Sunday, 4 October 2015

Macro and Credit - Sympathetic detonation

"I don't like to think that maybe I'm just getting old. I'm not too excited about watching a huge explosion. I'm more interested in people and characters." - Norman Jewison, Canadian director

Given the significant "blow out" in sovereign CDS spreads such as Brazil, the weakness in both cash credit and indices alike, with a continuation in the rout in Emerging Markets (EM) weakness, as well as the "Bayesian" price effect in the performances on US dollar denominated Emerging debt funds and weaknesses as well in "Total Return" funds, we thought this week's analogy had to steer towards the explosive one, hence our choice for "Sympathetic detonation".

A "Sympathetic detonation" (SD, or SYDET), also called flash over, is a detonation, usually unintended, of an explosive charge by a nearby explosion (in our case Emerging Markets). Sympathetic detonation is caused by a shock wave (think about the Taper Tantrum and the surge in Mack the Knife aka US dollar + US positive real interest rates), or impact of primary or secondary blast fragments. The initiating explosive is called donor explosive (commodities rout leading to Emerging Markets woes), the initiated one is known as receptor explosive. In case of a chain detonation, a receptor explosive can become a donor one, which is exactly what we are seeing in Emerging Markets and High Yield credit, particularly in the Energy sector which will no doubt lead to defaults and restructuring, rest assured.

We find our title analogy appropriate given that in a "Sympathetic detonation", detonators with primary explosives are used (surge in the US dollar and collapse in oil prices), the shock wave of the initiating blast (Taper Tantrum) may set off the detonator and the attached charge (Emerging Markets). However even relatively insensitive explosives can be set off if their shock sensitivity is sufficient. Depending on the location, the shock wave can be transported by air, ground, or water. The process is probabilistic, a radius with 50% probability of sympathetic detonation often being used for quantifying the distances involved. Often "Sympathetic detonations" occur in munitions stored in e.g. vehicles (mutual funds), ships (hedge funds), gun mounts, or storage depots (dwindling EM FX reserves), by a sufficiently close explosion of a projectile or a bomb. Such detonations after receiving a hit can cause many catastrophic losses (such as the ones received recently by investors in various asset classes except cash, still being "king" in a deflationary bust scenario). What we are seeing playing out, is of course what we warned about since 2011, namely a currency crisis, which is the wave number 3 we have discussed in numerous conversations.

Just remember this, before we dive into our conversation, from our credit perspective and in relation to our chosen analogy even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely.

Major equity / Credit divergences should always be taken very seriously to quote the Guest note from November 2014 from our good friends at Rcube Global Asset Management  entitled "US Equity / Credit Divergence: A Warning".

Whereas our friends were probably a little bit too early in their call, we think that the recent significant deterioration witnessed in Credit and in particular US High Yield (a subject we have discussed at length during this summer), is for us, and some others, showing that the credit cycle is indeed turning and taking, we think, a turn for the worse. 

In this conversation, we will again point out to a worrying instability sign we have indicated, namely the impact of positive correlations leading to "Bayesian" price movements. On that subject we would like to refer to our August post "Positive correlations and large Standard Deviations move".

While typing this very note, we mused on twitter with our estimate for Nonfarm payrolls at 155K 30mns before the number came out. Given our recent blunder in hoping the Fed would hike by 25 bps in September thanks to us succumbing to "Overconfidence effect", we decided to opt for the "contrarian effect" which this time around came to fruition as NFP came out with a miserable 142K, putting us firmly back in the "deflation" saddle thanks to our US long duration exposure (partly via our ZROZ ETF exposure) as well as our long gold miners exposure which suddenly sprung back to life. 


  • Increasing correlation between asset classes is leading to instability and weighting on diversification - are inflation linked-bonds a solution?
  • In US High Yield this time is not different.
  • Final chart - Correlation to Oil very positive and unusually high

  • Increasing correlation between asset classes is leading to instability and weighting on diversification - are inflation linked-bonds a solution?
As per our August post "Positive correlations and large Standard Deviations move",  the rise in +/-4 standard deviations moves or more in various asset classes can be solely attributed to rising positive correlations due to central banks meddling with asset prices.

As a reminder:
"The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."
For us, there is no "Great Rotation" from "bonds" to stocks" there are only "Great Correlations".

This can be ascertained from the graph below from Société Générale Special Report published this month and entitled "The virtues of inflation-linked bonds":
"The past two quarters have been characterised by an increasing correlation between asset classes and between equity and bonds. Diversifying a portfolio is becoming more difficult. On the other hand, in a context where inflation should gradually normalise in the next quarters, inflation-linked bonds bring some diversification benefit.
In the broader picture, on a historical basis, inflation-linked bonds have become quite correlated with other asset classes lately, in line with increasing average cross-asset

The US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme, bringing more diversification benefit (see chart in margin).
"The correlation between inflation-linked bonds and nominal bonds has increased significantly in recent years, particularly as themes such as secular stagnation, deflation and even Japanification of the economy are still part of the economic newsflow. The current low growth and low inflation environment has made inflation-linked bonds and nominal bonds move in tandem since 2013. As discussed earlier, we have decided to introduce inflation-linked bonds into our portfolio by giving a maximum weight to US TIPS. US TIPS look attractive not only on a valuation basis, but they also provide lower correlation to other developed markets nominal bonds compared to UK peers." - source Société Générale
Whereas in their long and interesting report Société Générale make the case for using inflation-linked bond as another layer of diversification and in particular US TIPS, we have to agree that given secular stagnation, and "Japanification" of the economy (which has long been our scenario, Europe wise), indeed US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor".

Unlike TIPS, gilt linkers do not have a "deflation floor" protecting the cash flows from deflation, hence the current favorable attractiveness of US TIPS. But, in similar fashion, French government issues inflation-linked Obligations Assimilables au Trésor (OAT) bonds, which reference either a pan-European inflation index (the Euro-Zone Harmonized Index of Consumer Prices excluding tobacco (HICP)) or a French inflation index (French CPI ex-tobacco) also feature a "deflation floor" in that the principal face value and coupon payment can never decline below the value at issuance. Swedish linkers as well provide a similar deflationary protection feature as per the table below from Pacific Alternative Asset Management presentation from the 3rd Quarter 2011:

"US Inflation-Linked Bonds
The largest market for inflation-linkers is in the United States, where the US government issues Treasury Inflation Protected Securities (TIPS). TIPS feature protection of principal and interest payments from inflation. The principal, which is payable at maturity, is linked to changes in the non-seasonally adjusted Consumer Price Index for Urban Consumers (CPI-U). The semi-annual coupons on the bond are also inflation-adjusted since they are based on the underlying inflation-adjusted principal amount. Notably, the bonds also feature a ‘deflation floor,’ as the amount owed on the notes can never fall below the original face value of the bonds. This floor also applies to the coupon, which can never decrease below the stated coupon rate at issuance. The floor is an important component that can protect investors against prolonged periods of deflation." - source PAAMCO
Indeed, in a prolonged period of deflation, such as the one we are currently experiencing, the embedded "deflation floor" both applied to the stated coupon as well as to the face value of the bonds. These are indeed very interesting features that should not be neglected when selecting an exposure to the index-linked sovereign bond markets.

