Tuesday, 14 October 2014

Credit - Actus Tragicus

"We live in an age of mediocrity." - Lauren Bacall

Looking at the dismal European data coming out of Europe with a plunging German Zew index in the October survey declining 10 month in a row ( -3.6 this month from 6.9 in September),  with German industrial output falling by 4% during the course of August (the biggest drop since January 2009) and weaker inflation in Europe with Spanish September HICP inflation coming in at -0.3% YoY, and French HICP inflation falling to 0.4% YoY (from 0.5% YoY in the previous month), with prices down 0.4% MoM and Eurozone Industrial Production coming at  -1.8% (below the expected -1.6%) in conjunction with new record lows on the German 10 year yield coming at 0.85%, we decided therefore to use another musical analogy, this time around drifting towards one of our favorite classical masterpieces, BWV 106, also known as Actus Tragicus, being a sacred cantata composed by Johann Sebastian Bach in 1708 when he was 22 years old in Mühlhausen and intended for a funeral. In the end it might be the most appropriate funeral cantata that could be used for the euro at some point given the growing dissent in both Italy and Germany, as well as the very open opposition between Mr Mario Draghi and Mr Jens Weidmann. Very few musical pieces touch our soul, arguably the first movement of BWV 106 aka "Actus Tragicus" is one of them, but we ramble again...

The tragedy playing out, of course, is the growing divergence between asset prices and economic fundamentals with central banks meddling with the most important variable in the capitalist system namely interest levels, more simply the "price of money", leading of course to "mis-allocation" of capital in the grand scheme of things. While large corporates in Europe have had no problem in gaining access to "credit", SMEs in Europe have been starved by the precipitation of the credit crunch leading to massive unemployment which has been accentuated by European banks deleveraging thanks to the EBA's fateful decision of "forcing" bank to reach 9% core tier one level by June 2012. We will not come back to that much commented and evident outcome which we have discussed at length on this blog.

What is of course of interest (and once again no surprise to us) is to see a continuation of the rally in US treasuries, which we had foreseen thanks to our contrarian stance which we indicated well in advance given our deflationary "bias" and our  "somewhat" understanding of the macro outlook. Since early 2014 we have indicated our long duration exposure, which we have partly played via ETF ZROZ as an illustration of us playing and understanding the "macro" game.

In this conversation, once again we have decided to focus on the credit cycle and where we stand when it comes to look at the "Global Credit Channel Clock", as designed by our good friend Cyril Castelli from Rcube Global Asset Management:

Last month we indicated the following in our conversation "Sympathy for the Devil":


"Whereas Europe sits more closely towards the lower right quadrant, it is increasingly clear that the US is showing increasing leverage in the corporate space, indicating a move towards the higher quadrant on the left of the Global Credit Channel Clock we think. What we have been seeing is indeed a flattening yield curve in the US with re-leveraging courtesy of buy-backs financed by debt issuance which is the point we made in last week Chart of the Day." - Macronomics, 9th of September 2014

We also argued:
"The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters."

Interestingly enough, high-yield outflows have continued for a 6th week in a row according to Bank of America Merrill Lynch's most recent Follow the Flow note published on the 10th of October and entitled "More in safety, less in yield":
"High-yield funds outflows continue for the sixth week
Even though US-domiciled HY funds flows bounced back, Euro-domiciled funds continued to see more outflows; the sixth week in a row. High-grade credit and money-market fund flows were on the positive side though, with the latter seeing the largest inflow so far this year. Note that over the past week, government bond funds saw a $1.9bn inflow, the largest in eight weeks.
Credit flows (week ending 8th October)
HG: +$1.5bn (+0.2%) over the last week, ETF: -$117mn w-o-w
HY: -$1.2bn (-0.5%) over the last week, ETF: -$114mn w-o-w
Loans: -$112mn (-1.3%) over the last week
Same patterns for another week in European credit funds, with more inflows into high-grade funds and more outflows from high-yield. "However, fund flows into W.E. regional funds (that we believe are more €-bond focused) have seen another inflow (of $478mn) last week. On the duration front, high-grade credit flows have been concentrated in the mid and long-term funds, with outflows continuing from the short-end for a second week.

More in safety, less in yield
Flows have been pointing to “safe” yield rather than any yield, lately. Over the past weeks, the trend has been notable, with more funds added in high-grade credit and government bonds, rather than high-yield credit and equity funds. YTD flows into high-grade and government bond funds have been in ~$65bn, while flows into highyield and equity funds have been a mere $22bn. Put that also on top of the record inflow into money-market funds last week  takes the 2014 YTD figure to $60bn." 

- source Bank of America Merrill Lynch

So much for the "Great Rotation" story of 2014 from bonds to equities...

Of course while the "Actus Tragicus" continue to play out in Europe in the "real economy", US and Europe Investment Grade credit continue to benefit from the flattening of the yield curve. The evolution of flows of course validates the "Great Rotation" namely the gradual move of investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit as we concluded our last conversation.

And what has happened in the last few years courtesy of Central banks generosity has been the multiplication of carry trades in various segments of the market. The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years is likely coming to an end as we move in the US towards the upper quadrant of the "Global Credit Channel Clock".

Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is  the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...).

As we posited in our conversation on the 13th of June 2013 "The end of the goldilocks period of low rates volatility / stable carry trade environment?":
"The huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space."

Looking at the continuation in both outflows from the equities space and the very strong compression in  the long end of core government bond space (US Treasuries and German Bund), it much more likely for us that we are indeed at risk of a significant "repricing" in the equities space.

Facts are as follows:
Commodity markets and the performance of global cyclicals versus defensives continue to point to a very, very subdued global growth environment.
Another "great anomaly" that investors should take into account is that low volatility stocks have provided the best long-term returns such as "Consumer Staples".

