Friday, 20 November 2015

Credit and Macro - Fluctuat nec mergitur

"The human race's prospects of survival were considerably better when we were defenceless against tigers than they are today when we have become defenceless against ourselves." - Arnold J. Toynbee, British historian.

While still reeling from the outrageous Paris attacks (one of us being a "born and bred" Parisian), and, looking at the continuous rally in risky assets, for our chosen title and in homage to the numerous victims of this senseless act, we decided that our chosen title should reflect Paris, hence our election for Paris coat of arms' motto "Fluctuat nec mergitur". It was officially established on the 23rd of November 1853 but dated back from at least 1358, a coincidental "number anagram". This motto could be translated as follows for Paris: "Paris is tossed by the waves but does not sink". 

When it comes to our analogy, Paris is like credit, resilient, it is tossed by waves but does not sink as reflected in the below graph from RBS The Revolver note from the 17th of November:
- source RBS

As we move towards the end of 2015, when it comes to credit European High Yield in the credit space has clearly outperformed US High Yield and even US Investment Grade. In this week's conversation, we would like to look at the prospects for credit for 2016 as well as pointing out some additional signs of credit cycle exhaustions as of late which, we think, warrants further monitoring.

  • LBO fatigue - yet another additional "caution" sign of the "credit cycle"
  • The US High Yield Market continues to be heading "South"
  • What to expect in 2016 - Will it be "Fluctuat nec mergitur" again for credit?
  • Final chart - Q4 US consensus profits growth is already forecast to be negative
  • LBO fatigue - yet another additional "caution" sign of the "credit cycle"
Whereas in recent weeks/months we mused around our favorite credit indicator for the lateness in the "credit cycle" being the "CCC Credit Canary" and its issuance issues, we also recently questioned ourselves in our conversation "Liebig's law of the minimum":
"Looking at the acceleration in M&A activity in recent days (DELL, AB InBev, etc.), which amounts to us, as yet another indication of us being in the last inning in the credit cycle, it appears evident that while credit corporate bond markets remain wide open, the last two months have shown clear signs of some form of "exhaustion" in the cycle, particularly for High Yield. It remains to be seen which next M&A deal or LBO will fall through." - Macronomics, October 2015
Indeed, whereas we have seen an acceleration in large M&A transactions, the continuous struggle of the "CCC Credit Canary" and the rise in the "cost of capital" have finally taken their toll and translated into the LBO market as shown in the  recent comments below from SG US derivatives desk highlighting that once again "weak feeling" we have on US HY credit markets, following a quickly erased October rebound:
"This week surprisingly weak demand for financing of the LBO of Veritas caught banks by surprise. The consortium led by Bank of America and Morgan Stanley ended upstuck with $5.6bl of the debt as they were forced to postpone the offering, even after they offered a discount to investors and a yield as high as 11%. The consortium of banks will now have to the debt on their books and wait for a more opportune time to sell the high yield debt. Earlier this year a group of Private Equity investors led by Carlyle agreed to buy Veritas from Symantec (SYMC) in an $8bl Leveraged Buy Out, the largest LBO of 2015.
The high yield debt market has seen stress from the energy sector, where default rates have risen to 8.2% last month from <1 beginning="" in="" nbsp="" of="" span="" style="color: red; line-height: 20.8267px;" the="" year.="">The stress seems to spread to other segments of the high yield market, as demonstrated by the failure to place debt of a tech company and a overall widening of spreads of risk free rates.
We launched an High Yield Thematic basket (SGUSHY Index) last week that replicates the HYG, but holds the stocks instead of the corporate bonds of the issuers in the Markit iBoxx High Yield index. The basket therefore offers a much more attractive transaction costs (1mL – 30 financing costs vs. 90bp borrowing rates for HYG (indicative prices))." - source Société Générale
For us, it was interesting to see the difficulties of the Veritas LBO refinancing deal, far away from the struggling oil sector. Different times, different situations, but some 2007 memories came to our mind, particularly when the first signs of the credit market peak came from a few struggling LBO refinancing deals at the time.
Within the general High Yield market tone of nervousness we also noticed on the US Convertible markets in the last few day some several "massive" spread widening moves, especially on the High Y iled "renewable energy" segment:  SUNE, SCTY…
 SPX vs US HY ETF HYG - source Bloomberg:
- graph source Bloomberg.
Also, we are also wondering about the increasing number of cash M&A deals met with market skepticism (with acquirers shares selling off on the announcement: ON Semi/Fairchild and Air Liquide/Airgas yesterday, Mylan/Perrigo and Dialog/Atmel situations in the last few weeks…). Are we seeing some signs of fatigue? It certainly looks like it to us.

In conjunction with LBOs losing their "mojo", flows have well have finally shown some signs of pause after the significant inflows we described in October. For instance, as shown in Bank of America Merrill Lynch High Yield Flow report from the 12th of November entitled "The pendulum swings for HY ETFs",  the rally experienced throughout October in terms of inflows have come to an end:
"High yield fund flows reverse trendUS high yield saw its first week of outflows (-$1.61bn) in 6 weeks with both ETFs and non-ETFs ending up in the red. HY ETFs saw a massive $3.91bn WoW swing with a- $1.37bn (-3.5%) outflow this week, while non-ETFs saw a less volatile $242mn (-0.1%) net outflow. These outflows from ETFs are not surprising given the nearly 17% AUM growth the asset class has seen over the previous 5 weeks. Additionally, as we have previously discussed, investors likely grasped at the opportunity to sell into the recent rally and lock in October’s impressive 2.73% return.Meanwhile, non-US high yield funds saw $1.08bn (+0.4%) in net inflows. Outside of high yield, high grade funds continued to grow their asset base with an $828mn (+0.1%) net inflow, their 5th consecutive weekly inflow. Loans posted yet another outflow ($347mn, - 0.4%), to bring their YTD %NAV to an even -11%. EM debt saw net outflows of -$1.2bn (-0.8%), likely suffering from the ever-increasing probability of a December rate hike. As a whole, fixed income funds saw -$3.30bn (-0.2%) in net outflows, their first weekly outflow in 6 weeks. Equities saw little change with a minor $2.41bn (+0.0%) inflow.
- source Bank of America Merrill Lynch
Whereas for US Investment Grade, we still believe in a "Fluctuat nec mergitur scenario for 2016, where a rising US dollar and "external" allocations (such as Japan's GPIF) to US credit should continue to be supportive of the asset class, we are getting more and more concerned on US High Yield with the accumulations of warning signs we are seeing. This brings us to our next bullet point.

  • The US High Yield Market continues to be heading "South"

More concerning to us as (apart from "inflows" and "outflows in High Yield) has been the flattening of the US High Yield CDS curve as shown below from CMA part of S&P Capital IQ for the CDX HY Series 25:
As of per the 19th of November 2015:

As of per the 1st of October 2015:
- source CMA part of S&P Capital IQ
This, for us is yet another clear sign of deterioration whereas Investment Grade continues so far to benefit from a steeper credit curve despite market expectations of a rate rise in December by the Fed.

We are not alone to have a "negative stance" on US High Yield, we also share the same concerns as Bank of America Merrill Lynch from their HY Wire note from the 16th of November entitled "Bonds to underperform loans again in 2016":
"Fool’s gold
Several weeks ago we mentioned that taking part in the October rally was a fool’s errand, and that the inflow of cash to primarily ETFs was responsible for the bottom fishing that occurred in the first two weeks of the month. In our view, selling into the strength, despite high cash balances was the prudent move- a position we continue to like today headed into year end.
The payrolls number from two weeks ago coupled with further weakness in fundamentals and commodities, disappointing retail sales and relatively hawkish comments from Chairwoman Yellen have created a perfect storm of worry among high yield investors, as our index has retraced almost 50% of the gain from last month (Chart 1). 

And for good reason too. Our house view is for the Fed to raise rates in December and it appears as though the divergence of the US economy from high yield fundamentals isn't changing anytime soon as Q3 earnings mark a 5th consecutive quarter of weakness. EBITDA growth for a third of the HY universe that has reported so far is still negative, and adjusted EBITDA growth is near zero (Chart 2).

And unfortunately, it’s getting increasingly harder to push the blame for dismal HY earnings on the strength of the dollar.
Furthermore, geopolitical headwinds still exist, and, liquidity (or perhaps the better word is "reality" as in the reality of the real prices in which bonds can trade) continues to present challenges. To make matters worse, we can't say we love quality here either though clearly given our disposition leaves us the least ill when thinking about positioning in a must invest world. Meanwhile triple Cs and single Bs are not the place to hide with just a few trading weeks left in the year. As such, expect next to no bid on any new deals with hair on them and for higher quality new issue to be the place to hide and put cash. Finally, despite loans holding up so well to bonds this year, we continue to like loans heading into 2016, and discuss below in detail some analysis that draws us towards that conclusion. " - Bank of America Merrill Lynch
Exactly. Going higher into the quality spectrum in US High Yield is a imperious necessity as we are witnessing a clear deteriorating trend in the "credit cycle". 

