Monday, 25 August 2014

Credit - Tokyo Drift

"As the blessings of health and fortune have a beginning, so they must also find an end. Everything rises but to fall, and increases but to decay." - Sallust, Roman historian

Watching with interest the continuation of the deflationary trend of peripheral yields in conjunction with the brewing turmoil in France given the recent dissolution of the latest government, we decided this week to use a relatively simple analogy, using the 2006 third opus of the "Fast and Furious" movie saga entitled "Tokyo Drift" as our title given the on-going "Japanification" process of Europe.

In fact, this "Japanification" process aka "Tokyo Drift" reminded us of our conversation from March 2012 entitled "St Elmo's fire" where we indicated the following:
"If Europe is moving towards a Japanese decade, there might be at least some solace for Spanish Golf players given that according to Bloomberg there has been a high correlation between Golf Membership fees and Tokyo land prices - source Bloomberg:"
The continuation of the European "adjustment" in similar fashion bodes well for European golfers but we ramble again...

Peripheral yields have been subdued even without the OMT being triggered. In similar fashion, the Euro has weakened without even QE being launched.

In this week's conversation, we will review the acceleration of the deflationary trend we are seeing and what to expect: QE or no QE?


Another sign of the "Tokyo Drift" in the European financial world can be seen in the Eonia which, as indicated by Morgan Stanley in their ECB Tender Tracker note from the 20th of August has been drifting towards Depo:
"Eonia fixing at new lows: Eonia has been fixing at record lows for the past two weeks, with spot Eonia currently being at 0.005% and 1y forward 1y Eonia at 0.042%."
"The next event the market will be watching out for is the first TLTRO take-up on September 18. At the press conference of the August ECB meeting, President Draghi quoted a lower range of the total take-up at the TLTRO from banks’ survey, i.e., €450-850 billion, compared to the ceiling of €1 trillion announced in June. While Draghi may have lowered the ECB’s expectation of the overall take-up at the TLTRO, our bank analysts’ estimates are at the lower end of the range – a total take-up of just €350-650 billion." - source Morgan Stanley
In fact 1 year 1 year Eonia has been trading down to -1.5 bps as of late.


When it comes to the "inflationary" trends in Europe, the deceleration of inflation has been intensified by the volatility in energy/food prices as indicated by Bank of America Merrill Lynch in their note from the 22nd of August entitled "Tracking deflation: more worries":
"HICP fell to 0.4% yoy in July, while it had been expected to be unchanged at 0.5% yoy. Looking at its components, the changes were driven by energy dropping aggressively from 0.1% yoy to -1% yoy. Alcohol and tobacco receded from -0.2% to -0.3% yoy, non-energy industrial goods were stable, while services grew 1.3% yoy, unchanged from June (Chart 6)." - source Bank of America Merrill Lynch

Another significant indicator of the deterioration of inflation expectations in Europe can be seen in spot inflation break-evens in the same report, showing the various maturities falling in concert:
"Spot inflation break-evens have resumed their fall and are now at levels close to 0.5% on a one- and two-year horizon. Five-year break-evens are also falling and stand at around 0.99%.
Forward inflation break-evens computed from swaps also started to fall again and, for the first time, the 5Y5Y forward has crossed the 2% line. - source Bank of America Merrill Lynch

Looking as well at the recent weakness of Euro versus the US dollar, it is for us the continuation of our "Generous Gambler" aka Mario Draghi being very apt in applying some of General Sun-Tzu's greatest concepts following his July 2012 OMT bluff:
“The supreme art of war is to subdue the enemy without fighting.” ― Sun Tzu, The Art of War

To that effect, Mario Draghi has once more played a very smart hand in lowering the Euro without even firing his QE bazooka. We agree with Morgan Stanley's comment from their latest FX Pulse note from the 21st of August that lowering the value of the euro was indeed an obvious monetary policy goal:
"No EUR Value
Meanwhile, the ECB’s policy tools to revive the ailing economy have become a constraint. Lowering the value of the EUR has become an obvious monetary policy goal, explaining why a declining EUR is now taken as a bullish sign by European asset markets. The weakening exchange rate is now an indicator of the success of the ECB’s easing approach. This interpretation makes sense as declining sovereign spreads failed to reduce peripheral private sector funding costs, as shown in Exhibit 3, and implicitly failed to raise private sector credit supply. 
Nowadays, low sovereign bond yields will help reduce the foreign value of the EUR. This is best illustrated by Exhibit 4 showing volatility-adjusted yield differentials no longer support peripheral bond markets."
- source Morgan Stanley

Indeed, declining peripheral yields have not transferred to peripheral private sector funding due to "crowding out" which we discussed a year ago in our conversation "Fears for Tears":
One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.
"Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments
It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

We also commented at the time:
"Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to be tested. But what we are concerned about is, as we indicated in our conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR 
As a reminder: AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase.
"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending." 

