Saturday, 19 April 2014

Credit - Hocus Bogus

"Fake is as old as the Eden tree" - Orson Welles

Watching with interest peripheral yields touching record lows (Italian yields touched 3.068%, the lowest since Bloomberg started collecting the data in 1993) in conjunction with the blazing placement success of Greece's new issue, we reminded ourselves of the magical powers of our "Generous Gambler" aka Mario Draghi and one of our favorite quotes:
"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

The current European bond picture with Italy and Spain 10 year government yields converging towards core European Yields - source Bloomberg:

This week's chosen title is a reference to the exclamation used by magicians, usually the magic words spoken when bringing about some sort of change. No doubt that the "whatever it takes" moment from our European magician Mario Draghi has indeed brought some sort of change, in yield terms for sure. 

But, our chosen title is as a well a literature reference to the great 1976 French novel "Hocus Bogus" by Romain Gary published under the pseudonym Emile Ajar. In this particular novel, the author goes back and forth from a clinic to a psychiatric institution in Denmark and whenever he receives visits, he feels cured without being cured and without any hope of leaving the dissimulation and delirium that affect him. Reality, lucidity and hope were nonentities for Gary/Emile, therefore continuously suspect. In similar fashion developed economies have been "cured without being cured" by central banks meddling and magician tricks hence the dual reference of this week's chosen title but we ramble again...

In this week's conversation we intend to once again to break our Magician's Oath in relation to market levels and economic woes in Europe and in particularly the deflationary bias plaguing the periphery. We will look as well at the magician tricks used by American banks to use cheap funding in order to meet new liquidity requirements. 

The Magician Oath
"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

When it comes to European magician tricks versus US magician tricks, so far the Europeans have indeed displayed a wonderful performance when one looks at Greek bond gains versus US Tech stocks as displayed by Bloomberg's recent Chart of the Day:
"Greek government bonds have been a more rewarding investment during the tenure of Prime Minister Antonis Samaras than any technology stock in the Standard & Poor’s 500 Index.
The CHART OF THE DAY compares price changes in Greece’s 10-year note and shares of First Solar Inc. since Samaras was sworn into office on June 20, 2012. First Solar, a power-plant developer and solar-cell maker, had the period’s biggest gain among companies in the S&P 500 Information Technology Index.
Greece issued the notes in February 2012 as part of the biggest sovereign-debt restructuring in history. They climbed 379 percent through yesterday under Samaras, who is seeking to revive the economy. Interest payments brought the total return to 393 percent. Shares of First Solar, which doesn’t pay any dividends, gained 344 percent.
“The market has a short memory,” Lyn Graham-Taylor, a fixed-income strategist at Rabobank International, said in a telephone interview yesterday.
Greece’s return to a budget surplus before interest costs has benefited bondholders, the London-based analyst said. The country ran a surplus of 2.9 billion euros ($3.9 billion) on that basis last year.
Both securities were close to record lows when Samaras became prime minister. The Greek notes set their low on May 31, 2012. Four days later, First Solar changed hands at the lowest price since the Tempe, Arizona-based company went public in November 2006." - source Bloomberg.

Credit wise both the US and Europe have managed to converge thanks to ECB's wizard in chief Mario Draghi when one looks at the trajectory of the respective investment grade CDS indices for Europe and the United States as "credit risk proxy" namely the Itraxx Main Europe and its US equivalent the CDX index since January 2011 - graph source Bloomberg:

But when it comes to stimulating inflation, both European and US magicians have so far failed to come up with the right "trick" given that the only inflation they have managed to create has been in asset price levels.

Central banks have indeed rekindled the "animal spirits" in true Keynesian fashion when it comes to asset prices, but also in true 2007-2008 spirit leading to a credit binge, particularly in the US junk-loan market as reported by Christine Idzelis in Bloomberg on the 15th of April in her article "Junk Buyout Loans Eclipse '07 Record in Deal Frenzy":
"The U.S. junk-loan market has never fueled so much dealmaking.
A total of $85 billion of loans have been raised this year to finance acquisitions, topping 2007’s record pace, data compiled by Bloomberg show. Issuance is set to accelerate as Avago Technologies Ltd. locks in the year’s second-biggest loan for its takeover of chipmaker LSI Corp. as soon as today and Men’s Wearhouse Inc. borrows $1.1 billion to fund its deal for Jos. A. Bank Clothiers Inc.
Leveraged loans are booming as the value of takeovers in the U.S. reaches levels last seen in 2008. While regulators have warned excesses may be emerging in riskier parts of the market as the Federal Reserve’s zero-interest rate policy extends into a sixth year, the loan surge underscores renewed confidence in the ability of the least-creditworthy companies to expand as the world’s largest economy strengthens.
“There’s a lot of money waiting to be put to work,” Judith Fishlow Minter, co-head of U.S. loan capital markets at Royal Bank of Canada, said in a telephone interview from New York. “The market is exceptionally strong.”" - source Bloomberg.