What interesting is that investors (or "yield hogs") seems to continue in many instances to disregard "safety" for "yield "as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 13th of November entitled "Yield is king":
"More in yield, less in “safety”Investors continue to embrace yield over “safety” for a fifth week in a row. Both high-yield and equity funds continued to see more inflows last week. On the contrary, flows into high-grade slipped back into negative territory. Likewise for government bond funds.
Optimism on the back of the previous week’s high grade inflow did not last long as the latest data shows; flows dipped back to negative. Nevertheless, note that high grade ETF fund flows remained positive for a fifth week in a row.

Looking at high-grade duration, both short and long-term fund flows turned negative during the previous week, while mid-term fund flows remained positive but only marginally.
A positive trend however continues in high yield, with the third consecutive week of $1bn+ inflows; the fifth inflow in a row. Last week’s flow also brought the year to date inflow for the asset class back into positive territory.
Government bond fund flows, on the other hand, moved deeply into negative territory suffering the biggest outflow in 19 weeks. Money market funds followed a similar path, but less extreme.
The week in fixed income flows therefore finished in negative territory, marking the first outflow in five weeks. YTD flows into FI funds are now negative.
 Looking at equity fund flows, the trend remains strongly on the positive side for the sixth consecutive week. YTD flows are now at $110bn+." - source Bank of America Merrill Lynch
Whereas, 2014 was not the year of "Great Rotation" from bonds to equities, 2015 was clearly supported by flows particularly in Europe thanks to the "divine" intervention and meddling of central bankers. This is leading us to our third point, namely what to expect in 2016, will it be "Fluctuat nec mergitur" again for credit?

  • What to expect in 2016 - Will it be "Fluctuat nec mergitur" again for credit?

This is particular true in Europe which, performance wise, was clearly supported by the actions of "Le Chiffre" aka Mario Draghi as indicated in Société Générale in their note from the 12th of November entitled "Risk Premium in Pictures ":
"Digging into corporate bond valuationsAt a time when the US Fed is expected to embark on the journey of normalising its monetary policy, we analyse the relative valuation of equity, corporate credit and government bonds.
With the exception of eurozone equities, most asset classes have delivered lacklustre returns in 2015. Rich valuations, a potential Fed rate hike and a slowdown in Chinese growth has weighed on asset prices this year. However, consistent with our constructive stance on eurozone equities, 2015 has indeed proved to be a fine vintage for eurozone equities.

Be ready for lower returns going forward. 
In the left-hand chart below, we plot the total return investors should expect across asset classes. Our proprietary risk-premium model suggests that most asset classes will deliver single-digit sub-par return going forward. 
However, it is clear that equities are expected to do well relative to fixed income assets. Within equities, we expect the euro area to perform best as growth expectations improve from the current bearish level." - source Société Générale

While we continue to expect Europe to outperform High Yield wise the US from a "relative value perspective", the actions of the ECB continues overall to be supportive of credit in Europ particularly in the light of continuous "financial repression", rising amount of short term negative yields in the continuation of the "Japanification" process. 

Credit wise, we are moving from a story of convergence, to a story of divergence, some would point out this is very "2011ish" in credit, but it is the reality, as the Fed and the ECB are set up for different courses. This was clearly indicated by the latest post from DataGrapple:
"The FOMC minutes released yesterday confirmed that the Fed are still on course to raise rates in December. Specifically, it was noted that “while no decision has been made, it may well become appropriate to initiate the normalization process at the next meeting”. Based on the Fed fund future market, the probability of a hike stands at 68%, but hardly anyone doubts that will go ahead. That is in stark contrast with expectations regarding the ECB next course of action. QE expectations in Europe are as high as they have ever been and investors are bracing themselves for a salvo of new easing measures mid-December. It will be the first time in a long long while that central banks in Europe and in the US embark on radically diverging paths. These contrasting environments are being played by credit investors, and some today were buying protection on CDXHY in the US while selling protection on iTraxx Crossover. Generally speaking, relative values are being played and it is obvious for all to see on the above grapple. While CDXIG and iTraxx Main (ITXEB) were trading 1bp apart at the beginning of October (at 96bps and 95bps respectively), they were trading 7bps apart early November (at 78bps and 71bps respectively) and stand 12bps apart at the close (at 84bps and 72bps respectively)." - source DataGrapple
This divergence, we think, will continue to play out in credit, from compression and convergence to decompression and divergence. Please find below our illustration on this subject - CDX Investment Grade US versus Itraxx Main Investment Grade Europe (roll adjusted) - data source Bloomberg:

- source Bloomberg - Macronomics

In this "beta" chasing game, some pundits would point out to the attractive "valuations" level of European banks. We continue to dislike the sector as the deleveraging and low profitability of the sector makes us prefer to play it through credit instruments à la "Japan". 

Equities wise, we believe the banking sector will continue to underperform "high beta financial credit", regardless of the bullish and overweight stance of Société Générale's Equities team and the below graph from their report European banks from the 13th of November entitled "A wake-up call":
"Top picks 
We are Overweight European Banks. There is value, with over half the sector (and €600bn of market cap) now trading below TBV. The earnings momentum has stalled post Q3, and banks need to wake up to the new reality of revenue stagnation. Restructuring and a focus on isolated areas of revenue growth will help. This can be supported by increasing capital strength. Our Top 5 list outlines the banks that can best benefit from these themes: Barclays, Erste Group, ING, Lloyds and UBS. We remain cautious on BBVA, CS, DBK and Nordea.

- source Société Générale - SX7P = Eurostoxx 600 Financials vs Eurostoxx 600 = SX7E

No "offense" to the equities guys but here are some facts about the banking system in Europe still being "capital impaired" as indicated by Linklaters on the 2nd of November:

  • Estimated €826bn of NPLs are currently sitting on the balance sheets of European banks that are supervised by the SSM
  • NPL volumes still remain close to levels revealed at the ECB’s comprehensive assessment in 2014
  • Significant differences between NPLs across different countries with high volumes in place across Italy, Spain, France and Greece
  • Greek, Austrian, Portuguese, Italian and Cypriot banks likely to be challenged further in future stress test

New analysis from Linklaters estimates that since the ECB’s Single Supervisory Mechanism (‘SSM’) was implemented on 4 November 2014, non-performing loan (‘NPL’) volumes across the banks it supervises remain high, reducing marginally from €841bn* to €826bn**. 
The NPL to Asset Ratio of these banks has also only slightly decreased from 4.13% (end of 2013) to 3.92% (H1 2015). 
Banks have been announcing plans to offload NPL portfolios and demand continues to be significant from investors with at least €40bn*** of distressed funds raised to buy these portfolios. But the research suggests that NPLs in certain countries are steadily increasing, causing a drag on banks’ profitabilities and market confidence. Tackling these credit risks will be a key supervisory priority for the SSM in 2016." - source Linklaters
No matter how our "equities friends" want to "spin it", we are not "buying it" and we will stick to "credit" when it comes to banking exposure in this "japanification" on-going process. There is much more "deleveraging" to go in Europe, in 2016 as well as shown in the never ending earnings revision in the sector as displayed in the same Société Générale report:
- source Société Générale.

So if you want "Fluctuat nec mergitur", when it comes to "banks" exposure in Europe, stick to credit.

In the end for credit, and markets, leverage matters, financial credit conditions matter and so does earnings for any rally to be sustained.

  • Final chart - Q4 US consensus profits growth is already forecast to be negative
Whereas during most part of the summer we have been musing around the credit cycle, leverage, defaults and indicators, more recently we have touched on the deteriorating picture and risk of "peak profitability in the US", earnings, regardless of the surge in the US dollar are facing "headwinds" and this, we think is linked to global financial conditions tightening. For our final chart, we would like to point out the fundamental problems facing equity investors given the weakening earnings picture. This is clearly illustrated by the below chart from Société Générale Global Equity Market Arithmetic report from the 16th of November entitled "US profits facing numerous headwinds":
"Equity investors face a variety of fundamental problems, including higher levels of debt, expensive valuations and weakening profits. And whilst earnings momentum has turned up recently, as it typically does during the reporting season (and from very low levels), the proportion of downgrades coming through remains elevated and is only likely to increase in preparation for Q4 reporting. Notably Q4 US consensus profits growth is already forecast to be negative even once financials and energy are excluded.

US dollar strength is clearly already a problem for US corporates and weak US import prices are taking its toll on industrial profitability. However a strong US dollar is not necessarily a given post the first interest rate rise. A quick back of the envelope calculation shows that whilst the US dollar typically appreciates in the 3 months leading up to the first rate rise, in 9 out of the last 10 interest rate cycles the US dollar was weaker in the 3 months thereafter." - source Société Générale

Remember when everyone is thinking alike, no one is really thinking...

"We cannot solve our problems with the same thinking we used when we created them." - Albert Einstein
Stay tuned!

