Monday, 17 November 2014

Guest Post - US Equity / Credit Divergence: A Warning

"One thorn of experience is worth a whole wilderness of warning." - James Russell Lowell, American poet.

Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the growing divergence in the US between credit and equities:

Major equity / Credit divergences should always be taken very seriously.

They were among the best forward looking indicators at almost every major turning point for equities over the last 20 years.

To recap:

In 1998, equities were rallying hard, but US HY spreads failed to print new lows. Instead, they started widening in late 1997. Credit was telling us back then that Asia and Russia were severely slowing down while corporate balance sheet health was deteriorating. It preceded the 1998 crash.

In 1999/2000, the divergence was even more pronounced. The S&P500 not only recovered from the Asian crisis but rallied strongly during the Tech bubble. US HY spreads had bottomed 3 years earlier! Corporate balance sheet were at the time very stretched. As a result, banks were tightening lending standards. The equity market eventually crashed, tracking the signal sent by widening credit spreads.

During 2007/2008, credit spreads bottomed in May 2007 and started widening immediately after, while equities kept moving higher for another 5 months (October 2007). Spreads were telling us just like in 2000 that private sector leverage had reach such an elevated level that banks were starting to close the credit flows. Again, the divergence timed the bear market that followed.

In 2008/2009, spreads topped out in December while equities made new lows that were not confirmed by a new high on HY spreads. At that time, corporate balance sheet had started to adjust violently to the crisis. Capex had been cut to zero, the corporate sector was issuing equity (net positive liquidity impact) and cash flows had already bottomed and were starting to rise. Balance sheet health was improving, as evidenced by tightening credit spreads. The bullish divergence timed the end of the bear market.

In 2011, spreads bottomed in February while equities made a new high in April, as spreads widened further due to the European sovereign crisis. Equities reversed shortly after.

Today, the divergence is visible again. US High Yield spreads bottomed in June and have widened substantially since then. Equities are still printing new highs. Are US HY spreads telling us that global growth is weaker than expected, a message also sent by flattening yield curves, depressed bond yields, defensive massive outperformance relative to cyclicals. Is it Europe? Russia? Emerging Markets?

The fact that all this is happening while bullish sentiment in the US is at record highs is of particular worry. Everyone is expecting higher equities due to lower yields and depressed food and energy prices. But when everyone is thinking alike, no one is really thinking….

The expanding wedge pattern, has a target for US equities below the October low.

Investors should at least start hedging risk. The most aggressive can simply trade the downside. Volatility has crashed, especially on the very short expiries, as no one is expecting any hiccups before early 2015. This makes short dated puts quite attractive.

"History is a vast early warning system." - Norman Cousins, American author

Stay tuned!

Wednesday, 12 November 2014

Credit - Chekhov's gun

"One must never place a loaded rifle on the stage if it isn't going to go off. It's wrong to make promises you don't mean to keep." -  Anton Chekhov

Listening with interest to our "Generous Gambler" aka Mario Draghi monthly ECB conference, where no doubt, our poker player has indeed regained some of his "Sprezzatura", given the dovish surprises contained in his latest press conference with his explicit reference to the planned balance sheet expansion of the ECB in the introductory statement, we reminded ourselves of Russian writer Anton Chekhov's dramatic principle when choosing this week's analogy given the continuous hope for the ECB to unleash at some point a QE program of its own:
"Remove everything that has no relevance to the story. If you say in the first chapter that there is a rifle hanging on the wall, in the second or third chapter it absolutely must go off. If it's not going to be fired, it shouldn't be hanging there." Anton Chekhov

One could argue as well that Chekhov's analogy amounts simply to Tuco's philosophy from The Good, the Bad and the Ugly:
"When you have to shoot, shoot. Don't talk" - Tuco

And when it comes to central bankers, it looks to us that Bank of Japan has indeed recently applied Tuco's recommendation when it comes to its latest merry go round of QE but we ramble again...

Of course this post is a continuation of what we discussed in our last conversation in relation to the need of QE in Europe:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility." - Martin Sibileau

Therefore in this week's conversation we will discuss into more details the need for a European QE and the potential effects the various QEs have had on the real economy.

When it comes to QE and its impact on asset prices, we have largely discussed its effect in our September 2013 conversation "The Cantillon Effects":
"Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with an increasing "exogenous" (central bank) money supply.

We also commented at the time about the increase of money supply on the art market as posited by our friend Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":
"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

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

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

It is was therefore not a surprise for us  to hear that a Portrait by Edouard Manet reached $65M at a fall art sale in NYC, making this auction a new record for the artist (the previous record was $33.2 million for a Manet). Sotheby's sale totaled $422.1 million, the highest for any auction in its history. This is yet another sign of central bankers' "generosity" and a clear effective mean of measuring "Cantillon Effects". As per our previous conversation, a clear application of "Pascal's Wager":

The only "rational" explanation coming from the impressive surge in asset prices (stocks, art, classic cars, etc.) courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods".

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)?"

The importance of domestic demand being a flow variable should not be underestimated particularly in the case of Europe due to the lack or slack in aggregate demand thanks to high unemployment levels and in many cases what Richard Koo has coined as "Balance Sheet Recession" (think Spain and Ireland when it comes to real estate bubbles and "damaged" households balance sheet).

As a reminder from our conversation "Zemblanity", it is very important to understand the core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on from their post entitled - How central banks contributed to the financial crisis: "We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b). 
 To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit."  - Mr Michael Biggs and Mr Thomas Mayer on

So you might wonder where we going when it comes to discussing "Chekhov's gun" and the impact QEs have had on real economy, Japan being a good illustration.