When it comes to gauging the risk in rising deflationary trends, the US Deflation hedge premium has been rising significantly recently as displayed in the below Bloomberg chart via @boes_ on twitter:

 - source Matthew B -  @boes_ on twitter
Furthermore, the global deflationary forces have been gathering steam as well as displayed in the below Gavekal Graph:
- source Gavekal

World CPI is falling, not a good indicator and no matter what central bankers are telling us, they are inept at re-igniting the "inflation" genie so far.

Furthermore, the US 10 year government bond market is pricing more and more a deflationary/quasi-recessionary picture:

- graph source Bloomberg

Post NFP data, we have broken again the lows on the US 10 year.

How can there be a recovery and a rise in "inflation expectations" when Average Hourly Earnings MoM are flat and Average Hourly Earnings YoY are growing at 2.2% when the market was expecting 2.4%?

This is proof that the US much vaunted recovery is weaker than expected.

Also the Atlanta Fed has revised its GDP outlook, On October 1, the GDPNow model forecast for real GDP growth in Q3 2015 is 0.9%. Many sell-side economists who also got their NFP call wrong (99 of economists polled by Bloomberg in fact) still suffer from "Overconfidence effect" when it comes to their US GDP growth expectations:
- source Atlanta Fed
Could the Fed really hike when US breakevens are falling rapidly, which is clearly indicative of deflationary forces at play? This also another reason why the embedded "deflation floor" in US TIPS is so enticing - graph source Bloomberg  - Robin Wigglesworth on Twitter

-graph source Robin Wigglesworth on Twitter

In September as well, Europe has clearly shown it was moving back into the dreaded "D" territory with the latest Eurostat Eurozone MUICP coming at -0.1% - graph source Bloomberg - Holger Zschaeptiz on twitter:
- source Bloomberg - Holger Zschaeptiz
Or, maybe you call this a recovery? 
Bloomberg graph displaying the Unemployment-to-Population Ratio vs Unemployment rate - graph source Bloomberg - Michael McDonough

  - graph source Bloomberg - Michael McDonough

Back in September 2012, in our conversation "Zemblanity",(Zemblanity being defined as the inexorable discovery of what we don't want to know), we discussed the relationship between credit growth and domestic demand and why ultimately our central bankers will fail in their useless reflationary attempts:
"credit growth is a stock variable and domestic demand is a flow variable"
We even asked ourselves at the time the following question:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"
What we have long posited is that while wanting to induce inflation, QE induces deflation.

This is what we discussed in March this year in our conversation "The China Syndrome". At the time, we quoted CITI's Matt King's 27th of February note entitled "Is QE Deflationary":
"It’s that linkage between investment (or the lack of it) and all the stimulus which we find so disturbing. If the first $5tn of global QE, which saw corporate bond yields in both $ and € fall to all-time lows, didn’t prompt a wave of investment, what do we think a sixth trillion is going to do?
Another client put it more strongly still. “By lowering the cost of borrowing, QE has lowered the risk of default. This has led to overcapacity (see highly leveraged shale companies). Overcapacity leads to deflation. With QE, are central banks manufacturing what they are trying to defeat?”
Clearly this is not what’s supposed to happen. QE, and stimulus generally, is supposed to create new demand, improving capacity utilization, not reducing it. But as we pointed out in our liquidity wars conference call this week, it feels ever moreas though central bank easing is just shifting demand from one place to another, not augmenting it.
The same goes for the drop in oil prices. In principle, this ought to be hugely stimulative, at least for net oil consumers. And the argument that it stems solely from the surge in US supply, not from any dearth of global demand, seems persuasive as far as it goes.
But in practice, the wave of capex cuts and associated job losses in anything even vaguely energy-related feels much more immediate than the promise of future job gains following higher consumption. The drop in oil prices, while abrupt, in fact follows a three-year decline in commodity prices more broadly. It’s not just oil where we seem to have built up excess capacity: it’s the entire commodities complex." - source CITI
No wonder Société Générale thinks US TIPS are enticing from a"diversification" perspective. They are not enticing because they are "cheap", they are enticing because of the "deflation floor" embedded!

The lack of evidence that consumers are spending what they are saving on gasoline should also start to concern investors.

Stronger USD leads to higher deflationary risk leading to lower long-term bond yields (that's what we are playing right now). Even though exports are only 13% of the US economy, 40% of S&P 500’s earnings now come from outside the US.

Given that "cheap money" went to fuel "overcapacity" hence the "commodity bust" and that as we posited earlier on in our conversation "cheap money" has to be paid back sometimes, the recent price action in US High Yield is exactly telling you that is becoming increasingly unlikely. This brings us to our second point namely that in US High Yield this time is not different.

  • In US High Yield this time is not different.
Back in July in our conversation "Mack the Knife", we discussed High Yield in particular and the scary CCC Credit Canary as an advanced early indicator of a deterioration in the credit cycle. No offense to the "macro tourists", "carry players" and "beta gamblers", but, we think that in US High Yield, this time is not different, it is worse.

Of course we were way in advance in sounding a warning on that subject in our conversation "The False Alarm" in October 2013 where we stated:
"If we take CCC Default Rate Cyclicality as an early indicative of a shorter credit cycle, then it is the rating bucket to watch going forward
Why the CCC bucket? Because there has been this time around a very high percentage of CCC rated issuers accessing the primary market in High Yield.
A rise in defaults would likely be the consequences of a deterioration in credit availability. Credit ratings are in fact a lagging indicator." - source Macronomics
We will re-iterate our 2013 advice for credit investors, watch CCC default rate going forward. Because it matters, more and more.

In September our "CCCs Credit Canaries" underperformed all else with a return of -3.2% while Bs were at -3% and BBs at -2%. All HY sectors posted negative total returns on the month.

At the time of our July conversation we did read with interest UBS's take in their Global Credit Comment from the 27th of July entitled "The scary reality":
"The problem, however, is some of the tourists underappreciate the exponential loss and mark-to-market functions for low quality high yield assets. As we have noted previously when the credit cycle turns annual triple C default rates can surge from 5% to 30% while average triple C prices can fall into the $40 - $50 range (versus $83 currently) - especially given expected recoveries average in the $20 - $25 context. The scary reality is those investors in triple Cs are seeking high single digit returns when they are likely to end up with negative total returns over the next several years (if our view of the credit cycle proves correct)." - source UBS
For us there are several ways of assessing the deterioration of the "credit cycle" from the US High Yield perspective. One of these ways is very simple, it is looking at the percentage of CCC issuers able to access Primary markets. 

The below chart from Bank of America Merrill Lynch from their October High Yield Credit Chartbook clearly shows that less and less CCC issuers are able to "tap" investors in the primary market:
"Are we there yet?
Let’s take stack of how far we’ve unwound in September. US HY has backed up a 100bps to 670bps, yields have broken into the 8 handle, and retail has pulled out at least another $1bn from mutual funds. At current levels, HY spreads are pricing in a 6.5% default rate for the overall market, and 4% on an ex-energy basis over the next 12 months. So, is it time to buy yet? To tackle that question, we don’t have to look too far. In 2011 when there was fear of a global contagion, yields reached 9.8%, and ex-commodity spreads 900bps. Yes, the source of contagion was different (Greece and US downgrade then vs commodities and EM now) but the transmission mechanism is still the same- investor risk aversion. And where we are today is arguably worse than where we were then from a credit standpoint because HY earnings then were better, leverage was lower and USD was weaker. Low quality issuers were still able to access the market and we had the Fed easing. Today, not only is the Fed in normalization mode, but the proportion of CCC issuers that have managed to access the market on an LTM basis stands at <20 font="" nbsp="">a far cry from the peak of 52% two years ago. Looking back, the periods when access to liquidity for lower quality issuers was this poor and going in the wrong direction, was in 2008, 1999 and 1989, just ahead of each default cycle (Chart above)." - source Bank of America Merrill Lynch. 

