relative to credit risk. But we believe this pricing is misguided. As our Rates strategists wrote last week, long-duration US Treasuries have support as declines in oil price and US CPI volatility have compressed term premia. Concerns over the impact of a Fed balance sheet roll off should be mitigated by recent performance; 30-year Treasury yields have fallen 10bps since the Fed suggested a faster balance sheet contraction than expected last Wednesday. Meanwhile, shorter-duration assets could struggle as the market has effectively priced little future Fed hikes, despite easy financial conditions and booming asset prices. It appears to us that short-duration high-yield is more vulnerable than long-duration investment-grade credit.
Hence, we recommend investors take advantage of under-priced credit risk to rotate further into US investment-grade over US high-yield. Our preference for 7- 10 year US IG credit has been a decent trade for us since the beginning of the year. 7-10year US investment-grade credit has returned 4.6% YTD, in-line with HY returns of 4.6% YTD. While absolute returns will surely be less for both markets going forward, relative returns for US investment-grade will be stronger as credit risk underperforms.
Aside from moving into US investment-grade credit, investors should look to hedge risk by buying put options on high-yield ETFs. 3-month implied volatility on HYG has collapsed to near record lows (Figure 4), with 90% ATM options on Sept '17 contracts costing only 20bps.
In the past, we have recommended investors hedge downside high-yield risk through a wider cash-CDX basis (selling CDX US HY for long exposure and short-selling HY ETFs for the short-leg). But as borrow rates have climbed on high-yield ETFs to around 1-2%, put options should now be utilized tactically to protect against downside. This is yet another example of a market that has grown far too complacent with credit risk.
Credit risks are not receding
While a precise market-moving catalyst is difficult to find (and time), there is no shortage of risk factors that keep one cautious on credit. While HY spreads relative to IG spreads are priced for a mid-cycle environment, Figure 5 shows how several fundamental variables we track are much weaker today.
Our credit-based recession model implies a 20% probability of a downturn over the next year, moderately higher than in the past two mid-cycle expansions. Perhaps surprising to most investors, weaker corporate earnings are the culprit. To reiterate, we look at US aggregate non-financial corporate profits from the US GDP report, which is a broader measure of pre-tax earnings than that from common equity or credit market indices. To put in terms of the S&P 500, unless the earnings rebound broadens beyond technology, financial, and energy firms (sectors with poor leading properties in the past two late cycle environments), downside credit risks are likely to remain elevated. The US GDP report next Thursday will be instructive in zeroing in on the specific sectors driving the weakness in Q1 GDP-based earnings.
In addition, suppliers of trade payables from the Credit Managers Index (CMI) continue to report a worsening use of collection agencies (ticker: NACCA/RC Index); this worsening has now occurred for 12 consecutive months (i.e. readings below 50 in the index), hardly consistent with prior periods (Figure 6).
Empirically, the usage of collection agencies has tended to slightly lead overall conditions in the Credit Managers Index, which we utilize extensively to gauge non-bank lending conditions.
Lastly, sector differences make US high-yield vulnerable relative to US investment grade. US high-yield has notably more energy & mining exposure (21% vs. 13%), and consumer discretionary exposure (14% vs. 7%) than US investment-grade. US IG exposure is highly tilted to financials, a sector that can do well when our credit signals are flashing yellow, but not red (Figure 7).
HY energy spreads are still trading tight relative to the overall index, even though some initial weakness has been seen in recent weeks (Figure 8).
If 12-month forward WTI hits the $40-45 range, this could cause a more rapid re-pricing as breakeven WTI levels will be breached for HY E&P firms. By contrast, US IG energy firms are more insulated, given a greater exposure to less oil sensitive MLPs, and more room to reduce capex if oil prices remain weaker than expected." - source UBS
Of course, we agree with most of the above, and indeed, the current risk reward with ongoing pressure on oil pressures validates even more our tactical negative stance on High Yield and our preference in quality (ratings that is) rather than quantity (yield chasing). When it comes to Goldilocks principle and the much talked about risk-parity strategies, the ongoing low volatility regime as the one that can be inferred by looking at the MOVE index on Bloomberg (The Merrill lynch Option Volatility Estimate Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options which are weighted on the 2, 5, 10, and 30-year contracts) clearly indicates a Goldilocks environment for these strategies currently. The key element for this low volatility markets is not only understanding that complacency is very high but also understanding that complacency can remain high for extended periods (sorry dear bond bears). After all, we have been remaining "Keynesian" bullish for the entire first part of 2017, but for the second part of the year, we remain cautious hence our defensive stance while more "Austrian" bearish from a longer term perspective.
Right now, flows remain very supportive for Investment Grade credit, not only thanks to retail being late comers to the show but there has been as well a noticeable return of foreign investors into US credit as indicated by Bank of America Merrill Lynch in their Credit Market Strategist note from the 23rd of June entitled "On a slippery slope":
"Final flows data for May
On Friday our vendor released the final data on US fund and ETF flows for the month of May. The inflow to high grade rebounded to $30.3bn from $17.9bn inflow in April, approaching the record $36.3bn inflow in March. The strong reading in May brings the year-to-date total inflows to high grade funds/ETFs to $134.7bn, 207% over the same period last year. Relative to April, inflows in May improved for both short-term (to $6.9bn from $1.9bn) and outside of short-term (to $23.4bn from $16.0bn, Figure 13).