On that specific case, we agree with Richard Koo, chief economist at the Nomura Research Institute in his latest note from the 11th of November entitled "BOJ's surprise announcement: monetary easing by a currency interventionist":
"QQE has had almost no impact on real economy
What effect has QQE had in the 18 months since it began? It has clearly had a major influence on the forex and equity markets, where surprises can be very effective tools, but has had almost no impact on the real economy.
Figure 1 shows Japan’s monetary base, the money supply, and domestic bank lending before and after QQE. If we rebase these aggregates to 100 at the point just before Mr. Kuroda became head of the BOJ and announced QQE, we can see that while the monetary base had surged to 187 as of this October, the money supply—the money actually available for the private sector to use—had risen only to 105, while bank lending stood at 104. Indeed, the money available for the private sector to use is expanding no faster than it did under Mr. Kuroda’s predecessor, Masaaki Shirakawa, in spite of QQE. In other words, QQE had no effect on the growth rates for either of these aggregates.

Central bank-supplied liquidity has nowhere to go without real economy borrowing
As I have repeatedly pointed out, the central bank can supply as much base money (liquidity) as it wants simply by purchasing assets held by private-sector banks.
But a private-sector bank cannot give away that liquidity, it must lend it to someone in the real economy for that liquidity to leave the banking sector.
For the past 20 years, Japan’s private sector has not only stopped borrowing money but has actually been paying down existing debt and increasing its savings in spite of zero interest rates.
Traditional economics never envisioned this kind of behavior, but the collapse of debt financed bubbles in Japan in 1990 and the West in 2008 left many businesses and households owing as much or more than they owned, prompting them to focus on repairing their damaged balance sheets.
QE without private demand for funds only generates mini-bubbles
While Japan’s private sector finally cleaned up its balance sheet around 2005–06, the debt trauma lingered on. That, together with the collapse of Lehman Brothers in 2008, led to a situation in which Japan’s private sector is still saving 5.7% of GDP in spite of zero interest rates and aggressive quantitative easing.
Unless the government borrows and spends this 5.7%, the funds supplied by the BOJ under quantitative easing would never leave the banking system and neither the money supply nor private credit would have increased—in fact, they might actually have decreased.

No matter how much the BOJ eases policy during this kind of balance sheet recession, the liquidity it supplies will not enter the real economy as long as there are no private sector borrowers. The only result is likely to be the creation of mini-bubbles in the financial markets.
While funds supplied under quantitative easing may provide a temporary boost to the prices of stocks and other assets, at some point those prices will correct unless they are justified by corporate earnings growth and other appropriate measures, and that will be the end of the mini-bubble." 
- source Richard Koo, Nomura Research Institute

If domestic demand is indeed a flow variable, the big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.
QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.

In textbook macroeconomics, an increase in AD can be triggered by increased consumption. In the mind of our "Generous Gamblers" (aka central bankers) an increase in consumer wealth (higher house prices, higher value of shares, the famous "wealth effect") should lead to a rise in AD.

Alternatively an increase in AD can be triggered by increased investment, given lower interest rates have made borrowing for investment cheaper, but this has not led to increase capacity or CAPEX investments which would increase economic growth thanks to increasing demand. On the contrary, lower interest rates have led to buybacks financed by cheap debt and speculation on a grand scale.

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.

In the case of Europe, deflationary forces can be ascertained by slowing global trade in the shipping industry as we discussed in our conversation of  January 2013entitled "The link between consumer spending, housing, credit and shipping - a follow-up":
"The relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending".
Any changes in consumer spending will directly impact global containerized traffic volumes. Containerized traffic is dominated by the shipment of consumer products."

The latest warning in slowing global trade sent across by shipping leader and giant Maersk as reported in the Financial Times in their article entitled "Maersk warns of slowing global trade" should not be ignored:
"“We see a slowdown in emerging markets, partly driven by a lower need for raw materials from China. Europe – it’s very slow growth, if any, at the moment, and there’s no reason to expect a big change here,” said Nils Andersen, Maersk’s chief executive." - source Financial Times

As indicated by the weaker outlook in shipping for Europe, QE on its own will therefore not be sufficient to have an impact on the real economy given the "japanification" process at play and as illustrated by Japan.

On the subject of the risk of continued QE and its negligible impact on AD and the real economy, we read with interest RBS's take on the subject in their note entitled "The Silver Bullet - The risks of QE infinity:
"The supporting idea for QE is that a positive wealth shock can support spending and confidence, and absorb other negative shocks to the economy. But what happens if QE continues, and consumers expectations' adapt to a QE-after-QE environment? 

In a basic (rational) economic model of consumption, households try to maximise lifetime income, i.e. the maximum value they can achieve with their wages. In a QE infinity world with stable/low interest rates and flat/negative inflation, the price of goods stays stable or declines over time, while the value of financial assets is expected to grow. The incentive for those holding financial assets can become to delay spending or investment. 

There are of course many factors in play when it comes to consumer spending and corporate investment decisions: expectations of long term permanent income, the life cycle, interest rates, confidence, etc. 
But there's consistent evidence across some points:

1. Rich people save more and spend less. There's plenty of historical evidence on this. As we show in the chart above, the saving rate for the top 1% and top 5% of the population is a multiple than the bottom 50% (see also  Do the Rich Save More?). 

2. Income inequality has increased since the crisis. The share of wealth owned by the top 0.1% is now over 20% in the US, vs around 15% in the 2000s. Inequality measured as such is as high as it was in 1916, according to the  Economist. The  debate still goes on, but there's evidence that QE may have contributed to rising inequality, and central bankers including the Fed are becoming more vocal on the topic.

3. The marginal impact of an increase in wealth to translate into consumption is lower for the richer brackets of the population. A recent ECB paper shows this clearly: as you can see in the chart above, the propensity to spend if wealth increases is 2-3x higher for the bottom 50% of the population.