Every single time the "CCC Credit Canaries" have been less and less "able" to tap the primary markets, the High Yield default rate went significantly upwards. As we have told you before, cost of capital, "hiking" or "not hiking" by the Fed is going up in an environment where issuers have weaker fundamentals, falling EBITDA and higher leverage which is not a good "credit recipe" for "total return players" (which by the way have a significant exposure in dollar terms) as well as for "forward returns" on the asset class itself.

Another illustration in the newsflow in investors "waning" appetite has been ALTICE SA which was only able to raise €1.61 billion in capital increase out of the €1.8 billion it was seeking to pay 60% in cash for the acquisition of US Cablevision. Also, it had to pay more in terms of coupon to entice bond investors in its latest bond placement for the rest of the funding for its acquisition as reported by the Wall Street Journal on the 28th of September entitled "Investors Pull Back From Junk Bonds":
"Altice on Friday sold $4.8 billion of junk bonds to fund its $10 billion purchase of Cablevision Systems Corp., according to S&P Capital IQ LCD. When the deal was shopped earlier this month, Altice expected to sell $6.3 billion of debt, investors said.
A 10-year bond was priced to yield 10.875%, compared with yields as low as 9.75% that were suggested by bankers initially, according to S&P Capital IQ.
Olin on Friday sold $1.2 billion of bonds to pay for its pending acquisition of Dow Chemical Co.’s chlorine-products unit. Earlier in the month, Olin was expected to sell $1.5 billion of bonds, fund managers and analysts said.
The annual interest rate on Olin’s 10-year bonds sold Friday was 10%, up from 7% expected earlier in the month, according to S&P Capital IQ. The steep increase in yield reflects growing concerns that slowing demand from China could hit sales of chemical makers." - source Wall Street Journal
ALTICE SA's total debt amounts €45 billion (including Cablevision). It represents nearly twice the turnover and 5.7 times gross results for the group whereas the average for the sector is around 2 to 3 times.

Back in June 2015 in our conversation "Eternal Return", we indicated that for us M&A activity was the last sign we were getting late in the credit cycle à la 2007. This is as well confirmed by the same Wall Street Journal article quoted above:
"Companies have announced $3.2 trillion of M&A this year, according to Dealogic, emboldened to merge by cheap debt and the long stock rally that began after the financial crisis. That puts 2015 on pace to rival 2007 as the biggest year ever for takeovers. Issuance of junk bonds backing M&A deals hit a year-to-date record of $77 billion through Friday, according to data from Dealogic."
A souring of investors on junk bonds could limit the availability of financing for deals that require a lot of borrowing. Banks have been under pressure from federal regulators to reduce their loans to such companies, and a pinch in the bond market could leave those deals struggling for financing." - source Wall Street Journal
Yes, dear readers, time to adjust to reality, this time it is not different and cost of capital is going up. Trade accordingly.

When it comes to High Yield, yes default risk matters, but more importantly, to repeat ourselves from our previous conversations, change in "earnings" as well. In the below Bank of America Merrill Lynch charts, you will see for yourself that not only is leverage higher Energy sector included or not, but, the YoY percentage changes in EBITDA growth have taken a turn for the worse. This is not a good harbinger for things to come in High Yield going forward. Caveat Creditors...

US High Yield Net Leverage (Net Debt/LTM EBITDA, X)

US HY EBITDAs, YoY Percentage Change

US HY Ex-Energy EBITDAs, YoY Percentage Change
US High Yield Cov-Lite Issuance as a percentage of Market Size

- source Bank of America Merrill Lynch

Contagion spreading from the Energy sector to other sectors in the High Yield market? Lower credit standards? Higher leverage? Weaker earnings? You bet!

If this time for US High Yield is not different, at least the latest sell-off compared to the one experienced in 2011 is "different" as most credit metrics are weaker. On the subject of the difference in the latest sell-off, we read with interest UBS's take in their Global Credit Comment entitled "US HY: This selloff is different":
"US HY: This selloff is differentThe speed and magnitude of the recent US HY selloff has caught credit investors offguard and captured the attention of the broader market. Spread widening of 46bps over the last 2 days1 was the worst seen since October 2011, leaving the overall market at 689 bps, 216bps wider than June 1st. Naturally, clients are asking what has changed and what is causing the selling pressure. Many would assume that credit markets are being hit with substantial retail outflows, leading to forced mutual fund selling. However, in context, the recent outflows are not commensurate with the spread widening experienced. From June 1st to yesterday, HY spreads widened 216 bps on $11.4bn of retail mutual fund outflows. Interestingly, from Sept 1st, HY spreads widened 97bps on effectively zero mutual fund outflows. This lies in stark contrast to prior recent selloffs during Taper Tantrum (+57bps on $12.8bn of MF outflows, Jun- 2013) and last summer’s swoon (+87bps on $21.6bn of MF outflows, Jul-Sept 2014). This begs the obvious question: What accounts for the greater severity of today’s price action vs. the prior two years?
At the core, we believe fund managers are aggressively raising cash in anticipation of a structurally more volatile and dangerous environment. Investors are no longer only experiencing the pain of mark-to-market pricing on their portfolios, but they are becoming acutely aware of downgrades and default risks emanating from falling commodity prices, weakening EM economies, and rising idiosyncratic risks. This fundamentally-driven selloff is also laying bare the problems of illiquidity, through the default-driven liquidity channel as we wrote about in “A Primer on Corporate Bond Liquidity”, Oct 2014.
In short, investors are internalizing that we are in the late stages of the credit cycle. We have seen aggressive cash-raising in the past when investor sentiment has shifted so rapidly, using the VIX as a proxy for overall risk appetite. There is a reasonably tight correlation (0.62) between HY fund manager cash balances (%AUM) and the average monthly VIX level through time (Figure 1). 

We indeed have also seen an increase in cash balances already, from 4.25% in May to 4.75% in August, bringing cash balances to the highest levels since February. We think future cash balances in September and beyond will easily surpass that seen earlier this year. Using a linear regression based on the relationship between cash balances and the VIX, we expect HY cash balances to increase to 6.5% of AUM in September. This would be consistent with cash levels seen in 2010/2011, during the depths of the Eurozone crisis.
Hence, we believe today’s selloff is fundamentally different than that experienced during Taper Tantrum and last summer’s swoon. Both of the latter selloffs, despite having larger retail outflows, saw little cash raising by funds (Figure 2). 
In fact, during last summer, cash balances were actually drawn down, which limited the impact of these outflows. This is consistent with the fact that overall risk sentiment did not shift enough for fund managers to change their behavior; the VIX during both episodes remained subdued. This is not the case today.
Another factor we may be missing is institutional outflows, which may be moving first, with retail outflows to follow later. Anecdotal comments abound that the bid for lower quality paper is not what everyone had envisioned. While we will not get preliminary Q3 data on institutional third-party flows until later in October, there is evidence that the institutional bid, once very solid during Taper Tantrum, is starting to waver, as we saw last summer (Figure 3). 