When it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:
Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". Investors should had bought Treasuries if they had anticipated the Federal Reserve reduction in its purchases, based on the last two times that the biggest buyer of bonds stepped back from the market (The yield declined by 126 basis points between the end of the first round of Fed purchases in March 2010 and the beginning of the second round in November that year).

Of course our positive stance on Investment Grade Credit which we discussed again in August 2014 in our conversation  "Thermocline - What lies beneath" has been confirmed:
"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." - Macronomics, 19th of August 2014.

While it is true that the "interest rate buffer" in case of a surge in rates is nearly exhausted in the current low yield environment, but the environment for investment grade credit is still favorable as highlighted again last week:
"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

Of course the current interest rate differential between the US and Europe, supported by a weakening Euro and negative interest rates in the front-end of some European government bond yield curve points towards a larger allocation to US fixed income we think.

On that point we disagree with the latest take from Bank of America Merrill Lynch' s credit team in their recent Credit Market Strategist note from the 10th of October entitled "Breaking up is so easy to do" given they don't see an acceleration into US fixed income:
"Breaking up is easy to do. US-European interest rate differentials are near historical highs whereas credit spread differentials remain near – though notably off - historical lows. With the economies out of sync, and resulting opposite central bank policies, our global interest rate strategists expect the rates differential to increase even further. As our European credit strategist, Barnaby Martin, maintains a constructive outlook for EUR IG, and we are tactically short US IG, clearly we expect the US-EUR spread differential to widen further. 
The push-back. 
Investors’ biggest push-back against this outlook is that, with US yields much higher than global yields we should expect a global allocation change and/or diversion of flows into US fixed income – including credit. The direct effect of such flows would be to dampen interest rate differentials and add strength to US credit at the expense of European credit. Furthermore, as interest rate risk is the key uncertainty for US credit, these flows would provide additional indirect support for US spreads. Hence any divergence between interest rates, credit spreads would be more limited than we are looking for. We think that, while global weakness asserts downward pressure on US yields, the mere existence of wide global yield differentials do not.
Our push-back against the push-back. 
We find it unlikely that the existence of big global yield differentials will accelerate inflows to US fixed income for two reasons. First, while we would indeed expect inflows in a high return environment of both high and declining US yields, with rising US interest rates – which our interest rate strategists expect – returns are much less attractive, despite the higher yields. Second, there appears to be little mean-reversion in interest rate differentials – at least between US and German interest rates. In fact in a statistical sense they appear well characterized as random walks – i.e. can wander far from current levels, in either direction. Thus, even though the difference between US and European interest rates is high, from a statistical point of view we are just as likely to see further meaningful increases from here, as we are to see meaningful decreases." - source Bank of America Merrill Lynch

Unfortunately, we think that flow matters and interestingly another note from Bank of America Merrill Lynch from their Liquid Insight team from the 10th of October entitled "Investing in a sub-zero world" makes some interesting contrarian points which we agree with when it comes to the amount at stake when it comes to "financial repression" in Europe:
"We take a look at the broader challenge to portfolio managers posed by negative yields. Since the ECB decided to first venture into negative rates in June 2014, 30% of the EUR domestic government bond market now trades at negative yields (by notional). For German government bonds this number is 46%. Investors need to move as far as the 4y part of the curve to see positive yields. Expressed another way: investors are willing to pay euro area governments to look after €1.3tn (when including bills). To avoid paying negative rates, investors have to either take more duration risk or more credit risk" - source Bank of America Merrill Lynch

From the same note:
"€1tn looking for a new home
We focus on the impact of negative yields on bank treasury and central bank portfolios for a number of reasons: (1) both tend to get managed against relatively restrictive benchmarks in terms of duration and credit risk; (2) both will therefore be disproportionately affected by negative rates compared to a mutual fund or an insurance company; (3) both have anecdotally reacted strongly to the rate cuts in June and September.
Table 1 shows our estimates of what a typical central bank, peripheral bank, core bank, and non-euro-area bank treasury portfolio looks like. 
Table 2 shows what has likely happened to the weighted average yield of these portfolios since the beginning of June, when the ECB had not yet ventured into negative rates, as well as the amount of assets in each portfolio that now trade at negative yields.

Unlike mutual funds which receive investors’ funds with the specific mandate to replicate (and preferably outperform) the risk-reward profile of a specific benchmark, or indeed an ALM manager who is trying to match specific liabilities, central banks and bank treasuries can be thought of as total return investors subject to a liquidity mandate. As such, they can be expected to take steps to avoid paying negative rates on the roughly €1tn of their holdings that have moved into negative rates since the beginning of June.

€400-600bn of additional demand for risk
Table 2 also shows how much demand for additional risk the ECB has potentially generated through its decision to cut rates into negative territory. 

If bank and central bank portfolios were to try and offset the hit to interest income since the beginning of June, this would generate demand for duration or peripheral risk or a mix of the two between € 400-600bn.
Clearly this number is an exaggeration of what bank treasurers and central bank portfolio managers are actually likely to do. Some will be uncomfortable taking so much additional duration and/or credit risk. Banks that are not capital constrained may decide not to accumulate zero risk-weighted assets but instead lend to the real economy. Other banks may decide to take steps to encourage deposit outflows to reduce investment needs.
Yet, what this exercise shows very clearly is that even in the absence of QE, the ECB is creating a pseudo-portfolio effect, achieved in the US and the UK through the outright purchase of government bonds. With the ECB now actively targeting a balance sheet expansion, we expect yields to move further into negative territory, aggravating the challenges for investors outlined aboveTherefore, over time we may well see a migration into risk approaching these numbers above." - source Bank of America Merrill Lynch

We therefore do think (and so far flows in US investment grade are validating this move) that interest rate differential will indeed accelerate inflows towards US fixed income, contrary to Bank of America Merrill Lynch's views. We do not expect a rapid rise in US interest rates but a continuation of the flattening of the US yield curve and a continuation in US 10 year and 30 year yield compression and therefore performance, meaning an extension in credit and duration exposure of investors towards US investment grade as per the "Global Credit Channel Clock" (although the releveraging of US corporates means it is getting more and more late in the credit game...).

