Sunday, 25 November 2012

Credit - It's Alright Spreads are Coming Back

"The trouble with the world is that the stupid are cocksure and the intelligent are full of doubt." - Bertrand Russell, British philosopher 

This week we decided in our title selection to make a veiled a reference to one of pop British group Eurythmics top hit from their 1985 second album namely "It's Alright (Baby's Coming Back). Given credit spreads seem somewhat totally detached from economic reality, for now, we thought, using the lyrics of the song and the latest raft of economic data would be totally appropriate as per our usual rambling habits.

While we already touched on the irony of the performance of credit in 2012 with the clear disconnect with economic reality in our conversation "The year of the empty hand", we thought this week we should focus on the outlook for credit in 2013, given we are indeed full of doubt and not cocksure like some.

It's Alright Growth's coming back...In Europe? Not really.

- source Thomson Reuters DataStream / Fathom Consulting.

It's alright spreads are coming back...

Yes, they have and in a very significant way in 2012 but the disconnect with deteriorating fundamentals would warrant caution in 2013 and the need for clear selective bond picking based on assessing properly issuer by issuers will be even more essential next year.
- source Thomson Reuters DataStream

The market context for credit and the outlook for early 2013 was nicely summarized by Suki Mann, Credit Strategist for Societe Generale, on the 22nd of November:
"We’re tightening up in cash with maximum effect in the high yield and X-Over space, while investment grade credit is edging better every session. Outperformance continues from peripherals. There’s a grab for yield, in what looks like the last hurrah for the year. It won’t be any different in January as we reset the counter, faced with corporate credit spreads tighter and corporate yields lower versus where they are now. We’ll still see much cash needing a home and more than likely a clear tightening dynamic to kick off the year. For now, holders of higher yielding paper who are comfortable with the issuer should not be thinking about selling (booking profits and so on), but adding where they can. Yesterday’s Bord Gais deal was 42bp tighter versus reoffer and had the effect of pulling the ESB 2019 deal with it – as if it needed it. The latter was tighter at around B+315bp having been launched earlier this month at B+371bp, while September’s deal from the ESB (maturity 2017), launched at B+590bp, was bid at B+312bp. With the plethora of deals lined up for next week, it looks like we’re seeing out the year with an upbeat tone and choosing to ignore the inability of the troika to agree a deal on Greece, while US fiscal cliff concerns seem to have abated and even Spain’s woes have been put on the back-burner."

The credit chadburn is clearly still on full ahead. IG returns YTD broke through the 12% barrier in November on a combination of lower bund yields and tighter credit spreads and demands for credit remains elevated, it is clearly due to "Yield Famine".

As Societe Generale put it in a recent note:
"The grind is relentless: There’s no mercy for those under-invested at the moment. Secondary market liquidity is very poor and the new issues are so oversubscribed that only the chosen few are getting anywhere near average or above average allocations. Corporate credit continues to grind tighter, pushing IG returns YTD to over 12% and HY to 20% (iBoxx index). The volatility from headlines/macro/elections is impacting equities and the iTraxx indices, but cash credit retains its lustre. This has been the story for much of 2012, and will be for 2013 as well. Spreads have fallen by 50% this year, and while we don’t think they will by as much next year, another 25-30% is feasible. For now, frustrated investors are generally looking to add, but the new issue market is the best route to get some paper on board. Issues are 4-7x oversubscribed and performing on the break in most cases. We look for the whole dynamic to stay intact into year-end." - source Societe Generale.

We are witnessing the "Japonification" of the European Credit Markets which we touched on in our July conversation "Yield Famine".