Friday, 13 November 2015

Macro and Credit - Rota Fortunae

"The less we deserve good fortune, the more we hope for it." -  Lucius Annaeus Seneca

Watching with interest the strong rebound in Nonfarm payrolls, beating expectations to the tune of 271K and somewhat confirming the rates lift-off for December according to most pundits, we decided to keep up with the philosophical analogies for this week's title and elected Rota Fortunae. The Rota Fortunae also called the Wheel of Fortune belongs to the goddess Fortuna, who spins it at random, changing the positions of those on the wheel - some suffer great misfortune, others gain windfalls. The Rota Fortunae was widely used as an allegory in medieval literature and art medieval writers who preferred to concentrate on the tragic aspect, dwelling on downfall of the mighty - serving to remind people of the temporality of earthly things. In similar fashion to the "Rota Fortunae", there is a Latin phrase "Arx tarpeia Capitoli proxima" (“the Tarpeian Rock is close to the Capitol”) which we have previously used, while discussing the different courses taken by the Fed under Ben Bernanke and the ECB under Trichet's guidance in 2011. In similar fashion to 2011, there is again another growing divergence between the Fed and the ECB when it comes to monetary policies, EUR/USD cross-currency (XCCY) basis swaps aside. Some have interpreted the Latin phrase to mean that “one's fall from grace can come swiftly”. Indeed, if ones look at the on-going demise of the entire commodity complex triggering as well convolutions in Emerging Markets, the Rota Fortunae has inflicted great misfortune. And talking about "Fortune", positive correlations and large standard deviations move are still on the menu if one looks at the 22% drop in Rolls Royce share prices, showing indeed the growing instability in an "overmedicated" market but we ramble again.

In this week's conversation, we will look at monetary divergence being back in play à la 2011 (Bernanke vs Trichet) whereas this time around it is the Fed being "Hawkish" and the ECB being "Dovish".

  • Policy divergence back in play when it comes to credit: A tale of Two Central Banks
  • What to expect from Le Chiffre (aka Mario Draghi) in December 
  • Final chart - Emerging Markets bank lending conditions the tightest in 4 years

  • Policy divergence back in play when it comes to credit: A tale of Two Central Banks
Whereas every pundits is trying to "second-guess" the intentions of Le Chiffre aka Mario Draghi in December it seems to us very interesting to look at the growing divergence between the Fed and the ECB in terms of monetary policy from a default cycle perspective (hence our more constructive approach on European High Yield versus US High Yield).

As in recent weeks we have been discussing our rising concerns when it comes to the lateness in the credit cycle in the US, the European credit market appears to us more favorable thanks to a divergence in leverage, but more importantly thanks to the divergence in monetary policies as once more central banks are in the driving seat and are calling the "spin" on the "Rota Fortunae".

From our credit perspective, there is indeed a growing divergence in the default cycle between Europe and the US given that Europe and in particular its Banking sector is an on-going story of deleveraging, whereas the US has been, credit wise, releveraging, at least from the corporate side. On the subject of default cycle divergence, we read with interest Bank of America Merrill Lynch's take from their Credit Derivatives Strategist note from the 6th of November entitled "Europe vs. US – trading different default cycles":
"Cycles, cycles, cycles
Markets are warming up to the possibility that the ECB could announce another depo cut in its next meeting. Meanwhile, it seems more likely than not that the Fed will embark on its first hiking cycle in over ten years in December. If both these events come to pass as expected, it will be the first time since May 1994 that the US had a rate hike while Europe had a rate cut. Just as Europe seems to be some years behind in its economic and monetary policy cycles, the credit cycle too is likely to play out with a lag relative to the US. In this environment, we expect CDX.HY to continue underperforming the Itraxx Crossover CDS 5 year index.
The fundamental story
In the US, leverage is rising and investor risk appetite is waning. We expect the default cycle to turn and the default rate to tick up to the mid-to-high single digits next year. It is difficult to be constructive on US HY in this environment. On the other hand, HY leverage in Europe is actually declining, thanks to QE. Note that double-B leverage is down to 2x from 2.9x in Q3’14. 

Just as Europe seems to be some years behind in its economic and monetary policy cycles, the credit cycle too is likely to play out with a lag relative to the US. In the US, after a five year credit binge, earnings for high-yield issuers has more or less stalled, leverage is rising and investor risk appetite is waning. It is difficult to be constructive on US HY market in this environment. We expect the default cycle to turn and the default rate to tick up to the mid-to-high single digits next year.

On the other hand, even as US HY corporates have been steadily releveraging over the last five years, leverage in Europe is actually declining, thanks to the ECB QE. With the ECB potentially extending/expanding QE and lending interest rate costs declining to multi year lows, the default outlook for European high-yield market next year appears to be quite benign
Default cycles have been broadly parallel, between the European and the US high-yield markets historically. There have been almost identical peaks and troughs since 2000.
However, more recently the cycle has turned decisively in the US, while Europe has managed to ‘decouple’ (chart above). This pattern – of lower defaults in Europe - is likely to continue for the next couple of years, not unlike the late 90s, which is a time-period we refer to quite often, in order to draw parallels to today’s conditions." - source Bank of America Merrill Lynch.
As we posited in our conversation "Blue Monday": default and leverage do matter, but looking at defaults on their one and assess their predictive matters like most "tourist" credit investors do, is pointless:
What is of course of interest is that looking at the current default rate doesn't tell you much about the direction of High Yield, as aptly explained by our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns"  in their very interesting previous note:
"Credit investors have a very weak predictive power on future default rates. Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates. " - source Rcube
All in all, looking at default rates on their own is akin to looking at the rear view mirror for too long while driving on the narrow credit road.

We rehammered our point in our "Le Chiffre" conversation when it comes to using defaults as a proxy for the direction of credit:
"So while Société Générale is right in pointing out the "low default rate" in Europe, it is we think "oversimplistic", leverage matters more and so does earnings when it comes to High Yield. Looking at default rates is like looking at the rear view mirror. It tells you what has happened, not what is going to happen and maybe indeed looking at the iTraxx CDS credit indices is a cleaner way to look at the pure credit risk, given the greater liquidity in these synthetic contracts versus cash. We like mostly as an early indicator, the ability of our "CCC credit canary" to tap the primary market when it comes to using an early warning indicator in rising default risk and exhaustion in the credit cycle.
As we posited in our September conversation "The overconfidence effect", when it comes to credit spreads and default risks and leverage, end of the day, earnings matter!" - source Macronomics, October 2015 
So yes, defaults and leverage matters, but as we posited back in October, end of the day earnings matter even more!

On that subject, we note with interest that High Grade earnings in the US declined further in the 3rd quarter which is yet another point confirming the divergence in the "credit cycle" between the US and Europe. Bank of America Merrill Lynch in their Situation Room note from the 10th of November entitled "High grade earnings decline further in 3Q" just confirmed our negative stance when it comes to assessing the "credit cycle" and the growing divergence between monetary policies in the US and in Europe:
"High grade earnings decline further in 3Q.
The 3Q earnings season is winding down. With the last busy week of the season behind us the pace of reporting now slows down considerably. By today 533 out of 601 (89%) US public high grade issuers have reported. Based on these results (and estimates for those that have not yet reported) earnings and revenues declined 2.9% and 5.0% YoY in 3Q, respectively. The actual earnings beat the bottom-up consensus expectations at the start of the season of a 4.5% decline, while sales disappointed, coming in below the expectations of a 3.0% deceleration vs. 3Q-14. Also, 3Q results were weaker relative to 2Q, when the YoY changes in earnings and revenues were -1.8% and - 4.1%, respectively. However, excluding the more global issuers (deriving more than 50% of revenues from abroad) and the volatile Energy and Finance sectors, the 3Q earnings growth at +9% was the same as in 2Q.
The large moves in oil prices and the dollar continue to exert downward pressure on earnings. First, excluding the Energy sector earnings grew 4.2% in 3Q. Second, companies deriving less than half of revenues from abroad (ex. Energy and Finance) – and hence less impacted by the dollar and the related global weakness – had earnings and revenue growth of 9% and 4%. In contrast the more global issuers – those deriving more than half of revenues from outside the US – reported a 2% and 4% declines in 3Q earnings and revenues. The impact of the weaker dollar on high grade credit is limited, however, by the fact that the global companies tend to have lower leverage.
- source Bank of America Merrill Lynch.

No surprise to see more domestic companies withstanding more easily the divergence between monetary policies and getting a more favorable outcome from the spin of the "Rota Fortunae"!

While last week in our conversation "Ship of Fools", we re-iterated the use of central banks’ credit surveys given that credit availability is the most predictive variable for default rates, if one looks at Europe, the most recent lending survey points indeed towards a "growing" divergence in defaults outcome between Europe and the US. This was as well confirmed in Barclays European and US Credit Focus note from the 6th of November 2016 default outlook:
We forecast a 1.75-2.75% issuer-weighted default rate for HY bonds in 2016 (1.5- 2.5% par-weighted) – still near historical lows, but slightly higher than the current default rate. While loose monetary policy should keep defaults lower, the reduction in primary liquidity for highly leveraged securities could spell trouble for issuers that need to tap the high yield market.

In leveraged loans, we forecast a 1.5-2.5% issuer-weighted default rate in 2016 versus 1.5% seen over the past 12 months. While benign funding conditions, limited refinancing pressure and improving fundamentals point to the default rate staying close to the post-crisis lows, we see risks to the upside from a potential spike in volatility and deterioration in funding conditions, should the global macro outlook continue to weaken.
The duality of markets: updating our default model
We apply both a top-down macro model and a bottom-up fundamental analysis to produce our forecast. Our default model uses two key factors to forecast the default rate, and when we backdate these factors by 12 months we have observed a remarkable correlation with default rates (R-Squared of 77%). Specifically our model uses:
• The percentage of the Barclays Pan European High Yield Index (excl. Financials) that the market currently views as at risk of default: we define this as bonds trading with a cash price below 70. As we calculate both a par-weighted and issuer-weighted default rate, we calculate the percentage of par outstanding and issuers for the respective models (Shown in Figures 2).
• The ECB’s bank lending survey, which reflects the net percentage of respondents reporting tighter lending conditions. This quarterly series comes from the ECB and is highly correlated with defaults 12 months forward, as it proxies the openness of primary markets (Figure 3).