4. Even when it comes to corporate investment, there is little relationship between QE and lower interest rates and more investment, which instead depends on other factors (economic outlook, fiscal policy, etc.)

Adding up points 1-4 highlights one risk. If QE is accompanied by other policies – like fiscal spending or a reduction in taxes – then it can work effectively. But if central banks are left alone with the burden of stimulating the economy, the risk of entering a cycle of QE after QE, or QE infinity is high, and the results can be self-defeating. 

For now, credit investors continue to anticipate more action from the ECB (and BoJ) – the next one being potential purchases of corporate bonds. But the impact on the real economy still depends on government action on spending, and support to the ABS programme, and so far we have seen little of it. 
Our view here remains: don't confuse QE with growth. If anything, QE infinity could be self-defeating without fiscal and reform support, as the ECB itself has warned. We expect more tightening in investment grade and double-B bonds on potential ECB action, but fundamentals for banks and lower-rated firms will remain weak into year-end and 2015, hurt by deflationary and weak growth (IFO institute head Hans Werner-Sinn just warned about an economic crisis being "really close", even in Germany).The ECB ABS plan is potentially a game-changer, and the ECB may start buying over the coming days, as Yves Mersch said yesterday. Let's hope that this time around, they'll get some help from governments." - source RBS 

Our take on QE in Europe can be summarized 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…).

“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?

When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend as indicated by Nomura by Alastair Newton on the 11th of November in his note entitled "Civil unrest: Going global - More economies look prone to protests":
"Common factors
The (largely) common factors remain those I identified last year, ie:
-A high level of economic inequality (using the World Bank’s assessment of individual economies’ Gini coefficient);
-A high level of perceived corruption (using Transparency International’s (TI) index);
-A 'local' – sometimes minor and often hard to anticipate – issue sparking widespread protests rooted in general unhappiness with the regime;
-Increased 'middle-classing' of civil society, often confirmed by a ‘core’ of the protestors being in or having had tertiary education;
-Effectively leaderless protests organised primarily over social networks, ie, in common with the 'Arab Spring';
-A shared sense among the protestors of not being listened to by allegedly corrupt and self-serving elites;
-Widespread protester use of mobile phone cameras in the 'propaganda war'; and,
-Allegations of police brutality escalating, rather than deterring, the protestor numbers.

As the recent demonstrations in Hungary underline, we should not assume that civil protest is limited to emerging markets. Notably in many EU countries we are increasingly seeing what are essentially protest parties capturing a significant share of the popular vote in elections. In 2015, look out in particular, therefore, for UKIP in the 7 May UK general election and for Podemos in Spain’s December elections (not forgetting the – related, in my view – drive towards independence in Catalonia)." - source Nomura

Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)

On a side note and on this "French" matter, we think it is time to revisit our August 2012 OAT / Bund Yield Spread Widener as per our conversation "France - Playing the nonchalance". While we highlighted at the time the lack of catalyst, this trade had been put in the drawer given market capitulation and Japanese investment support in buying French bonds.

We still believe France should be seen as the new barometer of Euro risk, particularly when one realizes that France will issue €188 billion of bonds in 2015 (same record amount as in 2010) and for the following reasons:
-The European Commission latest macroeconomic forecast for France expects a budget deficit of -4.5% in 2015 and -4.7% in 2016. France will be the worse European country in terms of budget deficit. If indeed global trade is slowing down, there is indeed a high probability the deficit could even reach the important psychological level of 5%.
-With the recent comments from Hedge Fund manager David Einhorn, fast money could potentially put back the trade on.
-While Japanese investors have in the past been very supportive of French OAT bonds, the real yield of US Treasuries (0.6%) in conjunction with a rising US dollar make the US bond market much more appealing than the French bond market

As a reminder from our conversation "Big in Japan", Japanese have been net buyers of OATs in 2012 to the tune of 4.07 trillion JPY (44.2 billion US), the most since 2005. The gain in yen was 26% versus 15% for US Treasuries and they only bought for 3.35 trillion JPY worth of US debt in 2012.

This makes more likely a slowdown of the Japanese support for French OAT bonds in 2015. If one looks at GPIF assets and expected changes in portfolio allocation as displayed in Nomura's Japan Navigator number 593 published on the 3rd of November, the greatest change will be on international stocks rather than international bonds:
- source Nomura

French 10 year OAT vs German 10 year Bund - graph source Bloomberg:
On current levels, this trade appears to us very "convex". Downside appears to us limited to 10 bps, roughly 1 point on OAT Futures on current sensitivity levels, carry is around -35 bps over one year. One can target 20 to 50 bps of widening in the next 6 months if indeed there is finally a catalyst playing out. One could as well play the trade flat carry by buying more German bund, which would of course be an even more bearish growth outlook trade. Why not...

This trade could be seen as a little convex trade versus a book of high beta risky assets (periphery credit, equities, etc.). 