Even in Q2 ’15, there were more institutional outflows than during Taper. We would expect to see further evidence of institutional outflows based on this trend. What is our prognosis going forward? This is a re-pricing of fundamental risk as the market transitions to a more volatile environment. As our equity colleagues detail , this risky environment is likely to persist due to a structural shift in monetary policy (from easing to tightening) and rising credit risks and losses. The result: Higher HY fund cash balances should be the norm for the foreseeable future, making the prospect of a significant tightening in spreads unlikely. On the downside, there is a clear risk that a further reduction in risk appetite would trigger significant retail outflows on top of funds raising cash, which would greatly exacerbate spread widening and illiquidity. However, if volatility stabilizes, even at these high levels, incremental cash will be put to work as investors tread carefully, leading to a slow grind lower in spreads from today’s elevated levels. In the shortrun, absent a further leg down in commodities, we would expect this grind lower in spreads to occur as the market is moderately cheap by our model estimates. Over the longer-run though, the downside risk of an outflow-driven selloff looms in the background." - source UBS
Of course, when it comes to outflows, there has been indeed a materialization of the "Sympathetic detonation" from the commodity rout, as reported by Bank of America Merrill Lynch in there High Yield Flow report from the 1st of October entitled "Here come the outflows":
"Significant outflows from high yield and loans
Amid the slowly worsening global macro backdrop, we saw a flight from risk assets into relatively safer areas this week. US high yield reported $1.5bn in outflows (-0.74%) for the week ended September 30th, which is the largest weekly outflow from the asset class since July 1st. The brunt of it was borne by ETFs, which saw -$809mn leave, while the remaining -$700mn came from HY non-ETFs. Loans reported $605mn in outflows (-0.61%), making it the worst performing asset class YTD, having lost 10% in AUM. Second worst YTD are EM bond funds, which realized outflows for the 10th week in a row, -$1.35bn (-0.52%), and now stand at -5.3% in terms of AUM lost YTD. High grade funds had a more modest $1.84bn outflow (-0.2%). The only fixed income classes recording inflows were munis, with $260mn (+0.1%), and money markets with $2.16bn (+0.1%). In aggregate, fixed income funds lost $3.57bn (-0.18%) to outflows on the week. The last week in which fixed income had more than $3bn in outflows was June 17th (-$4.17bn).
Other funds reporting outflows were equities (-$452mn) and non-US high yield (-1.49bn). Commodities and money markets recognized inflows of $268mn and $2.16bn, respectively." - source Bank of America Merrill Lynch
But High Yield and Emerging Markets have led as well to some other detonations as reported also by Bank of America Merrill Lynch in their Follow The Flow note from the 2nd of October entitled "Equities show outflows symptoms":
"Credit and equity fund flows – all negative
Market stress has been reflected in European fund flow data. Following a week of rising idiosyncratic risk outflows hit both credit and equity funds.
Outflows from high grade funds more than tripled from the previous week; and are now at four weeks high. The withdrawal from high yield funds quadrupled w-o-w as the asset class recorded their second biggest outflow of the year. Last week’s cumulative outflow from credit funds was the seventh in a row and the highest in four weeks. Credit ETF fund flows have also dipped into negative territory.
Equity funds inflows seem to have run out of steam. While the recorded outflow was only marginal, it remains indicative of a change in the trend. Note that this is the fifth week of the year where the asset class displays a negative flow number. Global EM debt funds continued to see more outflows; recording their tenth consecutive week of outflows. The asset class has suffered the most year-to-date with close to $15bn of outflows.
Commodities fund flows remained negative even though the outflow was not sizable it was the fifth week of continuous outflows.
The exception this week was European government bond funds, which posted a positive inflow, the first in six weeks. The asset class endured close to $7bn of outflows since the bundshock back in April." - source Bank of America Merrill Lynch
 If this is not indeed a "Sympathetic detonation", then we wonder what all of this is! In terms of initial blast (collapse in oil prices and surge in the US dollar), the shock wave has indeed set off the detonator in the credit market and the attached charge (leverage). This leads us to our final chart which once again shows how central banks meddling in asset prices leads to "unusual high correlations" with oil prices. 

  • Final chart - Correlation to Oil very positive and unusually high
While we started on the impact of positive correlations leading to "Bayesian" price movements which have been "abundant" as of late and a clear sign of "instability", our final chart comes from Morgan Stanley Credit Companion note from the 18th of September entitled "Focusing on the Fed, and Correlating with Commodities":
"US IG Credit Spreads:
Since we hit the double-digit tights of June 2014, US IG spreads have widened to 163bps over the past five quarters. This 60% jump in spreads stems from several factors at the management level which include increased buybacks, higher than expected issuance, and a heavy M&A pipeline (see Credit Continuum: The Buyback Bonanza, April 28, 2015 and Credit Continuum: M&A Makes Its Mark, June 10, 2015). However, the macro environment has also played a large role. Market volatility remains elevated as a result of macro growth concerns, and plunging oil prices have had a major impact on the Energy sector and to a lesser extent, the Basics sector.
Oil vs. Major Asset Classes:
Earlier this year, our Cross Asset and Commodity teams noted that recent correlations between oil and US High Yield have been unusually elevated, and have only been this high once before, during the peak of the 2008/09 crisis (see Cross-Asset Dispatches: Are You Just Trading Oil?, August 16, 2015). Certainly for IG, the story has been similar. 

- source Morgan Stanley
You can expect additional "Blue Mondays" going forward, more "Bayesian" price movements (+/- 4 standard deviations) and even higher positive correlations courtesy of your "local/global" central banker. This of course will lead to yet a bigger "Sympathetic detonation" to 2008, but that's another story and as any good story teller tells you: "To be continued..."

"Our duty is to believe that for which we have sufficient evidence, and to suspend our judgment when we have not." - John Lubbock, British statesman
Stay tuned!

Wednesday, 30 September 2015

Credit - A couple of charts summarizing recent credit markets violent moves

"The more violent the storm, the quicker it passes." - Paulo Coelho
Interesting entry points in cash bonds, if one believes in continuous Central Banks liquidity support and no recession. 

CDS Indices are finally starting to widen as well this week, but still massively lagging cash bonds recent moves (basis widening). For those with "liability visibility", basis trades are a safer way to play a “corporate bonds European QE” with less risk than o/r cash bonds longs.

Please see below a couple of charts summarizing recent credit markets violent moves via Bank of America Merrill Lynch, global cash bonds charts below (US / EUR / EM - IG &HY): 
- source Bank of America Merrill Lynch

US Investment Grade Index, Cash vs CDS basis :
- source Bank of America Merrill Lynch
As we posited in our last conversation the US "releveraging" has been fast and furious  which is not yet the case in European credit (far less "leverage" and "buybacks").

Therefore on European Investment Grade Credit as well as European High Yield, we have reached some interesting "entry" points when it comes to "cash credit". This could be an enticing play for investors "gutsy" enough to "front-run" a buying spree from the ECB on a much greater spectrum of corporate bonds than just a few issuers (which so far have been included in their buying program). 

Should the ECB decide to "ramp up" its balance sheet and include additional issuers in the corporate world, this would no doubt trigger a bull case for spreads. Of course, a potential rally in European credit would depend on additional "generosity" from our European central bankers, otherwise, the market will continue to struggle.