Of course the issue in Europe when it comes to the real economy has been weak aggregate demand plagued by high unemployment levels and the continuation of the "deleveraging" à la Japan.

The weaker macro outlook as part of the "Japanification" process is supportive of credit and the continuation of lower yields. On that specific subject we agree with Nomura's take from their latest Japan Navigator No. 590:
"As bond yields and stock prices apparently moved in line with the three-month cycle in the UST market until the first half of this week, we believed that investors should be positioned for lower stock prices and lower bond yields (bull flattening in the super-long space) until the 28-29 October FOMC meeting, which we view as the next turning point in monetary policy. However, the Fed demonstrated its dovish stance unexpectedly earlier in its 16-17 September meeting minutes, bringing rates lower substantially. Despite this, stock and crude prices continued to move lower this week. This suggests to us that the market has begun to expect changes in the real economy, i.e., a slowdown in the global economy, including the US, and potential easing by the Fed and other central banks, rather than looking at the excess liquidity-driven three-month cycle. This is only a tail risk at this point, but warrants due attention as it could have a substantial market impact. Indeed, we believe investors have added positions by pricing in this risk, likely adding momentum to risk aversion this week."
- source Nomura

Moving back to the subject of the credit cycle, JP Morgan's latest note from the 14th of October entitled "Where we are in the credit cycle?" highlights the situation based on credit fundamentals:
"A credit cycle is generally characterized by a rapid growth in the availability of credit, a decline in the cost of credit, and increased willingness of lenders to accept lower returns and to lend to riskier borrowers. At some point subsequent losses from this risky lending rise, and lenders retrench, leading to credit market stress and often a broader negative economic impact.

When companies have access to plentiful and historically cheap funding there is a risk that they use it in ways that support shareholders while making their credit profiles more risky. There are trends occurring in some credit markets that have historically been associated with a credit cycle that is reaching maturity. These include significant bond issuance, low spreads, a weakening of covenants, declining credit ratings, an increase in M&A activity, less favorable use of proceeds from issuance, and rising dividends and share buybacks. However, the starting point for deterioration is quite strong in some markets, and the extent of deterioration is not consistent across markets, and some are actually improving.
Monetary authorities globally are contributing to easy financing conditions for corporates through both low policy yields and a withdrawal of fixed income product supply through QE. A result of this is, since 2010, there has been a 33% increase in the outstanding amount of US corporate bonds, 166% increase in EM corporate bonds outstanding and 39% increase in European corporate bonds outstanding (figures exclude Financials). Some of this increase is substitution from other funding sources into the bond market. In EM markets some of it reflects a shift in funding from sovereign to state-owned (quasi-sovereign) issuers as well as substitution of syndicated loan facilities in 2012. In all regions low coupons have made the large debt burden more manageable from a cash flow perspective. Still, the rise in debt issuance has impacted leverage.
The key question is where we are in the credit cycle—are we at the 5th inning (for Americans, or halftime for Soccer/Football fans) or the 9th inning/close to full time? This varies by market, as shown below. The US HG market is perhaps the most advanced, exhibiting many signs of maturity. On the opposite end, Japanese credit metrics are improving sharply thanks to improved profitability driven by better growth and the weak yen.


-The credit cycle is not identical across market segments; we see the US High Grade market as most advanced in the cycle and the Japanese market as improving the most rapidly.

-In US High Grade markets the credit cycle is the most advanced, with increasing cash going to shareholders, rising leverage and increasing M&A.
-In US High Yield credit metrics are eroding modestly alongside new-issue quality, but robust corporate liquidity supports continued low default rates.
-In European HG leverage remains near historical highs, as the economic recovery has struggled to gain momentum. Companies are being conservative with dividends and M&A.
-In European HY markets companies are reducing debt but revenue is declining at about a similar rate, such that credit metrics are struggling to improve.
-In EM HG the rise in leverage has been driven by quasi-sovereigns where government policy remains a variable, but non-quasis have been stable.
-In EM HY credit fundamentals have weakened with slow GDP growth. There is still some pressure from commodity sectors, but maturities are light near-term.
-In Japan credit metrics are improving sharply with the pickup in growth and weak Yen. Companies are using the improved cash flow to pay down debt." - source JP Morgan

While the "Actus Tragicus" continues to play out in the deterioration in Europe of economic fundamentals putting additional stain on stretched equities valuation. In the credit space, at least in investment grade, thanks to the "Japanification" process, it continues to be "goldilocks" we think.

On a final note we leave you with the Chart of the day from Bank of America Merrill Lynch note from the 10th of October entitled "Investing in a sub-zero world" displaying our negative yields are indeed moving out the curve:
- source Bank of America Merrill Lynch


"Politicians fascinate because they constitute such a paradox; they are an elite that accomplishes mediocrity for the public good."- George Will, American novelist

Stay tuned!


Monday, 6 October 2014

Credit - Sprezzatura

"When you can't make them see the light, make them feel the heat." - Ronald Reagan

Listening with interest to the latest comments from our "Generous Gambler" aka Mario Draghi and the disappointment that followed his ECB conference with a significant wobble in European equities by more than 2% (given he didn't specify the size of the potential ABS program), we reminded ourselves for our chosen title and analogy of the Italian word originating from Baldassare Castiglione's "The Book of the Courtier" published in 1528. Sprezzatura is defined as the ability of the courtier to display "an easy facility in accomplishing difficult actions which hides the conscious effort that went into them" according to Wikipedia. In plain English, the word has entered the Oxford English Dictionary defined as "studied carelessness".

