Following up on our previous conversation relating to the growth divergence between the USA and Europe in May this year (Growth divergence between the USA and Europe? It's the credit conditions stupid...), we want to point out in this credit conversation that the aforementioned divergence has been growing as well in the credit space.
The divergence between US and European PMI indexes - source Bloomberg:
Back in our May conversation we indicated the following reasons behind the growth differential between both economies was due to credit conditions:
"In recent conversations as well we have been highlighting the growth differential between the US and Europe ("Shipping is a leading deflationary indicator"):
This divergence can as well be seen in the perception of credit risk for Investment Grade. This is divergence between the CDX IG 5 year CDS index and the European Itraxx Main Europe CDS 5 year index (125 Investment Grade entities), is at 32 bps but fell from the highest point reached of 64 bps in September 2011 thanks to the LTRO operations at the end of 2011 and the recent ECB pledge - source Bloomberg:
Given the latest forecasts for economic growth in both the USA and Europe (2% for the US and -0.4% for Europe according to the IMF), one can expect US investment grade credit to outperform European investment grade credit as implied by Morgan Stanley's 3 month forward model from their recent report:
For the last two years, European companies have been using the bond markets for funding to replace bank financing and particularly in Europe. In their latest Euro Consumer Takeaways from the 10th of October, independent credit research company CreditSights indicated the following:
While more recently we have been relatively concerned about the dwindling liquidity ("Yield Famine"), and the role of positive basis in credit as an additional indicator of our "uneasiness" ("The Uneasiness in Easiness"), low growth, low yield and low volatility regime in the current environment make allocation to non-financial credit (both High Yield and Investment Grade) essential.
Indeed, corporate deleveraging might imply a new golden age for credit because, as we indicated in April 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets", credit is far less volatile than equities (see above graph from Nomura).
Nomura in their recent report put forward this very central point:
“Given that the bulk of returns in equities is linked to earnings whereas the credit spread should be driven by distance to default and recovery rates, flat earnings are not necessarily bad for credit as long as risk premia remain under control. And policy appears to be aimed squarely at keeping a lid on risk premia. Clearly this argument would not hold if earnings fall back significantly, or in other words a recession became the central case. “
and also added:
"Total return in credit should be seen as less risky if the Fed is taking yields on the risk-free rate down at longer maturities." - source Nomura
Why is so?
We agree with Nomura namely that it depends who sets the cost of capital, markets or policymakers:
"So, if the drivers of returns remain precariously balanced, leaning together like drunks on a tram so to speak, then the undoubted outperformers we maintain are fixed income products, in particular HY and IG. What could go wrong with this? Well obviously two things – policy is ineffective and another recession occurs, or policy is effective and the economy booms.
Central banks are now well outside their “normal” remit of setting short-term interest rates and are instead attempting directly to set the cost of capital for a series of normally market-determined assets. In the US the Fed has embarked on twist, and now MBS purchases, and in the euro area the ECB has embarked on contingent shifts in front-end government bond yields toward a policy-mandated level. While the motivation for each may be rather different (market failure considerations versus stimulus), the impact on other asset classes is of a great deal of interest via portfolio rebalancing as competing required returns must react.
If we think about this in terms of the securities market line (SML) from the capital asset pricing model (CAPM) then the debate may be easier to get a handle on.
Normally we treat central bank policy action as shifting the intercept of the securities market line up or down with the setting of interest rate policy - the risk-free rate. The slope of the securities market line (SML) is seen as being set by fundamentals (how risky the market portfolio is seen to be and the general aggregate level of risk aversion). This does not mean that individual assets can't migrate up and down the SML as their perceived betas shift around - the most obvious recent one being the entire emerging markets fixed income world.
By setting the risk-free rate at (essentially) zero central banks engaging in QE, twist or OMT are instead shifting the required return on individual assets out along the SML. Now, the key question is whether by doing this they can lower the slope of the entire SML line via reduced expected risk and/or higher risk appetite.
The determining factor as to whether the whole line flattens or only the targeted asset beta shifts, we would argue, is the effectiveness of monetary policy (perhaps the slope of the IS curve might give us a clue). If policy is seen as being ineffective, then it is likely that a beta shift will occur only for the targeted asset and only if the new policy does not make the fundamentals worse. If policy is effective then the entire market portfolio does better even if the forward risk-free rate is expected to rise.