It is worth mentioning that historically we have used Moody’s default rates to perform our analysis. However, in September 2015 Moody’s revised its default rate calculation, which materially increased the number of financials in the default universe. As our analysis is focused on the default rates for corporates, we use Moody’s default rates from its August 2015 report for our forecast, so the universe is consistent with past analysis.
It is worth mentioning that historically we have used Moody’s default rates to perform our analysis. However, in September 2015 Moody’s revised its default rate calculation, which materially increased the number of financials in the default universe. As our analysis is focused on the default rates for corporates, we use Moody’s default rates from its August 2015 report for our forecast, so the universe is consistent with past analysis.
When constructing our model, other macro factors such as charge-off rates, GDP growth, Treasury curves and V2X were also considered; however none of these factors adds much value when the ECB bank lending survey series is included. For posterity, we also looked back at what our model forecasted for this year’s trailing 12m default rate at this point last year. Indeed, the model forecasted a 1.39% default rate for the period ending 31 August 2015, compared to Moody’s reported 1.37% default rate. This year, while our forecast still indicates a historically low default rate of 2.02%, this is in fact a slight increase from the current modelled rate of 1.82%.
Interestingly, the two factors we use for our model indicate divergent paths for default rates. For six consecutive quarters, lenders have reported easier lending standards for bank lending – the longest period since 2004-05 when lenders reported easier standards for seven consecutive quarters (Figure 3). With Monetary policy set to remain accommodating to lenders, it would not be surprising if this became the longest continuous stretch of easier lending in the history of the ECB. When modelled on this factor alone, predicted default rates for the upcoming year are slightly lower than current levels – at 1.23% (Figure 4).

We forecast a substantial increase in the default rate in 2016. Combining an econometric model of the default environment with a bottom-up review of credits in the high yield market, we arrive at an issuer-weighted default rate of 5.0-5.5% in 2016, up from the current 2.5% rate; we believe the par-weighted rate will rise from 2.5% to 4.5-5%. The bulk of the y/y increase will come from defaults in the energy and metals & mining sectors as the commodities credit cycle nears its end; we do not believe the end of the commodity cycle will lead to the end of the business cycle.
Defaults have ticked up slightly in recent months, but remain well below historical averages. As of the end of September, the trailing 12-month issuer-weighted default rate for the US speculative grade universe tracked by Moody’s was 2.54%, versus a long-run average of approximately 4.5%. The par-weighted default rate is nearly identical, registering 2.47% in the 12 months ending September 30, according to Moody’s, compared with a long-run average of closer to 5.0% (Figure 1). 

The speculative grade default rate masks some divergence in bonds and loans, with the former group registering 3.4% in the LTM period ending in September, and the latter nearly 2% lower at 1.6%.
Econometric Model of Defaults
As a reminder, our top-down default rate forecasting model relies on a two-factor regression1 of the 12-month forward default rate on the following variables:
• C&I lending standards: The net percentage of senior loan officers reporting plans to tighten lending standards for commercial and industrial (C&I) loans. This quarterly series comes from the Federal Reserve and is highly correlated with defaults 12 months
forward, as it proxies well for the openness of primary markets.
• Distress rate: The percentage of bonds in the Barclays U.S. High Yield Index trading with a spread of 1,000bp or higher. Besides capturing the market’s expectations of impending defaults, this factor also relates well to the likelihood of distressed exchanges, which Moody’s accounts for in its default rate.
Our econometric model has been very good at forecasting the default rate over a 12-month horizon (Figure 4), and predicts a 4.8% default rate.  
The uptick from current levels is due to increases in both independent variables in the regression. The most recent senior loan officer opinion survey (SLOOS) points to a potential reversal in the long trend of loosening underwriting standards. As shown in Figure 5, this diffusion index indicated modest net tightening (+7.4%) of underwriting standards among survey participants, following a nearly unbroken trend of net loosening (22 out of the prior 23 quarters).

The distress rate has also continued to rise since last year, and stands at 14.4%, largely due to the aforementioned distress in commodities sectors (Figure 6).
While both factors in our model point to higher defaults, approximately four fifths of the increase in our default rate forecast comes from the change in the SLOOS index. We continue to monitor underwriting standards closely because we have found this factor to be most correlated with default rates in the past. While we do not expect bank underwriting standards to weaken too much in the current regulatory environment, we believe the near-record $2.6trn in excess reserves of depository institutions held at the Fed should make significant tightening in standards less likely." - source Barclays
Whereas, of course we agree with Barclays' more favorable approach to European credit mostly thanks to the predictive nature of central banks' lending surveys, we do not share their optimism when it comes to pointing out the excess reserves in the US financial sector as a "mitigating" factor in 2016.

One might conclude that from a relative value perspective and in terms of "Rota Fortunae", investors would be better off being long European High Yield / Short US High Yield. European investors could favor as well US Investment Grade in the US, playing a continuation in the rise in the US dollar and also being less exposed to financial repression in Europe with negative yields rising in the European Government space (2 year German Schatz firmly in negative territory). The continuation of the "Dovish" tone of the ECB makes somewhat European High grade less appealing, but then again, the leverage in Europe is much lower. It seems you cannot have it both ways these days thanks to "diverging" monetary policies causing the "Rotae Fortunae" to spin in different directions.

Given the lateness in the credit cycle, which is much more advanced in the US, the fact as we pointed out that in the recent rally our "CCC Credit Canary" has underperformed in the High Yield bucket, does indicate to us that all is not well in the High Yield market to paraphrase yet again Shakespeare. Another clear illustration of the "CCC Credit Canary" playing out as well in Europe was also pointed out by Barclays in their 2016 defaults note:
"Stressed by default
Looking back over the past 12 months and looking ahead to next year, the default rate for European High Yield has been and will likely continue to be low. However, a cursory look at returns and spreads for the riskiest credit shows us that it is not merely the rate of default that impacts these bonds. A few high profile or unexpected blowups (Phones4U, New World Resources) drove a dramatic underperformance in CCC credit during the second half of 2014, while in 2015 insulation from larger macro risks (China, commodities), as well as the absence of any notable defaults have helped the impressive total returns for these bonds (Figure 11). 

Thus, the nature of defaults when they do occur, and how well prepared the market is for these events, can impact the high yield market much more than the pure default rate.
Further, spreads for these issuers have remained wide compared to last year, only recently moving inside levels seen after Phones4U defaulted (Figure 12).

The current reduction of secondary market liquidity increases mark-to-market risk for investors in lower-rated bonds even when default is not a true concern. Looking ahead, while continued monetary easing by the ECB should keep defaults muted, any increase in volatility will affect highly-leveraged issuers even more acutely than in the past." - source Barclays
Whether it is Phone4U bonds, Abengoa SA bonds (see our conversation "The Battle of Berezina"), Rolls Royce equities, Volkswagen and other recent stories, they all point out to the "overmedication" provided by central banks leading to significant large standard deviation moves described in our August conversation "Positive correlations and large Standard Deviation moves".

2015 is indeed a story of "sucker punches", in equities, credit FX (SNB move on CHF, China's summer surprise on Yuan devaluation), etc.

On a side note and given our credit inclinations, before we move on to our second point, please not the Russell Index is more positively correlated to Credit in the U.S (CDX IG in particular). should you feel an urge to look at a nice 2016 "short" trade if indeed we are in the late stage of the credit cycle in the US.