Moving back to our "Chekhov's gun" theme of European QE and in the case of Europe, the equity rally that followed the press conference of Mario Draghi doesn't appear warranted as it seems to us that investors have jumped the proverbial "Chekhov's gun". On this subject, we agree with Deutsche Bank's Behavioral Finance Daily Metals Outlook note from the 7th of November entitled "The far-out-of-the-money Draghi Put:
"Anyone who thought Mario Draghi would strike a more conciliatory tone in yesterday’s ECB press conference, following a Reuters report of dissatisfaction with his leadership style among members of the Governing Council, was doubly unsettled. Not only did he not backpedal on any of his more contentious statements about QE and the future size of the Bank’s balance sheet, he even made them more explicit, and presented an endorsement of his stance signed by all members of the Council. This dovishness lit a fire under European asset prices. Equity benchmarks rallied strongly as investors priced in the prospect of broad-based asset purchases. This reaction was perhaps overenthusiastic because the pre-condition for QE is that the economic situation in the eurozone worsens and/or that the current measures prove inadequate (which means precious time would have been spent finding out). So a ‘Draghi Put’ exists, but it is struck far-out-of-the-moneyEven gold in euro terms recorded its first positive session in over two weeks.
But it was far from being the most sought-after asset of the day; investors still preferred the dollar and US-based assets. If the global economic situation becomes gloomier, they reasoned, the Fed would probably still take more aggressive action than the ECB, and sooner. The strike price of the ‘Yellen Put’ is much closer to the money." - source Deutsche Bank

Indeed, when it comes to the ECB we have a case of "Chekhov's gun, whereas when it comes to the Fed and the Bank of Japan it is more akin to Tuco's philosophy: "When you have to shoot, shoot. Don't talk"

What we find of interest is that both the Fed and the Bank of Japan have been trigger "QE " happy, As we have argued in our last conversation, investors' belief in central bankers' omnipotence and deity status enabling them to sustain over extended asset price levels is being threatened we think by the changes in the communication of the conduct of monetary policy as indicated by Richard Koo, chief economist at the Nomura Research Institute in his latest note:
"The problem is that treating monetary policy like currency intervention also has side effects. Over the last decade it has become standard practice around the world to conduct monetary policy with a minimum of surprises based on careful dialogue with market participants.
Until the mid-1980s, monetary policy decisions tended to be made in closed rooms, something then-Fed chairman Paul Volcker was very good at. In Japan, it was even considered “acceptable” for authorities to openly lie in the lead-up to decisions on the official discount rate (or the timing of snap elections).
Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members.

Kuroda abandons forward guidance
It was because of this approach that the Fed has been able to conduct policy now known as forward guidance based on expectations of its future actions, something that had not been possible in the past. It was precisely because the Fed avoided surprises that market participants trusted it when it said it would keep interest rates at exceptionally low levels for a considerable amount of time.
Policymaking evolved in this direction because of a growing awareness that monetary policy has a major impact on the economy and is fundamentally different from intervention on the currency market, which basically involves only a handful of participants.
But with the 31 October easing announcement Mr. Kuroda deliberately chose to shock the markets. By doing so, he effectively removed forward guidance from the BOJ’s toolkit.
When the head of the central bank enjoys surprising the market, market participants will no longer take anything he says at face value. Mr. Kuroda claimed in his Upper House testimony just three days before the announcement that the economy was making “steady progress” towards achieving the 2% price stability target even as he was secretly moving ahead with preparations for the surprise easing.

Ending QE will now be far harder for BOJ than for Fed
The BOJ governor’s decision to utilize the element of surprise could lead to major problems when it comes time to bring quantitative easing to an end. Careful dialogue with the market—including forward guidance—is essential when winding down such a policy, as the IMF has repeatedly warned.
There is, of course, no guarantee that the exit from QE will proceed smoothly simply because the central bank maintains a close dialogue with the markets. Even Mr. Bernanke, with his reputation for being a good communicator, caused a great deal of turmoil in both the developed and the emerging economies when his remarks on 22 May 2013 concerning the possibility of tapering sent US long-term interest rates sharply
The Fed’s intensive forward guidance under both Mr. Bernanke and his successor, Janet Yellen, succeeded in calming markets by persuading them the Fed had no intention of raising rates in the near future. It remains to be seen how Mr. Kuroda will respond when he finds himself in the same situation.
In summary, the BOJ’s shock announcement could make it far more difficult for the Japanese central bank to end quantitative easing than it has been for the Fed." - source Richard Koo, Nomura Research Institute

To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but, when it comes to winding down QE, the exit from the program will not proceed that smoothly, rest assured.

While it has been easy to somewhat front-run the QE cowboys thanks to "Pascal's Wager", the end of QE in the US coincide with a renewed period of weaker global trade, historically high asset price levels and record low bond yields making it more likely we will see a return of higher volatilities regime in the near future making future equities return questionable and long bond US Treasuries enticing (we are keeping on our very long duration exposure via ETF ZROZ).

On a final note we leave you with a chart for Bank of America Merrill Lynch latest Thundering Word note entitled "Humiliation, Hubris & Gold" displaying Japan's free-float market cap as a percentage of world:
"Tokyo's all-out War against Deflation
Finally, Japan’s humiliating decline as % of world market cap (Chart 10) and the explicit war on deflation launched by the Bank of Japan keeps us overweight Japan, in contrast to China and Europe. In addition, Japan has high operating leverage and stronger earnings momentum. Our bullish view on volatility, particularly currency volatility, is strengthened by the knowledge that liquidity trends in the US and Japan will be moving in different directions over coming quarters." - source Bank of America Merrill Lynch.

"Every gun makes its own tune." - Blondie, The Good, the Bad and the Ugly

Stay tuned!

Friday, 31 October 2014

Credit - Pascal's Wager

"One person with a belief is equal to ninety-nine who have only interests." - John Stuart Mill

Watching with interest the results of the ECB's AQR (Asset Quality Review), we reminded ourselves of our July 2012 title "No test, no stress, no stress no test..." given the lack of deflationary scenario in the ECB's assessment. We also followed the minutes of the FOMC from the Fed in conjunction with the end of QE in the US while Japan launched another huge round of QE, which will no doubt export somewhat a "deflationary impulse" to the rest of the world in the process rest assured.

