Morgan Stanley: Our Conviction Has Only Grown Stronger That "Easy Is Over".

In our Global Strategy Mid-Year Outlook: The End of Easy, published in mid-May, my research colleagues and I suggested that multiple tailwinds from the last nine years were abating. While the outlook for macro economies remained promising, the outlook for risky assets was less so. A structural tightening in monetary policies, led by the total size of global central bank balance sheets peaking in mid-2018, stood at the heart of our concerns.

Now that we have entered the second half of the year, it makes sense to reassess this view. In short, our conviction has only grown stronger that easy is over. Monetary conditions continue to tighten across the globe, led by those in the US. What's more, financial conditions are tightening as well. The Fed's balance sheet normalization process not only continues, but accelerates this quarter and next. The caps that limit the amount the Fed's balance sheet can shrink by increase from US$30bn in 2Q18 to US$40bn this quarter. Then, in the final quarter of the year, the caps increase to US$50bn where they max out.

As the caps go up, so too does US Treasury issuance. As the Treasury supply related to balance sheet normalization hits the market, it soaks up the cash that may have otherwise gone into riskier assets. It's the once positive portfolio balance channel effect from the Quantitative Easing (QE) era – which supported risky assets all throughout that period – in reverse. QE has become QT (Quantitative Tightening) in the US. At the same time, the positive portfolio balance channel effect from the European Central Bank (ECB) is set to diminish further. On the ECB's own guidance, QE will be done by year-end.

Sounds complicated? It may get more so next year.

Earlier this week, several of my colleagues and I came out with a view that the Fed's balance sheet may not shrink as much as most people expect. We believe that the Fed will halt the normalization of its balance sheet by September 2019 and start growing it again in 2020 to ensure that the effective fed funds rate remains within the range the Fed targets.

We expect the Fed's System Open Market Account (SOMA) portfolio to be just above US$3.8 trillion at the end of 2020. In contrast, primary dealers and market participants polled by the New York Fed place a 68% and 60% probability, respectively that the SOMA portfolio will be smaller than US$3.5 trillion at the end of 2020.

Importantly for markets, we expect the Fed to begin guiding investors toward the end of balance sheet normalization in the minutes of its December 2018 meeting. While December may seem ages away, the topic is sure to be increasingly on the minds of FOMC participants into year-end. This raises the risk that guidance may come earlier than we expect.

To be sure, we do not believe that a technical adjustment to the size of the balance sheet will alter FOMC participants' views on appropriate rate policy. Balance sheet normalization will continue into next year even if the Fed ends the process earlier than it anticipated originally.

Junk Bond Crash Imminent? HY ETF Shorts Hit All Time High

It has been a tough year for junk bond funds, if not for junk bond spreads, which as we noted recently have shown impressive resilience and have solidly outperformed IG since the start of the year (largely thank to a scarcity in HY supply, and a deluge of IG bond issuance to fund a new M&A cycle as Goldman discussed last week).

Meanwhile, as junk has refused to sell off, junk bond funds have been far less lucky, and the constant stream of outflows that began before the start of 2018, hit a record 34 weeks of outflows at the start of July (it did however reverse last week, with a modest $0.5 inflow) prompting many to ask where is the high yield bid coming from?

To be sure, much of the negativity surrounding HY funds is the result of growing "late cycle" fears for credit (as discussed most recently last week), which according to Morgan Stanley willpeak in just two months (and in December for stocks)...

... coupled with concerns about Trump's global trade war.

Meanwhile, in a surprising development, even as junk bond spreads have failed to widen alongside their IG peers, investors are growing convinced it is only a matter of time before the junk bond market suffers an "event."

But first, a quick trip down memory lane: investors will recall that immediately before and after the market VIXplosion on February 5, when countless vol ETFs imploded as a result of massive short gamma exposure to the VIX, one of the side effects was a surge in high yield ETF short interest as many were convinced that the vol-induced market shock would promptly slam junk bonds next. This is what JPMorgan wrote at the time:

Both HYG and JNK short interest are at their highs for the period we track data from, suggesting that institutional  investor participation via shorting ETFs has contributed to the sell-off in recent weeks. This is similar to the rise in the short interest ratio on the largest investment grade corporate bond ETF, LQD, which has moved higher during the same period this year, albeit from very low levels.

