When it comes to Europe, will not change our stance in 2013, as we pointed in a "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October 2011 when discussing circularity issues:
"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."
- source JP Morgan Asset Management - Guide to the Markets - 1Q 2013 slide 48.
In "A Tale of Two Central Banks" in December 2011, we correctly argued:
"You cannot ask the ECB to suddenly morph into a Fed. This process will undoubtedly take time and a due process, but a larger involvement of the ECB is so far conditional to stricter fiscal discipline."
This is exactly what Fabius aka Mario Draghi has been doing with his OMT promises! Avoiding in effect pitched battles and frontal assaults so far with the Bond vigilantes (Hannibal). So, rather than fight, in similar fashion to Fabius, Mario Draghi has been shadowing Hannibal's army instead (aka the Bond vigilantes), sending out loud and clear messages against the Bond vigilantes to nullify Hannibal's superiority. Mario Draghi's strategy is similar to Fabius, given he has been wearing down the Bond vigilantes' endurance and so far discourage a break-up of the European Union, without having to challenge the "Carthaginians" to a decisive "monetization" battle.
"Hannibal's second weakness was that much of his army was made up of mercenaries from Gaul and Spain, who had no great loyalty to Hannibal, although they disliked Rome. Being mercenaries, they were unequipped for siege-type battles; having neither the equipment nor the patience for such a campaign. The mercenaries desired quick, overwhelming battles and raids of villages for plunder, much like land-based pirates. As such, Hannibal's army was virtually no threat to Rome, a walled city which would have required a long siege to reduce, which is why Hannibal never attempted it. Hannibal's only option was to beat Roman armies in the field quickly before plunder ran out and the Gauls and Spaniards deserted for plunder elsewhere. Fabius's strategy of delaying battle and attacking supply chains thus hit right at the heart of Hannibal's weakness; time, not energy, would cripple Hannibal's advances. The Fabian strategy, though effective in some ways, was perceived as cowardly and unbecoming of the Fabian name, established by his ancestors' victories in pitched battles." - source Wikipedia
The Fabian Strategy at play - European bond picture, the fall was dramatic for peripheral bonds in the second half of 2012 thanks to Mario Draghi's intervention with Spanish 10 year yields falling towards 5.00%, whereas Italian 10 year yields are now well below 5% around 4.25% and German government yields rising towards 1.60% levels with other core European bonds yields rising as well in the process - source Bloomberg:
So, what is our prognosis (literally fore-knowing, foreseeing the likely outcome of an illness) in relation to the European outlook for 2013 in general and credit in particular you might rightly ask? In our first conversation of the year we will share our views.
EUR/USD and Gold views for 1st quarter of 2013:
"Unintended Consequences according to Martin Sibileau:
"With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unaddressed. All these factors only contribute to prolong the recession and a high unemployment rate."Given today's decision of the FOMC to maintain US rates low until late 2014, it seems to us that the European recession can only be prolonged as indicated by Rcube Global Macro research in our previous conversation, increasing the likelihood of a Euro Breakup.
Again, like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content.
Does the FOMC's latest decision put a floor to the drop of the euro versus the dollar? Are the FED's swap lines and latest FOMC decision delaying a painful adjustment in Europe? We wonder."
The on-going "Risk-On" scenario is maintaining the Euro at an elevated level versus the dollar. While touching again on our recent subject of asset correlation (see our post "Risk-Off Correlations - When Opposites attract"), in "Risk Off" periods we have noticed that the 120 days correlation has been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, such as now, the correlation is falling to lower levels. The correlation between both the German Bund and US 10 year note is currently falling albeit at very smaller pace than in early 2012 - source Bloomberg:
Nota Bene: ("Risk On" refers to a period of time in which investors are putting money into risky assets such as stocks, commodities, etc. "Risk Off" meaning the exact opposite with investors putting money into safe haven assets such as cash and treasuries or German Bund).