When it came to choosing this week's title, we decided to veer towards philosophy this time around with the end of QE in the US (which we think is temporary) and with the Bank of Japan adding 80 trillion yen ($720 billion) of QE (given core inflation dropped to 1% from 1.1% in October). Once again central bankers are challenging investors' belief in their "omnipotence" which we touched in our conversation the "Omnipotence Paradox" in November 2012 where we discussed central bankers and the market's perception of their "omnipotence" in sustaining asset price levels.

In fact, in our conversation "Perpetual Motion" we mused around the notion of "perpetual motion" and its physical impossibility. As far as deities and omnipotence go:
"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its worldplan." - source Wikipedia.

So you might be already wondering why we chose Pascal's Wager as our title in this week's conversation. 

Pascal's wager was devised by 17th century French philosopher, mathematician and physicist Blaise Pascal (1623-1662). It posits that humans all bet with their lives either that God exists or not. In the investment world, we think investors are betting with their "life savings" that central bankers are either gods or not. 

Pascals Wager is of great importance and was groundbreaking at the time because it charted new territory in probability theory, making the first use of decision theory.

Pascal's Wager in the form of a decision matrix:
"Given these values, the option of living as if God exists (B) dominates the option of living as if God does not exist (~B), as long as one assumes a positive probability that God exists. In other words, the expected value gained by choosing B is greater than or equal to that of choosing ~B.
In fact, according to decision theory, the only value that matters in the above matrix is the +∞ (infinitely positive). Any matrix of the following type (where f1, f2, and f3 are all finite positive or negative numbers) results in (B) as being the only rational decision" - source Wikipedia

In similar fashion since 2009 investors have followed somewhat a similar decision matrix which we have tweaked for further explanation relating to our current choice as a title:

Therefore the only "rational" explanation coming from the impressive surge in stock prices courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods". 

Central bankers' omnipotence and balance sheet expansion:
- source Bank of America Merrill Lynch

Rest assured that at some point in time "belief" that "Central Bankers are not Gods" will ensure finite loss and in the end it might be the pagans who could have the final laugh in their "belief" in gold, this "relic of barbarism" to paraphrase Charles M Howell author of the book "Civilized Money "(1895) but that's another story...

In the meantime, the "barbaric relic" has indeed taken the proverbial spanking as illustrated by the sell-off in the ETF GDX - 1 year graph source Bloomberg:

ETF GDX from 31st of October 2007 until 31st of October 2014 - graph source Bloomberg:

In this week's conversation we will again focus our attention on central banks and the impact of their diverging monetary policies as well as the implications.

When it comes to stock prices, QEs, as displayed by a chart from Bank of America Merrill Lynch Thundering Word note entitled "The QE is Dead, Long Live the E!" from the 30th of October 2014 have been great propellers in conjunction with US corporate earnings:
"QE ends with deflation fear not inflation
As has been well-documented here and elsewhere, the Fed's QE has been the key driver of higher financial asset prices in the past 5-6 years (Chart 3). A recent US Treasury paper calculated that between Jan'09 and Apr'13 the S&P500 index rose 570 points in the weeks the Fed bought $5bn or more securities, 141 points in the weeks it bought up to $5bn, and fell 51 points in the weeks the Fed sold securities.
But the end of QE is coinciding with historically low levels of government bond yields and collapsing inflation expectations, rather than a surge in global growth. 10-year US Treasury yields are 50bps lower today than at the start of QE1, French 10-year yields are the lowest they have been in over 250 years (Chart 4),
and economists are cutting inflation forecasts rather than raising growth targets. All of this is great fodder for the Liquidity Bears who see QE as a failure, secular stagnation everywhere and warn of great, imminent bear markets in both credit and equities. For the bears the recent bout of volatility was merely a warning shot, in coming months will reveal unambiguous evidence that QE has failed to eradicate deflation and a loss of credibility in central bank policy will send asset prices into a tailspin in early 2015. "
- source Bank of America Merrill Lynch

For those who have listened to our musings from our last conversation, they should have applied the Pascal's Wager and its decision matrix to Japan. The recent big move by both the GPIF and the Bank of Japan have indeed been handsomely rewarding those short JPY (like ourselves) and long Nikkei FX hedged as indicated by the latest move in both the Japanese Yen and the Nikkei index:
"Given the Nikkei index is particularly more sensitive to away earnings, than by domestic earnings, going long again on the Nikkei currency hedged (Euro hedged) could make sense if ones would like to front-run again the Bank of Japan and their GPIF friends (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro)." - source Macronomics

In regards to Japan, we will reiterate what we posited in November 2013 in our conversation "Cold Turkey":
"While some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we think that we are in an early second stage for the Multistage Japan rocket"

When it comes to adding rocket fuel to the Japanese rocket, the latest decisions by the Bank of Japan will accentuate further both the rise of Japanese equities and the fall of the Japanese yen as displayed by the below graph from Barclays displaying the size of the balance sheet expansion of various central banks as a percentage of GDP:
- graph source Barclays.

In terms of the implication for Europe (as discussed in the "Coffin Corner"), the aggressiveness of the Japanese reflationary stance spells indeed more deflation for Europe, unless the ECB of course decides to engage as well in a QE of its own:
"Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think." - Macronomics - 27th of April 2013.

Japan has already been the subject of numerous posts already on Macronomics, such as "Big in Japan", "Japan - the rise of the Kagemusha", "If at first you don't succeed..." or  "Have Emerging Equities been the victims of currency wars?".