To the surprise of many, this did not happen, however the lack of a HY crash appears to have only cemented the bearish bias, because fast forward 6 months to today, when according to the latest JPMorgan Flows and Liquidity data the short interest in Global HY ETFs as a % of outstanding shares, is on the verge of hitting 25%, and is by far the highest on record.

How should one read this peculiar divergence in the data: on one hand, the record HY shorts point to the risk of a sharp blow out in credit spreads in the coming weeks should risk-off sentiment return, if traders start selling ahead of the ECB's QE end at the end of the year, if trade war escalates further and hits the high beta credit space, or alternatively, if oil and energy names - all heavily represented in the junk bond sector - tumble as a result of a drop in oil.

Alternatively, should a negative catalyst not emerge, the risk for the shorts is one of a historic squeeze, and one which also collapses spreads to record tights.

Needless to say, the first outcome is more concerning from a broader, market perspective. And while a move wider in spreads would not be catastrophic, it could still lead to a broad liquidation panic at the synthetic credit level, at which point the main risk becomes the underlying threat latent within all ETF products, first voiced by Howard Marks in March 2015: "what would happen, for example, if a large number of holders decided to sell a high yield bond ETF all at once?" This is how Marks answered his own question:

in theory, the ETF can always be sold. Buyers may be scarce, but there should be some price at which one will materialize. Of course, the price that buyer will pay might represent a discount from the NAV of the underlying bonds. In that case, a bank should be willing to buy the creation units at that discount from NAV and short the underlying bonds at the prices used to calculate the NAV, earning an arbitrage profit and causing the gap to close. But then we're back to wondering about whether there will be a buyer for the bonds the bank wants to short, and at what price. Thus we can't get away from depending on the liquidity of the underlying high yield bonds. The ETF can't be more liquid than the underlying, and we know the underlying can become highly illiquid."

Of course, there is the very real possibility that "someone knows something", and is putting on a massive short bet, even as the broader market refuses to budge. In any event, based on the record accumulation of junk bond ETF shorts, we may soon find out if Marks' "worst case" scenario plays out as envisioned, and what exactly happens when everyone tries to sell a synthetic product that is far more liquid than its underlying constituents, especially during a market panic., or alternatively, a historic short squeeze.

World's Largest Shipping Company Collapses As Trade War Reality Strikes

While US equity markets (well a few mega-cap tech stocks anyway) have remained resilient in the context of rising protectionist fears, the world's largest shipping company is seeing its stock eviscerated as investor anxiety over trade wars finds an outlet that makes rational sense.

A.P. Moeller-Maersk A/S may struggle to make a profit this year after the U.S. and China descended into a trade war that is already showing stress in sentiment surveys.

As Bloomberg reports, Maersk, which is based in Copenhagen, has already lost almost a third of its market value this year as investors gird for more bad news, and it is losing value in line with the collapse in the US Treasury yield curve.

Trade protectionism means less demand, and history suggests the shipping industry will struggle to make the necessary supply cuts. What's more, Maersk is now more exposed to shipping as the former conglomerate divests its energy business.

Per Hansen, an investment economist at Nordnet in Copenhagen, saysMaersk is currently "in the eye of the hurricane" when it comes to the damage that will be inflicted by a trade war.

The company said earlier in the week it will need to temporarily scale back its service between Asia and North Europe as a result.

"It's highly likely that Maersk's valuations could sink to its trough valuations in the coming months as investors avoid shipping stocks until more excess capacity is being removed," said Corrine Png, chief executive officer and founder of Crucial Perspective, a Singapore-based research provider focusing on transport.

So just keep buying Amazon and Netflix, oh and for good measure, keep buying bonds.

The Market Gods Are Laughing

President Trump escalated the trade war this week, making a kamikaze attack on a vast armada of Chinese imports – $200 billion in total – headed for California.