So QE or no QE?
Not yet.
We have to agree with Bank of America Merrill Lynch's take from the 19th of August entitled "Rates market still not priced for ECB QE as displayed in their Chart of the Day - 5y5y Euro inflation swap rate - breaking below the 2% level last Friday:
"Inflation swaps point to rising risk of no QE
Last but not least, the past two weeks saw a clear break in the relationship between forward nominal rates and breakevens, with a sharp fall in inflation forwards. While the rally in nominal forwards over the past few months used to be reflected in lower real rates, the last two weeks saw it translate into a drop in inflation forwards. The 5y5y inflation swap rate, closely monitored by the ECB as an indicator of long-term inflation expectations, has crossed the 2% on Friday, for the first time since October 2011 (Chart of the day). The drop in inflation forwards is even more noteworthy given that the end of July/start of August often sees firmness in breakevens because of July index events and the absence of supply." - source Bank of America Merrill Lynch

We also agree with Bank of America Merrill Lynch's comment on the heightened risk of "disappointment":
"Weak GDP but tighter spreads may seem consistent with QE…
Last week, the release of weaker-than-expected 2Q GDP for the Eurozone was still accompanied by a tightening in peripheral spreads. Many interpreted this as the market pricing in increased likelihood of QE. We would disagree with that view. While the weak data places more pressure on the ECB to act, we find the moves in peripheral spreads and other rates products inconsistent with the rates market discounting greater chance of QE. Unfortunately, there is no straight way to measure the probability that the market assigns to ECB QE, and even surveys have indicated a very large range of expectations, depending on investor class (Chart 5).
- source Bank of America Merrill Lynch

From a contrarian stance and from a risk reversal point of view, there is indeed a potential for a correction of the consensus long US dollar trade we think. Particularly when everyone is long gamma on EUR/USD as indicated by Bank of America Merrill Lynch in their note "Trading a new USD vol regime" from the 25th of August:
"There was significant demand for EUR/USD gamma over the last week as the pair weakened below 1.32. In the short term there is a strong likelihood of a rebound in the pair following the completion of a triangle breakout (Closing our tactical €/$ short). With short EUR/USD positioning at stretched levels, this rebound is likely to be volatile." - source Bank of America Merrill Lynch

But, then again, one of the real reasons behind the weakness in the Euro as of late has indeed been equity outflows as pointed out by Bank of America Merrill Lynch in their Liquid Cross Border Flows entitled "USD marching higher" from the 25th of August:
"Equity outflows drive EUR lower
Real money selling has been the main driver of EUR weakness in recent weeks, also reflected by outflows from Eurozone equities (Chart 5)
The CFTC data shows EUR shorts near a two-year high and our quant and technical analysis warn of a short-term pause in EUR weakness. However, as long as the ECB avoids more aggressive easing, equity outflows could weaken the Euro in the medium term." - source Bank of America Merrill Lynch

Should the rebound in European equities accelerate, this could as well play for a rebound in the euro in the near term we think.

In similar fashion, the strong move of the US dollar versus the Japanese Yen appears to us slightly overdone and we might see as well some pull-back from a "contrarian" point of view but technicals, indeed appear less favorable for now when it comes to the yen trade.

From a credit perspective, we continue to believe in the safety of Investment Grade versus the risk of renewed volatility in the High Yield space. Our stance is as well confirmed by recent flows as described by Bank of America Merrill Lynch in their HY flows note entitled "Back to positive" from the 22nd of August:
"Safety over yield
European investors have poured more funds into high-grade and government bond focused funds over the last couple of months. On the other hand, investors have cut risk on more high-beta and growth related asset classes, like equities and high-yield credit. We present this dichotomy of trends in chart 2, by using the cumulative 4 week average flows per pair."
"Credit flows (week ending 20th August)
HG: +$2.0bn (+0.3%) over the last week, ETF: +$183mn w-o-w
HY: +$734mn (+0.3%) over the last week, ETF: -$94mn w-o-w
Loans: -$96mn (-1.1%) over the last week
High-yield flows are back in positive territory after 5 weeks and a total of $13.4bn of non-stop outflows. High-grade inflows remained upbeat, with another $2bn (almost) inflow for another week. High-grade fund flows have been a strong 7.1% of AUM, the strongest since 2010. On the ETFs side, flows continued to decouple, as high grade ETF funds continued to see inflows, while high-yield suffered another outflow over the last week."
- source Bank of America Merrill Lynch

Flows continue to validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets" which we mentioned again in our last conversation. We like being long duration in European investment grade credit.

On a final note, as far as the Tokyo Drift is concerned and Japan in particular, the continuation of the increase in bank lending in Japan warrants close monitoring we think when it comes to assess Japan's never ending fight against the "deflation beast" - graph source Bloomberg:

"Harmony makes small things grow, lack of it makes great things decay." - Sallust, Roman historian

Stay tuned!

Tuesday, 19 August 2014

Credit - Thermocline - What lies beneath

"History has not dealt kindly with the aftermath of protracted periods of low risk premiums." - Alan Greenspan

Seeing finally that Germany entered the "below 1% yield club", in effect joining Japan and Switzerland in the process, (confirming indeed our deflation bias when it comes to assessing European woes in particular), as well as the low trajectory of bond yields with US 10 year at 2.37%, and the continuation of the lower risk premiums being seen in the credit market and "risks" not being detected, we reminded ourselves of the particularity of summer and its effect on the thermocline (negative refraction) when it came to choosing this week's title. No doubt it needs an explanation from our part for the aforementioned chosen title, and its relation to low risk premiums as quoted by the inept former central banker Alan Greenspan. 