This is exactly what we envisaged when we wrote our post "2014: the Carry Canary":
"Looking at the continuous rally in the credit space, one has to wonder whether 2014 will indeed be the year of the credit carry trade which, as we posited last week, would be supported by a return of M&A, LBOs, as well as structured credit in similar fashion the year 2007."

Of course the carry game being played in the credit space is also seeing a rise in leverage as indicated in the same Bloomberg article quoted above:
"First-lien borrowings at speculative-grade companies equaled 4.2 times their earnings before interest, taxes, depreciation and amortization in the first quarter, the highest since the 4.6 ratio in the last three months of 2007, according to S&P Capital IQ Leveraged Commentary & Data.
A total $760 billion in mergers and acquisitions of U.S. companies were announced in the year ended March 1, according to data compiled by Bloomberg. That’s the most for a 12-month period since April 2008." - source Bloomberg.

Credit is of course not the only place where leverage is being used with maximum effect courtesy of central banks generosity, equities have also shown signed of increasing leverage being used for buying stocks in the US as illustrated by the rise of the S&P index (blue) versus NYSE Margin debt (red):

Yes, we know some people argue that concerns on the record amount of borrowing for US stocks are misplaced because, lower interest rates have made the borrowing much less expensive, as illustrated by  this Bloomberg chart:

We did use a reference to Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit": "That Which is Seen, and That Which is Not Seen". 

In similar fashion it can be used for the NYSE Margin debt. This is clearly illustrated in Bank of America's recent Monthly chart portfolio of global markets published on the 14th of April:
"Margin debt: absolute extreme but the 12-month rate-of change not extreme
Margin debt is a gauge of market sentiment and positioning. While the absolute level of margin debt is a source of investor concern, the YoY rate of change (RoC) is lackluster at 27.2% and did not test the extremes near 78% and 68% that accompanied the S&P 500 peaks in 2007 and 2000, respectively. The recent high for the YoY RoC was 42% in April 2010 and the rate of increase in NYSE margin debt from a May 2012 low of -12% in the YoY RoC is not consistent with the prior market peaks from 2007 and 2000."

Risk: Net free credit at -$178b – exceeds extreme negative level from Feb 2000
Net free credit is free credit balances in cash and margin accounts net of the debit balance in margin accounts. At -$178b (from -$159b in January), this measure of cash to meet margin calls is at an extreme low or negative reading that has exceeded the February 2000 low of $-129b. The risk is if the market drops and triggers margin calls, investors do not have cash and would be forced to sell stocks or get cash from other sources to meet the margin calls. This would exacerbate an equity market sell-off.
- source Bank of America Merrill Lynch

Many investors hope that the central banks magician spell "Hocus Bogus" will last long enough for them to exit in both credit and equities in an orderly manner, they once again suffer from "optimism bias" we think.

Moving back to central banks issues in coming up with the right magician "inflation trick", an illustration of the ECB's inflation conundrum can be seen in the deflationary forces at play plaguing the periphery like in Spain for instance, where deflation risk is clearly on the increase as depicted in the following Bloomberg chart:
"With deflation risk growing across the euro area, southern Europe economies' delivery on austerity targets will likely regain focus. Spain's budget deficit fell to 6.6% in 2013, just shy of the 6.5% European Commission target. With inflation falling 0.2% in March, vs. consensus calling for a 0.1% increase, the budget deficit target of 3% of GDP by 2016 may now require deeper fiscal adjustments, further denting GDP and the outlook for lending." - source Bloomberg.