When it comes to the end of the tapering from the Fed and the impact on some asset classes, all "inflation hedge" trades such as Gold, Gold miners and Tips have been impacted as displayed by Bank of America Merrill Lynch Flow Show note entitled "Death of the inflation" trade from the 23rd of October:
"Death of Inflation trade: flows into Gold & TIPS collapsed past 18 months…now Floating Rate outflows (Chart 2)"
- source Bank of America Merrill Lynch

In continuation to European woes, the much vaunted AQR and ECB's support, many pundits believe that the move towards the European Banking Union will enable credit growth to resume and therefore help economic growth in the process. We beg to disagree on this subject. We have long argued that no credit, meant no loan growth and no loan growth meant no economic growth and no reduction of budget deficits. 

The only thing that matters is QE being launched or not in Europe as we have argued in November 2013 in our conversation "In the doldrums" where we discussed the possibility of a credit-less recovery:
"So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from last week conversation that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:
"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe."

When it comes to credit growth in Europe, Citi published an interesting note on the 31st of October entitled "Credit and The Eurozone Malaise":
"Overall, we expect the fall in credit growth to continue to moderate and for credit conditions to gradually improve from restrictive levels, with a modest boost from the end of the CA. However, we expect credit conditions to remain subdued. This is because private sector debt in many Eurozone continues to be very high, business sentiment is falling and the outlook remains very uncertain, which will continue to weigh on credit demand, while some pockets of credit supply constraints will probably persist even after the CA.
Credit availability matters, and particularly so in countries that do not benefit from strong FDI inflows and strong private liquidity positions such as France and Italy. But the relationship between credit growth and GDP growth has weakened in the post-financial crisis period and we therefore caution against using historical and in particular pre-crisis relationships between credit growth and GDP growth as good lead guides in the Eurozone. 
We also stress that the Eurozone malaise is unlikely to be resolved by improving credit conditions alone. Stronger aggregate demand is needed, and fixing credit supply is only one of many required steps. Additional measures required to reinvigorate the Eurozone economy include further monetary easing (including through large-scale asset purchases by the ECB), a looser fiscal stance, a restructuring of the debt of excessively indebted households and businesses as well as structural reforms to boost animal spirits." - source CITI

We have repeatedly highlighted the weakness in aggregate demand in the Eurozone. We argued in the past that the growth divergence between US and Europe were due a difference in credit conditions. This can be further illustrated by the following comments from the same CITI report displaying bank lending growth:
"Across countries, differences in credit growth remain large, with private sector borrowing still falling quite sharply in Greece, Ireland and Spain whereas it is growing at around 3%YY in France (Figure 5). 
Overall, however, credit trends remain very subdued in the Eurozone, both in historical comparison (growth in private sector borrowing in the Eurozone was 9% pa in 2003-07 and 7% pa in real terms) and relative to GDP growth (nominal private credit growth is running at 3pp below nominal GDP growth, whereas it was 4-5pp higher than GDP growth in 2003-07).

The question is why credit growth is so weak? ECB President Draghi has 
highlighted on various occasions that credit growth tends to lag GDP growth in 
recoveries and that the Eurozone’s current experience fits this pattern. By contrast, 
the IMF recently argued in its Global Financial Stability Reports that at least in 
stressed Eurozone countries credit growth is lagging behind the average experience 
in historical countries (see Figure 6). Whether the current experience in the 
Eurozone is in line with the historical evidence or not, that still leaves open the 
question of what holds back credit growth."

Indeed, bank lending standards in the Eurozone have tightened for most of the period between 2007 and 2014. However, there seems to be some light at the end of this tunnel: the ECB’s quarterly Bank Lending Survey published on 29 October showed that Eurozone banks‘ lending standards in Q3 eased for all loan categories for the second survey in a row (see Figure 7). 
Nevertheless, the level of lending standards is probably still very tight, at least in comparison with the pre-crisis period, given that lending standards tightened 26 quarters in a row until Q2 this year. Banks also recorded growing loan demand for all loan categories, for the third survey in a row, and banks expect credit standards to ease further and demand to rise further in the coming three months. But, again, having fallen 10 quarters in a row including Q1, the level of credit demand is probably still very low.
Interest rates are also still high, at least in some countries and in real terms. The 
ECB’s composite cost of bank borrowing measure for Eurozone NFCs was at 2.7% 
in August. This is roughly 150bp below the 2003-07 average in nominal terms and 
100bp lower than in 2011. However, in real (CPI-adjusted) terms, NFC borrowing 
costs are in fact 20bp above the pre-crisis average and have not fallen much at all 
recently, as Eurozone inflation has fallen faster than nominal borrowing rates (see
Figure 8). 
Cross-country divergences in real borrowing costs are also very high, 
with borrowing costs of 0-1% in Austria, Finland or Germany vs 5-6% in Cyprus, 
Greece or Portugal. The ECB’s Coefficient of Cross-Country Variation in bank 
borrowing costs of NFCs across Eurozone countries remains near all-time highs. In the periphery countries, the fall in inflation rates has meant that real borrowing costs have in fact risen in the last 12 months." - source CITI

The disinflationary factor and deflation risk of course have not been taken into account in the AQR. 
As we indicated in our conversation relating to the growth divergence between the United States and Europe ("Growth divergence between US and Europe? It's the credit conditions stupid..."), it is all about Stocks versus Flows:
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

When it comes to Europe and Pascal's Wager, we have to mention once more the issue of circularity as pointed out previously by our friend Martin Sibileau (who used to blog on "A View From The Trenches"), here is a reminder from his work which we quoted in our conversation "The law of unintended consequences" in Macronomics on the 25th of January 2012:
"With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance."  - Martin Sibileau

And as indicated by Martin Sibileau:
"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

While the depreciation of the Euro is a welcome respite for European companies, the latest merry go round of Japanese QE risk offsetting an already precarious economic situation which has been aggravated by the sanctions taken against Russia and impacting particularly German exports in the process.