What we find of interest in our chosen analogy is that Castiglione wrote his book as the portrayal of an idealized courtier - one who could successfully keep the support of his ruler, in our European case, the support of Germany. 

It seems our "Generous Gambler" is losing his "Sprezzatura" we think when we hear about the rising German dissent for degrading further the quality of the ECB's balance sheet as indicated by the comment of Jurgen Stark, the former chief economist of the ECB:
“The ECB’s decision to double down on stimulus is an act of desperation. Its willingness to buy ABSs is especially risky and creates joint liability, with European taxpayers on the hook. The ECB lacks the democratic legitimacy to take such far-reaching decisions,” - Jurgen Stark

Of course it is of no surprise to us to see growing German dissent as we have long argued Germany holds the key to the unravelling of the European game. The essence of "sprezzatura" is making difficult tasks seem effortless: "whatever it takes", "believe me it will be enough", etc. 

Those who possess sprezzatura need to be able to deceive people convincingly. As of late our "Generous Gambler" hasn't. Also as per Wikipedia, Sprezzatura's negative attribute is "the art of acting deviously":
"This "art" created a "self-fulfilling culture of suspicion" because courtiers had to be diligent in maintaining their façades. "The by-product of the courtier's performance is that the achievement of sprezzatura may require him to deny or disparage his nature". Consequently, sprezzatura also had its downsides, since courtiers who excelled at sprezzatura risked losing themselves to the façade they put on for their peers."  - source Wikipedia

The "Sprezzatura" performance of our "Generous Gambler" Mario Draghi made us remind ourselves our quote from our conversation "Sympathy for the Devil"given that, in order to achieve "sprezzatura", it required Mario Draghi to deny or disparage his nature:
"The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.

While the euro has indeed fallen by more than 9% against the US dollar since May, it won't be enough to sustain economic expansion we think, which unsurprisingly is falling, a subject we will discuss in this conversation as well as our continuous nervousness with the continuation in the rally in the US dollar, meaning tightening and dollar scarcity and the confirmation that CCCs credit being indeed the canaries in the risky asset coal mine.

As we posited in our previous conversation, as years have gone by in the European tragedy, we have become somewhat immunized from our great magician's spells and "sprezzatura" tricks.

It appears though that, we are not the only ones being less "receptive" to the "sprezzatura" skills of our "Generous Gambler" given that at the latest 2014 Global Macro Conference in London from Bank of America Merrill Lynch, some clients revealed their strong convictions through a survey, one being that bank lending will not step up post EU stress tests (83%) and that EUR will be the worst performing (32.7%) over the next three months:
"1. Will stress tests prove to be a turning point for market confidence in the balance sheets of European banks?
a.  Yes  37%
b.  No  63%

2.   Will bank lending step up meaningfully after the stress tests?
a.  Yes  17%
b.  No  83%" 

Which currency do you expect to be the worst performing over the next 3 months?
1. JPY  16.3%
2. EUR 32.7%
3. RUB  20.4%   
4. BRL  18.4%
5. SEK 9.2%
6. Other (specify) 3.1% "
- source Bank of America Merrill Lynch


Taking on the first subject of our conversation, the continuous fall of the Euro won't be enough to sustain economic expansion, we read with interest Natixis take on the subject from their note from the 18th of September entitled "What is the correlation between the euro's exchange rate and growth in the euro zone?":
"A 10% depreciation of the euro:
• Increases euro-zone exports by 4.2% (given the increase in their relative price);
• Increases euro-zone imports by 3.1% (given their relative price);
• Therefore increases the euro zone’s level of GDP by only 0.2 percentage point.
Historical relationship between the relative growth of the euro zone and the euro’s exchange rate
We look at the link between growth in the euro zone relative to the United States and to the world (Chart 9A) and the euro’s exchange rate. 
Chart 9B shows that growth in the euro zone relative to the United States was high in 2001 (with a weak euro) but also in 2006-2007 (with a strong euro), and then declined while the euro depreciated. 
Chart 9C shows that growth in the euro zone relative to the world fell from 2001 to 2003 (with a weak euro) and has since been stable. We see no link between the relative growth of the euro zone and the euro’s exchange rate.
The divergent prospects for growth and interest rates between the United States and the euro zone explain the euro’s depreciation despite the euro zone’s external surplus. Is the euro’s depreciation good news if we take into account the weight of the euro zone’s necessary imports? First we looked at the elasticities of euro-zone export and import volumes and prices to the exchange rate. We saw a slightly positive effect of the euro’s depreciation on real GDP in the euro zone. Next we looked at the link between euro-zone growth relative to the United States and the world and the euro’s exchange rate. It appears no such link exists." - source Natixis

What is of course of interest is that the euro zone's massive external surplus has never been so large and creating indeed a very large imbalance. This of course, reminded us of Nobel Prize Robert A. Mundell 2000 book "The Euro as a Stabilizer in the International Economic System":
"The EU should also change its attitude towards the balance of international payments. Being a key currency issuer, it has the responsibility to provide the rest of the world with sufficient amount of euros. If it always keeps a surplus status, the euro cannot be an important international key currency. Other countries can obtain euro assets either directly through a trade deficit or a capital account deficit. But such a deficit is not a bad thing for the EU. It will bring seigniorage to the euro zone. The Asian countries traditionally belong to the dollar area. This is mainly because we have a trade surplus with the US or we have net capital inflows from the US. If the euro is going to be widely used in Asia, it should invest or lend more money to Asia. It should also expand its trade relations with Asian countries." - Robert A. Mundell, "The Euro as a Stabilizer in the International Economic System