While the "Hocus Bogus" spell from our magician at the ECB has indeed supported peripheral yields, it has also enabled Spanish banks to rely less on debt issuance but more on the increase of deposits for their funding needs as displayed in the below Bloomberg graph:
"Santander and peer Spanish banks held 590 billion euros ($818 billion) of retail (household) deposits pre-crisis (mid-2007). This represented 21% in liabilities of a total 1.38 trillion non-bank deposits. Retail deposits have grown to 760 billion euros in 1Q, while corporate deposits declined 1% and funding from insurance companies, pension funds and other financial institutions has declined 5%. The banks' reliance on debt funding has fallen to below 10% of total liabilities, from 15%." - source Bloomberg

Whereas Italian banks have relied more on debt issuance for their funding needs as described by Bloomberg in the below graph:
"Debt outstanding for euro zone banks fell 3.6%, or 163 billion euros ($226 billion), in the seven years to 1Q. Italian banks' debt in issue (as reported by the ECB) grew 50% to 860 billion euros in the same period, with the 280 billion euro growth in outstanding debt almost 30% higher than French banks' debt growth. At 21% of total liabilities, Italy's utilization runs at 50% more than the 14% average across the euro zone. This growth has largely replaced the decline in interbank deposits." - graph source Bloomberg

On top of that, the deleveraging for Italian banks has hardly run its course and in similar fashion to the Italian government shedding real estate and its car fleet, Italian banks are as well busy shedding non-performing loans backed by real estate as indicated by Sharon Smyth and Elisa Martinuzzi in their Bloomberg article from the 16th of April entitled "Italy Banks May Sell $69 Billion of Bad Loans Amid U.S. Interest":
"Prelios SpA, the Italian asset manager studying a merger of two units with those of Fortress Investment Group LLC, said it expects Italian banks to sell as much as 50 billion euros ($69 billion) of bad loans in the next two-to-three years.
Italian banks are sitting on 160 billion euros of non-performing loans, a figure that will swell to 200 billion euros in the next two years as Italy emerges from recession, according to Riccardo Serrini, chief executive officer of Prelios Credit Servicing SpA, a unit of Milan-based Prelios.
“We’re currently assisting investors bidding for 10.9 billion euros of NPLs,” Serrini said in an interview in his office in Milan. “Ninety-five percent of investors are from the U.S. and about 70 percent of the loans are secured by real estate.”
U.S. investors, including some without a presence in Italy, are making up for the shortfall of Italian funds that can absorb the planned disposals, Serrini said. Italian banks, which have so far resisted distressed-debt sales, are now accelerating plans to shed bad debt, which has reached record levels. They are considering pooling bad loans into separate units, or bad banks, in an attempt to free capital and increase lending capacity, as well as selling loans." - source Bloomberg.

So it looks to us that Italy is indeed for sale.

Moving on to the subject of banking wizardry from American banks, they have indeed find cheap funding in order to meet new liquidity requirements thanks to the Federal Home Loan Bank system as reported by Clea Benson in Bloomberg on the 16th of April in her article entitled "Basel Rule Spurs Big-Bank Borrowing from US Home Loan Banks":
"Four of the nation’s largest banks, led by JPMorgan Chase & Co., are driving a surge in borrowing from the Federal Home Loan Bank system as they raise funds to buy assets that meet new liquidity requirements.
Lending at the 12 regional Home Loan Banks rose 30 percent to $492 billion between March of 2013 and December 2013, largely the result of advances made to JPMorgan, Bank of America Corp., Wells Fargo & Co. and Citigroup Inc., according to a report released today by the Federal Housing Finance Agency Office of the Inspector General.
The concentration of Home Loan Bank lending in four large institutions could present safety and soundness risks, the report said. In addition, auditors questioned whether lenders created to support housing finance should be providing funds so banks can meet standards set under the international Basel III accord.
“The increasing use of advances by members to meet Basel III’s liquidity requirements could raise public concerns about the system’s commitment to its housing obligations,” the report said.
The Federal Home Loan Banks, established by the government in 1932 to support mortgage credit, have an implicit government guarantee, meaning that investors expect they won’t be allowed to fail. They make advances to their 7,500 member financial institutions that can be used to originate home loans or for other purposes.
Citigroup, JPMorgan, Bank of America and Wells Fargo accounted for 27 percent of total advances from the Home Loan Banks at the end of 2013, up from 14 percent the year before, the report said. Lending to JPMorgan increased the most, to $61.8 billion in December 2013 from $13.3 billion in March 2012." - source Bloomberg.