The current "Risk-On" phase will continue to put as well some downward pressure in the short term on Gold prices and commodities. Dollar index versus Gold - source Bloomberg:
This short term bearish pattern on Gold has been reflected in the Gold Options market - source Bloomberg:
Gold could recede towards 1550-1600 levels during this quarter before bouncing back when "Risk-Off" will materialise again.
Economic outlook in Europe in 2013 is depending on "genuine" credit growth:
As we posited in numerous conversations, "genuine credit growth" to the real economy (not LTROs which amount to "Money for Nothing") is key in order to generate sufficient economic growth to counter solvency risks. Given corporate loans supply is still falling in Europe, we do not think the deflationary forces in Europe in 2013 will be countered, far from it - source Bloomberg:
We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits:
"So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans."- "Subordinated debt - Love me tender?" - Macronomics, October 2011
Spanish Real GDP growth and Loan Growth since 2006 - source Bloomberg:
As displayed by the latest Spanish misery index making new highs, the deflationary spiral is still playing out - source Bloomberg:
Back in October we argued that Spain surpassed 90's perfect storm:
"Generally rogues waves require longer time to form, as their growth rate has a power law rather than an exponential one. They also need special conditions to be created such as powerful hurricanes or in the case of Spain, tremendous deflationary forces at play when it comes to the very significant surge in nonperforming loans."
In percentage term, it is true that the latest figure of 11.23% is significantly above the 1994 record of 8.99% but, in absolute term, Spain is not facing a perfect storm but the mother of perfect storms when it comes to the absolute size of the non-performing loans in billions of euros - source Thomson Reuters Datastream / Fathom Consulting:
"The key challenge for the eurozone in 2013 is the prospect of continued weak growth. On balance, the fiscal stance for the region will continue to be a drag on growth, and monetary policy is unable to provide an offset because of ongoing deleveraging dynamics in key banking systems, and tightening credit conditions in peripheral countries. The currency channel has for now not worked either. Meanwhile, consumption and investment remain weak as the deleveraging process continues its course. In that context, the only meaningful source of growth in the region will be externally driven, in our view. Our baseline scenario for the euro area is one of contraction on average for the region (of -0.8% in 2013) with deep recessions in peripheral countries and shallow recessions in the core." - source Nomura, 14th of December, Euro Area - The 2013 Challenge.
Since 2008, European policy makers approved more than 5 trillion euros of state aid to banks with Ireland and Denmark leading recipients according to Bloomberg:
- source Bloomberg
We expect to see a much larger bailout figure for Spain in percentage terms of GDP in 2013.
The big beneficiaries of the "Fabian Strategy" in 2012 have been European Banks - source Bloomberg:
"Following Mario Draghi's late-July promise of ECB action to protect the euro, the Bloomberg Industries Emerging European Banks Index rallied 29% to year-end 2012. With the fiscal cliff averted for the time being, the keys to share price performance in 2013 include attaining a "grand bargain" on the U.S. budget and a lasting solution to Europe's debt crisis, including the proposed banking union." - source Bloomberg
Given the unconditional support provided by the ECB, you can expect Core European Banks to continue to rally during the 1st quarter in 2013. Senior Financial bonds from peripheral banks should as well continue to perform. The recent 5 year Spanish bank BBVA new 1.5 billion euro senior financial issue has been easily absorbed by investors (5 billion euros worth of orders in the book from more than 400 investors), and performed significantly at the launch last Thursday. Initial guidance was mid-swaps +310 bps and launched at +295 bps. Last September BBVA issued a similar bond offering at +380 bps.
So we still expect the US to outperform significantly Europe when it comes to economic growth!
The divergence which we explained in our conversation "Growth divergence between the USA and Europe" should persist in 2013. US PMI versus Europe PMI - source Bloomberg
Short term, we do expect a minor reduction in the divergence as 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:
The story for 2013 in Europe we think, will be France:
In relation to France, in our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").