"I believe that truth has only one face: that of a violent contradiction." - Georges Bataille, French writer

Stay tuned!

Wednesday, 23 September 2015

Macro and Credit - The overconfidence effect

"Well, I think we tried very hard not to be overconfident, because when you get overconfident, that's when something snaps up and bites you." - Neil Armstrong, American astronaut
Watching with interest the increasing pressure on Emerging Markets and various asset markets alike with Brazil getting Pink Floyded as "all in all it was just a BRIC in the wall", and with VW being taken to the proverbial woodshed with its market cap decimated thanks to another "Bayesian" movement on both its stock and CDS prices, and us as well, like many pundits, being wrong footed on our Fed 25 bps hike call, we reminded ourselves for this week's title analogy of a well-established bias namely the "Overconfidence effect". 

With this "bias" a person or market pundit's confidence in his judgement is reliably greater than the objective accuracy of those judgements, especially when confidence is relatively high.

Overconfidence effect is indeed a good illustration of "miscalibrating" subjective probabilities (hence a Bayesian outcome in many asset prices as of late...). Truly, last week, our confidence in the Fed exceeded clearly our "accuracy" meaning we were more "sure" than "correct" to say the least.

When it comes to "overconfidence" distinctions, and in relation to the Fed and other "generous gamblers" aka central bankers, one specific "overconfidence" distinction comes to our mind, namely the "illusion of control" which describe the tendency for central bankers to behave as if they might have some control when it fact they have none. 

"Overconfidence" has also been called the most “pervasive and potentially catastrophic” of all the cognitive biases to which human beings fall victim. It has been blamed for lawsuits, strikes, wars, and stock market bubbles and crashes but, guess we are rambling again...

In this week's conversation we are going to revisit once more how the credit clock has been ticking faster this time around courtesy of the Fed, meaning we are indeed very late in the credit cycle with a Fed losing credibility facing weaker global growth and lacking ammunitions apart from launching another round of QE.

  • Default risk is rising, spreads are widening and the price action is becoming "Bayesian" in some High Yield names
  • US corporate leverage is in full gear while US corporate earnings are weakening - not a good recipe
  • Emerging Markets have also been plagued by the "overconfidence effect"
  • Final chart - Annual change in US 12 month forward S&P500 EPS expectations points towards recession
  • Default risk is rising, spreads are widening and the price action is becoming "Bayesian" in some High Yield names
Back in July 2015 in our conversation "A Cadmean victory", we already indicated that the credit channel clock was ticking faster and not only for High Yield:
"Over the course of the summer we expect credit spreads to widen, particularly in the High Yield space. We keep repeating this but in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger."
This of course was not a case of "overconfidence effect" but, from our point of view understanding the "overmedication" in the credit markets.

We also indicated at the time:
"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 as per our previous conversation when it comes to High Yield."
Of course when it comes to High Yield, perception of default risk matters and when it comes to the Energy sector currently in the eye of the storm given the significant fall in energy prices with European coal slumping below $50 and having declined 26 percent so far in 2015, default risk no doubt is rising as indicated by Fitch on the 21st of September in the summary of their latest report:
"Energy TTM Default Rate Approaches 5%; Highest Level Since 1999

•Fitch Ratings’ trailing 12-month (TTM) U.S. high yield par-weighted default rate climbed to 2.8% in August from 2.5% in July.

Default volume exceeded $4 billion for the second consecutive month, an event not seen since June 2009.

•90% of third-quarter default volume is in the energy and metals/mining sectors following the September distressed debt exchange for Halcon Resources and chapter 11 filing for Samson Resources.

•September TTM energy and exploration/production rates will approach 5% and 8.5%, respectively, assuming no additional defaults this month.

Second-quarter leverage (debt/EBITDA) rose to 5.4x from 5.1x in the first quarter, while coverage (EBITDA/interest expense) dropped to 3.3x from 3.5x.

•Leverage and coverage remained essentially unchanged from the prior period, removing the 87 energy and metals/mining companies from the sample." - source Fitch
 As a reminder from our conversation "Blue Monday":
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
So 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.

When it comes to convexity and price movement, in our August conversation "The Battle of Berezina", we indicated that we were following with interest the situation of Abengoa SA (ABGSM) the Spanish company involved in the Renewable Energy sector which is particularly exposed to Brazil and that S&P had a recovery value of just 30%. As indicated on the 21st of September by Bloomberg, bonds due March 2021 tumble to 27.7 cents on the euro and the CDS now signals 93 percent probability of default within five years in their article "Abengoa Bonds Fall to Records After Report HSBC Withdrew Support":
"Abengoa SA’s bonds fell to records after a report that HSBC Holdings Plc withdrew support for the company’s planned capital increase.
The Spanish renewable energy company’s 500 million euros ($564 million) of 6 percent notes due March 2021 fell 12.6 cents on the euro to 27.7 cents, pushing the yield to 38.5 percent, according to data compiled by Bloomberg. Credit-default swaps insuring Abengoa’s debt signal a 93 percent probability of default within five years, CMA prices show.
HSBC retracted an agreement to back 120 million euros of the Seville-based company’s 650 million-euro share sale last week, Spanish news website El Confidencial reported today without saying where it got the information. HSBC, Banco Santander SA and Credit Agricole SA had agreed to be standby underwriters of the increase last month, according to people familiar with the matter." - source Bloomberg
A good illustration of the price action can be seen in the below chart from S&P Capital IQ displaying Abengoa SA 8.875% 2017 bond price moves:
- source S&P Capital IQ
Getting closer to "recovery" value...30% that is.

This clearly illustrates our thoughts from August 2013 in our conversation "Alive and Kicking" where we argued the following when it comes to convexity and bonds:
"In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..." - source Macronomics, August 2013.
Of course when it comes to the "overconfidence effect", "overmedication"  and credit market in terms of issuance on "steroids" courtesy of the Fed, it can be ascertained from the below chart from Bank of America Merrill Lynch's European Credit Strategist note from the 17th of September entitled "Fed for thought":
"Goodbye to ZIRP…
We think the end of zero rates in the US means the end of credit market “excesses” in the US. During the post-Lehman era, the Fed’s zero interest rate policy was a boon for US corporations. Many took advantage of low rates to releverage balance sheets, fund share buybacks and reward shareholders. The behaviour was reflected in the rapid growth of the US credit market."
 - source Bank of America Merrill Lynch

This is particularly of interest given the potential "outflows" risk and "overconfidence" in market participants in avoiding a disorderly "exit" from their investors given there has been a rising share of funds holding the bulk of corporate bonds over the years as illustrated by Bank of America Merrill Lynch Credit Strategist note from the 18th of September  entitled "Long for longer":
"Forensic flow analysis for 2Q 2015
According to the Federal Reserve Flow of Funds data released today foreigners ($172bn) and mutual funds ($116bn) remained the biggest purchasers of corporate bonds in 2Q 2015, followed by life insurance companies ($14bn) and pension funds ($9bn). Notably purchases by foreigners rose significantly from $80bn in 1Q. Households – a residual category that also includes hedge funds and non-profits - sold $122bn of corporate bonds in 2Q compared to selling a more modest $24bn in 1Q (Figure 16). 