We are therefore coming back in full circle towards the need for QE in Europe as posited as well by our friend Martin Sibileau (which we quoted on numerous occasions in our posts):
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility." - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:
"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

Back in November 2013, in our conversation "Squaring the Circle" we argued:
"Markets being extremely feeble creatures in the face of uncertainty will obviously react "rationally" when it comes to being provided with "explicit guarantees".

Obviously the lack of German Constitutional support could indeed prevent the whole "whatever it takes" European moment from moving from the "implicit guarantees" towards more "explicit guarantees" we would argue.
As pointed out by Bloomberg editors in their column from the 6th of November 2013 entitled "Europe's unfinished business threatens another recession",the European Banking Union is a must have. For us Europe is just trying to "Square the Circle:
"The most important stalled reform is in banking. Another round of bank “stress tests” has just been announced -- and this time, the ECB says, it’s serious. But there’s still no agreement on what happens to the banks that fail the tests. It’s universally agreed that the euro area needs not just a single bank supervisor -- which it now has in the form of the ECB --but also a single bank-resolution mechanism. That won’t fly, because Germany and like-minded countries won’t hear of bailing out failing banks or their financially stressed national governments.
This reluctance is understandable. But without a single bank-resolution mechanism, the euro project remains fatally flawed. The toxic link between distressed banks and distressed governments will remain. So long as that’s true, recovery will be held back and the euro area’s supposedly integrated capital market will be at risk of further splintering into separate zones. If the euro is to survive and its member countries prosper, a real banking union is indispensable." - source Bloomberg

To illustrate further the horrible issue of circularity and European banking woes, we think the failing of Banca Monte dei Paschi in the AQR will be a proxy of what happen to a European bank that fail sthe test as well as the application of "bail-in" for bondholders.

Since the AQR MPS stock price has been down by more than 35%. MPS's capital shortfall is put at €2.1 billion and has until November 10 to deliver its solution to the ECB. MPS's market capitalization is now €3.1 billion compared to the €5 billion raised in right issues this year. Placing Contingent Convertible notes (CoCos) also called AT1 to cover the capital shortfall is impossible. On this specific issue we read with interest Bank of America Merrill Lynch's note entitled "Numbers do actually matter" published on the 31st of October:
This is the level of impaired assets that Monte Paschi was carrying in its balance sheet at the end of June. At the end of 2012, it was €29.5bn so in the last year and a half it has gone up by 30%. These impaired loans account for 25.8% of the loan book. With such a vast portfolio of impairments, it doesn’t surprise us that there was scope for extra provisioning. The large portfolio of impaired positions undermines MPS’ viability, in our view.
Note that the NPE ratio used by the ECB is the much more benign 18.1% on which there is apparently 40.1% coverage. The sample analysed by the ECB, on which they found such severe provisioning needs, is in fact a smaller one that what we would consider to be the full portfolio of impairments. However, it does extrapolate, to a degree, in an attempt to cover the whole book.

€4.2bn is the ECB’s assessment of the gross impact on capital from risk in Monte’s credit portfolio. The adjustments come from large corporate (an adjustment of €711m), real estate (€1.6bn) and large SMEs (€1.9bn) in Italy. Recall that, for the Italian banks in particular, we’d always thought that the stress test wasn’t even that stressful – so this is a poor result arguably for the bank.

In our view, it ends once and for all the idea, recently propagated in some quarters, that Italian banks’ NPL numbers are ‘optically’ worse only because they are more strictly classified vis-à-vis other European banks. We have never subscribed to that view and neither does the ECB, it appears. Italian NPLs are not more strictly classified. In fact the ECB exercise has found that they are consistently under-recognised.

€1,394.8m is, apparently, the offsetting tax impact at Monte Paschi, which reduces the capital needs to €2.9bn in the ECB’s analysis. It’s equivalent to a large (33%) ‘benefit’ to the bank. We’ve heard doubts expressed about its reliability, because it is a large offset.

Coincidentally, €4.2bn is the gross aggregated capital shortfall that the ECB has identified in the adverse scenario for Monte dei Paschi.

The Bank of Italy has put MPS’s capital shortfall, including all capital strengthening measures, at €2.1bn. This seems to us to be a minimum number – for a large bank such as Monte’s solvency to be supportive of economic growth, we’d imagine that its capital would have to be much higher than this basic shortfall would suggest. The difference between this number and the previous number is the €2bn rights issue that was retained in the bank.

This is the adjusted capital ratio for MPS in the adverse scenario under the EBA analysis.

The EBA discloses the fully phased CET1 of MPS as -3.5%. The market will judge the robustness of the capital of the bank on a fully phased basis, so we’d argue that any capital actions taken need to be robust and credible, not papering over the (rather large) cracks.

These two negative ratios together underline the work that needs to be done to ensure MPS is robust to get through a reasonable stress scenario.

€5bn, €3bn and €1bn
€3bn is the amount of capital that the bank returned to the Italian Government this year after the €5bn capital raise. Had it not done so, we would be writing a different note about MPS now. However, €3bn was the amount that was in the repayment schedule for 2014 for the state aid, so the bank had to repay it. 
There is still €1bn or so of state aid outstanding and the Italian Government, as a first step, could convert this into equity now. However, we believe it is reluctant to do so, and the State may instead sell on the Monti bond to a third party that could trigger the conversion and own 30% of the bank on the cheap, potentially. Perhaps there is a certain reluctance to do this, because of the dilution of the investors that provided €5bn to the bank earlier this year.

More likely, we are mindful that the state aid approvals relied on the repayment of the New Financial Instruments according to the following schedule (see Table). Whilst conversion of the state aid to equity is foreseen, it would be a major derogation from the agreement between Italy and the EC and we think could potentially necessitate the re-opening of the MPS file by the EC. See for example, paragraph 134 of the state aid approval which reads:
If MPS is unable to repay the new instruments, MPS commits to re-notify a modified restructuring plan with additional measures. The Commission welcomes that commitment as it underlines the credibility of the repayment plan.