In addition to the above, Deutsche Bank published today a very interesting report entitled "Euroglut: a new phase of global imbalances":
"This report argues that both “secular stagnation” and “normalization” are incomplete frameworks for understanding the post-crisis world. Instead, “Euroglut” – the global imbalance created by Europe’s massive current account surplus will be the defining variable for the rest of this decade. Euroglut implies three things: a significantly weaker euro (we forecast 0.95 in EUR/USD by end-2017), low long-end yields and exceptionally flat global yield curves, and ongoing inflows into “good” EM assets. In other words, we expect Europe’s huge excess savings combined with aggressive ECB easing to lead to some of the largest capital outflows in the history of financial markets." - source Deutsche Bank

Of course a symptom of this phase of global imbalance has been the very weak aggregate demand in Europe caused by the European crisis and the credit crunch triggered by the EBA in 2012 which accelerated the deleveraging of European banks and the lack of credit transmission to the real economy. 
"What is Euroglut? Euroglut is a global imbalances problem. It refers to the lack of European domestic demand caused by the Eurozone crisis. The clearest evidence of Euroglut is Europe's high unemployment rate combined with a record current account surplus. Both are a reflection of the same problem: an excess of savings over investment opportunities. Euroglut is special for one and only reason: it is very, very big. At around 400bn USD each year, Europe's current account surplus is bigger than China's in the 2000s. If sustained, it would be the largest surplus ever generated in the history of global financial markets. This matters." - source Deutsche Bank

Global Imbalances are indeed larger than before the Great Financial Crisis:
- graph source Deutsche Bank

The Euroglut according to Deutsche Bank:
"Europe has been running a current account surplus over the last two years but also benefited from
portfolio inflows as Eurozone risk premia normalized. This surplus was plugged by outflows in the “other investment” component of the balance of payments. This was mostly related to falling bank liabilities to foreigners. Even though banks reduced their foreign assets (deleveraging), their foreign liabilities dropped by more as foreigners reduced their euro loans and deposits." - source Deutsche Bank

Another issue we mentioned was the crowding-out effect which meant that the incestual relationship between European banks and their governments have led to investments being directed to "carry-trade", with credit not directed where it matters most, namely European SMEs.

On the matter of FX depreciation, in conjunction with Natixis take, Deutsche Bank argues that it will not be an effective tool:
"Domestic policy implications
A domestic implication of euroglut is that FX weakening will not be an effective policy response. Does the euro-area need an even bigger trade surplus? Europe faces a problem of domestic, not external demand. The global environment is hardly conducive to export-led growth either. Japan has engineered a close to 50% appreciation in USD/JPY yet exports have failed to recover. This lack of FX responsiveness does not mean that the ECB doesn't care. Absent fiscal policy or other "animal spirit"-boosting initiatives, there is very little left for the central bank than to push yields and the currency lower. QE in Europe will be ineffective, but it will happen anyway - it is the only tool the ECB has to protect its mandate.

From a "Macronomics" perspective the impact should indeed be substantial as posited by Deutsche Bank:
"Global impact
Euroglut means that as the world's biggest savers, Europeans will drive international capital flow trends for the rest of this decade. Europe will become the 21st century's largest capital exporter. This statement is close to an accounting identity - a surplus on the current account implies capital outflows elsewhere. Our premise is that the next few years will mark the beginning of very large European purchases of foreign assets. The ECB plays a fundamental role here: by pushing down real yields and creating a domestic "asset shortage", it is incentivizing European reach for yield abroad. Think about policy over the next few years: at least 500bn-1trio of excess cash will be sitting in European bank accounts "earning" a negative rate of 20bps. In the meantime, asset-purchases will drive yields down across the board – there will be nothing with yield left to buy. The asset implications are huge:
1. Currency weakness. As equity, fixed income and FDI outflows pick up, the euro should face broad-based weakening pressure. Our end-2017 forecast for EUR/USD is 95cents.
2. Very flat fixed income curves. What will Europeans buy? With the US Treasury - bund yield spread at record highs, US fixed income should be a primary beneficiary of European demand. "Secular stagnation" implies a low terminal Fed rate resulting in low long-end yields. "Euroglut" suggests that the level of neutral Fed funds doesn't matter. If there is sufficient demand for long-dated instruments, the US 10-yr yield could easily trade below terminal Fed funds. It happened during the 2000s "bond conundrum", it is even more likely now - global imbalances are bigger.
3. Good EM could survive. The Global Financial Crisis has seen a rotation of current account surpluses away from EM to Europe. At face value, this makes EM more vulnerable. But the sum of countries' current account surpluses is larger now than before 2008, so there is more spare capital around. European current account recycling should mean that the marginal demand for EM assets is likely to go up, not down." - source Deutsche Bank

We agree with the above, US investment grade has already seen large inflows and the flattening of the yield curve will continue to be supportive of credit. What we also found of great interest on the subject of the euro, current account surplus and global monetary policies was in a recent note from Exane BNP Paribas from the 2nd of October entitled "A Frankfurt Accord for a lower euro?":
Imagine the unimaginable: Europe and the US agree on a lower euro
The markets' focus is on the ECB taking more credit risk by purchasing Eurozone assets. But what
if the ECB buys US treasuries, instead of buying Eurozone government bonds, as is widely expected to happen sooner or later? This would help the ECB in its endeavour to bring its balance sheet back to 2012 levels (+EUR1trn needed). In other words, the ECB intervenes in FX markets, with the blessing of US authorities. We have coined this hypothetical scheme the ‘Frankfurt Accord’.
This ‘out-of-the-box’ idea is worth considering based on the following reasons:
1) The ECB avoids the legal and political uncertainty of buying Eurozone sovereign debt
2) FX intervention and US treasury buying is within the ECB’s mandate
3) A lower euro would quickly feed into the economy with a positive effect on prices and exports.
4) The main challenge is that the Fed and the US government would have to agree. The benefits for the US would be that it would delay Fed tightening and keep 10-year yields low, thereby supporting the US mortgage and residential real estate markets.

