Zollverein

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by: Macronomics

"An empire founded by war has to maintain itself by war." - Montesquieu

Watching with interest the evolution of the Brexit negotiations in conjunction with the tone down stance between Italy and the European Commission surrounding the budget, while waiting for the next G20 and potential US and China ease in trade war tensions, when it came to selecting our title analogy, we reminded ourselves of the Zollverein, or German Customs Union. The Zollverein was a coalition of German states formed to manage tariffs and economic policies within their territories, organized under the Zollverein treaties in 1833 and formally starting on the first of January 1834.

The foundation of the Zollverein was the first instance in history in which independent states had consummated a full economic union without the simultaneous creation of a political federation or union. The original customs union was not ended in 1866 with the outbreak of the Austro-Prussian War, but a substantial reorganization emerged in 1867. The new Zollverein was stronger, in that no individual state had a veto.

The Zollverein set the groundwork for the unification of Germany under Prussian guidance. After the defeat in 1918, the German Empire was replaced by the Weimar Republic and Luxembourg left the Zollverein. The rest, as we usually say, is history...

In this week's conversation, we would like to look at what the latest widening in credit spreads mean in terms of outlook for 2019.

Synopsis:

  • Macro and Credit - So, you want to short credit?
  • Final charts - Change is in the air for global asset markets

Macro and Credit - So, you want to short credit?

While we touched in our previous conversation on the widening of credit spreads in general and the impact of falling oil prices on high beta US High-Yield CCCs in particular, there has been a lot of chatter recently around the lofty valuations in leveraged loans in conjunction with the fall in prices of the asset class.

Sure, no doubt US High-Yield CCCs are in the line of fire when it comes to its exposure to the Energy sector:

Source: Bank of America Merrill Lynch

Oil prices and US High-Yield are highly connected (15%). The CCC bucket is feeling the pain right now with 20.1% of exposure to the Energy sector:

Graph source: Bloomberg

For sure US High Yield being "high beta" no wonder they raced ahead of the pack when it was a good time to be long Oil. Given the recent unwind of the speculative long positioning in oil and clear deterioration in the global growth narrative, no wonder credit in general and high beta in particular is starting to feel the heat and there is more "heat" to come as per the below chart from FactSet displaying the S&P 500 Energy Forward 12-months EPS vs Price of oil for the last 20 years:

Graph source: FactSet

As well, we argued in the past that the growth divergence between US and Europe were due a difference in credit conditions.

The divergence between US and European PMI indexes is all about credit conditions. This is why the US is ahead of the curve when it comes to economic growth compared to Europe. We have shown this before but for indicative purposes we will show it again, the US PMI versus Europe and Leveraged Loans cash prices US versus Europe - source Bloomberg from our November 2013 conversation "In the doldrums":

Graph source: Bloomberg

There is a clear relationship we think between credit and macro from our perspective. Today the picture is more contrasted.

While previously the data for Europe's aggregate PMI was more easily available, the below charts points to a faster deterioration in global growth in Europe (red line), while in the US given the credit cycle is more "advanced," Leveraged Loan prices have started in the US to fall faster than in Europe (blue line):

Graph source: Bloomberg

Many financial pundits and central bankers are clearly worried, for good reason about the froth in the Leveraged Loan markets as we are seeing not only prices falling rapidly, but the growth of the sector has been significant as per the below chart from LCD, an offering of S&P Global Market Intelligence displaying the rapid growth in US Loan Funds Assets Under Management:

Graph source: LCD, an offering of S&P Global Market Intelligence

As we pointed out again in our last conversation, our readers know by now that when it comes to credit and macro, we tend to act like any behavioral psychologist, namely that we would rather focus on the "flows" than on the "stock." As pointed out by the website "LeveragedLoan.com," outflows in both leveraged loans and high yield are starting to "bite":

"Investors Withdraw $2.2B from US High Yield Bond Funds, ETFs

U.S. high-yield funds reported an outflow of $2.19 billion for the week ended Nov. 21, according to weekly reporters to Lipper only. This result reverses positive readings in the prior two weeks, and brings the year-to-date total outflow to roughly $26.5 billion.