What we find a great source of concern is that the Federal Home Loan Banks were established to support mortgage credit in the first place. But, looking at the state of US mortgage lending contracting to levels not seen since 1997 as per Bloomberg's recent article by Kathleen M. Howley, Zachary Tracer and Heather Perlberg entitled "Lending Plunges to 17-Year Low as Rates Curtail Borrowing", one might wonder if banks benefiting from implicit governement guarantee thanks to their borrowing binge are not indeed a clear violation of  the system's mission, namely supporting residential mortgage lending in the first place:
"Wells Fargo (WFC) & Co. and JPMorgan Chase & Co., the two largest U.S. mortgage lenders, reported a first-quarter plunge in loan volumes that’s part of an industry-wide drop off. Lenders made $226 billion of mortgages in the period, the smallest quarterly amount since 1997 and less than one-third of the 2006 average, according to the Mortgage Bankers Association in Washington." - source Bloomberg

From the same article:
"Lenders also are tightening credit standards, requiring higher FICO scores. More than 40 percent of borrowers in 2013 had scores above 760, compared with about 25 percent in 2001, according to a Feb. 20 report by Goldman Sachs Group Inc. analysts Hui Shan and Eli Hackel. 

JPMorgan originated $17 billion of home loans in the first quarter of 2014, lower than at any time during the housing crash. The New York-based bank made $52.7 billion of mortgages a year earlier. Marianne Lake, JPMorgan’s CFO, cited severe winter weather as among the reasons for the first-quarter drop." - source Bloomberg

This recent article follows another article written by Jody Shen on the 10th of October 2013 in Bloomberg entitled "JP Morgan Taps Taxpayer-Backed Banks for Basel Rules":
"FHLBs, cooperative institutions owned by their borrowers, were created in 1932 to provide savings-and-loan institutions with a way of tapping stable funding after a string of failures caused by runs on deposits. Their Washington-based trade group now says the aim “is to support residential mortgage lending and community growth in all areas of the country.”
In 1989, Congress allowed commercial banks to join the network, which comprises 12 regional FHLBs that raise money jointly in the bond market to fund lending to members and their investment portfolios. Because of the perception the government would step in to prevent a default, FHLBs can sell securities at yields similar to Treasuries and the bonds carry the top rating from Moody’s Investors Service and the second-best from Standard & Poor’s, the same as its U.S. ranking." - source Bloomberg.

Of course the reason behind the drop in mortgage origination is that the leverage community such as private-equity forms, hedge-funds and real estate investment trusts and other institutional landlords have been perfectly positioned to benefit from the "Hocus Bogus" recovery and in the front line to gain on the 23% surge in home prices since the post-bubble low in March 2012 according to the S&P/Case-Shiller index. According to Bloomberg more than $20 billion has been spent so far by the leverage community to buy as many as 200,000 rental homes in the last two years.

No wonder US Family Housing Starts has been falling in conjunction with US Furniture sales, as well as the Baltic Dry Index as of late, pointing, we think to some important "crosswind" in the much vaunted US recovery- graph source Bloomberg:
Since 2006:
- in red the Baltic Dry Index,
- in orange US Family Housing Starts
- in blue US Furniture Sales.

As we indicated in our January 2013 conversation "The link between consumer spending, housing, credit growth and shipping" :
"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."

Top US Imports by commodity - source Bloomberg:
"The top five U.S. imports account for about 35% of the total in 2013, and include furniture, machinery, electrical equipment, apparel and vehicles. Furniture has been the top containerized U.S. import over the past six years, at 11.6% of the total in 2013, according to Datamyne. China was the largest furniture exporter to the U.S., followed by Vietnam and Malaysia in 2012. Higher imports may help absorb excess capacity and boost rates for containerliners." - source Bloomberg.

Any change in consumer spending trends is depending on a more pronounced housing market revival and will directly impact container traffic, it is that simple.

But when it comes to mortgage origination, mortgage volumes have fallen 57% year on year as shown in the below Bloomberg chart:
"Mortgage volume may have fallen 57% yoy in 1Q, driven by a 71% decline in refinance volumes, according to Mortgage Bankers Association forecasts. Volume is expected to be 23% lower compared with 4Q. Profitability indicators are also modestly lower yoy, though relatively stable with 4Q. Mortgage banking volumes should remain well below those of recent years in 2014, though revenue pressure may begin to be offset by expense cuts, including significant staff reductions." - source Bloomberg.