The Chinese say they will retaliate.

Phony Wars

Last month, we opined that the trade war wouldn't go any better than Vietnam… or Iraq… or any of the feds' other phony wars – against drugs, poverty, or terrorists.

It will be expensive, futile… and perhaps disastrous.

But that doesn't mean it won't be popular. Wars give the spectators something to live for – us versus them… good guys against bad guys… winners versus losers.

Their hat size swells as their champion wallops the Chinese. Their girth shrinks as he challenges and taunts the Canadians. Their manhood grows when the enemy gives in and admits defeat.

But while this puerile entertainment is taking place in the arena, the real action is going on in the expensive skyboxes, where the elite collude against the fans.

Wars shift resources from the boring and productive win-win deals in the private sector to the magnificently absurd win-lose deals of the feds and their cronies. The only real winner is the Deep State.

Weatherman David

We saw our colleague, former U.S. budget chief under President Reagan, David Stockman, on TV this week. The interview was painful to watch.

He was bravely trying to explain the trade deficit and why it was caused by monetary policy, not by trade ramparts that were too low.

But the young, know-it-all newscasters were such numbskulls – so lacking in any experience, theory, or historical perspective – he might as well have been instructing a walrus on how to chew gum. The lesson was in vain.

The three TV experts saw no problem with the trade deficit… and no danger approaching from Trump's war on it.

If there were any clouds on the horizon, they didn't see them; if there was any thunder, they didn't hear it; whether lightning was striking the light posts near them or not, they had no idea. They wouldn't even look out the window.

Instead, they seemed eager to get Weatherman David out of the studio so they could go back to their bubble chatter.

They were so confident… so vain… and so dismissive of all risk…

…we thought we heard a bell ringing.

Bubbleheads

The bell, of course, was the one they don't ring just before the market collapses. They don't ring it because they are all sure that nothing could go wrong. And there hasn't been any real trouble for so long that they've forgotten where they put it.

Trade deficits have been growing ever since the U.S. went off the gold standard in 1971 (while tariffs have been going down!).

The stock market has been going up (with only three significant slips… in 1987, 2000, and 2008) since 1982.

The bond market, too, has been rising since 1980 (though it probably topped out two years ago).

The current GDP expansion has been going on since 2009 – and is now the second-longest expansion in history.

And the USA has been a going concern, growing in power and wealth since 1781, when the French beat the English at Yorktown, Virginia and thereby rescued the American Revolution.

All of these trends – except the current economic expansion – are older than any of the three bubbleheads David confronted on CNBC. David had to give them a "heads up" on trends: "They go on until they stop," he warned.

Market Gods

We could practically hear the cackling of the market gods as the twits on TV assured David that nothing could go wrong:

"Oh yeah?"

Will the economy suddenly tip into recession? Will the stock market crash? Will the bond market sink?

Yes… most likely… all of those things will happen.

But what will set them off? What trick will the gods play? What trap will they set? What surprise have they got waiting for us?

We don't know. But the trade war gives them more to work with.

Tariffs on lumber coming from the evil Canadians are adding about $9,000 to the cost of a new house, according to the National Association of Home Builders.

Washing machine prices have jumped some 15% this year, the fastest increase ever recorded by the Bureau of Labor Statistics.

As for auto prices, CBS News reports:

Consumers may see an average price increase of $5,800 if a 25 percent import tariff that Mr. Trump has threatened goes into effect, according to estimates cited by the Alliance of Automobile Manufacturers (AAM), a lobbying group for carmakers.

That's a "$45 billion tax on consumers," the group said, citing an analysis of Commerce Department data.

Automotive news website AutoWise says the top 10 best-selling automobiles will see price increases from $1,000 to $3,600.

Farmers are getting hit hard, too.

The American Farm Bureau says it expects farm incomes to drop to a 12-year low this year, largely because of the trade war.

An agricultural economist at Purdue University, Christopher Hurt, added that 1,000 acres ofcorn and soybeans would have made a farmer a $42,000 profit on June 1. Now, it could net him a $126,000 loss.