The year-to-date total exit continues to mark an unprecedented outflow from high-yield funds, outpacing last year's total outflow of roughly $14.9 billion, which stands as the largest exit on an annual basis to date.

Mutual funds led the way, posting their largest outflow since February at $1.51 billion. ETFs saw another $682.4 million pulled by investors during the observation period. The four-week trailing average narrowed marginally to negative $427 million, from negative $470 million in the prior week.

The change due to market conditions was a decrease of $1.49 billion, according to Lipper. Total assets at the end of the observation period were roughly $193.4 billion. ETFs account for roughly 22% of the total, at $41.8 billion. - Jon Hemingway

US Leveraged Loan Funds See Hefty $1.7B Cash Outflow

U.S. loan funds reported an outflow of $1.74 billion for the week ended Nov. 21, according to Lipper weekly reporters only. This is the second major outflow of the past four weeks, and just the eighth negative reading of 2018.

Last week's outflow was the heaviest since the week ended Dec. 16, 2015 ($2.04 billion) and comes just three weeks after a $1.51 billion exodus over the last week of October (this excludes a nominal $1.3 billion mutual-fund outflow for the week ended Nov. 8, which came as the result of a reclassification at a single institutional investor).

With that, the four-week trailing average slumps to $767.8 million, its lowest level in nearly three years.

As with the other recent outflow, mutual funds led the way with $1.07 billion pulled out, while the total for ETFs was roughly $673 million. For ETFs that is the largest exit on record behind the $551.5 million loss for the week ended Oct. 31. Of note, ETF flows were positive in the weeks between, whereas mutual fund flows were negative for the fourth consecutive week.

While last week's outflow puts a dent in the year-to-date total inflow, it remains a substantial $8.6 billion.

The change due to market conditions last week was a decrease of $774.3 million, the steepest decline since Dec. 16, 2015. Total assets were roughly $105.5 billion at the end of the observation period and ETFs represent about 11% of that, at roughly $12.1 billion. - Jon Hemingway - source LeveragedLoan.com

The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, lost returned -0.52% in the month to date and 3.46% in the YTD. Sure, some pundits would like to point out that contrary to the dismal performance of credit in 2018, in similar fashion to 2008 as indicated by Driehaus on their Twitter feed:

"YTD return is negative on each of the main US credit indexes (High Yield, Investment Grade and Aggregate). 1st time since 2008 that returns for all 3 indexes are negative through mid-November. Lately, I find myself saying "first time since 2008" a lot more frequently" - graph source Bloomberg - Driehaus - Twitter feed.

Sure, the S&P/LSTA U.S. Leveraged Loan 100 Index is roughly around +3.5% YTD, so still overall unscathed some would argue. Also in 2008, the index was down by a cool -28%, for perspective but we do think that if you want to go "short" credit, then indeed Leveraged Loans are a "prime" candidate" as pointed out by Peter Tchir in a July 2018 tweet:

"Many forget LCDX traded worse than HYCDX during 2008 due to positioning and then loans were more clearly senior." - source Peter Tchir, Twitter

Given the considerable size in Cov-Lite Loans in this credit cycle, then indeed, if the credit markets start unravelling, Leveraged Loans are clearly in the front line:

Graph source: Bank of America Merrill Lynch

Of course, Leveraged Loans are starting to follow the painful path of other segments of the credit markets already in conjunction with global growth decelerating:

"Those of you glued to action in US equities to guide investment positions may want to devote some attention to this chart of returns to senior leveraged loans (SRLN) in excess of T-bills. Likely to be an epicenter of action in the next crisis, and currently breaking trend." - source Adam Butler - Twitter feed

Clearly, if indeed credit markets start "breaking bad" in 2019, then for those of you not having the necessary ISDA to short the synthetic LCDX index could use ETFs to express their "short" view on Leveraged Loans as indicated by IHS Markit by Sam Pierson on the 26th of November in his article "ETF lending continues to thrive":