The original plan was premised on the return of MPS to viability and seems to explain the problems of the bank in terms of its over-exposure to Italian sovereign debt, which was having a bit of confidence problem at the time. This is now obviously not the case – it is the significant amount of impairments that is causing the bank’s solvency problems, and the Bank of Italy has itself acknowledged a €2.1bn capital gap at the bank. Obviously the current plan as approved does not restore MPS to long-term viability because it focused on the wrong areas. Given the work that the ECB has now done, we think the opening of the file would necessitate some significant changes to MPS, perhaps quite drastic ones, with far reaching implications for the bank. We can quite understand the reluctance to re-open the file; yet we struggle to see how else it could be if there is a desire that MPS should survive in anything resembling its current form.

Zero is apparently the amount of capital that the Italian Government wants to give 
the banking sector to help it overcome the deficiencies that have been elucidated 
in the stress test – hence its insistence on a private solution. This reminds us of 
the Portuguese authorities’ hopes for a private solution in the recent restructuring 
of Banco Espirito Santo." - source Bank of America Merrill Lynch

As we argued in our conversation - "Peripheral Banks, Kneecap Recap"
"We believe debt to equity swaps will likely happen for weaker banks as well as full nationalization for some."
As our good credit friend said in November 2011:
"The path will be very painful for both shareholders and bondholders."

When it comes to MPS, for us it is the most likely option to happen. From the same Bank of America Merrill Lynch note:
We estimate that MPS has about €5.4bn of Tier 2 subordinated debt outstanding, about €2.6bn of LT2 and €2.8bn of UT2 (dated). It also looks like there was a further €406m of Tier 1 securities in circulation, though this may be even harder to track down and there’s the issue that they are deferring at the present time. Equitizing or part-equitizing these bonds in some way would resolve the capital problems of the bank, we think, but it doesn’t appear to be on the agenda at the moment. The old Tier 1 bonds (the old 7.99% ISIN XS0121342827) appear to have dropped 20 points from their summer highs though – and appear to trade rarely.
We believe the base of the problem is the undertakings given by the Italian Government to the European Commission at the time that the State Aid for the MPS restructuring was approved just over a year ago. These would have to be revisited, which could be embarrassing. In particular, amongst the commitments given by Italy to the EC, we read that:
BMPS will not undertake any Liability Management Exercise (including calls) unless it is implemented at conditions by which it occurs at a […] discount in percentage points from nominal value and at no more than […]% above the market price. Any Liability Management Exercise will be timely submitted to the Commission services for approval. (Commitment #11 from the State Aid approval, November 2013) " 

This commitment effectively limits the ability of the bank to do a generous debt-for-equity swap, we think. It appears it would have to be punitive. Our assessment is that there is also effective lobbying from a major holder of the UT2 bonds – remember that the EC, very exceptionally, allowed an UT2 coupon when it should have been deferred if precedent had been followed?

This seems more powerful to us than the argument that perhaps some of the 
bonds are held by retail and there are fears of contagion. But if the Government 
doesn’t want to put extra cash into the banks, perhaps this should be revisited, as 
options look very limited outside the subordinated debt to us. And it is not as if 
this hasn’t been a well-trodden path to help bank with limited capital options to 
recapitalize throughout the rest of Europe. However, reopening the MPS state aid 
file, which would effectively be what they would have to do to get a generous LME 
away, may not be considered appetizing.
The sub bonds usually have large minimum denominations which don’t 
necessarily suggest a big retail presence, we’d argue, with the possible exception 
of the €2.16bn issue of UT2 bonds which does appear to have been placed 
directly to retail.
Moody’s downgraded the senior subordinated bonds of MPS to Ca on Thursday 
According to the agency:
"In addition, MPS's senior subordinated ratings were downgraded and placed on review for further downgrade. This reflects an increased likelihood that the bank may require public support, in Moody's opinion, which would trigger state aid rules and bail-in of subordinated debt. Further, given the repeated instances of bailouts using state aid over the past years, the rating agency does not rule out the imposition of more extensive restructuring measures for MPS which could affect all creditors of the bank."

Since the AQR/stress test, MPS stock has fallen about 34%, from €1.03 to €0.68 on Thursday evening.

Credit has been more measured, mostly because the technicals are more favourable, we think. Monte senior cash bonds were still trading well above par (3.625% bonds at €101.3), in spite of the fact that this is quite a distressed bank, though spreads do look to have widened 15-20bps today. It is one thing not to believe that anything too nasty can happen to senior bonds in Italy, quite another to look at these levels and believe we are seeing anything like fair value. Also, Moody’s talked, in their review for downgrade, of the imposition of more extensive restructuring measures for MPS which could affect all creditors of the bank."  source Bank of America Merrill Lynch

We believe that the path will be very painful for both shareholders and bondholders of MPS and that not only subordinated bondholders but seniors as well will face the music in the case of MPS, making MPS the precedent for future bail-in processes in the European banking landscape.

On a final note we leave you with a graph from Nomura from their recent report entitled "The coming cycle of higher volatilities" displaying the need for investors for a higher rate of return in their "Pascal Wager" making it most likely that if US productivity cannot deliver, then there is indeed room for disappointment and price decline:
"While the current cycle is not too different from past secular bull markets, investors are requiring a higher rate of return (i.e. earnings yield)"
- source Nomura

"The risk of a wrong decision is preferable to the terror of indecision."- Maimonides, Spanish philosopher

Stay tuned!