France's industrial production and GDP growth since 2001 - graph, source Bloomberg:
As far as France's sovereign CDS is concerned, it now trades 9 bps above Belgium's sovereign CDS, Belgium being in a better fiscal position (not because of the recent arrival of Gérard Depardieu, there is more to it!) - source Bloomberg:
Is the OMT a game changer courtesy of our "Generous Gambler" and Fabius aka Mario Draghi? We do not think so:
On that subject we agree with Nomura's take from their 10th of December paper - Italian political uncertainty highlights the insufficiencies of the EU firewall:
"The insufficiency of the eurozone’s “firewall” Many investors validate long positions in peripheral debt markets based on the presumption of a "Draghi put", or that the ECB will indeed do all that is necessary to remove the risk premium from markets and preserve the EUR. However, the ECB has actually backtracked on many of the commitments made in July and August to the point where the forthcoming OMT programme appears to even less effective than the unlamented SMP it has replaced:
-Seniority. The ECB originally said it would ensure that the OMT would be pari passu to private investors, but Draghi stated in October that rules against direct monetary financing of sovereigns preclude the ECB taking a hair-cut on its bond holdings or even an NPV loss. As such, the subordination problem of the SMP seems likely to recur in the OMT.
-Predictability. One problem with the SMP was that investors were unable to embed their bond purchases in their asset allocation strategies. It would buy into weakness, but not necessarily follow through into strength, and would be out of the market for long periods. The OMT looks even less predictable than the SMP as the ECB has said it will buy for 1-2 months before pausing to see if a country passes its conditionality test. This would impose on countries such as Spain and Italy the quarterly event risk that originally helped undermine liquidity in GGBs. In this respect, while some investors may have purchased 4-5 yr SPGBs or BTPs in expectation of sliding down to the ECB‘s 1-3 year intervention zone, the current parameter actually stresses that the timeframe for investors looking to "co-invest" with the ECB might need to be 1-2 months rather than 1-2 years.
-Market access. An additional problem of the OMT is that it can buy only as long as a country has full market access. This precludes the OMT supporting countries such as Portugal, and increases the risk of the ECB actually being able to buy SPGBs or BTPs: technically, the OMT will not be able to operate if Spain or Italy lose market access during the 3-4 week gap that will exist between a country asking for ESM support and requisite approvals allowing the ECB to buy bonds.
Because of these factors, the OMT appears less flexible and effective than the SMP was, especially when one considers that the OMT will only be focused on the 1-3 year part of curves. Moreover, the aspect of the firewall designed to support sovereigns beyond 3yrs – the ESM – appears even weaker than the OMT. We have already noted how we are concerned that the OMT might not be able to fund itself at a pace and price sufficient to finance the degree of primary market bond buying that may be needed in Spain and eventually Italy. Moreover, the ESM‘s "Plan B" of transforming itself in part into an entity that issues first-loss certificates is fundamentally flawed as the ESM cannot legally take a first loss." - source Nomura.
In our late 2012 conversation "Synchronicity" we approached the subordination issue coming from the introduction of Collective Action Clauses in the European government bond market in 2013:
In addition to the above points made by Nomura, we also agree with the views of Protesilaos Stavrou, from his blog posted in September 2012:
Credit views for 2013:
We share similar views with Citi when it comes to the perspective for credit in 2013 after a stellar performance in 2012:
"In forming our views for 2013, first we'll make the case that corporate credit quality is deteriorating by more than what seems to be consensus. Leverage, measured as net debt / EBITDA, has risen notably from the low of two years ago. Moreover, we'll argue that the systemic risk has now been priced out of the market even though it could very well return under similar or different guises later in the year.
However, it is getting harder and harder to find anyone prepared to put such fundamental arguments above all-powerful "technicals". Like Pavlov's dogs, it feels like the credit market has been conditioned by central banks to assume that any selloff is self-defeating as it will be met with yet more liquidity, with yet more inflows pushing asset prices up again.
Examining the link between central bank interventions and asset prices, what strikes us is that although the central banks clearly have huge leverage over markets, their influence is not constant. The last three years demonstrate that. When asset prices are elevated their incentive to stimulate further wanes – and indeed central banks may want a certain amount of market pressure from time to time to keep politicians committed to painful reforms.