Thus the corporate bond market continued to grow largely based on demand from just two types of investors, both of which to some extent are not long term investors - foreign investors and mutual funds/ETFs. As result mutual funds/ETFs now hold 26.5% of the IG+HY corporate bond market (Figure 17).
 - source Bank of America Merrill Lynch.
As per our previous musings, rising defaults could lead to "availability heuristic" which would entail "overconfidence" failure and disorderly exit and significant outflows in the asset class.

It was therefore not a surprise to read in Bloomberg on the 22nd of September that Mutual funds are facing new rules for preventing investor runs as reported by David Michaels:
  • "SEC commissioners vote 5-0 to propose liquidity protections
  •   Regulation allows bond funds to penalize investors who exit
A hallmark of the $18 trillion mutual-fund industry is that it promises easy entry and exit for investors. U.S. regulators now want new protections to ensure that pledge can be met due to concerns that firms have loaded up on hard-to-sell assets.
The five-member Securities and Exchange Commission voted unanimously to pass a measure Tuesday that addresses criticisms that its rules haven’t kept pace with the evolution of the fund industry. The SEC’s proposal follows warnings from the Federal Reserve and International Monetary Fund that some funds could struggle to meet investor redemptions during a market rout.
Under the proposal, funds would have to maintain a minimum cushion of cash or cash-like investments that can be sold within three days. Funds also could charge investors who pull their money on days of elevated withdrawals.

Protecting Investors

“Changes in the modern asset management industry call on us to now look anew at liquidity management in funds and propose reforms that will better protect investors and maintain market integrity,” SEC Chair Mary Jo White said.
Mutual funds, which are held by 53 percent of all U.S. households, already face a legal requirement to return cash to investors within seven days. In search of higher returns, many fixed-income funds have migrated into riskier debt that doesn’t trade often and could be difficult to sell at fair value during a period of market stress.
A key concern is that any problems will be exacerbated when the Fed raises interest rates, causing bond prices to plunge and prompting fund investors to run for the exits.
The SEC’s plan would force funds, including exchange traded funds, to adopt liquidity-management plans and classify how long it would take to convert positions to cash. Funds would have to hold a minimum amount of cash or cash equivalents, meaning the assets could be sold within three days. A fund’s board of directors would decide what percentage of a portfolio must be easily liquidated." - source Bloomberg.
Welcome to Hotel California Bond funds:
"you can check out anytime you like, but you can never leave"
Of course this is the result of our "sorcerer's apprentices" aka central bankers and their taste for markets meddling on a "grand scale" leading to rising positive correlations (hence the on-going volatility) as well as instability as indicated by "Bayesian" price movements.

The issue this time around is that the US "releveraging" (not yet the case in European credit!) has been on "steroids" and the earnings picture is slowly but surely deteriorating. This leads to our second point about "overconfidence" in leverage and a weakening earnings picture. Caveat creditor...

  • US corporate leverage is in full gear while US corporate earnings are weakening - not a good recipe
On the subject of rising corporate leverage which we previously discussed during this summer, we read with interest UBS take on the subject from their 22nd of September Global Credit Comment entitled "Late Cycle Re-Leveraging: No End in Sight?":
"Late Cycle Re-Leveraging: No End in Sight?
The corporate leverage cycle continues to kick into full gear as late cycle dynamics become more evident. Friday’s data release from the Federal Reserve’s Flow of Funds estimated total Q2 ’15 US Non-Financial Corporate Liabilities at $7.94tn, an 8% Y/Y increase. This increase is starting to close in on growth rates seen in the latter stages of prior credit cycles (10-11% Y/Y in late 90s, 11-12% Y/Y in 2007). This level of debt growth has historically been dangerous, but it wouldn’t necessarily be so if corporate earnings were sufficient to match it. However, US non-financial corporate earnings aren’t just lagging, they are actually contracting, albeit marginally, at -0.16% Y/Y. (Figure 1) 
Weak global growth is a major driver; US non-financial profits earned from abroad (which nearly total 25% of total profits) are now falling at a 5% Y/Y pace. Profits earned domestically also are muted, but they still remain in positive territory, growing 1% Y/Y (Figure 2). 

Further headwinds from a stronger dollar and/or renewed problems out of China/EM would likely exacerbate the situation, though an improving European economy could still act as an offset.
While it may seem surprising that debt growth is accelerating when earnings growth is tepid, this is actually the norm historically. What is not surprising is the impact on credit spreads. Weakening corporate fundamentals will eventually place credit spreads under pressure and this cycle is no exception. We find a strong relationship between the excess of debt growth over earnings growth (Y/Y) and BBB credit spreads over time, including in recent months (Figure 3).
The re-leveraging cycle for now will be dictated primarily by the evolution of M&A activity, which our equity colleagues believe will remain robust. Sluggish earnings will not be enough to upset this trend, in our view; indeed this predicament may even encourage more M&A activity. As earnings struggle and margins reside tenuously at peak levels, we think firms are unlikely to aggressively raise dividends, and buying back stock at more expensive levels is becoming less attractive. With growth opportunities low, the one option left is M&A activity, and shareholders are indeed rewarding companies with higher share prices (both the acquirer and the target). Empirically, we see this as well; M&A cycles generally correspond with either falling and/or weak earnings growth, including in the present environment (Figure 4).
Also, as we wrote in Animal Spirits: M&A Feasting on US Credit, S.Caprio, Aug 2015, we think the Fed is highly unlikely to slow the cycle. Higher interest rates have not impeded past M&A cycles; to the contrary, M&A volume has generally moved in lockstep with higher Fed Funds rates. Last Thursday’s FOMC decision also suggests to us that the Fed will be quite gradual and cautious when it does tighten monetary policy, only responding to very tangible signs of improved growth and rising asset prices, in our view. Hence, the emergence of a more hawkish than expected Fed that chills risk appetite is not probable, in our view. Increased market volatility from events abroad may take froth off the pace of M&A issuance, as they did in late August, but even here, recent large M&A announcements indicate the demand for acquisitions is still there.
All told, US corporate leverage will likely increase further in coming months as the usual dynamics of a late stage credit cycle unfold. We believe this will continue to juice non-financial IG corporate issuance and keep non-financial IG credit spreads at elevated levels for the foreseeable future." - source UBS

It is getting late in the game, when it comes to US credit! This is exactly what we concluded relating to M&A in our June conversation "Eternal Return":
"Most acquisitions are often over-valued as they are often made at the top of the cycle, when valuations are excessive and when stocks already include hefty premiums. 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. This is the case today." - Macronomics, June 2015
Once again, the trends that are occurring in the US credit markets have historically been associated with a credit cycle that is reaching maturity.

Also in our June 2015 "Chart of the Day - S&P500 - Leverage and performance", we mused around the "spicy" cocktail of buybacks/M&A at the high of the cycle financed by debt in true "Eternal Return' fashion.

This was indeed a sign for us that the Investment Grade rally of the last few years was getting exhausted particularly in the US (as a reminder):
  • significant bond issuance
  • low spreads 
  • weakening of covenants, 
  • declining credit ratings, 
  • increase in M&A activity, 
  • less favorable use of proceeds from issuance
The continuation of this M&A wave is clearly indicating that we are moving into the final inning  of the credit cycle. The lack of investment in CAPEX means that corporate CEOs are now using M&A following multiple expansions through buybacks, which are now slowing down. M&A is indeed the last US corporate CEOs' "gameplay".