After foreign investors drove the big acceleration in HG bond fund/ETF inflows to begin the year, retail money has returned in the usual way - chasing performance (Figure 14, see: ECB+BOJ>Fed, redux).
Data on daily flows also suggests that inflows in June so far have been steady (Figure 15).
Finally, note that flows data on the full universe of mutual funds and ETFs is released monthly with about a two week lag. A subset of funds and ETFs accounting for about half of the total AUM report flows more frequently, such as daily or weekly." - source Bank of America Merrill Lynch
Whereas inflows into Investment Grade continue to be solid, as of late there has been a weaker tone in both loans and High Yield according to Bank of America Merrill Lynch:
"The biggest change in flows was in high yield, where an outflow of $1.23bn followed a $0.94bn inflow the week before."
- source Bank of America Merrill Lynch
As we posited above, when it comes to Goldilocks principle, you should take notice that the Fed is currently envisaging changing its "porridge" recipe, you have been warned. Also, something the Goldilocks story told us, you don't want to wait for too long for the three bears to return. While it might not be the right time to do like Goldilocks, to waking up with a fright to reality when she sees and hears the bears and jump from the bed and run away as fast as you can, but it does mean that you should take notice of the change of tone of the doves turning as of late into hawks, at least that's what the US flattening of the yield curve is telling you we think.
While the Goldilocks principle has led so far to a very favourable environment for risk-parity strategies and unquenchable yield hunters, there is one segment which has fared fairly poorly in recent years, and it has been US Corporate Pensions as per our final chart.
Final chart - US Corporate Pensions? Stuck in the Middle with You
Our reference for our bullet point is of course 1972 song by Stealers Wheel which was used in Quentin Tarantino 1992 debut film Reservoir Dogs during the scene in which the character Mr. Blonde (played by Michael Madsen) taunts and tortures bound policeman Marvin Nash (Kirk Baltz) while singing and dancing to the song. In similar fashion, despite the rally in stocks and modestly higher Treasury Yields, US Corporate Pensions have been taunted and tortured and have not in any way managed to plug their funding gaps. No wonder General Motors (NYSE:GM) will raise $3 Billion in debt to fund pensions. The final chart comes from a Wells Fargo (NYSE:WFC) Rates Strategy note from the 23rd of June entitled "Balancing Act". It displays the dismal fact that no matter our rosy it has been for some asset allocators, US corporate pension funds aggregate funding ratio saw no improvement in 2016:
"U.S. Corporate Pensions Are Stuck in the Mud
- The corporate pension solvency ratio remained unchanged at a dangerously low 81% in 2016 despite a rally in risk assets and moderately higher Treasury yields
- The long-running shift from "risky" assets into high-quality bonds probably has contributed to pension underperformance.
- We continue to see a pullback from fixed income and moderate re-risking among corporate pensions. The 2016 company data appear to validate this view.
Higher equities and Treasury yields fail to improve status-quo
Higher stock prices and bond yields are supposed to be a good thing for U.S. defined benefit corporate pensions. From this perspective, the current state of affairs among company pension funds is particularly disheartening. S&P 500 returned almost 12% in 2016, while 10y Treasury yield rose 16 bps. Yet the large universe of corporate pensions we track saw no improvement in its blended solvency ratio last year. The average figure ended the year right where it started: with a gaping 19% funding deficit (Figure 11).
Has the situation improved much thus far in 2017? Our estimates show only a negligible 1% rise in the solvency ratio (Figure 11). Worse, the 82% funding level is the mean across all companies we track, meaning that plenty of pension funds have even lower solvency ratios. Those with deficits reaching 30% or higher may not be able to remain solvent without major injections of capital from the parent companies.
Half-trillion dollar total funding gap?
Low solvency ratios translate into staggering shortfalls in dollar terms. Figure 12 shows the $420 billion funding gap for our pension universe at the end of 2016. We suspect the shortfall would worsen if we included all companies. According to our assessment, U.S. corporate pensions' funding gap is near 2.5% of the nation's GDP. Policymakers take notice: corporate pension deficits could grow into another major challenge to U.S. fiscal health. A significant portion of unfunded company pensions could end as the taxpayer's responsibility via the statutory backstop provided by the Pension Benefit Guarantee Corporation (PBGC), a U.S. government agency." - source Wells Fargo
No matter how the Goldilocks principle has played out for some thanks to the "Wealth Effect", it seems that US Corporate Pensions shifted away from "risky" assets into fixed income with the blended allocation to bonds from Wells Fargo universe (which includes roughly 470 companies from the Russell 2000 index with pension liability of at least $100 million each) jumped from 29% just before the credit crisis to 41% at present while allocation to stocks plummeted from 58% to 35%. It seems they didn't get the memo and missed out on both sides, while lower for longer yields always cause the present value of pension liabilities to go up. On top of that, the rising cohorts of retiring "baby boomers" is in similar fashion to Mr. Blonde's abilities in Tarantino's movie is inflicting additional acute pain to pension funds having to face rising "capital calls". US Corporate Pensions are truly stuck in the middle we think...
"Only when the tide goes out do you discover who's been swimming naked." - Warren Buffett