  • What to expect from Le Chiffre (aka Mario Draghi) in December 
In our recent conversation on Le Chiffre aka Mario Draghi we indicated that in the movie Casino Royale, Bond knew he could beat Le Chiffre as he was confident that he would catch his tell and get an insight into his game and strategy (bluffs included). Given the growing divergence in monetary policies à la 2011 between the Fed and the ECB, we think it is important to remind us of the law of diminishing returns of QEs once more from our previous  "Bond" related conversation:
"In similar fashion to Liebig's law of the minimum, the law of diminishing return means that at some point, adding increasingly more fertilizer (liquidity via QE) improves the yield by less per unit of fertilizer (QE), and excessive quantities can even reduce the yield (check out 2 year Italian and Spanish government yields...)." - source Macronomics, October 2015
But, given that Le Chiffre is truly a poker prodigy, one should not underestimate is "bluffing" abilities and card tricks for December:
"If we were to conclude that our medium-term price stability objective is at risk, we would act by using all the instruments available within our mandate to ensure that an appropriate degree of monetary accommodation is maintained." - Mario Draghi
This is brings us to the current divergence between the Fed and the ECB as explained by Bank of America Merrill Lynch in their Ethanomics note from the 6th of November entitled Fedexodus which also explains how Le Chiffre has been honing his skills since disappointing markets on the 8th of December 2011 when everyone was expecting him to unleash a big "bazooka":
"The prospective policy divergence between the Fed and other central banks is modest by historic standards. For example, the Fed and ECB balance sheets are similar in size and the roughly 100 bp divergence in policy rates over the next year is not high by historic standards (Chart 3). 
Moreover, we disagree with the idea that policy easing by the ECB and other foreign central banks hurts the US economy. Unless the dollar reacts much more than normal, foreign central bank easing is a net positive for the US.
In the eventLet’s dig a little deeper and explain why a dovish ECB is good for the US. As we wrote last week, in standard model simulations a dovish European Central Bank hurts the US via a stronger dollar, but helps the US on net by stimulating other asset markets. In particular, ECB easing has two positive spillovers to the US. First, by stimulating European asset markets it boosts aggregate demand in Europe, boosting imports. Second, the rally in European asset markets stimulates US asset market, boosting US aggregate demand. On the other hand, the consensus view essentially assumes away all of these positive channels, leaving just the negative currency effect. Which story is correct?
Here we look at the empirical evidence using an “event study” approach. In particular, we look at the market response to seven major ECB announcements during the Draghi era (From November 2011 to present). If markets are efficient they should respond to policy makers when they signal policy changes, rather than wait for the actual policy to be implemented. If there is no other major news out on the day of the announcement, this gives a relatively clean test of how the markets read the ECB.
In our view, daily moves in the dollar and the European and US equity markets together give a good gauge of how news is digested.
• If dovish ECB moves are interpreted as a “currency war” that benefits Europe at the expense of the US, then the dollar should strengthen, European equities should rally and US equities should sell off. This is a negative sum game.
• If the dovish move is seen as a stimulus to global financial conditions then the dollar should rise slightly and both the European and US equity markets should rally. A rising tide of liquidity raises all ships.
• Finally, the markets could read the ECB action as inadequate and see the announcement as signal of economic weakness in Europe. In this case, European and US equities should fall and the Euro should weaken.
The results are compelling (Chart 4).

In none of the episodes was ECB policy viewed through the lens of a currency war. In all cases, the US and European equity markets rose or fell together. In six instances both equity markets celebrated the easing as a positive sign of more liquidity. On these days an average gain of 1.9% in the STOXX 600 index triggered a 1.4% gain in the S&P 500. In one episode, both equity markets were disappointed by the news. 
According to the Reuters, on December 8, 2011 the markets were expecting a big “bazooka” liquidity announcement and they were disappointed by both the small size of the new program and the downbeat commentary out of Draghi that day. Apparently, Draghi has learned his lesson and has been very good at delivering positive surprises to the markets ever since.
The market response is similar for smaller ECB announcements. On their website the ECB lists 11 other key event days. In 9 out of 11 days the European and US equity market moved in the same direction. There is no correlation between the dollar and US equities on these days: on 5 days they moved together, in 5 days they moved in opposite direction and on one day the dollar did not move.
Is the more recent period different? Actually, the strongest examples come from this year. Both dovish announcements in January and October have triggered a stronger dollar, yet in each case the US equity market has followed the lead of European equities, rallying 1.5% and 1.7% respectively on the day. Maybe the ECB is not the Fed’s enemy?" - source Bank of America Merrill Lynch

While we agree with Bank of America Merrill Lynch's take on Mario Draghi's being quick on the steep learning curve of central banking, we think their argument that stimulating European assets is boosting Aggregate Demand (AD) is dubious at best. In our conversation "Le Chiffre" we quoted Richard Koo on the impact of QE on the real economy:
"Central bank-supplied liquidity has nowhere to go without real economy borrowing." - Richard Koo
On the impact of QEs on the "real economy", it is a subject we already discussed at length in our November 2014 "Chekhov's gun":
"In relation to Europe, the decrease in imports and lower GDP means consumer have indeed less money to spend. We cannot see how QE in Europe on its own can offset the deflationary forces at play" - source Macronomics, November 2014
A clear indication of the "lack of borrowing" which could stimulate AD can be seen in the below Bank of America Merrill Lynch's graph from their Euro Area Economic Viewpoint from the 11th of November entitled "ECB after US payroll: it’s still about QE":
- source Bank of America Merrill Lynch

So what will Le Chiffre do in December? While some pundits argue that he might cut further the depo cut, we would have to agree with Bank of America Merrill Lynch Gilles Moec's take on the subject from the same note quoted above, namely that cutting further the depo cut would have unintended consequences given the on-going "Japanification" process in Europe and many Peripheral banks being still capital impaired from their NPL bloated balance sheet. It is still a story of deleveraging in Europe à la Japan:
"The ambiguous economics of a depo cut
For a large part of our client base - especially those located in the US where the Fed actually PAYS banks to keep excess reserves - the debate on the depo cut in Europe is probably quite arcane. Here is a somewhat pedestrian guide to this issue.
Let's start with a simplified version of a bank balance sheet. On the asset side, banks hold loans, bonds, foreign assets and claims on the central bank (their balance on their account at the CB, which usually exceeds their reserve requirements). On the liability side, they have to service capital, debt and borrowing from the central bank (what they took against collateral in CB refinancing). Quite simply, banks make money if the average return on assets exceeds the cost of their liabilities, or funding costs.
What usually happens if the interest rate the CB pays on the banks' reserves falls? Not much. It is normally accompanied by a drop in the interest rate paid by banks on its borrowing from the central bank, and banks can also take further steps to ensure that the drop in the average return on assets is matched by a drop in their overall cost of funding by taking down the rate they serve on their customers' deposits (they control that, not the IR on their debt).
Things do not work the same way when cutting the depo rate deeply in negative territory. Indeed, unless the CB also cut the refinancing rate, the "transformation margin", i.e. the difference between the rate of return on assets and the cost of funding, shrinks. Banks can try to mitigate this by taking further down the rate they pay on their customers' deposits, but there are downward rigidities when savers' remuneration is already close to zero.
Incidentally, this has wide-ranging distributional consequences. While large banks can offset the cost over a large and internationally diversified balance sheet (they may hold CB cash out of the jurisdictions where the deposit rate is negative) smaller banks struggle. This is reason why deep depo cuts are often "fudged" (i.e. apply only to a small fraction of deposits).
But the hope of the proponents of the depo cut is that banks will try to offset the deterioration in their transformation margin by re-allocating their assets towards those with a higher return (loans to the domestic private sector, or foreign assets). This would be positive from a macro point of view, boosting lending and/or depreciating the currency.
The problem with this is that all banks will do the same and compete for credit demand by taking their lending interest rates down. This will be a profitable operation for banks only if the increase in volume supersedes the drop in margins. QE initially worked through this channel: by reducing the interest rates on government bonds, it incentivised banks to re-allocate towards loans by reducing the lending rate. Still, at the time the average level of those retail rates was very high, and massive pent-up demand for loans could be tapped. Banks could re-allocate, and still find a more than decent margin on an expanding volume. And don't forget that contrary to reserves held at the CB and government bonds, enjoying a zero risk weight, loans entail a significant capital cost, so that one cannot easily compare the "facial" relative returns.
Interestingly, after a swift drop, margins have re-increased lately throughout the Euro area (Chart 2).

This may indicate that banks are less convinced that the interest rate on loans cover the risk that they are taking (NPLs remain high in large swathes of the region, especially after taking into account the capital charge).
If they are not convinced it makes any economic sense, banks are not forced to reallocate across assets. They can simply shrink their balance sheet. The easiest way to do this would be to redeem early the long term funding they took from the ECB through the TLTROs. This would defeat the ECB's purpose in offering lightly conditional cheap money to banks in exchange for more loan origination.
At the beginning of the year excess reserves in the Euro area stood at c.EUR200bn. It has now tripled to reach nearly EUR 600bn and will continue to rise in line with QE (to purchase bonds from banks the ECB credits their cash accounts). By September 2016 we could reach EUR1.2trn, and in our baseline this would continue as QE would be extended. A further cut in the deposit rate by 50 bps (towards Swiss levels) would thus cost banks c. EUR6bn per year. This would be equivalent to 0.25% of banks' capital and reserves (in the ECB definition). This is not entirely insignificant… Of course the ECB could mitigate the adverse effects on banks by lowering the entirety of the interest rate corridor. Taking the refi rate in negative territory as well, but while such move would probably be very powerful to lower the exchange rate, this would be a very controversial decision for the ECB from a political point of view.
In sum, operating via the deposit rate to try to force banks to lend more seems to us a very convoluted and not bullet-proof approach. Sometimes, simple is good. Rather than reducing the average rate of return on banks' assets, cutting the average cost of banks funding further could make more sense. This could be done for instance by extending by another year the TLTROs, or extend QE which will reduce the cost of debt issuance for banks for longer, by taking the long term risk-free reference interest rate (government bonds) down." - source Bank of America Merrill Lynch
Given the need for some weaker banking players to continue to strengthen their balance sheet , we could not agree more, a deposit cut would be a too costly decision. We would like to think that  we have caught Le Chiffre's physical tell (A tell in poker is a change in a player's behavior or demeanor that is claimed by some to give clues to that player's assessment of their hand) and that indeed, he will go towards the "easing" path of QE for longer while extending TLTROs. This will push further European government short terms yields into negative territory and will continue to represent a "Goldilocks" boon for European credit investors à  la Japan. Credit will therefore continue to perform at least until the end of the year. For 2016's Rota Fortuna and misfortunes, it's another story...particularly for EM corporates but we ramble again!

