Saturday, 13 October 2012

Credit - Growth divergence between the USA and Europe. It's in the credit prices stupid!

"I don't believe we're seeing the beginning of a divergence. We have seen a partial divergence on this case." - Mario Monti 

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"):
"We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe (US economy will grow 2.2% this year versus a 0.4% contraction in the euro area, according to the median economist estimates compiled by Bloomberg):
"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation -The LTRO Alkaloid - 12th of February 2012."

The divergence of growth between the US economy and the European economy has been indeed reflected in credit prices such as the US leveraged loan cash price index versus its European peer. You can clearly notice the uncanning similarity with the above graph from Bloomberg indicating the evolution of the PMI index - source Bloomberg:

While both the PMIs and Leveraged loan prices cratered in 2008, you can see the impressive rebound in 2009, leading in the rapid surge in cash prices for leveraged loans and the increasing divergence in cash prices as indicated by the growing spread between US leveraged loan prices and European leveraged loan prices now at 7 points apart.

Similarly, the evolution of Credit indices such as the Itraxx Main Europe representing 125 entities of investment grade companies and the CDX IG index for US Investment Grade are both reflecting a similar divergence as reported by Morgan Stanley in their European Credit Strategy report from the 8th of October:

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:
- source Morgan Stanley Research, Markit, Bloomberg Company Reports.

Europe vs US Loan prices - source Morgan Stanley, S&P LCD, European Credit Strategy, 8th of October 2010:

Morgan Stanley's economic forecast between Europe and the USA,  not only points towards a growing divergence between both but an environment which still present value for credit given the low yield and low growth current environment:

So why the continued growing divergence? It is all about deleveraging and access to funding.

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:
"For at least two years, European corporates have been using the bond markets to replace bank financing as a major source of funding. Given the size and stability of European food and beverage companies, that exit from bank financing was less pressing than for smaller, more leveraged companies. But a similar trend now looks to be coming to pass in food and bev. AB InBev, Heineken and to a lesser extent, Nestlé have all pre-financed acquisitions in the bond markets when putting bank facilities in place would have been the norm. In addition, we would note that the publicly-issued and privately-placed US dollar bonds have been the instruments of choice. Seven of our coverage have issued dollar debt this year. This looks like a diversity play for both the companies and the investor base. The companies want access to another funding source. In some cases, they have borne the costs of swapping into their domestic currency. The investors seek the attraction of non-US exposure in a relatively risk-free industry in order to provide portfolio diversification without the euro currency risk. Interestingly enough, the tranche-ing of the four multi-billion dollar deals from SABMiller at the start of year to Heineken in early October has been relatively similar. This suggests that investor preferences on maturities haven't really changed through the course of this year, implying that the ebbs and flows of the global business environment haven't really changed where investors see value. Anecdotally, there seemed to have been good dollar appetite so perhaps, once SABMiller set the template early this year, it might have been a case of 'if it ain't broke, don't fix it'. Maybe that is the real lesson of investing in European Retail and Food and Beverage this year."

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.
As a reminder on the definition of basis in credit:
The basis represents the difference in spread between credit default swaps (CDS) and bonds for the same debt issuer and with similar, if not exactly equal maturities. In the credit derivatives market, basis can be positive or negative. A negative basis means that the CDS spread is smaller than the bond spread.

Nomura's Fixed Income Research team made some very important points we think in their latest report entitled - Who sets the cost of capital? Policy makers or markets? - on the 11th of October :
“Our argument is that the financial risk of firms has been falling more than business risk as cash balances have been increased, balance sheets have been deleveraged and the maturity of debt structures increased. In addition, this has come at the expense of medium-term growth expectations as retained earnings have not been used to boost capital spending but rather to de-risk corporate balance sheets. And this marking down of medium-term growth expectations produces ever lower expected forward risk-free rates underscoring the improved financial risk of the corporate sector. So we make the case that the business risk component of corporate risk has fallen by less than the financial risk and as such credit represents a better source of alpha than equity. This sort of thinking leads naturally to Robert Merton's work on valuing corporate debt. He views debt and equity as contingent claims on a firm‟s assets, with option pricing being the vehicle of choice for finding the value of those claims. In Merton's world owning a corporate bond is equivalent to holding a risk-free bond plus selling a put option on the firm's assets to equity investors. Seen from this perspective the yield spread is merely the premium for selling the option. It is not a huge jump to see falling implied equity volatility as a green light to look for at worst stable credit spreads and therefore carry trades to be the focus. “ 
"Simply put, lower levels of leverage mean more of the intrinsic un-diversifiable risk within the firm is being passed on to equity holders than debt holders." - Nomura

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:
"The CHART OF THE DAY compares the amount of consumer credit outstanding with the total excluding student loans, as compiled by the Federal Reserve. Borrowing for school expenses accounted for all of this year’s 2.9 percent growth in credit. Any gains for retail chains will be limited to “some incremental spending” made possible by the education loans, John Heinbockel, an analyst from Guggenheim Securities LLC based in New York, wrote two days ago in a report. The current rate of borrowing may be unsustainable, the report said. This year’s average monthly balance of consumer loans rose 4.6 percent through August from a year earlier. The increase exceeded growth in household income by 1.4 percentage points, about twice the average gap since 1969." - source Bloomberg.

“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.

 Stay tuned!

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