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Presenting SocGen's "Most Frightening Credit Chart"

"I sometimes feel like ‘The Grim Reaper’, scouring the research savannah in a ghoulish quest to harvest bad news with a forceful sweep of my scythe. Imagine then my perverse delight when our credit team produced what is one of the scariest charts I have seen for a very long time. Markets shrugged off the Brexit vote in a couple of days. They shrugged off Donald Trump’s election in a single day. They shrugged off the Italian Referendum result in a couple of hours. Heck, in this mood they would shrug off an alien invasion of planet Earth. But global political risk is now at such elevated levels that investors must surely be on another planet."

      - Albert Edwards

 

Has the reflationary blow to bond markets from “Trumpflation” and the euphoria in global equities tempered Soc Gen’s Albert Edwards’ decades long "Ice Age" bearishness?  Not a chance, as he explains in his latest note “Presenting our credit team’s most frightening chart”. In contrast, Edwards admits to the “perverse delight” at his discovery of the aforementioned chart which reassures him that global risk is at such elevated levels that “investors must surely be on another planet.”

While our take has generally been that it’s central bankers that are on another planet - the rest of us merely forced to play on it - we know what he means.

The chart below was created by Edwards’ colleague in EM credit, Guy Stear, who the former describes as “unlike this author he is a normal, well-adjusted person not prone to uncontrolled outbursts of bearish hyperbole. And people actually like him!” It shows the comparison between Global Economic Policy Uncertainty (EPU) and Global Credit Spreads.

The EPU is the work of three American academics, Messrs Baker, Bloom and Davis (BBD). Along with global credit spreads, the EPU peaked in 2008 and 2011, but the correlation has broken down.

As Edwards explains:“The EPU index is up at all-time highs, but spreads are at the median levels of the period going back to 2008. The chart implies that given the current level of economic policy uncertainty, global spreads should be twice as wide. This ought to worry the bulls.”

The report provides a link to the EPU creators’ website www.policyuncertainty.com. We were took a quick look at their methodology and, without getting in to too much detail, BBD scan leading newspapers in 12 countries (including all of the G-10) for certain key terms. As they explain for the US:

“Our index reflects the frequency of articles in 10 leading US newspapers that contain the following triple: ‘economic’ or ‘economy’; ‘uncertain’ or ‘uncertainty’; and one or more of ‘congress’, ‘deficit’, ‘Federal Reserve’, ‘legislation’, ‘regulation’ or ‘White House.”

The Global EPU is calculated as a GDP-weighted average of “monthly EPU index values for US, Canada, Brazil, Chile,UK, Germany, Italy, Spain, France, Netherlands, Russia, India, China, South Korea, Japan, Ireland, and Australia, using GDP data from the IMF’s World Economic Outlook Database.”

It seems that BBD’s Global EPU is suddenly getting some traction among the investment community as it was only two hours before we read Edwards’ new report that we saw the chart below on the twitter page of Maleeha Bengali (of MB Commodity Corner). This time, we see the EPU versus the VIX.

So, we are led to the conclusion that we’re all too well aware that, courtesy of the interventions of our central banking friends, asset prices are significantly under-pricing risk…no matter how much and for how long they deny it. 

Divergences abound in the markets currently, and the recent surge in bank equities has led to charts like the ones below. First, Goldman’s  CDS (green line) versus the equity (white line).

Second, the same chart for Deutsche Bank.

So one might ask…what is the best measure of risk? One which also reflects the actual and relative impact of central bank policies including rate divergences, QE or no QE, funding requirements in major currencies and regulation. 

The answer? It’s the dollar…and it’s something we’ve argued in detail twice in only the last three weeks.

Firstly, in “The VIX Is Dead: According To The BIS, This Is The New "Fear Indicator", we highlighted the BIS report, “The bank/capital markets nexus goes global” BIS' head of research, Hyun Song Shin, argued that the negative relationship between leverage and the VIX had broken down and:

“The mantle of the barometer of risk appetite and leverage has slipped from the VIX, and has passed to the dollar."

The following day in “Dollar Illiquidity Getting Critical: A $10 Trillion Short Which The Fed Does Not Understand”, we discussed a report from ADM ISI which argued that:

“The price of the dollar acts like a ‘Global Fed Funds Rate.’ A rising dollar tightens economic conditions globally, adding considerable deflationary pressure…”

So, logically…

If the US dollar (yellow line) and the Global EPU (white line) are valid methods for more accurately measuring risk, it should follow that…

Putting it another way…Quod Erat Demonstrandum.

The problem is the ability/cost for regional banks and borrowers (especially in EM)  to continue rolling over the funding of more than $10 trillion of offshore dollar debt when the value of the dollar keeps rising and big Eurodollar banks (e.g. Citi, JPM, BoA, HSBC, etc) are less willing to offer dollar balance sheet due to regulation/risk aversion.  

Since the problem is being exacerbated by policy divergence between the Fed and other major central banks, more stringent regulation they are implementing and the lack of a dollar swap facility between Fed/PBoC, we leave it up to readers to decide who will be responsible when something goes wrong.