When corporate balance sheet leverage rises, default probability increases down the line, period.

High Yield earnings are also weakening and so is the global economy outlook. On this specific subject we could not agree more with Bank of America Merrill Lynch's take from their High Yield note from the 17th of September entitled "Global growth concerns spread from us to Fed":
"A slow moving train wreck
Today’s Fed decision was the second worst outcome for risk markets, in our view. We have written on numerous occasions that if the Fed didn’t hike rates today initially markets would rally modestly before selling off. The realization that global growth concerns are not only real, but very dangerous right now should cause a risk off environment. And with no room to cut rates, we question the Fed’s ability to manage any further slowdown through what would have to be QE4. However, we can’t see how additional quantitative easing will help, as the goals of QE have already played out: the banking system has recovered, rates are low, investors have driven debt issuance and asset prices to uncomfortable levels, and the housing market has recovered enough to not be a concern.
Furthermore, lower rates don’t help high yield at this point. Whether the 10y is at 2.20% or 2.0%, does the asset class really look all that more compelling? Not in the slightest. In fact, outside of hiking while sounding very hawkish, not hiking and sounding very dovish while expressing concern about the global economy may be the worst thing that could have happened today.
We have been saying for months that the global economy is weak and the Fed’s dovish disposition today only bolsters our view. Europe is about to enter QE2 as inflation and growth remains poor. Japan and Brazil were just downgraded. Commodities remain under pressure and we think, at some point, the narrative could turn from a supply driven story to a demand driven one. Domestically it becomes harder to argue that a strong dollar and the lack of inflation can be viewed as transitory and this headwind is continuing to hurt high yield corporates. Manufacturing is uneven, consumer spending hasn’t improved in a year, and 2014 real median income was down 6.5% versus 8 years ago (and down 7.2% from the 1999 level). Although auto sales remain strong, we would expect as much given low gas prices, an aging fleet and the fact that auto loans are one of the few places in the economy where it’s easy to obtain credit.
Additionally, high yield corporate earnings remain incredibly weak, with yoy earnings growth negative for the first time since the recession (even ex: commodities EBITDA growth is only slightly positive). Leverage is at all-time highs (again, even excommodities) and the High Yield index is more globally exposed than it has ever been (35% of the market generates 45% of its revenue from outside of the United States, and that doesn’t include Energy, which is globally exposed despite not realizing significant direct sales abroad).
Not only are earnings weak, but there has been next to no capex investment, debt issuance has been massive, and buybacks and dividends have driven equity valuations as CEOs and CFOs, afraid to invest in organic growth, have chosen to buy growth instead. And as a result, recovery rates are 10-15ppt below historical norms and defaults and downgrades are creeping into the market. Although we understand many will say its just commodities, is it really? What started as coal weakness 18 months ago became coal and energy weakness. But it wasn’t really just the commodity sectors, as retail was also already weak. Now it’s the commodity sectors, retail and wireline (but definitely not all of telecom). The situation almost seems unbelievable, as everything that seems to go wrong is explained as being isolated (AMD, well, of course semiconductors are in a secular decline) and treated as a surprise (Sprint)." - source Bank of America Merrill Lynch
If that's not a case of "overconfidence" effect taking place in US High Yield credit markets thanks to the Fed's "overmedication", then we don't know what is!

When it comes to credit spreads and default risks and leverage, end of the day, earnings matter!

Back in November 2012 in our conversation "The Omnipotence Paradox" which is in effect, yet another manifestation of "overconfidence" by our central bankers, we argued the following:
"We believe the biggest risk is indeed not coming from the "Fiscal Cliff" but in fact from the "Profits Cliff". The increase productivity efforts which led to employment reduction following the financial crisis means that companies overall have reached in the US what we would call "Peak Margins". In that context they remain extremely sensitive to revised guidance and earnings outlook" - Macronomics, November 2012
US corporate leverage would be less worrying from an historical context if indeed there wasn't a picture of deteriorating operating profits in the background as illustrated in the below chart from Société Générale's Credit Strategy weekly note from the 18th of September entitled "Turning Point":
"Operating profits for the universe were flat year on year in Q2 and contract slightly in Q1, and when the impact of falling oil prices and the stronger dollar is fully felt, perhaps the numbers will be even worse.
However, here again there are reasons to be cautious. The year on year decline in operating profits in 2008-2009 were clearly much bigger than the recent falls. And weak profit data in 2011-2012 proved to be misleading, with the market soon turning around and recovering.
Our suspicion, then, is that global credit markets are discounting a lot of bad news in the Q4 earnings season which starts in mid-October, and they may be pleasantly surprised. This is one of the strong reasons why, at the start of the month, we called for spreads to peak in late September." - Société Générale
Perhaps? Place your bets accordingly.

Furthermore, when it comes to "overconfidence effect", hot money flows and Emerging Markets, they have as well been plagued by this truly toxic cognitive bias as per our third point.

  • Emerging Markets have also been plagued by the "overconfidence effect"
While we recently touched on the "stock" and "flow" approach to assess Emerging Markets vulnerability from a balance of payments point of view, the hot money flows thanks to the Fed's easing policies, not only have led to a faster increase in corporate issuance and leverage in the US, but also had some significant impact on EM external borrowings in recent years (see our prior reverse Macro osmosis theory).

We believe than even with the Fed's recent dovish stance, EM assets will continue to be under pressure for the time being.

Thanks to "overmedication" and "overconfidence" EM's vulnerability to external shocks has increased. On that note we agree with Barclays's take from their FX Themes note from the 22nd of September entitled "EM FX: Not cheap given China and Fed risks":
"EM vulnerability to external financing shocks has increased
On the flipside, EM external borrowings have increased substantially in recent years, reflecting cheap financing in DMs and weak growth outcomes/low real rates in DM versus EM. Indeed, external borrowings were crucial in boosting domestic credit across the EM space (Figure 4). 

As the Fed leads the DM out of the low rates environment and with external borrowings by EMs being primarily USD denominated (eg, 87% of external issuance is in USDs), we believe a Fed tightening represents a liquidity shock that would lead to weaker EM FX and higher EM rates.
As Figure 5 shows, the correlation of short-term EM real rates with the US is low, but it is substantially higher for long-term real rates.

Nonetheless, a Fed hike of short-term rates is likely to lead to a move lower in EM FX as real rate differentials narrow. Weaker EM FX is likely to increase the repayment of external borrowings and increase refinancing in local markets – pressuring domestic interest rates higher. A Fed delay will likely be seen as temporary as the Fed seeks to ensure a recovery, which would leave long-term real rates in EM vulnerable. Hence, we do not see either scenario as supportive of a constructive view on EM assets, especially those local-currency denominated.
…and reserves have not kept pace with increased leverage
EM reserves have been declining since peaking in 2010 (Figure 6). 