Us being fans of all things maritime we thought this week we would use an analogy to the specific feature of thermocline and its major importance in submarine warfare. During the summer it gives a distinct advantage to submarines to stay undetected. In our case "lower risk premiums submarine" could torpedo rapidly the "economic ship" we are sailing on if there was a sudden rise of volatility due to increased geopolitical tensions in the near term.

But what is the thermocline?
The thermocline is a thin but distinct layer in a large body of water in which temperature changes more rapidly with depth than it does in the layers above or below. In the open ocean, the thermocline is characterized by a negative sound speed gradient, making the thermocline so important in submarine warfare because it can reflect active sonar and other acoustic signals, in effect providing stealth coating for submarines. Technically, this effect stems from a discontinuity in the acoustic impedance of water created by the sudden change in density. If a submarine is submerged at the layer of thermocline or immediate below the layer, the submarine (risk) will not be “captured” from the wave (market participants), and the submarine (risk) will stay undetected until it is too late.

There are usually two layers of a thermocline during summer. One layer is on about 15 to 20 metres of depth, and another one is about 150 meters of depth. Depth of 15 to 20 meters is the most important. During the summer, at afternoon, if weather conditions are good, a submarine cannot be detected from standard (hull mounted) ship’s sonar making the depth perfect for observing and torpedo launching. If the surface ship wishes to detect a submarine, the ship has to be fitted with towed sonar. In that case, the sonar must be submerged below the thermocline.

The thermocline and the impact of negative refraction: 
During the summer temperature of water decrease by depth of the water. Sound wave is bending towards the sea bottom. If submarine is on smaller depth, near the sea surface that is, our "economic" ship's sonar can’t detect the submarine (the risk that lies beneath). Range of the sonar is bigger if the submarine is merged on deeper depth (higher risk premiums):

In similar fashion to the actual record low yields and continued low volatility reached during the summer, the negative refraction seen in the markets means to us that "risk" is just below the surface, and it cannot be appropriately detected currently we think, hence our lengthy explanation and title.

In this week's conversation and in continuation to last week's post, we will put forward some of our short term views as well as other indicators pointing to risk that lies beneath in the coming months in similar fashion a submarine lurks below the thermocline in the summer, but we ramble again...

Interestingly we have been tracking over the summer months the growing divergence in the performance of the Standard and Poor's 500 index and the Eurostoxx in conjunction with the significant rally Italian 10 year government yields - source Bloomberg:
The lag in European stocks given the very recent negative tone in Europe due to the Russian sanctions have made them much more volatile. Should the "Risk-On" scenario persist in the coming weeks it should lead once again to an outperformance of European stocks versus US stocks.

We have seen today the start of this outperformance materializing in the pan-European Euro Stoxx 600 Index which was higher thanks to Danish shipping and oil group giant Moller-Maersk reporting better than expected net profit for its second quarter and indicating as well that demand for container transportation was set to grow. Its shares rose in sympathy by nearly 5 % leading European benchmarks higher in the process.

It is no secret to our readers that Moller-Maersk has been one of our favorite bellweather stock due to our affinity with all things maritime and the use of shipping as a leading credit/deflation indicator. In fact, we identified Moller-Maersk as the best candidate in the survival of the fittest contest happening in the shipping space when we wrote extensively on the link between consumer spending, housing, credit and shipping back in August 2012:
"If you want to pick winners in this survival of the fittest contest, you have A.P. Moeller-Maersk A/S investing in fast and fuel efficient vessels (Maersk vessels are designed to operate efficiently at both high and low speeds),  and so is Evergreen Group, owner of Asia's second biggest container line is as well adding more fuel efficient vessels to its fleet as well as Neptune Orient Lines Ltd" - Macronomics, August 2012.

Of course they are buybacks at play which have just been announced by the company which will no doubt boost furthermore the stock price of the Danish giant, but more importantly, the fuel efficient company is benefiting more than others due to the deployment of it new fuel efficient fleet from the evolution of bunker prices which have fallen by 19% since the peak of 2012 for its margins - graph source Bloomberg:
The only issue will be coming from the continuous fall in oil prices which should impact the earnings of the oil group part of the Danish conglomerate.

When it comes to shipping and our survival of the fittest theory, back in March 2012 in our conversation "Shipping is leading deflationary indicator", we argued that shipping was in fact an important credit and growth indicator, but most importantly a clear deflationary indicator. We also indicated that consolidation, defaults and restructuring were going to happen, no matter what in the shipping industry. We discussed at the time the restructuring process involving one of the biggest container shipping companies of the world CMA CGM. We followed up on this shipping discussion in April in our conversation "Shipping is a leading credit indicator", where we indicated that the deterioration of credit would accelerate the demise of some shipping companies due to many banking institutions paring back drastically funding or pulling-off completely from structured finance operations such as shipping.

Given the worst U.S. drought in more than a half century in 2012 in conjunction with dry weather from Europe to Australia, the shipping market experienced the biggest contraction in grain cargoes for 19 years and unprofitable rates for owners of Supramax commodity carriers, it wasn't a surprise to hear about the demise of Eagle Bulk Shipping Inc., the largest US operator of the vessels filing for bankruptcy earlier in August. Rest assured some other operators will continue to struggle while some others, the fittest, such as Moller-Maersk will benefit. The fourth quarter is usually the most important for Supramaxes hauling grain as it coincides with the Northern Hemisphere’s harvests. Normally this period generates the best average returns in four of the past six years. With Soybeans on a roll with a four-session winning streak after USDA estimated this autumn's U.S. harvest could reach a record 3.82 billion bushels, roughly in line with analysts' estimates, some US Supramaxes carriers will strongly benefit from this record harvest.