Is it likely to happen?
The ECB buying US sovereign debt is not our main scenario. However, we think that markets currently underestimate the political risk attached to large-scale purchases of EMU sovereign debt and the consequent possibility that the ECB may yet again have to become more creative in its conduct of monetary policy. The appropriate framework for such a political agreement is a G7 FinMin meeting (10 October in Washington, Germany takes over the presidency next year)." - source Exane BNP Paribas

On that interesting scenario unravelling, obviously our "Generous Gambler" Mario Draghi would have to regain his "sprezzatura" and the support of his masters as indicated by Exane BNP Paribas in their interesting note:
"Who has to agree? US treasury, Fed and European politicians
In the G7 context, the implicit political rule is that large-scale FX intervention should first be blessed by the major parties involved. Therefore, the US treasury and Fed would have to agree to the ECB buying US sovereign debt. And of course Eurozone politicians should be on board as well. This was the political procedure followed in 1985 for a lower USD (Plaza accord), and in 1987 to stabilise the USD (Louvre accord). It was also the case in 2000, when the ECB intervened in EURUSD to stabilise the euro, initially on a co-ordinated basis between the ECB, the Fed and BoJ.
Ideally, the Japanese authorities would also agree
The ECB would only be active in US and not Japanese markets. However, in our view, this should not be too much of an obstacle as a weaker USD is in Japan’s interest as well. The more sensitive issue would be EUR-JPY. We believe the currency pair may fall a bit, but given that we expect the BoJ to opt for another round of QE in 2015, we do not see a “brutal” decline. Hence, the ECB buying US treasuries may not be that much of a problem for Japan.
The most delicate country to deal with is China
A higher USD leads automatically to a Chinese currency appreciation vis-a-vis the Eurozone. This is not necessarily China’s preferred policy mix. Authorities would most likely prefer a supportive export environment through a low currency, which allows them to tighten monetary conditions domestically to counter developments in shadow banking and the property sector. So in a way, a significantly higher USD increases the risks for a Chinese devaluation of the RMB against the USD."  - source Exane BNP Paribas

As we wrote back in our conversation "The Shrinking pie mentality" in April this year, China is more likely to seek a weaker RMB against the USD to avoid bursting its credit bubble à la Japan and  its Nikkei 39,000 of 1989:  
In relation to the aforementioned Chinese devaluation, we do agree with both Russell Napier and Albert Edwards that a Chinese devaluation is a strong possibility given that the Chinese have studied carefully Japan's demise from its economic suicide thanks the fateful decision taken to revalue the yen following the Plaza Agreement of 1985 (a subject we discussed with our good credit friend back in March 2011 in our conversation "Fool me once, shame on you; fool me twice, shame on me..."). In its most recent commentary, the US Treasury states that the Yuan is “significantly undervalued” and suggests that it must appreciate if China and the global economy are to "enjoy" stable growth. Unfortunately for the US Treasury the Chinese are not stupid as indicated by this article displaying the Chinese view on the Japanese economic tragedy written in 2003:
"Under US pressure, the Japanese government and banks "honestly" carried out the "Plaza Agreement", starting to interfere the yen exchange market on a large scale together with the US. As a result the exchange rate of yen against US dollars skyrocketed, exceeding 200:1 by the end of 1985, going beyond 150:1 at the beginning of 1987 and nearing 120:1 in early 1988. This means that the Japanese yen had doubled its value against US dollars in less than two years and a half!"People's Daily, September 23 by Professor Jiang Riuping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

In order to fulfill its balance sheet expansion the ECB could possibly apply similar intervention levels as did the Bank of Japan and the SNB in order to lower their currency as indicated by Exane BNP Paribas:
Applying similar intervention amounts to the euro (as a % of daily FX turnover) points to annual ECB purchases of between EUR400bn (SNB) and EUR800bn (BoJ). In the current context, with the EUR-USD already having turned, we believe intervention sizes suggested by the BoJ’s precedent overstate what is needed to manage down EURUSD.
As the ECB committed itself to expanding its balance sheet by EUR1tr, the ECB’s FX intervention would have to be unsterilized. Hence, US treasury purchases would lead directly to a balance sheet expansion.
In terms of ECB balance sheet composition, the ratio of FX assets / euro denominated assets has been declining since the start of the Eurozone. Expanding them by EUR500bn would lead to a ratio of 38%, all else being equal.
- source Exane BNP Paribas

And Exane BNP Paribas to conclude their interesting intellectual exercise with the following comments:
"ECB easing has to start now
Given current inflation and growth readings, it is quite clear that ECB easing has to start now, and not vaguely at some point next year. This is of course already happening, as ABS and covered bond purchases are set to start in October. As we are not too sure whether the US would subscribe to rapid monetary tightening as of now, it could be that a broad based agreement cannot be reached this side of Christmas.
Nevertheless, keep an eye on the G7 meeting on October 10. Next year, Germany takes over the G7 presidency, so perhaps our imaginative agreement would have a German name. Is it all likely to happen? Our spontaneous reaction was that ‘this is a banana republic approach’. However, the more we think about it, the more we like it…" - source Exane BNP Paribas

Taking on the second subject of our conversation, being our continuous nervousness with the continuation in the rally in the US dollar, meaning tightening and dollar scarcity, Bank of America Merrill Lynch came with interesting comments on the 3rd of October in their US Economic Weekly note entitled "Greenback grief":
"What kind of reaction?
Recent work finds that a 10% appreciation of the trade-weighted dollar leads to about a 0.3pp decline in GDP growth over four quarters, and a 0.25pp drop in inflation. 
As other currencies weaken, those economies should benefit, all else equal. But that effect happens only with a lag, and recent data have softened in several large economies, with the global outlook now looking less favorable. This creates a one-two punch for US exports, as both price and income channels work against them. Also, with a much larger share of corporate profits than GDP exposed globally, a strong dollar could have a bigger drag on stock prices, which might feed back adversely into confidence and spending.
On the inflation side, the Fed has undershot its target for much of the post-crisis period. Inflation accelerated somewhat earlier this year, but now seems stuck at 1.5%. If a dollar appreciation started to push down inflation —particularly core, and not just cheap imported energy and food — it would almost certainly stop Fed discussion of normalizing rates dead in its tracks. In our view, the Fed will not hike until inflation is expected to be on a sustainable path toward the 2% target. Indeed, pushing inflation down toward 1.2% or lower in the past has led to more easing not tightening. Markets may be expecting a further appreciation, but do not appear to be pricing in a shift from modest jawboning to a meaningful shift in Fed communications away from rate hikes next year." - source Bank of America Merrill Lynch