All in all, this is indicative of the shift in mortgage origination and also indicative of the latest system abuse by US banks to obtain cheap funding to meet liquidity requirements set up by the regulators. 
While we previously argued that LTROs in Europe amounted to "Money for Nothing", the latest US banking regulatory trick does indeed display a similar feature given that even with better FICO scores lending standards have been tightened.

End of the day, if central bankers are powerful magicians, bankers are no doubt accounting wizards.

"I will speak of one man... that went about in King James his time... who called himself, The Kings Majesties most excellent Hocus Pocus, and so was he called, because that at the playing of every Trick, he used to say, Hocus pocus, tontus talontus, vade celeriter jubeo, a dark composure of words, to blinde the eyes of the beholders, to make his Trick pass the more currently without discovery, because when the eye and the ear of the beholder are both earnestly busied, the Trick is not so easily discovered, nor the Imposture discerned." - Thomas Ady, A Candle in the Dark, 1656

Stay tuned!

Saturday, 29 March 2014

Credit - Too Big To Fall

"Risk comes from not knowing what you're doing." - Warren Buffett

Watching with interest the ever compressing credit space with the Europe High Yield CDS risk gauge Itraxx Crossover tighter by 30 bps to 290 bps since the new series launched on the 20th of March, we are indeed feeling the same nervousness around the rapidity of the spread compression we experienced firsthand in 2007. We also reminded ourselves lately of the epitome of the financial crisis namely the expression  "Too Big To Fail" which led to the definition of systemic importance for some banks. We decided this time around to play along this famous or infamous expression (whichever you prefer) in our chosen title given the abandon and frenzy with which investors seems to be seeking whatever is on offer in the credit space with a decent coupon, regardless of the risk (or covenant protection in some instances), but more importantly disregarding the growing "liquidity" risk we have often warned about, leading us to our chosen title, as we believe credit markets are indeed becoming "Too Big To Fall" given the shrinking balance sheet of  banks has led to paltry dealers book to accommodate any major selling pressure should it materialise in the near future.

On the subject of liquidity and credit markets, we could not agree more with Axa's recent take on the subject as reported on the 21st of March by Roxana Zega in Bloomberg:
"Regulatory change imposed on banks to make them safer may ironically end up sparking systemic risk, with current spreads failing to compensate for greater illiquidity, Mark Benstead, global head of SmartBeta Credit at Axa IM says in 2014 outlook.
 -Regulation has stopped market makers from being either willing or able to supply former levels of market depth for corporate credit
 -Central bank liquidity has engineered falsely low default rates
 -Axa says there’s a mismatch between size of credit market and the ability to trade it
 -Carry will be the main source of return for credit as capital appreciation is unlikely this year, with yields barely expected to budge
 -“Credit events” could dent returns, so careful selection is needed to dodge isolated risks
 -Expects central bank policy to be more divergent in 2014 than at any other time in past 5 years
 -Axa IM managed ~EU547b as of end 2013
 -Note: BNP said March 13 that low liquidity is main risk to credit" - source Bloomberg

A good illustration we think of risks coming from "not knowing what you are doing", from a credit perspective, can be ascertained from the growth of convertibles under ETF format in the US in assets under management (AUM), particularly when one looks at the growth of CWB US, the US convertibles ETF (SPDR State Street) which includes convertibles and preferred, leading it to be highly "equity" sensitive. Please keep in mind that when it comes to convertibles issuance, the US market has seen a strong pick-up in issuance from the technology and biotechnology sectors.

The surge in AUM has indeed been staggering - graph source Bloomberg - ETF Market Capitalisation:
- graph source Bloomberg

Of course the surge in the AUM has been closely following the surge in the price of the aforementioned ETF:
- graph source Bloomberg.

As we indicated recently there is a great article in Forbes by Bill Feingold on the high price being paid on some convertibles:
"A wise trader once said, “There are no bad bonds, only bad prices.”

If you’ve been following this space, you know that I’ve been trying to encourage companies to take advantage of a historic opportunity to issue convertible bonds on favorable terms.  The opportunity has come about for the same reason most things get more expensive:  increasing demand and limited supply.