Another clear indication of what lies beneath in the thermocline layer of shipping can be seen in the evolution of the Drewry Container prices. No matter how many successive rate increases (already 5 in 2014 and in continuation of what happened in 2012 and 2013), the industry has been struggling in counter balancing the "deflation" effect stemming from the credit bubble that plagued the industry with overcapacity. The effects have yet to be fully digested by the shipping industry - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark declined 4.6% to $2,075 a 40-foot container (FEU) in the week ended Aug. 13. Rates retreated after an Aug. 1 $600 general increase per FEU by the Transpacific Stabilization Agreement (TSA). Rates are only up 1.9% yoy and illustrate the effect slack capacity has on the industry's ability to raise rates. The TSA has implemented five general rate increases in 2014 totalling $1,800 per FEU." - source Bloomberg

Further away from the shipping industry, when it comes to being contrarian, we have been long US duration since early 2014 and continue to believe in the trade due to the continuous slack in economic data from the US, pointing towards continued accommodation by the Fed. The US economy is weaker than expected we think. It is muddling through rather than the strong economic recovery scenario put forward by some pundits. Until we see a significant rise in wages in the US, we won't be buying the story that the US economy has reached "escape velocity" speed from the deflationary forces.

When it comes to assessing currencies in general and the US dollar in particular, we have to agree with CITI's recent take on the subject in their note entitled "Lower Yields Delay USD upside" from the 18th of August:
"G10 FX continues to be driven by monetary “surprises”. Recent ambiguous US data have allowed 10y UST yields to break to one year lows, yet again disappointing extended fast money USD bulls. With shorts in the bond market still extended, a move to 2% is possible near term which would almost certainly entail further USD losses over 0-3m. Similarly, delayed tightening in the UK should set back GBP given extended long positioning. Meanwhile, lack of additional stimulus in both Japan and Europe should generate short term JPY and EUR gains." - source CITI

Given Europe's cumulative 12m Eurozone current account surplus was 2.4% of GDP in June 2014, up from 2.1% of GDP in June 2013, one should expect the Euro to strengthen in the near term unless of course our "Generous Gambler" aka Mario Draghi unleashes QE in Europe, but we think QE is not a done deal at the moment. In fact there is a risk that QE could be "torpedoed" by German's unwillingness in increasing its liabilities from being implicit to contingent and not tolerate that the ECB launches its own QE. As we previously wrote:
"By managing to keep Germany’s liabilities unchanged German Chancellor Angela Merkel has been in fact the clear "winner""

Remember, on  the 18th of October 2012, Chancellor Merkel in her address to the German lower-house has indeed craftily defended again Germany's liabilities by declaring:

"Financial aid without conditions attached has in some cases frustrated the drive to streamline economies, and therefore joint liability is the wrong answer"

Another risk when it comes to our "submarine" analogy and what the Banco Espirito story has shown is the European banking sector. It is still an on-going story of deleveraging and never-ending recapitalization process. The ongoing AQR (Asset Quality Review) ambitions to reveal "what lies beneath" the European banking sector as the ECB is gradually becoming the sole supervisor. But it doesn't alleviate our concerns for additional provisioning and more goodwill writedowns which traditionally happen during the second semester. While financials in the credit space have been outperforming, being a pure beta play, banking stocks continue to struggle as displayed by the relative change in Bloomberg consensus 2015E EPS from Nomura's recent EU banks strategy note entitled "Taking stock of troubled earnings" published on the 13th of August:
"Earnings momentum: Retail upside vs IB and EM weakness
Within the sector, the best earnings momentum continues to come from northern European retail banks, driven by improving asset quality and cost control. Some of the Spanish banks also benefited from earnings upgrades as a lower cost of funding offset declining profits from the carry trade. By contrast, investment banks continued to suffer from weak top-line momentum and higher-than-expected litigation charges. Also weak were emerging-market exposed banks as well as some other Spanish banks on asset-quality concerns, although we expect revenue momentum to improve in Asia over the coming quarter". - source Nomura

Of course, as we pointed out last week, expecting the single European banking supervisor to be supportive of lending in peripheral countries amount to "wishful thinking we think":
"We beg to ask where the demand is going to come from? Yet another illustration of "Cognitive dissonance" from the ECB"

From Nomura's note, there are as well too many uncertainties when it comes to expect a pick-up in credit in Southern Europe:
"Southern Europe: Margin upside vs coverage adequacy
Southern European banks’ presence among the best and worst of the earnings momentum reflects on the one side better margin performance after a disappointing 1Q as retail funding costs improved and asset yields remained quite high, and on the other side a need to build coverage levels even as NPLs appear to be passing their peak. Looking forward, as we discuss in this note, maintaining asset yields could become increasingly difficult as securities portfolios mature and weak loan growth is weighing on overall NII. We caution that analysts still model a strong pickup in NIM in Iberia over the next two years in contrast with more cautious estimates, even in economies with more aggressive expected rate cycles.