"Not all ETFs can be created out of borrowed securities, in particular those with exposure to illiquid asset classes. One such example is the Invesco Senior Loan ETF, BKLN, which consists of a basket of leveraged loans. The fund has seen increased demand from short sellers in Q4, with over $800m in current loan balances. Only a small handful of the underlying loans have any availability in securities lending, so borrowing shares from long holders of the ETF is essentially the only means of sourcing the borrow. Lenders have attempted to pass through increased rates, though the increased fees in late October and early November saw an immediate response of returned shares, driving fees lower. Once the borrow fee declined the balances picked up and fees have started to move up again. It's worth noting that BKLN has a 67bps expense ratio, which means that if short sellers can borrow for less than that rate there is an arbitrage assuming no movement in the underlying asset class. Additionally, the YTD increase in OBFR means that short selling any easy-to-borrow asset will result in a positive rebate to cash proceeds."

The $BKLN ETF is a popular way to hedge/short the asset class, in part owing the 67bps expense ratio (short sellers benefit from higher expense ratio, all else equal), though increased borrow costs over the last week may, again, dampen demand." - source Sam Pierson, Twitter feed.

As we have argued in our recent November conversation "Stalemate," Housing markets turn slowly then suddenly, same thing goes with Leveraged Loans as pointed out by Peter Tchir.

The question that everyone is asking when it comes to credit markets as we move towards 2019 and the sell-side is sending out their outlooks is asking ourselves if we will be entering indeed a "bear" market in credit. On this subject we read with interest Morgan Stanley's synopsis and note from their 2019 Outlook for North America published on the 25th of November and entitled "The Bear Has Begun":

"We believe the credit bear market, which likely began when IG spreads hit cycle tights in Feb 2018, will continue in 2019, with HY and then eventually loans underperforming, as headwinds shift from technicals to fundamentals.

A more challenging macro backdrop: In 2018, weakening flows and tighter liquidity conditions served as the key headwinds in credit, but as an important offset, the US economy remained solid. In 2019, we think it gets tougher on both fronts - monetary policy will likely near restrictive territory for the first time this cycle, while the tailwind from a booming economy fades as growth decelerates and earnings growth potentially slows to a standstill. As that happens, late cycle risks may morph into end-of-cycle fears, continuing to break the weak links along the way, especially the more levered parts of corporate credit markets.

Late cycle and beyond: A turn in the credit cycle is not a specific point in time, but instead occurs in stages, over multiple years, beginning when growth is strong. With credit flows turning, financial conditions tightening, and idiosyncratic risks rising, we think that process has already started, slowly for now. And remember, the vulnerabilities in a cycle are always ignored on the way up. As this process continues to unfold and credit conditions tighten, the bull market excesses - this time centered around non-financial corporate balance sheets - should become increasingly clear.

A few silver linings: While we certainly do not think the consensus has embraced the idea that end-of-cycle risks are rising fairly quickly, at the least, sentiment is much less uniformly bullish than it was at the beginning of 2018. Additionally, while spreads are nowhere near where they will likely peak when the cycle fully turns, after the recent sell-off, valuations are not as extreme in places. Both of these factors help at the margin. That said, we very much stick to our bigger picture view that the credit bear market is under way, and until valuations have truly priced in long-term fundamental risks, investors should use rallies to move up-in-quality.

2019 forecasts: In our base case we forecast a -0.8% IG excess return, a 0.5% HY total return and a 1.3% loan total return. We expect $1.24tr, $183bn, and $436bn in IG, USD HY, and institutional loan gross issuance, respectively. Lastly, we project a 2.9% HY default rate.

Recommended positioning: In IG we prefer As over BBBs, Fins over non-Fins, the front-end of the curve, low $- priced bonds, US over European banks, and European over US BBBs. In HY and loans we remain up-in-quality, and prefer short-duration HY bonds. We have a modest preference for loans over HY, but think that view may change later in the year. In derivatives we prefer long CDX risk to cash, owning long-dated vol, positioning for decompression, and buying BBB CDS protection vs index." - source Morgan Stanley

As we pointed out in our previous note, credit mutual flows matter and it probably matters as well for the Fed as well given the most recent dovish rhetoric coming from its chairman Jerome Powell. The latest price action in both the US dollar and Emerging Market equities is giving some much-needed respite to the Macro tourists, who have been on the receiving end of the Fed's QT and hiking policy.