Below are some key points highlighted by BNP Paribas relating to investor views and summarizing the views of several (fixed income focused) hedge funds, asset managers and private banks they have visited recently, eerily reminiscent of the 2005/2006 market context before the credit bubble burst:
"- Most had a very good performance and intend to protect their performance (have reduced exposure recently).
 -“Search for yield” demand applies to everyone. The focus was on hybrid corporate bonds, Financials, high yield bonds, EM and ABS instruments. 
- Some were eyeing an exit from high grade credits. The yield of non-fins iBoxx index is now below 2% and this isn’t enough for some institutional investors. 
- There was appetite brewing for high yield, EM and illiquid credits to capture more yield
- Even the most skeptical are “no longer negative on Europe” 
- Consensus view was to “buy on dips”, which according to one HF could trigger a rally (with nobody to sell it) 
- One investor thought the ITRX Main could trade at 50-60bp next year (currently 130) given a decrease of volatility and shortage of assets. 
- There is strong appetite for EM bonds from private banks in particular. 
- No one was active in sovereign CDS anymore."

As far as fixed income allocation is concerned, it has been the big winner in 2012 as indicated by CreditSights recent note on the 21st of November on Euro Investment Funds entitled - No Stocks, Just Long Bonds:
"As part of that stretch for yield, investment funds' purchases of bonds have also been overwhelmingly in longer-dated instruments. Over the four quarters to 3Q12, net allocations to short-dated bonds have been zero; all €168 bn in net allocations to bonds were to two-year-plus instruments."  - source CreditSights

"I'll be your cliff (you can fall down from me)."- It's Alright (Baby's Coming Back)  lyrics - Eurythmics 1985

In last week's conversation we focused our attention to the risk of "Profit Cliffs" rather than the highly commented fiscal cliff. We would tend to agree with a recent chart from Bloomberg from the 20th of November, indicating that the budget gap hinges on the economy, not the fiscal cliff - source Bloomberg:
"Sustaining U.S. economic growth may narrow the federal government’s budget deficit more than raising taxes or reducing outlays, according to James W. Paulsen, Wells Capital Management Inc.’s chief investment strategist. The CHART OF THE DAY tracks deficits and surpluses as a percentage of nominal gross domestic product, unadjusted for inflation, since 1969. Paulsen included a similar chart in a report two days ago. Deficits totaled 6.9 percent of nominal GDP for the 12 months ended in September, according to data compiled by the Treasury. The gap narrowed from 10.4 percent in December 2009, six months after the latest recession ended, even as President Barack Obama and a Republican-led House of Representatives sparred over fiscal policy. “We’ve had gridlock throughout this recovery and yet the deficit’s been improving all on its own,” Paulsen said during a Bloomberg Radio interview on the 19th of November. At the current pace, the budget gap is poised to fall below 5 percent of nominal GDP in two years, according to the Minneapolis-based strategist. Any “grand bargain” by the White House and Congress on the so-called fiscal cliff of tax increases and spending cuts runs the risk of cutting off economic growth, which is mainly responsible for the shrinking deficit, he said. Nominal GDP has expanded at a 3.8 percent to 4.5 percent pace since the second quarter of 2010, based on year-over-year changes. Last quarter’s growth amounted to 4 percent." - source Bloomberg.

Last week we argued:
"We believe the biggest risk is indeed not coming from the "Fiscal Cliff" but in fact from the "Profits Cliff". The increase productivity efforts which led to employment reduction following the financial crisis means that companies overall have reached in the US what we would call "Peak Margins". In that context they remain extremely sensitive to revised guidance and earnings outlook as we moved towards 2013." - Macronomics - The Omnipotence Paradox.

Indeed, dimmer profit outlook has been seen weighting on stocks as of late as indicated by Bloomberg:
"Lower earnings estimates are dragging down stocks from this year’s highs and their full effect has yet to be felt, according to Hasan S. Tevfik, a global equity strategist at Citigroup Inc. The CHART OF THE DAY compares the performance of an earnings-revision index, or ERI, compiled weekly by Citigroup with MSCI Inc.’s All-Country World Index since the beginning of last year. Tevfik had a similar chart in a report yesterday. Since the first week of May, the revision index has been less than zero, which means there were more estimate cuts than increases among analysts. The MSCI gauge of stocks in developed and emerging markets rose to its peak for the year in September and then lost as much as 6.7 percent. “ERI remains an anchor for global equity markets,” Tevfik wrote. A similar disparity between estimate changes and share prices in 2011 was resolved when stocks declined in July and August of that year, the London-based strategist added. The chart highlights the earlier retreat. Earnings projections for next year are poised to decline further, he wrote, citing the gap between analysts’ estimates for companies and strategists’ projections for stock indexes. Citigroup strategists are collectively calling for profit growth of 7 percent, trailing a 12 percent increase implied by company-specific estimates, Tevfik wrote. The lower figure maybe too high, he added, as economic growth slows worldwide." - source Bloomberg, Chart of the Day - 20th of November

Mind the Gap...