Asset quality stabilising but some risks of additional provisioning
On a positive note monthly NPL data in Spain and Italy appears to be stabilising, which should fund improvements in profitability through 2015-16. However, despite pre-emptive action ahead of the AQR and stress test, NPL recognition and coverage still diverge widely across the sector. In many cases this is warranted by loss experience and business mix (e.g., a high level of mortgages at ING). In other cases capital deductions for expected loss would limit the impact of any increased coverage on capital ratios). However, we caution that banks with lower coverage (e.g., POP) could run a greater risk of additional provisioning needs in 2H." - source Nomura

Given we pointed out last week a change in the Business cycle in Europe turning South which we called a "Cognitive dissonance" indicator coming from a Bank of America Merrill Lynch note, we have a hard time believing in a credit-less recovery and that additional provisioning will be avoided as Europe struggles with lack of overall aggregate demand, particularly with Germany now being impacted and France sliding more into trouble. French Minister Sapin is talking about budget deficit being above 3.8% for 2014, rest assured it will be North of 4%. If you have 0.5% of growth it should equate to 4.3%.  We also expect additional goodwill writedowns happening for peripheral banks during the second part of the year, meaning once again some bank analysts earnings forecasts will be torpedoed thanks to the undetected "European banking submarine" resting in the thermocline.

If the European ship wishes to detect European bank submarine risk hiding in the thermocline, the ship has to be fitted with towed sonar. In that case, the sonar must be submerged below the thermocline:

One of the way to detect "risk" arising from a European bank submarine hiding in the thermocline which we pointed in October 2012 conversation "When causation implies correlation"  is to track the issuance of putable bond issuance from financials. It is a typical instrument used by financial institutions under stress. For us, a big red flag. Putable bonds are fixed-income securities which investors are able to redeem before maturity. It is a very dangerous option given the funding shock it could create should investors decide in concert to exercise their option.

Another towed sonar that needs to be used for high yielding credit investors in corporate high yield is the call risk, which we pointed out in our conversation "The Departed" in January 2014:
"When it comes to credit risk and luck, recently some investors in hybrid securities learned the hard way when ArcelorMittal called early some subordinated bonds at 101 when they had been trading recently around 108.96 cents, a good sucker punch for some unwary investors."

We could also recommend using the towed sonar analogy for the CDS orphaning risk which was so clearly illustrated in the SNS case and the Banco Espirito story, but, as we pointed out in our conversation "The Week That Changed the CDS World" in May 2013, hopefully the new CDS contracts due to be launched in September should suppress this "submarine" risk of orphaning for financial subordinated debt CDS.

Also, whenever loans of corporate high yield bonds are trading above par, you introduce an additional risk element as there is limited call protection, hence the need to switch on your "towed sonar" for call risk should you decide to navigate further on the treacherous credit seas where submarines are lurching and defaults can easily torpedo your credit exposure.

For those that need to seek comfort in a safe haven, we believe Investment Grade credit while tight from an historical point of view, still benefits from positive exposure thanks to the Japanification process. In that sense, we expect the Fed to keep a dovish tone in this muddling through economic situation in the US meaning that the releveraging process taking place in the US is still positive for credit. From that perspective, we would like to point out to Morgan Stanley's recent take on the subject from their note Credit Continuum note entitled "Rationalizing the Resilience" published on the 18th of August:
"What Are the Rates Markets Telling Us About
Credit?
We think a rates rally may not result in a severe spread widening for credit. Interestingly, the correlation between the two markets has changed markedly. Typically spreads are inversely correlated to government yields, but recently rates returns and credit excess returns have moved together as both credit spreads and rates have tightened during a large part of the past twelve months. The main reasons for this coupling are complex and not entirely related. The credit reasons were listed earlier. On the rates side, weaker than expected US growth in 1Q14, weak European economic data, and a flight to quality over global conflicts have been the primary drivers (Waiting for Godot, Aug 1, 2014). But in a bear case scenario, if we assume that correlation falls further into negative territory (as it has recently), then this spread widening episode would only get marginally worse. Our Rates Strategy bull case (our bear case) for 4Q14 is 2.15% or roughly ~20bps tightening from here. Using our simple -4:1 rates:credit spread change ratio, the rates rally may result in a ~5bps widening in credit, which would result in a total incremental increase of ~13bps from this episode’s tights. Although this outcome is certainly not desirable, it is better than the post-crisis average mentioned earlier of 36bps." - source Morgan Stanley

This somewhat validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"-Corporates around the world have been deleveraging for longer than most people realise, starting around the time of the tech bubble in 2000.
-Deleveraging is generally bad for equities, but good for credit assets.
-In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute).
-As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities." - source Nomura

On another note what has clearly torpedoed the short US treasuries stance as of late has been the continuous appetite from Japanese Life Insurers for foreign bond investments as depicted in the below graph from Nomura's recent Japan Navigator note number 583 posted on the 18th of August:

"At the Jackson Hole meeting over the weekend, Fed chair Janet Yellen and ECB President Mario Draghi will give speeches.
As concerns over geopolitical risks subside in the near term, we believe investor focus will shift onto ECB easing and/or the potential of central banks turning more dovish. We do not expect the Fed to send any message at the Jackson Hole meeting that may prompt the market to bring forward its expected timing of a rate hike. Instead, we believe the ECB will speak in such a way as to suggest its intention to take further easing action. In this environment, we expect the Goldilocks market to continue (strong bonds and stocks coupled with low volatility), barring a sharp fall in macro indicators and/or a more imminent risk of a credit crunch.
We note that, since geopolitical tensions over Ukraine heightened, G3 bond yields have fallen globally in tenors longer than 10yrs. Looking at each of these markets, we find that the yield curve has flattened beyond the 10yr in the euro area, steepened in the US and shifted down parallel in Japan. We believe these moves reflect the conditions of these economies, which have translated into their respective monetary policy outlook.
We believe the steepening of the UST curve reflects the relative strength of the US economy, which leads the others in a recovery cycle. Faced with this, we believe few investors are likely to price in a dovish shift by the Fed. Rather, they may be looking at the risk of Fed policy falling behind the curve, in our view. In this respect, we will watch to see when volatility begins to rise in the UST market.
When the Fed policy outlook changes next, we would expect it to be either changes in the FOMC statement “maintain the current target range for the federal funds rate for a considerable time” or FOMC members’ expectations of rate hike in mid-2015. As the “considerable time” is widely believed to suggest at least six months, the statement will be inconsistent with a forecast rate-hike by end-2014." - source Nomura

We agree with the above, the Fed is far from normalizing its interest rate policy hence our positive stance on investment grade credit. As a side note, investing in long dated Apple corporate bonds following the taper tantrum has been a good strategy, we believe keeping a long duration exposure on quality investment grade credit is still a valuable trade.

Also the weaker tone of the US economic strength can be ascertained from the breakdown of the remaining reliable pair, namely the 2 year treasury yield relationship with the S&P500 as displayed by Bank of America Merrill Lynch in their recent  Credit Market Strategy note entitled "Oh rates" published on the 15th of August 2014:
"Oh rates
The two key developments this week were declining geopolitical risks – even with today’s escalation between Russia and Ukraine - and interest rates taking another leg significantly lower on a couple of softer than expect data readings on Retail Sales and Jobless Claims, strong demand in auctions, as well as today’s geopolitical tensions. Declining uncertainties compared with last week – measured by implied volatilities ) – and a slower moving Fed, should we continue to see softer data, finally broke the lone relation between rates and stocks that has held up this year, as stocks have risen significantly since Thursday last week while 2-year Treasury yields continued to decline (Figure 6)." - source Bank of America Merrill Lynch

Another chart worth mentioning as a "towed sonar" we think and showing that the market has been getting wrong signals from the thermocline, can be seen in the below chart from Bank of America Merrill Lynch displaying TIPS forward real and BE rates being consistent with renewed QE:
"Forward yields move into QE territory
The bull flattening of the Treasury yield curve has been remarkably persistent. When we look at the move in terms of forward rates of TIPS real yields and forward breakevens, the current environment resembles early 2012, when the Fed was undertaking Operation Twist and preparing the market for QE3. The Chart of the day shows a time series of these 5y5y forward real and breakeven inflation rates.

In the last several years, the relationship between real rate and breakeven inflation forwards has described several QE-based regimes. When anticipation and expectations for QE3 were most intense, in late 2012 and early 2013, BE forwards were high and real yields were low, with the former driven by expectations of higher inflation from debt monetization and the latter by the Fed's demand for Treasuries.

From mid-2013 to early 2014, we see the effects of the taper tantrum, when forward real yields rose and forward breakevens fell. At the moment, we seem to be in a middle state between these two extremes, with real rates falling back down but forward breakevens holding roughly steady since March. However, the rally in real rates has occurred without any corresponding shift in the Fed balance sheet, other than the actual implementation of the taper. Something is causing the market to behave in a manner in some ways similar to an expansion of QE." - source Bank of America Merrill Lynch

On a final note, the reason we believe far more into a sluggish recovery than an outright recovery as vaunted by many can be seen in the Capital spending by US companies as displayed by Bloomberg in its recent Chart of the Day:
"Capital spending by U.S. companies has been hampered by “a traumatized economy” and will require more time to rebound, according to Milton Ezrati, a partner at Lord Abbett & Co.
The CHART OF THE DAY illustrates how Ezrati drew his conclusion, presented in a note two days ago. He tracked the percentage gap between outlays and depreciation expenses among domestic businesses, as compiled by the Commerce Department.
Last quarter’s spread, 27.7 percent, was the widest since the current economic expansion started five years ago. Even so, it was only 0.2 percentage point higher than the average during the previous period of growth, from 2002 to 2007.
“This is a very different and much less robust picture than in the economy’s past,” Ezrati wrote. The shift reflects the legacy of the 2007-2009 recession and financial crisis and the federal government’s policy response, the note said.
“These retarding forces will change only slowly at best,” the Jersey City, New Jersey-based senior economist and market strategist wrote. In the meantime, capital spending may expand no faster than it has in recent years, he wrote.
Spending on buildings, equipment and other capital items during the second quarter totaled $2.24 trillion at an annual rate. Depreciation, an accounting charge taken to reflect thewear and tear on assets, amounted to $1.75 trillion." - source Bloomberg.

"Beware of little demand for lending. Lack of demand for lending due to weak aggregate demand will eventually sink the great European ship." - Martin T. - Macronomics

Stay tuned!