Weakening flows clearly have been a trend this year in credit markets as indicated by Morgan Stanley in their long interesting outlook note:

"Restrictive Fed Policy and Decelerating Growth - a Tougher Combination

Tightening liquidity conditions should remain a headwind in 2019, at least initially, as the Fed pushes rates near restrictive territory, while continuing to shrink its balance sheet at the maximum rate, for now. Taking a step back, for most of 2018, we argued that a tightening in Fed policy, especially in the current cycle, was a material headwind for credit. In a nutshell, central bank stimulus was massive in this cycle, and highly supportive of credit. We thought the process in reverse, at the least, would weaken the flows into credit markets, driving higher volatility, with less of a "liquidity buffer" to cushion the shocks. In our view, these headwinds have materialized, just slowly and in stages. As we show in Exhibit 2 and Exhibit 3, flows into credit markets did weaken in 2018 across multiple sources.

Weakening flows clearly hit global credit markets this past year, one-by-one. For example, Exhibit 4 shows the spread widening in 2018 in US IG, in EM credit, in European credit, and most recently in US high yield, with financial conditions tightening in the process.

As we have frequently argued, fundamental issues are easier to hide when liquidity is flooding into markets, and it is not anymore. As liquidity conditions get squeezed, it is natural for dispersion in performance across asset classes, regions, sectors, and single names to pick up, with the weak links breaking first. US high yield was more resilient for most of the year than other markets, in part due to very low supply, and in part given its close ties to the strength in the US economy. But even HY, the "resilient" credit market, has only managed a roughly flat total return YTD, despite very strong earnings growth, a solid US economy, and supply down ~30%, which we think speaks to the importance of this tightening in liquidity conditions.

Looking to 2019 - two points are key to remember: 1) The liquidity withdrawal is going to accelerate, at first, and 2) unlike in 2018, it will happen as growth is decelerating. We think this will create an even more challenging backdrop, with the outperformance of higher beta credit fading as a result. On the first theme, as we alluded to above, our economists expect two more rate hikes in 2019 (after one more hike in December 2018).

We can debate where monetary policy sits in relation to neutral, but in our view, the flattening in the Treasury curve this past year, the tightening in financial conditions, as well as some of the weakness in key interest rate-sensitive parts of the economy, such as housing and autos, tells us that monetary policy is already pretty close to 'tight.' And remember, this tightening will not be just a US phenomenon going forward, as we see it. The ECB will be done buying bonds next year and hike in 4Q19, and the BoJ and BoE will hike in 2Q19, with the BoJ likely to reduce JGB purchase amounts as well, according to our economists.

But remember, throughout 2018, investors could consistently fall back on the idea that the US economy was booming with extremely strong earnings growth. Hence, it was easier to write off the multitude of macro headwinds (i.e, tighter Fed policy, tariffs, China/EM weakness, Italian politics, etc…) as "noise." Going forward, these dynamics are changing. We expect US growth to decelerate notably, from 3.1% in 2018 to 1.7% in 2019, (with GDP growth of just 1.0% in 3Q19) as fiscal stimulus starts to fade, the interest rate-sensitive parts of the economy (i.e., autos/housing) continue to soften, financial conditions tighten, and tariffs weigh on business investment.

As we show in Exhibit 9, the global economy has already slowed, with the US bucking the trend so far, thanks in part to atypical late-cycle fiscal stimulus, but we think the US will converge to the downside as 2019 progresses.

Even more importantly, our equity strategists expect a material slowdown in earnings growth, with the likelihood of an outright earnings recession for a quarter or two in 2019 reasonably high. In their view, comps get very challenging next year, and margins will compress, with slower top-line growth and costs rising in many places, despite consensus expectations for margin expansion. We think markets are finally waking up to these earnings/growth risks with this recent sell-off.

Yes, 1.7% GDP growth is still manageable, and far from recessionary levels. In fact, one could make the case that this level of growth is ideal for credit - not too hot, not too cold. While we don't disagree at a high level, we think details matter. In our view, slower growth in the middle of a cycle, which drives very accommodative central bank policy, is ideal. A slowdown in growth near the end of a cycle as a result of a restrictive Fed is not, and we think runs the risk that investors start to price in a higher likelihood that the cycle is coming to an end.