In the present era we have made the case before but feel it is worth restating, that market confidence/sentiment has taken the place of the traditional credit channel of monetary policy. Central bankers want to generate improving expectations as a result of policy, which in turn begets better growth expectations and a flatter SML line and so on and so forth.
Anything that detracts from that bullish sentiment undermines the credibility of the policy. Detractions can be mistakes elsewhere - i.e. Europe or EM growth - or perverse effects of the policy itself. In terms of the former, note how EM equity betas rose as the Fed engaged in Twist. This is partly because EM growth concerns began to rise then.
And in terms of policy having perverse effects, we have argued that the attempt to set a lower cost of capital for all assets merely causes a distortion (unless there is genuine market failure) in the cost of capital across different quality firms and assets, which is unwarranted given their intrinsic risks.
This may go some way to explaining the curious lack of M&A, buy backs and private equity deals over recent times. Could it be that strong firms are loath to pay what are perceived to be high prices for weaker firms? Could it be that by shifting the entire SML down policy has lifted all boats including the weakest and thus has delayed or actually removed the need for poor, value-destroying businesses and managements to change business strategy or be ¡°taken out¡± of the market?
If this is the case then it is an extremely important consideration since it implies that we should continue to expect only modest growth in aggregate demand since cash balances will continue to be held rather than "worked" and firms that by definition are using capital unproductively will continue to exist.
The unpleasant side effect of intervening to set the cost of capital is that it probably means more modest medium-term growth expectations than otherwise might be the case, which leads to lower expected returns being attached to equities and initially at least a higher required return for holding them (i.e. a fall in price now). And this can happen without high volatility owing to liquidity swamping risk premia." - source Nomura
Arguably in our recent conversation "The World of Yesterday", we posited that a Mouse trap, or Bull Trap, had indeed definitely been loaded in the credit space, looking at the worrying trend of the return of Cov-lite loans financing (Back in May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz..."). Not only are we seeing the return of dubious financing that peaked before the financial crisis such as Cov-lite financing, but we are also seeing the return of payment-in-kind notes as reported by Sarika Gangar and David Holley in Bloomberg in their article - Bubble-Era Financing Returns as Profits Falter on the 11th of October:
"A type of financing that peaked before credit markets seized up four years ago is staging a comeback just as concern mounts that corporate profits are falling and the global economy is losing steam. Offerings of $2.1 billion in the past 30 days of so-called payment-in-kind notes, which allow borrowers to pay interest with extra debt, account for more than a third of this year’s $6 billion of deals, according to data compiled by Bloomberg. Pharmaceutical Product Development Inc., a Wilmington, North Carolina-based contract research firm, sold $525 million of the notes yesterday. Sales of high-yield, high-risk bonds are soaring to a record pace as interest rates hover at unprecedented lows send investors toward riskier assets. JPMorgan Chase and Co. says credit metrics are deteriorating, with leverage at investment- grade borrowers potentially approaching financial crisis levels by year-end, as the International Monetary Fund lowers its global growth forecast to the slowest pace since 2009. “You only hear about PIK bonds when the high-yield markets are really frothy,” William Larkin, a fixed-income money manager who helps oversee $500 million at Cabot Money Management Inc. in Salem, Massachusetts, said in a telephone interview. The trend “is OK if we’re at that part of the cycle where things start to accelerate. But we don’t know that.” " - source Bloomberg.
So yes, the above confirms that the Credit Mouse trap has indeed been set and loaded as confirmed by the conclusions of the quoted Bloomberg article:
"While PIK bonds may perform for a while, “when they stop performing well they become virtually unsellable at times, and they can drop in price rather substantially,” James Kochan, chief fixed-income strategist at Wells Fargo Funds Management LLC in Menomonee Falls, Wisconsin, said in a telephone interview." - source Bloomberg
On a final note as far as Consumer-Loan growth is concerned, according to Bloomberg Chart of the Day, it helps schools, not stores:
“As long as the music is playing, you've got to get up and dance." - Citigroup's ex-chief executive, Charles O. Prince - July 2007.