Tuesday, 12 August 2014

Credit - Cognitive dissonance

"The difference between stupidity and genius is that genius has its limits." - Albert Einstein

Watching with interest the significant compression of German bund towards the 1% level as deflationary forces à la Japan gather strengths in the European space with disappointing ZEW index pointing to lower growth in conjunction with Russian sanctions hitting hard some European economies, we decided to venture once more towards psychology when it came to choosing this week's analogy for our title (We already touched on the subject of cognitive bias in our "Dunning-Kruger effect" conversation. Cognitive dissonance in psychology which is when people are confronted with information that is inconsistent with their beliefs. For instance, in the case of Europe, the much vaunted "recovery" is no doubt going to be tested by the next GDP prints in the European space with France, no doubt straying towards recession in similar fashion to its Italian neighbor we think (-0.2%). Of course the prophecy of the "recovery" will fail in similar fashion to what was illustrated in Leon Festinger's 1956 book "When Prophecy Fails", which was an early version of cognitive dissonance. A good illustration of "Cognitive dissonance" is in the belief that having a single European banking supervisor will be supportive of lending in peripheral countries as indicated by the ECB and reported in Bloomberg by Maxime Sbaihi in Bloomberg:
"The transfer of power to a single European bank supervisor should be a game changer. The ECB is hoping to do more than simply strengthen financial stability. It also envisions unified authority as a tool to repair the broken channels of monetary policy transmission, prompting banks to make their comeback at the periphery and improve credit conditions there. The central bank timidly expressed this wish in its latest financial integration report, stating that “the banking union is expected to contribute indirectly to the return of crossborder credit flows.” - source Bloomberg
We beg to ask where the demand is going to come from? Yet another illustration of "Cognitive dissonance" from the ECB, or more akin to "wishful thinking" we think, but as always we ramble and rant.

In this week's conversation we will look at "Cognitive dissonance" informations which we think are inconsistent with many pundits' beliefs in the much vaunted "recovery" and cautious signs coming from various indicators for risky assets in the coming months we think.

Like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content. Not only as human beings we suffer, from optimism bias, but we suffer as well from "deception" and we also all play "deceit" to some extent. We are all "great pretenders", some way or another.

After all, one only need to look at the German 2 year yield  turning negative again to realize that credit wise Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:
Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 0.4% inflation rate is telling you. It is still the "D" world (Deflation - Deleveraging).

As we indicated in our conversation of November 2013 entitled "Squaring the Circle", when it comes to optimism bias and "Cognitive dissonance" we reminded ourselves of the "wise" words from Olli Rehn:
“I’m sure that we will be able to find a satisfactory solution as regards to how to ensure the fiscal gaps will be filled and the fiscal targets will be met.” - Olli Rehn

We also pointed out at the time:
"As far the "optimism bias is concerned, a majority of analysts believe the German Constitutional court will allow the OMT to stand on the basis that EU treaty allows for purchases in the secondary bond market. We beg to differ. 
Once a debt is a contingent liability, for instance "super senior" there is no turning back, but the ESM being capped and the OMT yet to be firmly backed by Germany, the nuclear option is still an option rather than a reality."

In this previous conversation we also argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months. Looking at the fall in Sotheby's stock price on the 8th of August following a second-quarter profit fall of 15% with the share plunging 11% after its earnings miss, we wonder if indeed the S&P 500 is indeed not vulnerable down the line using the aforementioned relationship we discussed - graph source Bloomberg:
Mind the gap...Also note that Sotheby's private sales fall by 50% in first half of 2014 as reported by Philip Boroff in Artnet on the 12th of August in his article entitled "What Sotheby’s Doesn’t Want You To Know About Its Private Sales":
"Sotheby’s private sales have plunged following the auctioneer’s public feud with activist investor Daniel Loeb.
Long a focus of company executives, private sales tumbled 48 percent in the first half of the year, according to an August 8 Securities and Exchange Commission filing. The value of private transactions, in which Sotheby’s discretely brokers art and other collectibles to one prospective purchaser at a time, dived to $294 million in the first half of 2014 from $561 million a year earlier. It was the lowest private sales total since 2010. The drop contributed to a 15 percent decline in quarterly earnings and an 8 percent drop in Sotheby’s stock on Friday. The shares are off 15 percent in the past year, as the benchmark Standard & Poor’s 500 Index rallied 15 percent." - source Artnet.

The role of Sotheby's stock price  as an indicator was as well confirmed by our good friends at Rcube Global Asset Management  back in our November conversation but them using MSCI World as a reference - graph source Bloomberg:
"The Art market has always been an interesting indicator. The only major public auction house is Sotheby's since its floatation in the mid-1980s. It has proved a timely indicator of potential global stock markets reversal.
Whenever its price reached 50 or so with sky high valuations, a reversal was not far away. We can also take notice of the extremely weak jewelry and contemporary art auctions recently."

Another "Cognitive dissonance" sign which has been put forward by our friends at Rcube Global Asset Management  in their latest monthly review is another warning coming from the MSCI World:
"According to various measures, bullishness in the US was back to January's levels and at historical extremes. Leverage also seemed to have increased in June to new highs, while the MSCI World had just reached its 2007 top." - source Rcube Global Asset Management 

While in our last conversation "Nimrod" we discussed the outflows in the High Yield space through the ETFs markets in general and ETF HYG in particular, while recently there was some price recovery, we have to agree with our friends from Rcube Global Macro Asset Management namely that the massive increase in shares repurchase indicates that High Yield spread should be considered too tight.