Still, small potatoes? Maybe.

They don't ring a bell when the end comes. But they do put bubble-brains in front of TV cameras.

China GDP Growth Slows After Record Contraction In Shadow Banking Credit

Following the largest contraction in 'shadow banking system' credit, and a record low for M2 growth, fears were building that China's economic growth prospects may lag expectations.

By way of background for tonight's economic data deluge, here are the lowlights.

The drop in shadow bank was particularly sharp for the second month in a row: this has been the area where Beijing has been most focused in their deleveraging efforts as it's the most opaque and riskiest segment of credit. And, as the chart below show, the aggregate off balance-sheet financing posted its biggest monthly drop on record in June

the lass granular M2 reading also posted a growth slowdown, rising only 8.0% in June, down from May's 8.3%, below consensus of 8.4%, and the lowest on record.

Both of which do nothing to help China's credit impulse. Investors see China's liquidity tightening...

Commenting on the ongoing slowdown in China's credit creation, Goldman said that the latest money and credit data highlighted the challenges the government is facing in loosening monetary policy.

But before we shift to the market's perceptions, don't forget, China's trade surplus with the US just hit a Trump-tantrum-creating record high...

Oh, and don't forget, Chinese stock markets have tumbled...

And bond markets have collapsed as defaults surge...

And Yuan has plunged...

So the big picture was not rosy heading into tonight's big data deluge.

Early signs for June pointed to weakness. The official and Caixin PMIs indicated a slowdown in momentum – with export order gauges weakening.

China stocks were down, Yuan flat, and China 10Y bonds 3bps lower in yield as the data hit.

And this is what the data looked like..

• China Q2 GDP YoY MET EXPECTATIONS rising 6.7% - equal to the weakest since Q1 2009 (against expectations of +6.7% but slowing from Q1 growth of 6.8% YoY)

• China Retail Sales YoY BEAT rising 9.0% (against expectations of +8.8% and notably up from May's 8.5% YoY - the lowest since May 2003)

• China Industrial Production YoY MISS rising just 6.0% - weakest since Dec 2015(against expectations of +6.5% and well down from May's 6.8% YoY)

• China Fixed Asset Investment YoY MET EXPECTATIONS rising 6.0% - the lowest on record (against expectations of +6.0% and down from May's 6.1% YoY - record low)

Visually - down and to the left...

Not pretty. It is clear that momentum in the world's second-largest economy is slowingamid deleveraging and intensifying trade friction with the US...

Though there is one silver-lining, as Bloomberg's Enda Curran notes, the rebound in retail sales is noteworthy as it's an indicator of confidence in the wider economy. Granted it was from a low base in May, but it shows that consumer confidence is holding up, despite the trade tensions - although auto sales are down 7% YoY (and petroleum is up 16.5% YoY). Also bear in mind that retail sales print is likely flattered by the fact that the yuan tumbled over 4% from end May through June.

In case those charts look a little odd to you, they do to us too... and amid the world's craziest decade ever in terms of monetary policy experimentation, extremes of leverage and debt, nuclear armageddon proximity, and now global trade wars, somehow, China has managed to crush all uncertainty out of its business cycle...

It's almost as if they rigged it?!

In many respects today's numbers are already history (with most analysts expecting China to have an overall 'OK' first half of the year), it's the second half that will be tougher.

Huatai Securities estimated in a report over the weekend that if the U.S. implements its tariff plan on $200 billion of Chinese imports, China's exports growth should decrease by 0.8 percentage point and GDP growth by a quarter percentage point.

Finally, as a reminder,  if investors are hoping for China to reflate its way back out of this, Chinese billionaire Zhang Baoquan has a warning (via iFeng: 张宝全：中国人缺乏投资工具 把不动产当硬通货 = Zhang Baoquan: Chinese people lack investment tools, and real estate is hard currency.)...

"China now has two 'bombs', one 'bomb' is a real estate bubble and the other is a local debt. Any explosion to the Chinese economy is devastating."