"I will be your storm at seas" - It's Alright (Baby's Coming Back)  lyrics - Eurythmics 1985

According to Bloomberg:
"The bank systems of Spain, Italy, Portugal, Ireland and Greece collectively borrowed a record 865 billion euros (gross) from the ECB in June 2012, 250% more than a year earlier. Since the commitment from Mario Draghi to "do whatever it takes," lower and more stable yields and a gradual opening of wholesale markets should afford banks the ability to reduce ECB reliance."

2013 could be a story of lower yields, lower volatility and lower ECB reliance. 2011 was dominated by capital shortfalls for banks leading to liability management exercises (bond tenders, debt to equity swap, skip of calls for Lower Tier 2 bonds, and other interesting exercises we discussed at length in numerous conversations) in conjunction with the dearth of liquidity (issues with dollar funding) leading to the ECB saving the day by providing cheap funding via the LTROs. 2013will also be a story for banks of additional deleveraging and restructuring of some of their activities. For instance structured finance was a big victim in 2012, and we discussed the impact it had on shipping in our conversation - "Shipping is a leading credit indicator" - A follow up - April 2012.

The current European bond picture with slightly lower Spanish 10 year government bond yields at 5.68% this week and Italian 10 year government bond yields at 4.77% with somewhat rising Core European Government bond yields  - source Bloomberg:

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
A story of falling High Yield risk premiums as indicated by the fall in the Itraxx 5 year Crossover index spread level back towards 500 bps in 2012 and falling volatility (now at 21%).

"I'll even be your danger sign." - It's Alright (Baby's Coming Back)  lyrics - Eurythmics 1985

"Given credit investors are anticipatory in nature, in 2008-2009, credit spreads started to rise well in advance (9 months) of the eventual risk of defaults" - Macronomics - The Omnipotence Paradox.

Although default rates have remained low in 2012 as indicated by the below graph from Societe Generale, when it comes to anticipating default risks, credit spreads should indeed be your danger sign in 2013:
- source Societe Generale Cross Asset Research - Happy Hunting - Credit Weekly - 9th of November.

While credit yields are indeed heading towards 2% as shown by Societe Generale Cross Asset Research:

Credit nevertheless remains a compelling asset class in this low government yield environment given the yields are many times higher than that of government debt:
- source Societe Generale Cross Asset Research - Happy Hunting - Credit Weekly - 9th of November.

So if indeed Europe is repeating Japanese mistakes and we are witnessing the "Japanification" of credit markets, as we wrote in April in our conversation - "Deleveraging - Bad for equities but good for credit assets", credit could continue to outperform equities in 2013 but if the US economy is Japan on "fast forward", it should grow much faster than Europe in 2013:
- source Nomura - 14th of November 2012.

On a final note, the US is set to return as Japan's top export buyer as indicated by Bloomberg:
"The U.S. is poised to displace China as Japan’s largest export market as American consumer confidence improves and a territorial dispute strains relations between Asia’s two largest economies. The CHART OF THE DAY shows the percentage of Japanese exports purchased by the two nations, and the Conference Board’s confidence index for the U.S. since the end of 2008. China has been the bigger market from February 2009, except for a single month. So far this year, China has taken 18.2 percent of shipments compared with 17.3 percent for the U.S. A dispute over islands in the East China Sea claimed by both Asian nations has damaged economic and political ties, with Japan’s exports to China declining for the five months through October from a year earlier, finance ministry data show. China’s share of Japanese shipments was as high as 21 percent in late 2010 and early 2011, while the U.S. proportion dipped to as low as 13 percent in April 2011." - source Bloomberg

"Worry is the interest paid by those who borrow trouble." - George Washington

Stay tuned!

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