Massive outflows recently as pointed out by Bank of America Merrill Lynch in their recent Flow Show note from the 7th of August entitled "Credit Capitulation":
"Biggest week of outflows ($11.4bn) from HY bond funds EVER in dollar terms; 4thlargest week of HY outflows as % AUM ever (Chart 1)"
- source Bank of America Merrill Lynch

But recent price "recovery" of ETF HYG and another illustration of "Cognitive Dissonance" - graph source Bloomberg:
HYG and JNK are the two largest High Yield ETFs accounting for 80% of assets.

Nasdaq Buyback achievers vs Standard & Poor's 500 index - graph source Bloomberg:
The Nasdaq gauge consists of companies that repurchased at least 5 percent of their shares in the previous 12 months. The US equities market has been increasingly being boosted by buybacks, yet another artificial jab in the on-going liquidity induced rally. Repurchases are largely designed “to boost earnings per share as revenue growth slows.

For our friends at Rcube Global Asset Management, corporate credit spreads are far too tight on US HY bonds, when we consider the massive increase in shares repurchase activity:
A measure of balance sheet leverage, which compares net equity issuance to corporate cash flows, also shows that HY spreads are too tight.

While spreads have narrowed massively over the last 2.5 years, liquidity has clearly not followed. The liquidity spread shown in the chart below measures changes in the short‐term differences in the bid and ask prices on 3‐Month US Treasuries, which reflects liquidity in financial markets. A widening spread signals illiquidity in the market, which is associated with growing stress.

What is interesting in the current episode is that despite much better fundamentals since the 2008 meltdown, strong inflows and tightening spreads, liquidity clearly has not improved.

Another illustration of the "liquidity risk" can be seen in the levels of inventory sitting on US primary Dealers as an illustration as displayed by Bank of America Merrill Lynch in their European Credit Stategist report from the 11th of August entitled "When it turns...":
“When it turns…”
“…it’s gonna be nasty” is the punchline in credit, used to describe today’s world of growing buyside assets and lower street liquidity. Admittedly, street bids have been somewhat of a rarity over the last few trading session, and the move wider – especially in Crossover – has been eye-catching.
But it’s easy to spin the party line on liquidity during a big risk-off moment. Dealer holdings of corporate bonds are clearly way down on where they were in the ’06 and ’07 era (chart 12), but banks are also more nimble in managing their mark-to-market risks, and overall exposures on their securities portfolios." - source Bank of America Merrill Lynch.

Another "Cognitive dissonance" indicator is also coming from the same Bank of America Merrill Lynch, pointing towards a change in the Business cycle in Europe turning South:
“It’s not me, it’s you!”
In our view, the risks for credit over the next few months stem more from continued equity weakness, than from any big changes in credit fundamentals. For spreads to tighten materially again, we think European equities need to stabilize. But as our equity team has been pointing out, stocks are currently undergoing a rotation from high-beta into defensives, due to the business cycle having moved from the Boom to Slowdown phase.
What does a rotation in equities look like? Bring up a chart of European Auto stocks (SXAP) against the Food and Beverage index (SX3P). Autos have underperformed by almost 8% this year, after having outperformed the Food and Beverage sector by 17% last year.
The bad news is that business cycle phases tend to last for some time, with the European cycle having only just rolled over earlier this year (and more recently for the periphery, as chart 3 shows).
While geopolitical risks and sanctions will only serve to dull the growth outlook in Europe further, the good news is that China is strongly surprising to the upside.
We think this has the potential to help lift growth expectations in Europe sooner.
But weak equities aren’t enough for us to suddenly become big bears on credit, though, although we admit the longer equities struggle the tougher it will be to get near to our big spread tightening targets for year-end, especially for high-yield credit." - source Bank of America Merrill Lynch.

On the potential rebound from China which would help lift growth expectations in Europe sooner, we disagree with Bank of America's take. Also, from the latest US Trace information is showing from the High Yield market, investors are selling CCC exposure to move up the rating chain towards single Bs which also can be seen in the resilient flows seen in the investment grade space as investors are playing "defense" in similar fashion to some players in the equities space. In the on-going European "Japonification" process as we pointed out in numerous conversations, credit can indeed outperform equities (see our conversation "Deleveraging - Bad for equities but good for credit assets") when of course management stays conservative and protects its balance sheet rather than "releverage".

On a final note, given Japan’s 10-year government bond yields around 0.51% today after reaching an all-time low of  0.315% in April 2013 and given it hasn’t been above 2 percent since May 2006, and that Switzerland is the only other country whose 10-year yields are below 1 percent, according to data of 25 developed nations tracked by Bloomberg, you can indeed expect Germany to join shortly the below 1% club. Another indicator we have tracking on our side has been the 30 year Swiss yield relative to Japan which is now as well getting close to the 1% level - graph source Bloomberg:
Since the beginning of the year, and in similar fashion to other Core long bonds, Swiss long yields have fallen significantly. For instance Swiss 30 year bonds have fallen by 63 bps relative to Japan 30 year bonds. We expect this divergence to increase.

"A man should look for what is, and not for what he thinks should be." - Albert Einstein

Stay tuned!