The 5y5y breakevens are now approaching levels at which the Fed has typically engaged in easing via asset purchases. Please keep that in mind. So, with the Fed scheduled to end QE3 by the end of the month, the bar to engage into additional purchases is indeed high making the October 10 central banks meeting a very important event indeed. What is indeed extremely evident to us is that the US yield curve will continue to flatten as it has been all year, in particular in the popular 5-30s part of the curve.

From the same Bank of America Merrill Lynch note, we agree that the velocity of the appreciation of the US dollar matters, particularly on the inflation front, which could postpone the normalization dead in its track:
On the inflation side, the Fed has undershot its target for much of the post-crisis period. Inflation accelerated somewhat earlier this year, but now seems stuck at 1.5%. If a dollar appreciation started to push down inflation —particularly core, and not just cheap imported energy and food — it would almost certainly stop Fed discussion of normalizing rates dead in its tracks. In our view, the Fed will not hike until inflation is expected to be on a sustainable path toward the 2% target. Indeed, pushing inflation down toward 1.2% or lower in the past has led to more easing not tightening. Markets may be expecting a further appreciation, but do not appear to be pricing in a shift from modest jawboning to a meaningful shift in Fed communications away from rate hikes next year." - source Bank of America Merrill Lynch

What is also of interest is that the surging dollar and falling US treasury yields have happened in conjunction with falling commodity prices and particularly a sharp drop in energy prices. This is therefore reinforcing the possibility of coordinate actions from central banks as it seems to us that the deflationary forces are once again taking the upper hand in the eternal struggle (see our post "The Night of the Yield Hunter").

Taking on the third  and last subject of our conversation, namely the confirmation that CCCs in credit  are being indeed the canaries in the risky asset coal mine in continuation of our take from our conversation "Wall of Voodoo", our earlier call was indeed confirmed for this segment of the market when we looked at the price action in the Euro CCC space in September as displayed in Bank of America Merrill Lynch's note from the 2nd of October entitled "The canary in the credit mine":
"In September, the pain was firmly felt in the lower reaches of the credit market. European CCC-rated bonds widened 240bp last month, a 3 standard deviation move, and the worst month of performance for CCCs (-5%) since November 2011 (-8%).
Why the reappraisal of low-quality risk in credit? A lot, we think, has to do with the recent negative credit events of Phones 4U and Banco Espirito Santo. These bonds dropped precipitously, with the effect filtering through to the rest of the market. 
But the ECB’s recent policy salvo (TLTROs, ABS purchases) have also been a subtle admission that Eurozone growth is faltering. None of this is conducive to the performance of low-quality bonds.
Inadvertently, the ECB may have called time on some of the euphoria that had crept into the credit market in 2014. Note that the Euro Stoxx index has been 90% correlated to CCC bond spreads since the start of 2012. But over the last month the two have hugely decoupled, with equities barely correcting." - source Bank of America Merrill Lynch

As a reminder low inflationary environment tend to be the ones where defaults can spike.

On a final note, when it comes to the "credit clock" and leverage in the High Yield space, since mid-2013 the net leverage has increased at a faster space as displayed by the following Goldman Sachs graph from their recent Global Macro Research note entitled "The Credit Trader: Not all dips are buys, but this one is" from the 30th of October:
- source Goldman Sachs

Obviously recent flows in High Yield with -$2.1bn (-0.9%) over the last week and ETF with -$138mn w-o-w counters somewhat the positive take from Goldman Sachs given the star of the again has indeed been investment grade saw $48 billion of inflows in high grade-credit fund in the last week of September with flows being tilted towards mid to long-term funds. EU domiciled funds have continued to see outflows for a fifth week in a row according to the latest Follow the Flow report from Bank of America Merrill Lynch from the 3rd of October.
This is confirming the gradual move of institutional investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit but that is another story...

“Practise in everything a certain nonchalance that shall conceal design and show that what is done and said is done without effort and almost without thought.” -  Baldassare Castiglione, The Book of the Courtier

Stay tuned!

Monday, 29 September 2014

Is art a good investment?

“Nothing great in the world has ever been accomplished without passion.“- Georg Wilhelm Friedrich Hegel

Miss Mai Pham Ngoc, founder of Art&Heritage LTD in collaboration with Macronomics

Is art a good investment?

The question in itself seems legitimate at first, but, in order to answer more precisely the question asked one has to reduce art to a simple investment instrument. Art could be therefore easily comparable to other financial investment instruments such as bonds or equities based on financial analysis, its performance, rate of return, and other measures, when it really isn’t a simple investment. 

Art is first and foremost an “emotional” investment we think.

Based on this clearer definition one can relate more easily to our above quote from German philosopher Hegel whose lectures on Aesthetics are regarded by many as one of the greatest aesthetic theories to have been produced since Aristotle.

Indeed, how can one achieve “financial” success in building up an art collection without passion? All great collectors share a common trait, a strong passion for the art works they are attracted to.

Why do these collectors see value in art works we do not see? 