Here’s a statistic that should get your attention. I mentioned it the other day but once was not enough. The only significant exchange-traded fund dedicated to U.S. convertible bonds, CWB, has seen its assets explode over the past 12 months. Barely over $1 billion a year ago, the fund now has nearly $2.5 billion under management.  It’s a passively managed fund designed to track Barclays BCS +0.45%’ index of large U.S. convertible bonds (each component must be over $500 million, or about twice the size of an average convertible).

That growth should tell you all you need to know about how demand for convertible bonds has been expanding. It’s understandable—investors and their advisors are worried about rising interest rates but want to stay with an asset class that, unlike stocks, promises principal repayment.

However, companies haven’t been issuing convertibles nearly enough. New issuance in the U.S. bottomed at $20 billion in 2012, compared with around $100 billion annually in the years leading up to the financial crisis. 2013 was a lot better, with almost $50 billion, but that was barely enough to replace maturing deals.  Current issuance is simply nowhere near enough to keep up with demand.

Unfortunately, this means that in many cases, investors who are just now putting their money into a generally terrific asset class may be getting on the wrong side of value. In some cases, this can be rather severe."  - source Forbes, Bill Feingold.

We think there are growing risks of seeing liquidity vortexes where the lack of bid will make prices gap down violently, hence our chosen title. New Basel regulations have pushed banks to re-assess their balance sheets and are less in a position to absorb secondary offerings when markets turn South. Like others, such as Matt King from Citi, we have been warning about the fact that spreads reflect less and less "liquidity" risk in the current environment, convertibles being no exception, as clearly indicated by Bill Feingold in his Forbes article. 

As posited more recently by Matt King from Citi, liquidity is indeed a growing concern because it is extremely fat-tailed:
Citi Matt King - Investing in fake markets - March 2014 - How is the distribution in markets?
- source CITI - Matt King - March 2014 - Investing in fake markets.

Highly leveraged funds in the case of a sell-off will be particularly hit hard in that case. The issue of course would be to hold a higher proportion of cash to mitigate the redemption risk, unfortunately, cash buffers have been going down in many cases. Negative convexity risk in callable bonds for instance can be as well mitigated by increasingly playing credit via the CDS market. Recent hybrid calls at 101 for Telecom Italia and Arcelor Mittal are stark reminder of the need of pricing "optionality". Another advantage of the CDS market is the added liquidity on the credit exposure you want to add to your portfolio. Of course you are somewhat switching liquidity risk for counterparty risk. It is never a zero sum game but we ramble again. For illustrative purposes, the graph below from Matt King from Citi, illustrates further the liquidity issue, volatility and risk you run between cash bonds and CDS:
 "The vol you see is not the risk you're running"
- source CITI - Matt King - March 2014 - Investing in fake markets.

When we talk about investors getting outside their comfort zone and adding risk they might not perceive, the Junk-Loan ETF space is growing at a very rapid space in an environment which is becoming more and more reminiscent of 2007 as indicated by Sridhar Natarajan in his Bloomberg article from the 26th of March entitled "Junk-Loan ETF Asset Surge Heralds Higher Rates":
"Investors just can’t get enough of exchange-traded funds that buy junk-rated loans.
After more than tripling their assets in 2013, the loan funds are now growing four times as fast as the rest of the $262 billion market for fixed-income ETFs, according to data compiled by Bloomberg. The biggest leveraged-loan ETF, Invesco Ltd.’s $7.4 billion PowerShares Senior Loan Portfolio, has already amassed almost a billion dollars in new money this year.
The popularity of speculative-grade loans, which have rates that rise with benchmarks, has soared with debt investors seeking shelter from higher borrowing costs as the Federal Reserve moves up its rate-increase projections. While the demand has been a boon for ETFs that invest in loans to the neediest companies, it’s also prompted regulators to warn that excesses which contributed to the credit crisis may be creeping back." - source Bloomberg

As Warren Buffet quote goes, risk does indeed comes from not knowing what you are doing given that single-B rated loans now make up the largest portion of the junk-loan market compared with 2007, when double-B rated loans were the most popular. As a reminder, during the credit crisis, loans were the worst performers among the major credit asset classes, losing 23 percent in the last quarter of 2008.