  • Final chart - Emerging Markets bank lending conditions the tightest in 4 years
Will 2016 bring some suffer great misfortunes? We have highlighted the global tightening financial conditions (except Europe where overall financial conditions appear to be so far more "accommodative hence our positive relative value stance on European High Yield). Our final graph comes from Société Générale's Fixed Income Weekly note from the 5th of November entitled "Fade that sell-off" and displays EM bank lending conditions which are clearly indicative of upcoming deteriorating credit metrics and consequent headwinds for some:
"We see the EM rally as corrective and probably short lived. This is a position clean-up following the PBOC rate cut and signs (hopes?) of stabilisation in China. We have met a number of investors over the past two weeks, especially in Europe and Asia, expressing positive thoughts about recent Chinese data, e.g. rising home and land prices. This seems to have supported short covering. However we see the EM problems as structural, with the debt leverage accumulated over the past five years likely to prove a durable drag on growth. A recent IIF survey shows that EM bank lending conditions are the tightest they’ve been in nearly four years (Graph 4). Our credit and equity strategists and analysts focus on downside risks in a new cross-asset note: “What if EMs slow further?” Our fear in particular remains that 2016 may see a rise in EM bad loans, leading to a widening in EM hard currency corporate bond spreads and keeping the whole EM complex under stress. The sharp rise in leverage over the past five years is now starting to cause trouble, as fresh announcements from Standard Chartered suggest."

- source Société Générale

Whereas the 2015 Rota Fortunae has brought some great windfalls for some (European High Yield investors), some suffered great misfortune (EM), we think that, in 2016, EM is indeed set for additional pain and that indeed, the short covering rally in EM should be faded, unless of course the Fed decides to change its mind in the course of 2016 but that's another story...

"It seems to never occur to fools that merit and good fortune are closely united." - Johann Wolfgang von Goethe
Stay tuned!


Thursday, 5 November 2015

Macro and Credit - Ship of Fools

"Life is a dream for the wise, a game for the fool, a comedy for the rich, a tragedy for the poor." - Sholem Aleichem, Russian writer and author of Fiddler on the Roof.

Looking at the early and continuous Santa Claus rally without having seen Santa yet as Le Chiffre aka Mario Draghi has not even delivered the Christmas presents, we reminded ourselves, for this week's chosen title of a more philosophical reference when it came to selecting our selected analogy. The ship of fools is an allegory originating from Plato which has long been prominently featured in Western literature (1492 Ship of Fools by Sebastian Brant, 1962 novel by Katherine Anne Porter and 2002 science fiction novel by Richard Paul Russo), in art (Albrecht Dürer), movies (1965 move with Vivien Leigh, Lee Marvin and Simone Signoret) and in music (Pink Floyd, Dr Strangely Strange, The Doors, John Cale, Grateful Dead, Robert Plant, etc.).The allegory or parable depicts a vessel without a pilot (financial markets and the world economy), taken over by force or persuasion by those who are deranged, frivolous, or oblivious (political and banking "elites"), and seemingly ignorant of their course (central bankers "deities"). This mob is willing to kill anyone in the way (euthanasia of the rentier à la Keynes, shutdown of democracy by the European Commission), and to drug the captain if necessary (large injections of liquidity via QEs and a swath of propaganda). The true pilot, that knows the stars, the wind, and how to stay on course, is considered useless by the mob (investors). The allegory is compared to how a philosopher is rejected by the state.

There is of course a deeper analogy, no surprise there, to our chosen title. We apologies in advance but we will take a slight philosophical and historical detour before starting this week's conversation as we think the recent "political" events in Europe are very relevant to our chosen title.

If one refers to Portugal's recent election stalemate, where Mr Costa's Left-wing alliance was not chosen to form a new government by Portugal's head of state president Aníbal Cavaco Silva leading to a constitutional crisis, it ties up well with Plato's allegory of the "Ship of Fools" and the weakness of the democratic system. 

Plato's take on democracy is contained in book 8 of the Republic. Plato, in essence, described how a democracy is an "unlikely stable" political proposal given, he argued, it offers freedom but it neglects the demands of proper statecraft. He therefore predicted an almost certain collapse of democracy and decline into tyranny with a total loss of freedom (Patriot act, Bill on Intelligence in France, Spain's strict anti-protest laws, etc.). Plato argued that in a system where political power (‘cratos’) lied in the hands of the people (‘demos’) it was not guaranteed, and mostly unlikely, that those best equipped to rule would get a chance in managing public affairs.  The only case on the European continent, where we think there is a "stable" political proposal where political power lies in the hand of the people is Switzerland, no offense to Plato. Whereas in Europe, the loudest incompetent voices have dominated, leading to irrational, ill-motivated decisions which has turned the management of the European project to a complete crazy circus as shown by the recent migrant crisis plaguing Europe. 

In similar fashion, Joseph Schumpeter, came somewhat to a similar conclusion to Plato in his seminal 1942 book "Capitalism, Socialism and Democracy":

Schumpeter view on democracy:
"In the same book, Schumpeter expounded a theory of democracy which sought to challenge what he called the "classical doctrine". He disputed the idea that democracy was a process by which the electorate identified the common good, and politicians carried this out for them. He argued this was unrealistic, and that people's ignorance and superficiality meant that in fact they were largely manipulated by politicians, who set the agenda. This made a 'rule by the people' concept both unlikely and undesirable. Instead he advocated a minimalist model, much influenced by Max Weber, whereby democracy is the mechanism for competition between leaders, much like a market structure. Although periodic votes by the general public legitimize governments and keep them accountable, the policy program is very much seen as their own and not that of the people, and the participatory role for individuals is usually severely limited." - source Wikipedia

In his masterpiece, Schumpeter assumed that the decay in capitalism was indeed somewhat leading to some new form of "fascism". Schumpeter argued that capitalism's collapse from within will come about as majorities vote for the creation of a welfare state and place restrictions upon entrepreneurship that will burden and eventually destroy the capitalist structure.

In last's week conversation we re-iterated our take on QE in Europe from our "Chekhov's gunconversation as follows:
"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 
It is also not a surprise UKIP leader Nigel Farage has been comparing the EU to Former USSR very recently following the events in Portugal. This is exactly what we expected a few years ago with our August 2012 analogy to Milan Kundera's masterpiece "The Unbearable Lightness of Being":
"We do see similarities in the current European "complacent" situation with the Brezhnev Doctrine, first and most clearly outlined by S. Kovalev in a September 26, 1968 Pravda article, entitled "Sovereignty and the International Obligations of Socialist Countries". This doctrine was announced to retroactively justify the Soviet invasion of Czechoslovakia in August 1968 that ended the Prague Spring, along with earlier Soviet military interventions, such as the invasion of Hungary in 1956.
"In practice, the policy meant that limited independence of communist parties was allowed. However, no country would be allowed to leave the Warsaw Pact, disturb a nation's communist party's monopoly on power, or in any way compromise the cohesiveness of the Eastern bloc. Implicit in this doctrine was that the leadership of the Soviet Union reserved, for itself, the right to define "socialism" and "capitalism"." - source Wikipedia.
The Brezhnev Doctrine is interesting in the sense it was the application of the principal of "limited sovereignty". No country would be allowed to break-up the Soviet Union until; the "Sinatra Doctrine" came up with Mikhail Gorbachev.
"The "Sinatra Doctrine" was the name that the Soviet government of Mikhail Gorbachev used jokingly to describe its policy of allowing neighboring Warsaw Pact nations to determine their own internal affairs. The name alluded to the Frank Sinatra song "My Way"—the Soviet Union was allowing these nations to go their own way" - source Wikipedia
"The phrase was coined on 25 October 1989 by Foreign Ministry spokesman Gennadi Gerasimov. He appeared on the popular U.S. television program Good Morning America to discuss a speech made two days earlier by Soviet Foreign Minister Eduard Shevardnadze. The latter had said that the Soviets recognized the freedom of choice of all countries, specifically including the other Warsaw Pact states. Gerasimov told the interviewer that, "We now have the Frank Sinatra doctrine. He has a song, I Did It My Way. So every country decides on its own which road to take." When asked whether this would include Moscow accepting the rejection of communist parties in the Soviet bloc. He replied: "That's for sure… political structures must be decided by the people who live there." - source Wikipedia 
No country is allowed to leave the European Union and the political structures are not decided anymore by the people who live there.

Back in June 2012, in our conversation "Eastern Promises" we made the following prediction:
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in "The Daughters of Danaus")."
Remember, it is still a game of survival of the fittest after all:
Euro Breakup Precedent Seen When 15 State-Ruble Zone Fell Apart - by Catherine Hickley, Bloomberg:
"While differences between the Soviet Union and the EU are greater than their similarities, there are parallels that may prove helpful in assessing the debt crisis, historians say. Both were postwar constructs set up in response to a collective trauma; in both cases, the founding generation was dying out as crisis hit and disintegration loomed." - source Bloomberg.
As far as Europe is concerned and given the growing economic chasm between France and Germany we are sticking to our view that in the end, Germany will eventually "defect" and we will move from a Brezhnev doctrine to a Sinatra doctrine.