With growth slowing, and financial conditions tightening, will the Fed stop hiking? For now, we think the Fed "put" is fairly deep out of the money. Unlike at past points in this cycle, the Fed's hands are more tied, with growth well above trend, unemployment at ~40 year lows, and core PCE now at 2%. That said, our economists expect the Fed to pause its rate hike cycle in 3Q19 and to end balance sheet normalization in Sep-19. For a short period of time, these dynamics could certainly boost sentiment. Longer term, we are not sure that they would be so bullish for markets. If the Fed stops hiking because they are at their perceived neutral rate and they believe inflation trends are benign, that may be positive. But if they stop hiking because the economy is weakening, that may be quite negative. In fact as we show in Exhibit 12, the biggest bouts of spread widening in a cycle, especially in HY, happen from the point when the Fed stops hiking, until deep into the rate cutting cycle, as that is when growth is rolling over.

Regardless of exactly when the Fed pauses, in this cycle, buying when growth is booming has not worked well (Exhibit 13), and we think this time will be no different as the macro backdrop reverts back down to, or even below, trend.

Adding everything up, we think macro challenges will grow in 2019. Monetary policy will continue tightening, with global central banks committed to removing stimulus, for now. All while the environment of very strong US growth and very robust earnings growth will fade. We think that backdrop will become even tougher for credit, especially some of 2018's outperformers like US HY and loans, and continue to expose the fundamental challenges in the asset class built up over nearly a decade-long bull market." - source Morgan Stanley

Rising dispersion has clearly been the theme in 2018 when it comes to credit. The Fed's tightening stance in conjunction with QT and the surge in the US dollar have clearly been headwinds for the rest of the world. Yet the US has shown in recent months that it wasn't immune to gravity and deceleration as the fiscal boost fades in conjunctions in earnings and buybacks. 2018 also marks the return of cash in the allocation tool box and many pundits have started to play defense by parking their cash in the US yield curve front-end. Clearly, the narrative has been changing and as we stated in our previous conversation:

"When the Credit facts change, I change my Credit mind. What do you do, Sir ..." - source Macronomics

Our final chart below indicates that change is in the air for global asset markets and that 2019 could prove to be even trickier than 2018 as the credit cycle continues to gradually turn.

Final charts - Change is in the air for global asset markets

The latest "dovish" take from Fed Jerome Powell's speech is clearly enticing to trigger some short-term rally; we do think that 2019 will eventually be even more challenging as global growth is decelerating. Our final charts come from Bank of America Merrill Lynch from their Commodity Strategies 2019 outlook from the 18th of November and show that there is a trend for higher interest rates and volatility ahead of us:

"Equity markets are sowing winds of change

While higher real interest rates have been a clear headwind to gold, the rise in the global risk free rate also seems to push up equity market volatility. Our equity derivatives team has been warning about this trend of higher interest rates and higher volatility for some time (Chart 134).

True, global equity markets have been a tale of two cities this year, with US equity markets rising and the rest of the world lagging (Chart 135). But the pickup in volatility suggests that change is in the air for global asset markets

A rising VIX will eventually force the Fed to slow...

It is easy to forget that the S&P500 total return index posted a Sharpe ratio of 3.0 last year, but it is running just on 0.5 this year. Of course, the large pick up in equity market volatility (VIX) is hurting risk-adjusted equity market returns (Chart 136).

But also equity markets have struggled to break higher this year on a number of factors. The most important issue for gold here, however, is that a further drop in equity market values could eventually encourage the Fed to slow down its monetary tightening path (Exhibit 6).

So higher equity vol will likely lend support to the yellow metal going forward." - source Bank of America Merrill Lynch

When it comes to our Zollverein analogy, while Italy continues to be a concern, we believe that France should clearly be on everyone's radar as the situation is deteriorating in conjunction with its public finances. It remains to be seen if 2019 will see the New Zollverein aka the European Union coming under pressure as it did in 1919, leading in Germany to the introduction of the Weimar Republic but, we ramble again...

"Look back over the past, with its changing empires that rose and fell, and you can foresee the future, too." - Marcus Aurelius

Stay tuned !