Loan ETFs are yet to be tested, by our "liquidity" fat-tail concerns but they are sure becoming "Too Big To Fall", and if indeed selling pressure does materialise, they will probably sell-off fare more than the index because they might not be in position to redeem the assets at the pace of the money being pulled out. Caveat investor...

In a world of increasing "positive correlations" where convertibles ETFs as well are getting even more sensitive to "equities", last year's sell-off in the credit ETF space for High Yield (ETF HYG) and Investment Grade (ETF LQD) illustrate, we think the "redemption" risk - graph source Bloomberg:

Another illustration of the "Cantillon Effects" at play and outside the credit space has been the London real estate market courtesy of Central Banks' generosity as indicated by Bank of America Merrill Lynch in their Thundering Word note from the 27th of March entitled "Hey Crude, don't make it bad":
"London...the last great EM “speculative fervor”
Prime London real estate is up 2X since 2006, 3X since 2000 and 4X since 1998.
And yet UK rates are the lowest they have been in 300 years. In our view, London property is a classic outcome of the Max Liquidity-Min Growth backdrop of the past seven years. We believe the risk of "speculative fervor" remains high. The UK could prove a useful early warning system.

Prime London real estate has doubled since 2006, tripled since the 2000 and quadrupled since the last great Asia/EM crisis of 1998 (Chart 3). 
And yet the Bank of England's policy rate is at its lowest level in 300 years (Chart 2)."
- source Bank of America Merrill Lynch - The Thundering Word - 27th of March 2014

As per our conversation "Cantillon Effects", we too, have an our own useful warning system, being the art market in general and Sotheby's stock price versus world PMIs since 2007 - graph source Bloomberg:
We have argued previously 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.

As a reminder, why did we choose art as a reference market in describing "Cantillon Effects" and asset bubbles you might rightly ask?

Well, as posited by a very interesting study by Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":
"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.

Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

Nota bene: Classical equation of exchange, MV = PQ, also known as the quantity theory of money. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.
-Endogenous money, PQ => MV (Hume, Wicksell, Marx)
-Exogenous money, MV => PQ (Keynes, Monetarist)

In our Cantillon Effects, we get:
Δ M  => Δ Asset Prices

Sales of art and antiques increased 8 percent from a year earlier to 47.4 billion euros ($65.9 billion), according to a report compiled by Arts Economics and published on the 12th of March as reported by Bloomberg by Katya Kazakina on the 12th of March in her article "Art Market Nearing Record as Global Sales Reach $66 Billion":  
"The results fell just short of the record 48 billion euros in 2007. The value of postwar and contemporary art transactions increased by 11 percent from 2012, reaching its highest-ever auction sales total of 4.9 billion euros as records were established for artists such as Francis Bacon, Roy Lichtenstein and Andy Warhol." - source Bloomberg.

Yet another example of "illiquid asset" such as London real estate to monitor closely in the near future and another illustration of our 2007 feelings we think.

On a final note and relating to our deflationary monitoring stance, we have been tracking with interest the shipping space as you know and looking at the recent Asia to Europe container shipping rates, it continues to fall and has indeed fallen to a 21 week low:
"Shipping rates for 40-foot containers fell 5.1% to $1,684 for the week ended March 27, marking the ninth-straight weekly decline and the lowest price since mid-December ($1,660), according to World Container Index data. None of the major trade lanes increased. Rates from Shanghai to Rotterdam (11.9% lower) and to Genoa (down 5.7%) declined the most for the fourth consecutive week, as rates for both lanes dipped to the lowest levels since October." - source Bloomberg.

The latest reading from the Drewry Hong-Kong/Los Angeles container rate benchmark tells a similar story - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5% to $1,886 for the week ended March 26, reversing last week's gain and the eighth week in 2014 below the $2,000 mark. Slack capacity continues to pressure prices, with rates 13.4% lower yoy and 25.1% below the July 2012 peak of $2,519. Carriers are expected to implement a $300 general rate increase per 40-foot container from Asia to the U.S., effective April 15." - source Bloomberg.

What is of course of interest is the additional rate increases to counter the deflationary forces at play still wreaking havoc on the shipping industry as a whole. As a reminder, Containership lines have announced 13 rate increases, totaling $5,450, on Asia-U.S. routes since the beginning of 2012.