Here ends our long detour, apologies dear reader as we resume our normal macro and credit musing services below.

  • The Q3 release of the Fed Senior Loan Officer Survey on the 3rd of November is yet another warning sign of tightening financial conditions and the lateness in the "credit cycle"
  • On credit we remain short-term "Keynesian" bullish / long term "Austrian" bearish
  • Final charts - Buybacks have replaced dividends in the US

  • The Q3 release of the Fed Senior Loan Officer Survey on the 3rd of November is yet another warning sign of tightening financial conditions and the lateness in the "credit cycle"
For tracking credit availability, you need to use the central banks’ credit surveys. The most predictive variable for default rates remains credit availability. 

For the US you need to follow the Senior Loan Officer Survey of 60 large domestic US banks and 24 US branches and agencies of foreign banks. This is updated quarterly such that results are available in time for FOMC meetings. Questions cover changes in the standards and terms of the banks' lending and the state of business and household demand for loans.

As a reminder from our May 2013 conversation "What - We Worry?", exceptional liquidity provisions by central banks (QEs from the Fed, LTROs and QE from the ECB) as well as “amend and pretends” on banks balance sheet in Europe have arguably kept default rates artificially low, at least below levels consistent with economic fundamentals. 

Lower growth (recently revised downwards globally) should normally led to a rise in default rates, in that context, a widening in credit spreads should be a leading indicator given credit investors were anticipatory in nature, in 2008-2009, and credit spreads started to rise well in advance (9 months) of the eventual risk of defaults. We pointed out at the time UBS work on the subject of the predictorynature of both leverage (a subject we discussed at length this summer) and credit availability:
"Average leverage of non-financial corporate sector (Nonfinancial Corp Debt/Nonfinancial Corp Earnings, source Federal Reserve).

In terms of predictive value, the SLO survey and Non-financial leverage are two clear winners and these two factors alone produce an R^2 of about 0.6 in the best two-factor model." - source UBS
Whereas we have shown in previous conversation the significant rise in leverage in the US for HY and Investment Grade companies (which has not been yet the case in Europe hence our more favorable "approach" to European credit from a "relative value perspective"), the most recent Q3 release of the Fed Senior Loan Officer Survey is yet another cause for concern for 2016 when it comes to assessing the lateness in the credit cycle. As such we agree with UBS take on the subject from their Global Credit Comment note from the 4th of November entitled "Credit Cycle Update - Now Bank Standards Tighten To Cycle Lows":
"Credit Cycle Update: Now Bank Standards Tighten To Cycle Lows
As we detailed earlier in October, the significant tightening in non-bank lending standards, through lower HY issuance and deteriorating terms of trade credit, posed a structural risk to the credit cycle with potential knock-on effects to bank standards. Yesterday’s Q3 release of the Fed Senior Loan Officer Survey illustrated this latter point well; bank lending conditions have now hit multi-year lows (Figure 1). 

A net 1.5% of banks tightened standards on C&I loans to small borrowers, vs. -6% in Q2 and the worst since Q1’ 12. More surprisingly, a net 7.4% of banks also worsened terms for C&I loans to large borrowers, vs. -7% in Q2 and the worst since Q4’09. To be fair, these levels, particularly for smaller companies, are not very high and are far from levels seen prior to past recessions. But the trend has begun to shift.
What does this mean for our forward credit spread and default targets? It reaffirms our view that today’s spreads are merely fair-value for what is a late cycle environment. Even though spreads may tighten a bit more from today’s levels given positive momentum and a reduction in market volatility, we ultimately believe spread tightening will be limited and will gravitate back to current levels. Our 6 month ahead forecast for IG spreads is now 156bps (vs. 157bps currently) and HY spreads is now 603bps (vs. 596bps currently). Our 12 month forward HY default rate forecast is now 3.4%, though this doesn’t fully capture the extra defaults likely coming from the energy/mining sectors if commodity prices stay low. We have been consistently calling for a 4-4.5% default rate through 1H 2016. With this tightening in standards, there is greater upside risk to the high 4% or low 5% range toward the latter half of 2016.
Why have bank lending standards taken a turn for the worse? Quite simply, fundamental concerns about the economy are leading the way. Figure 2 makes this clear. For those banks that cited the economy as an important reason to change its lending standards, only 37% eased conditions (i.e. 63% suggested the economy motivated them to tighten standards) (Figure 2). 

This was the worst showing since Q1’10. For banks that cited industry-specific issues as important, only 25% suggested that was a positive, the worst showing since Q4’09. Competition from other banks and non-bank lenders was effectively the only reason why banks were still easing standards. To be clear, this is a positive in the short-run as it keeps the cycle going; however it is a negative structurally. Lending based on competitive factors alone is a game of musical chairs, in which the music will assuredly stop before long without an improvement in the economy.
Have October non-bank lending indicators provided any glimpse of trends for Q4?
Right now, it’s too early to tell. October’s Trade Credit Survey registered an improvement in overall conditions (from 52.9 to 53.9, where 50 = neutral). However, this reading is actually slightly less than the Q3 average and the components related to debtor-creditor disputes improved less. The rate of deterioration has slowed, but the trend is unclear at this point (Figure 3).
October’s HY issuance total was anemic at $9.4bn, continuing a theme where issuance is falling despite a larger overall market size, a worrying sign for future refinancing risks. With that said, November has started out strong, almost matching October’s total already in two days, albeit skewed more to higher quality BB names. We would need to see more follow-throughs to B/CCC names to better signal a risk-on trend." - source UBS
Furthermore, despite their alleged high degree of sophistication, credit investors have a very weak predictive power on future default rates. This was largely discussed by our Rcube friends in their long March 2013 guest post entitled "Long-Term Corporate Credit Returns":
"When default rates are low, credit investors believe that stability is the norm, and start piling up on leverage, inventing new instruments to do so (CLOs, CDOs, CPDOs etc.). This recklessness leads to mal-investment, and sows the seeds of the next credit crisis.

Spreads moves between June 2007 and October 2008 (from 250bp to 2000bp in just 16 months) were a great illustration of this manic-depressive behaviour (which can also be related to Minsky’s model of the credit cycle)." - source Rcube
From a medium term perspective and assessing the "credit cycle" we believe the latest US Senior Loan Officer Survey points to yet another "warning" sign in the deterioration of the on-going credit cycle which has been so far pushed into "overtime" by central banks with ZIRP and their various iterations of QEs.

But what does it means for the weeks ahead when it comes to our "fundamental" view of credit? This leads us to our second point.

  • On credit we remain short-term "Keynesian" bullish / long term "Austrian" bearish
As we indicated in our "Bouncing bomb" October conversation, given the strong inflows in the asset class (US High Yield in particular), we remain Keynesian bullish short term when it comes to credit:

"While we have been "tactically" short-term "Keynesian" bullish, when it comes to our recent "credit" call, we remain long term "Austrian" bearish, particularly when it comes to our "credit" related "Bouncing bomb" analogy and the High Beta gamblers. We would recommend moving into a higher quality spectrum in terms of "credit ratings" and exposure." - source Macronomics
From a tactical and leverage perspective, we would overweight European High Yield versus US High Yield and remain more inclined towards US Investment Grade credit versus Europe taking into account the risk for a potential hike in December and from a European investor perspective, favoring in essence a USD credit exposure.

We would not at the moment go against the "flow" given the latest inflows so far in US High Yield have been very significant, hence our tactical "Keynesian" bullishness and as indicated by Bank of America Merrill Lynch High Yield Wire note from the 30th of October entitled "Spooky action":
US high yield saw $3.252bn (+1.6%) net inflows this week, the largest dollar change in AUM since October 2011. HY ETFs recorded net inflows of $1.14bn (+3.2%) to bring their MTD change in AUM to a record $3.67bn. Non-ETFs made up the remaining $2.1bn (+1.3%) this week, the asset class’ largest weekly net inflow since November 2014’s $2.9bn gain.
DM high yield issuance was light once again this week with 3 companies pricing bonds for a total of $1.45bn on the week. 2 deals ($660mn aggregate) came out of the US while the other deal ($790mn) came from Canada. In the loan market, 3 companies priced 4 deals this week to bring $1.8bn in new money, all coming from the United States.
Ratings performance within US corporates was mixed, though all segments posted positive gains. BB paper was the top corporate segment last week, adding 3.25%. Meanwhile B’s were up 2.39% and CCC’s gained 1.32%. Sector performance was positive with 17 out of 18 high yield sectors gaining on the week"  - source Bank of America Merrill Lynch

But, clearly our recommendation of moving into a higher quality spectrum in terms of "credit ratings" and exposure has paid-off and we continue to do so. Use the on-going rally to climb up the rating spectrum. It is time we think to start thinking about "playing defense" for 2016.