It is striking that EM reserve growth has not kept pace with the increase in total external debt and has been significantly slower than the growth in short-term debt. In both cases the decline of reserve cover has been significant as EMs have increased leverage in the domestic economy.
In EM FX/Local Markets – Assessing FX reserves adequacy in EM, 19 January 2015, we used an alternative approach to assess FX reserves adequacy in EM economies. Essentially, we conducted a stress test on the capacity of EM central banks to intervene directly in the FX market to protect their currencies should capital outflows accelerate. Our updated ranking is shown in Figure 7.
Our results suggest that the TRY, ZAR, ARS and MYR are likely most vulnerable should EM risk aversion and external financing conditions deteriorate further. It also means that central banks in these countries would likely be constrained in limiting currency weakness through direct market intervention. They would likely be forced to tolerate more currency weakness, or rely on capital control measures.
At the other end of the spectrum, Asian currencies such as the PHP, KRW, THB and the CNY have FX reserves levels high enough for central banks to intervene comfortably in FX to limit the extent of currency depreciation from capital outflows. That said, given our view of further CNY depreciation and broad USD strength going into 2016, we do not think these countries would resist currency depreciation. In fact, authorities in Korea and Thailand are relaxing overseas investment measures to encourage resident outflows to offset the pressure from their large current account surpluses." - source Barclays
When it comes to China and its CNY current stability issues, as we pointed out in our part 2 of our long conversation "Availability heuristic", something will have to give:
"Without further flexibility in its CNY currency in terms of "flows", its large "stock" of FX reserves could be viewed as a Maginot line, playing useless defense in the FX market without widening the yuan's trading band. This will further weaken Asian currencies in the process we think (hence our recent HKD short post)." - source Macronomics, 
This is as well confirmed by Barclays in their FX Themes CNY note from the 22nd of September entitled "CNY: Unsustainable stability":
"Rising cost of maintaining currency stabilityAlthough we were surprised by the way that China moved to allow its currency to weaken (we expected a widening of the daily trading band), we were not surprised by the direction of the CNY move after the policy change. In our view, China’s move on 11 August to adjust the fixing mechanism for USDCNY is likely to open the door to further CNY depreciation in the months ahead. While we do not see the policy change as a panicked move towards a devaluation strategy in order to boost growth, nor as a signal of a loss of control (as discussed in Asia Themes: China: Consequences of a New FX Regime, 14 August 2015), we think the policy change will allow for more flexible adjustments in USDCNY. While China assured the G20 that it is not pursuing competitive depreciation, this does not mean stability in USDCNY will continue indefinitely, especially given the risk of a sharper drawdown in FX reserves if the Chinese authorities continue to aggressively defend the CNY.
Success at a cost
Amid growing capital outflows and pressures on the exchange rate, Chinese authorities have been using FX reserves to hold up the CNY.
As we discussed in EM Asia Strategy: China: The heavy cost of intervention, 3 September 2015, FX intervention in recent weeks has been sizeable according to our estimates, which has had a major cost in the form of domestic liquidity tightening and a consequent need to provide liquidity to sterilize FX intervention. China reported a sharp drop of USD94bn in official FX reserves in August, or closer to USD104bn after accounting for valuation effects of exchange rate changes on the composition of FX reserves. This marks a step up in FX intervention from about USD50bn in July and an estimated USD140bn from December 2014 to March 2015, which underscores the significant pressure from capital outflows. This also suggests that the recent relative stability of spot USDCNY could be misleading and coming at a cost.
Although China’s FX reserves appear to be relatively healthy at USD3.65trn, continued FX intervention at the current rate would result in a swift drawdown in reserves. If the current pace of FX intervention continues, we estimate that the PBoC could lose up to ~14% of its FX reserves (ex-valuation adjustments) during June-December 2015. Moreover, we estimate that China’s central bank would have to reduce the reserve requirement ratio by ~40bp/month just to offset the impact of its FX operations on domestic liquidity.
Illicit outflowsAnother way to look at the sustainability of current exchange rate policy is by examining illicit capital outflows. Although China’s capital account is closed, several illicit channels of capital outflows have made the capital account rather leaky. We discuss these and their impact in China: Leaky capital account: estimating outflows and policy implications. We estimate that capital outflows from China could rise from the current 8-10% of GDP, driven by slowing growth, financial market volatility, policy uncertainty and currency overvaluation. In an adverse scenario, total outflows on the capital account could rise to a significant ~15% of GDP. Since these outflows are much larger than current account inflows of 5% of GDP, they will pressure China’s FX reserves and/or the CNY exchange rate. If China absorbs the balance of these outflows (USD1trn) completely by selling reserves and meeting hedging demand (in forward markets), this implies a drawdown of 28% of the current reserve portfolio. We believe this is a significant amount, especially if authorities are unable to slow capital outflows. We expect a weaker CNY over the medium term and significant jump risk for USDCNY as sustained intervention of such a size is unlikely given the uncertainty of success.
How much further does the CNY need to fall to stabilize capital flows?With our valuation models suggesting that the CNY is about 5-10% overvalued, and with China’s growth prospects deteriorating, we see risks of capital outflows and CNY depreciation pressure persisting. Indeed we think a 10% fall in the CNY versus the USD is needed to stabilize the REER and capital outflows. China’s challenging backdrop calls for a more flexible currency regime, and we maintain our forecast of USDCNY 6.80 by year-end. The deterioration in growth prospects have led us to downgrade our China 2015 and 2016 GDP forecasts to 6.6% and 6.0%, respectively (see China: Lowering 2015-16 growth forecasts following recent soft data, 13 September 2015). That said, we estimate that 10% CNY REER depreciation would add only between 30bp and 40bp to growth. However, we believe a much larger depreciation against the USD could pose serious risks to financial stability that government officials may prefer to avoid." - source Barclays
There you go, regardless of the "stock" of FX reserves put forward by many pundits, what matters in the case of China and the "overconfidence" effect are flows and particularly "outflows" in the form of a leaking capital account akin to "negative FCF". Remember financial crisis are always triggered by "liquidity" issues and in the case of sovereigns "over leaking" capital accounts.

So there you go, there are indeed evident signs of "overconfidence" effects in both  the credit and macro  pictures. When it comes to US equities and economic outlook, the annual change in US 12 month forward EPS is a harbinger for weaker earnings, therefore wider credit spreads thanks to weaker balance sheet due to cheap credit binge releveraging triggered by the Fed.

  • Final chart - Annual change in US 12 month forward S&P500 EPS expectations points towards recession
Earnings matters as we clearly indicated in our conversation when it comes to leverage, rising defaults and wider credit spreads. While the Fed has indicated its concern about global growth, there is cause for concern when it comes to the global earnings momentum.

The final chart comes from Société Générale Global Equity Arithmetic note entitled "US profits growth has never been this weak outside of a recession published on the 21st of September:
"That the US Federal Reserve is only now declaring itself worried about global economic growth is perhaps the only real surprise of last week. After all, global earnings momentum (the ratio of analyst upgrades to estimate changes) has plummeted from a respectable 47% in May this year to a recessionary 32% last week. Even once the weak Energy sector is excluded, global EPS momentum has still dropped to 35%, also from around 47% in May.
The chart below shows the annual change in 12-month forward S&P 500 EPS expectations. This series is based on forward consensus expectations and therefore excludes many of the write-downs and exceptional items that are currently pushing down actual reported profits. It is more akin to operational profits and has never been this negative outside of a recession!"
 - source Société Générale
Is the "overconfidence effect" warning out? Looking at the recent "price-action" it's certainly looks like central bankers are losing their "Chutzpah"!

"Without the compassionate understanding of the fear and trepidation that lie behind courageous speech, we are bound only to our arrogance." - David Whyte, English poet
Stay tuned!