Maybe Hegel was right when he came to defining why art was such an “emotional investment”: “The beauty of art is beauty born of the spirit and born again, and the higher the spirit and its productions stand above nature and its phenomena, the higher too is the beauty of art above that of nature. Indeed, considered formally [i.e. no matter what it says], even a useless notion that enters a man’s head is higher than any product of nature, because in such a notion spirituality and freedom are always presented.” - Georg Wilhelm Friedrich Hegel

No great collection, in private hands or displayed in museums was ever achieved without passion, making art itself a separate asset class of its own.

But how do you value art?

How can one understand that since 1985 until 2012, the AMR Art 100 index has provided an average annual return of 10 percent when in the same period the MSCI world has only returned an average annual return of 5.9 percent as reported in a study made by ArtAssure - Art Market Analysis 2013?
- source ArtAssure - Art Market Analysis 2013

Why in recent auctions new records have been broken? What makes the art market so different than a bond, or a company stock?

First, the use of fine art is an effective diversification tool as art is removed from the capital structure of the economy. Put it simply, Art is an insiders’ market driven by limited supply and the demand is strongly correlated to economic expansion of a country.

Growing global wealth and the emergence of new private and institutional buyers is leading a strong
demand for the “emotional” asset class. 

One of the chief reason behind record auction prices for the high end market of art is due to new buyers from Emerging Markets boosting prices for postwar and contemporary artists as the works are perceived as strong investments.

Second, think of art somewhat as “venture” capital investment in the sense that insiders, the ones investing in the primary market of the new “venture” have the highest probability of making much more significant “exponential” returns than the ones investing in the secondary market during an IPO

Why is so and why this comparison relates to the art market? 

Art follows a power law. In statistics, a power law is a functional relationship between two quantities, where one quantity varies as a power of another. For instance the primary market price for a work of art will be less for a large series or works of art than for a unique work of similar size, medium, and appearance by a specific artist. 

Once art passes out of the hands of the “insiders”, its commercial value is determined by the principle of supply and demand, but it can be “influenced” by the artist’s primary dealer in the sense that many art galleries will participate to some auctions to sustain the price level of the artist they represent, in similar fashion banks can sustain a share price for a certain period of time following an IPO. 

When we hear of “great price variations” in the art market, it seems to us that the behavior of the prices in the art market is similar to what can be seen in the complex options financial markets and difficult to value “American” options (An option that can be exercised anytime during its life). Since investors have the freedom to exercise their “American options” at any point during the life of the contract, they are more valuable than European options, which can only be exercised at maturity. In similar fashion a video on youtube.com can suddenly attract millions of views, in the art markets, the price of the work of art can vary very significantly upwards at any time due to an artist becoming mainstream or suddenly “fashionable”. But, the prices of contemporary artists can fall significantly as well as seen in 2008. It  can make it difficult for some art funds with tie-up clauses to realize timely their gains. Art remains an unpredictable “emotional investment”, subject to changes in trends and fashion.

How does one invest?

So, how does one invest? Demanding outside counsel and expertise is a necessity because of the very particular nature of the market and its different segments as well as the common risk of forgery. 
Either you are passionate enough to become your own expert (many top collectors end up being experts), or you rely on external art experts to help you build up a long-term collection. Such curating services are generally provided to ultra-high net worth individuals (UHNWI) who often rely on their own curators to manage and build-up their collections. The continuation of the on-going economic crisis has led to an accentuation towards tangible assets such as gold, real estate and works of art. Wealthy individuals hold an estimated US $4 trillion in “treasure/emotional assets”, an average 9.6% of their total net worth according to the World Wealth Report 2012 from Cap Gemini and RBC Wealth Management and Barclays Wealth. 

What we are seeing is the development a new trend « art and investment » which is pushing for complimentary services to be added to existing services provided by wealth management companies, private banks, as well as law firms, specialized or not. Furthermore, the development of internet based auction solutions backed by the growing number of “big data”providers from specialized art internet companies is adding more traceability and efficiencies to the growing art market. 

It is also worth pointing out that the higher returns of the art market also come with lower volatility. While the AMR Art 100 has an annual volatility rate of 12 percent from 1985 until 2012, the MSCI World Index had a volatility rate of 16 percent as indicated by the study made by ArtAssure - Art Market Analysis 2013

Counter-intuitively, this illiquid market is prone to less volatility. The upcoming opening of a port franc in Luxemburg as well as the commercial agreements between Asia and Luxembourg will no doubt sustain even more the buoyant activity in the art market with new money in Asia chasing old money in Europe. The art market throughout the history of mankind has always tend to follow money. When it comes to long-term trends, Asia-Pacific (ex Japan) is expected to be the second-wealthiest region in 2014, and the wealthiest by 2018 but that is another story (we highly recommend reading Angus Maddison's book Contours of the World Economy, 1-2030 AD, Essays in Macro-Economic History).

The art market, a fast growing segment

No doubt that the art market is a very fast growing segment of Global Private Financial Wealth Management. According to a recent survey conducted by the BCG (BCG Riding a Wave of Growth, June 2014 report), Global Private Financial Wealth grew by 14.6% in 2013 to reach a total of US $152 trillion with the fastest growth coming from Asia. The number of HNWI is on the rise and as an illustration, of the rise in Chinese art, in 2002 not a single Chinese artist was in the list of the top 100 contemporary artists. 10 years on, you find 45 and the overall turnover in China for the contemporary Art Market represented 25.6% of the global turnover.

Conclusion
To conclude, art is no doubt an “emotional investment” but, with proper counsel and advice, it remains a resilient allocation tool in wealth management. It can allow you to build long-term wealth with lesser commotions than in the stock market in addition to providing you with the pleasure of owning an aesthetics’ mean, more precisely, an object produced by the science of sensation, of feeling as postulated by Hegel.

For more on this subject and in relation to outside counsel and expertise services available you can contact Miss Mai Pham Ngoc at the following e-mail address:
mai@art-heritagepartners.com