The interaction between these two opposing fundamental and technical influences will probably determine much of your fund performance in 2013. Ask us about our "forecasts" and we don't end up very far from our peers: We expect € cash spreads to tighten 10-15% generically and total returns of 2.5% in IG and 5% in HY.
However, we are not on board with the emerging consensus that systemic risk has been all but eliminated for now, and that volatility will be much lower from now on. That view feels complacent to us. Central bank technicals probably have the upper hand longer-term, but we think it is very unlikely that the year will pass without one or more of the risk-off periods as seen in recent years. But when?
Chances are the selloff will occur exactly when the last skeptic has capitulated and lots of crowded longs have accumulated. And the trigger will be an event that is either impossible to predict or insignificant relative to the size of the market movement it causes. We didn't say it would be easy!". -source Citi - Credit Outlook 2013.
We don't believe the hype in credit and as we argued in our conversation "Hooke's law" previously the "credit mouse-trap" has been set by Central Banks:
"So, in relation to our title, in true Hooke's law fashion, given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894)."
Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."
Citi's final thoughts from their 2013 Credit Outlook:
"In our opinion, the biggest decision investors face this year is whether the OMT really is an effective backstop against perceptions of systemic risk, allowing credit markets to trade on an idiosyncratic basis. If it is, then the next decision is whether the liquidity rush will be strong enough throughout the year for spreads to go on ignoring the deterioration in most credit metrics.
The consensus that appears to be emerging is that the answer to both is 'yes'. On that basis, it is no wonder that markets have been performing so well.
However, we'd answer those questions a little differently. To us, systemic risk is dormant, but not eliminated. It could crop up from any number of angles. We expect that the ECB backstop and others like it will be tested during the year in what remains an exceptionally challenging economic environment for Europe. Moreover, we struggle to see markets disregarding the weakening credit metrics and rating downgrades indefinitely.
We do concur with the consensus position that these challenges will ultimately be circumvented, but just not without a certain amount of kicking and screaming in markets.
Quite likely it will be from spread levels that are significantly tighter than currently – and indeed tighter than our full-year forecasts imply. But it is exactly in a significant overshoot that credit becomes vulnerable: central banks are likely to do less, money is likely to flow elsewhere, issuers will take advantage of tight spreads and investors will have extended themselves.
The market we operate in today is just inherently more prone to volatility than previously. Consider that in 2007, a 5% reduction in exposure by US mutual funds in credit sold to the dealers would have increased their positions by just 10%. Today, a 5% outflow from mutual funds would double dealers’ exposure!
As such, when it comes to 2013, much more than is reflected in the modal forecasts, the devil really is in how spreads are distributed through the year."
“It may feel antisocial to switch to the orange juice when the party’s still in full swing, but the last few drinks are always the ones you end up regretting later.” – Matt King - CITI
and particularly when your drink has been spiked by Central Banks' Rohypnol (Rohypnol rose to prominence as the date rape drug because it was colourless, odourless, tasteless and easily dissolved)...
We would like to use again a reference to Bastiat in relation to liquidity and Credit Markets (from our conversation "The Unbearable Lightness of Credit"): "That Which is Seen, and That Which is Not Seen"
The "Fabius Strategy" followed by Mario Draghi and the liquidity injected have effectively done "Rohypnol" wonders to Swap pressures - source Bloomberg:
As we argued in "The Omnipotence Paradox", the Zero Rate policies induced by our "omnipotent" Central Banks are destroying capitalism in the sense that capital because of lack of return cannot be deployed efficiently and is once again "mis-allocated. It is as well, to some extent, neutering volatility: VIX shows Economic-Policy Risk are overlooked - source Bloomberg:
In 2013 it is still deflation in Europe:
"When it is hard to get money because banks will not lend, or for any other reason, there is less power to bid for goods. Prices then fall, because people lack money with which to pay." - Irving Fisher - The Money Illusion, 1928.