From our "Austrian" medium to long term bearishness credit perspective, we continue to advocate a more defensive play when it comes to "beta exposure" and US High Yield. On that point we share our concerns with Bank of America Merrill Lynch from the same note:
"Cash in, cash out – The rally and why you should fade it
It’s no surprise to our readers that we believe we are at the beginning of the end of the credit cycle, as easy monetary policy has benefitted corporate issuers’ ability to gain financing despite poor fundamentals. Leverage is high, a lack of capex has led to low recovery rates, EBITDA growth is anemic and the price of risk has skyrocketed over the last several months. Furthermore, what started as weakness in commodities and retail has spread to wireless, wireline, media, semiconductors, healthcare, and chemicals. Throw in a scandal or 2, a plummet in CCC issuance, and a general move from refinancing issuance to M&A issuance, and our view remains that the death by a thousand cuts scenario we forecast earlier this year has quite a bit longer to play out. Furthermore, we question the ability for the equity market to sustain high multiples by levering up returns in a market where debt financing has become increasingly more expensive. In such a world, a negative feedback loop from the equity market to credit and vice versa, coupled with retail flows and hedge fund redemptions could leave the exit narrow for many large cap structures and their debt holders.
With such a strong conviction about the longer term prospects for the market (read: the next year) we have found it easier to talk about the strategic view more than the tactical over the last several months. Our feeling has been that one could make just as easy of a case as to why high yield could sell off headed into year-end as it could make for why the market could rally. However, we feel compelled to address how technicals clearly favor the asset class today and reiterate that due to the lack of liquidity in the market, would take opportunities of strength to sell paper into year end.
Cash inTo begin with, the market has undoubtedly seen a large influx of cash so far this October – both through inflows but also through organic means. In fact, as we have been on the road largely since Labor Day, we have heard a huge increase in the number of accounts discussing a pickup in pension fund mandates and inquiries. So far high yield has generated about $6.8bn in cash in October when accounting for issuance, coupon, maturities calls and tenders. With 21.7% of the market owned by open ended mutual funds, and an inflow of $3.2bn mtd (note, this number will change at month-end once all filers report), retail funds have seen an increase in cash of nearly $4.7bn so far this month, or an increase of 1.7ppt in cash levels. For accounts that have been managing higher than normal balances (4%+), a 1.7ppt increase is quite a lot of cash to have in the portfolio, likely creating a bit of a buying pressure ahead of year-end.
More than mutual fund flows, however, the biggest driver of strength has been high yield ETFs. Note that open ended mutual funds routinely see cash balances inflate and deflate- a 1.7ppt increase, though substantial, isn’t out of the norm- but ETFs, have seen an increase of nearly 15ppt in cash levels, or an increase in $5.1bn in buying power from these instruments. We note that despite this technical bid, the market has still only recovered to mid-September levels and is still significantly off May highs.
Low IssuanceYet another strong technical has been the lack of primary issuance lately. Developed market issuance so far this month has been just $3bn, which is the lowest since the summer of 2011. US issuance is even lower, at $1bn, also the lowest since the $930mn priced in Aug 2011. Issuance is running 9% behind last year’s pace in the US (note our forecast for 2015 was -10% yoy), a sharp contrast to earlier in the year, when we were running well above it (Chart 3).
So what’s driving the sudden drought? First, there are not a whole lot of event driven deals in the market right now. And for opportunistic supply, the new issue clearing yields have become significantly more expensive in a short period of time. Chart 4 shows how the clearing yields in the last four months are now at the highest level all year. And as a consequence, the number of issuers tapping the market has fallen significantly.
What’s different about this stretch is the length of it – yields have been greater than 6.5% for 4 months now, which has choked supply. The last time we saw new issue yields remain high for an extended period was post taper tantrum when 5yr rates jumped 85bps. In contrast, over the last 4 months, the benchmark risk free rate has actually fallen 20bps, inclusive of the move yesterday post the hawkish Fed remarks. Meaning today’s bond pricing is clearly dictated more by the risk premium than than by rates.
All that glitters is not goldWhile the prospects of jumping into today’s rally may be tempting, there are a number of reasons not to. A technical rally, driven by a combination of high cash and low issuance does not, in our opinion, scream buy. All the technicals currently favorable to HY can just as easily turn tomorrow. History is witness to how fickle retail money can be, especially in and out of ETFs, which is where most of the recent inflows have been concentrated. More so, the inflow into open-end funds has been dictated by a handful of accounts, with top 3 funds accounting for 66% of the inflows. Back in February, HY retail funds saw a larger inflow (-$9.5bn), only to be followed by 6 months of continuous outflows. It won’t be misplaced to expect a similar pattern this time around.
On the same note, issuance will not stay at the same depressed levels for an extended period of time. We know that accounts are flushed with cash, and have been buying bonds in the secondary, (high beta ones at that) as evidenced by the intensity of the spread tightening (85bps in last 2 weeks). It seems to us a matter of time before the accumulated dry powder starts chasing stable, money-good credits in the primary, and issuance picks up. Additionally, the Fed’s hawkish stance at yesterday’s meeting only makes it more likely that issuers will start tapping the market before December, more so if the October payrolls don’t disappoint.
Finally, and most importantly, nothing has changed fundamentally. Companies continue to disappoint on earnings and revenue alike, even outside of commodities (Chart 6), with each passing day reminding us that the very same reasons that pushed the HY spreads higher over the summer and into the fall still exist today.
The illusion of liquidityPerhaps a bigger issue today is that liquidity, or the lack thereof, makes it challenging to express tactical views in the HY space outside of the indices (TRS, ETFs, CDX). We would caution investors who plan on legging into risk into year end with the expectation of selling early next year as a plan that sounds better on paper than in reality. The most common push-back we get against this view (and the views are varied when it comes to liquidity) is that the total traded dollar volume in HY has gone up- and that statement is not wrong. In fact, even when measured as a percentage of market outstanding, daily HY trading levels have been steadily improving per FINRA (Chart 5). 

However, when we break down what’s trading at the bond level, we find that the trend has unequivocally been towards trading of new issues.
Liquidity is where the heart isBelow is a chart that shows the components of what is being traded on a daily basis as judged by the total number of months since issuance of the bond traded. In 2015, bonds issued in the last one month (dark blue in the chart below) have on average made up 14% of the trace volume on any given day, going up to 30% on certain days. In contrast, the average contribution of recently issued bonds was less than 7% in 2013, peaking at 10%. What’s more is that the dynamics seemed to change in Q2 2014, right about the time we first starting sensing a turn-around in investor sentiment from worrying about  being saddled with non-core holdings in the long run than missing out on the next big rally. There may have been lapses in that collective investor sentiment before too, just like right now, but that hasn’t changed the larger trend which seems to verify what we have been hearing anecdotally for a year now- that the liquidity in the marketplace today remains elusive. Note that the recent fall in trading issuers that came to market in the last month may have as much to do with the lack of issuance of late than anything else. What is startling, though, is the proportion of trades last October following a strong September issuance vs. the proportion of trades in October 2013 following a strong September 2013 calendar. In the post QE world where indiscriminate beta compression is dead investors have consciously gravitated towards liquidity; and as a consequence, trading has become concentrated in more on-the-run securities.

In light of all these issues, it hardly makes for a good strategy for us to buy a technical rally only to have to make a complete U-turn to position, in a low-liquidity environment for what we are forecasting to be a mid-single digit type default year in 2016. We would rather take this opportunity to sell into strength any credits that we don’t consider to be either long-term core holdings, or on the margin yield enhancers." - source Bank of America Merrill Lynch
In essence while remain on the "Ship of Fools", you should continue dancing but ensuring that you are dancing closer to the door given the rising signs in the lateness of the credit cycle. What is of interest to us and as pointed out above, clearly the behavior of our "CCC Credit Canary" in terms of performance clearly underlines the lateness in the "credit game" as far as we are concerned.

Whereas the markets have been viciously choppy in terms of corrections and rebound, we feel strongly that this early "Santa Claus" rally is once more central banks driven and given the "lack of performance" for many "balanced funds", it could well extend until December, when we will "discover" what the captains of the Ship of Fools have in mind (Fed and ECB).

Obviously, positive correlations and large standard deviation moves, given the fickleness of "retail investors", could indeed trigger some large reversals before year end. Whereas the Fed has clearly indicated it is "data dependent", the two most important data points will clearly be the next Nonfarm payroll releases.

  • Final charts - Buybacks have replaced dividends in the US
In the US cheap credit has led to a "buyback binge" hence the reduction of the number of shares leading to an increase in leverage given many corporates have issued bonds to finance their buybacks program. A large part of the rise in the S&P 500 can be attributed to "multiple expansion" rather than "strong earnings" growth thanks to the "buyback" policy. As of late Margin debt has stopped expanding given corporate earnings are to some extent faltering. Margin debt balances at NYSE member firms sustained a $19.5 billion decline (-4.1%) in  September, the biggest monthly fall in margin utilisation since August 2011 ($33.9 billion or -11%). More interestingly, "Buyback" have replaced dividends in the US, which we think is an interesting development as displayed in Société Générale's below graph from their Global Investor Slide Pack for November 2015:
"Buybacks have replaced dividends in the US
But, Buybacks are used to pay for stock option issuance
And, Buybacks are mainly funded by debt
 - source Société Générale

To paraphrase Charles Gave of Gavekal research for whom we have great respect:
"if there is more money than fools then market rise, and if there are more fools than money markets fall"
End of the day, you are going to have to decide if indeed you are on a "Ship of Fools" or not, when it comes to your "allocation" strategy.

"A fool thinks himself to be wise, but a wise man knows himself to be a fool." - William Shakespeare

Stay tuned!

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