So what is the new trick to offset deflationary forces, you might rightly ask? It is called "Container Liner Alliance" by the U.S. Federal Maritime Commission (FMC) when it should be called "Oligopoly" or more simply a cartel:
"The U.S. Federal Maritime Commission (FMC) approved the alliance of the three largest containerliners Maersk, Mediterranean Shipping and CMA CGM, dubbed P3, on March 20 to set sail in 2Q.
The alliance of 252 vessels (2.6 million 20-foot equivalent units) represents 42% of Asia to Europe, 24% of Trans-Pacific and 40% to 42% of Trans-Atlantic capacity, according to the FMC. P3 may help reduce costs and manage excess capacity, stabilizing rates." - source Bloomberg.

So in the competition of survival of the fittest, the set-up of a de facto "cartel" in the shipping space  with the benediction of US authorities has no doubt "boosted" the probability of survival of the big three. This latest "intervention" does indeed validate our January 2014 musing "Shipping and Deflation - Only the strong survive":
"In a Bear Case scenario, only the strong survive such as Maersk. The world's largest container shipping line with 15% of the world's market share, did report an 11% increase back in November in third-quarter profit after cutting costs by 13% in the quarter helped as well by its new line of triple-E ships being introduced which has been countering the deflationary trend in freight rates." - source Macronomics, 9th of January 2014

Looks like the containers industry is like the banking industry after all, it's "Too Big To Fail".

"If my survival caused another to perish, then death would be sweeter and more beloved." - Khalil Gibran, Lebanese poet

Stay tuned!

Friday, 21 March 2014

Guest Post - Equities: Frothy Sentiment

"The good news is, we're not bankrupt. The bad news is, we're close." - Richard J. Codey

Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the frothy sentiment building up in the equities space:


The MSCI World (developed markets) briefly tested its 2007 all‐time highs last week.
The strength in US equities explains most of the rise since 2009, but more recently Europe also helped the advance. The remarkable thing about this is how quickly sentiment towards stocks has reached and in many indicators even surpassed previous peaks in euphoria.

The indicator that has really caught our attention lately is the % of US IPOs with negative earnings. Most observers would have guessed that the 80% level reached back in 2000, at the height of the tech bubble, would never be reached again, but we are almost there again. Bloomberg reports that currently about 75% of all IPOs are money‐losing companies. So on top of the fact that rising equity issuance is negative for stocks’ expected returns in aggregate, the poor health of companies issuing shares is another medium‐term warning.


This goes hand in hand with extreme retail optimism which can be also tracked by looking at the RYDEX bull bear ratio. This is more interesting than the classic bullish/bearish ratios because it is based on actual money invested and not on surveys. It tracks the ratio of AUM between bullish and bearish RYDEX funds. As the chart below shows, it is at all‐time highs.


The net debit margins at the NYSE has reached almost 300bln and penny stocks’ trading volume has soared.


We also notice that the US market "breadth" is poor. The S&P Small Cap Index (S&P 600) has been printing new historical highs for 12 consecutive months with fewer and fewer shares trading above their 50 days moving average. Indexes are lifted by a small number of shares; this kind of negative divergence is rarely a good sign.

Additionally, we are now amazed to witness that Short VIX ETFs are almost as popular as Long VIX products. For us, who have been consistently selling equity volatility on spikes from 2009 until early 2013, when both retail and investment professionals were pouring money over Long volatility instruments at the worst possible times (vol was mispriced and the vol term structure curve was steep), it is astonishing to see retail investors now doing the opposite with vols in the low teens and the term structure now flat or slightly inverted.

While most of these indicators are usually useless to time equity markets on a short-term basis, they are nonetheless very useful for longer term expected returns.

From a long term technical analysis perspective, the US market is in an expanding wedge pattern. Each high is higher than the previous one, while each low is lower than the preceding bottom. The pattern ends once the third top is in; the "technical" target is lower than the 2nd bottom (March 2009 in this case).

This is the same pattern as in the 1970s.

From a behavioral finance point of view, the extreme levels of sentiment indicators we are watching make that catastrophic scenario a remote possibility that needs to be carefully examined. An energy price shock, similar to both 2000 and 2008 (fast rise in oil and gas prices) would seriously increase the odds of that happening. This is why, a move for Brent above 113 and followed by a sharp upside acceleration would send in our opinion a very negative signal for global stock markets around the world.



"You never want to have to give your child bad news of any kind."Jonathan Dee, American novelist

Stay tuned!