Listening to the many conversations relating to a potential early exit from QE in 2013 and the conflicting analysis around the dire potential for losses the rise of government bonds could have on Credit in particular (Investment Grade), and assets classes in general, we would have to agree with Exane BNP Paribas recent strategy note from the 14th of February 2013 entitled "When doves cry", namely that 1994, which was a nasty year for risky assets is indeed a case study of the risk scenario:
We do agree with their views, namely that while early 2013 are most likely to be still supportive for risky stories, the second part of the year might be a different story altogether:
"Make your money in H1
The macro backdrop should remain supportive of equity markets through the early months of the year. The global growth / inflation backdrop looks favourable – and equity valuations are likely to rise as a result. We think the oft-cited event risks – be it European elections or US sequestration - are unlikely to result in sustained market weakness.
H2 could be tougher
The risk to equity markets rests in the evolution of the macro cycle. The debate around US monetary policy is likely to intensify later in the year. The first move to withdraw monetary stimulus usually prompts a correction in equity markets. This time that move is likely to take the form of an ending of QE rather than a policy rate hike - but we expect similar price action to result." - source Exane BNP Paribas
Japanese stocks rising in conjunction with Yen weakening versus the Euro - source Bloomberg:
While 1994, was the year of a big sell-off in many risky assets courtesy of a surprise rate hike, 1994 was as well the year of the demise of "Czar 52" on the 24th of June 1994 which saw the tragic crash of a Boeing B-52H "Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force Base during practice maneuvers for an upcoming airshow. The demise of the BUFF (the nickname among pilots for the B-52 meaning Big Ugly Fat Fellow) was due to Colonel Bud Holland's decision to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick".
So what is the link, you might rightly ask, between "bold banking" and "bold piloting"?
A subsequent Air Force investigation found that Colonel Bud Holland had a history of unsafe piloting behavior and that Air Force leaders had repeatedly failed to correct Holland's behavior when it was brought to their attention (not French president Hollande in that instance but we digress...).
When it comes to "reckless banking" and "reckless piloting", we found it amusing that current leaders have repeatedly failed to correct central bankers' policies, like the ones pursued by former Fed president Alan Greenspan and current Fed president Ben Bernanke, or, the ones pursued by Japan. These policies are instigating, bubbles after bubbles at an inspiring rate. When one looks at the fragile state of the "House of cards" and the "boldness" of credit investors dipping their toes, once again in very risky credit structures such as CLOs made up more and more with Cov-lite loans, we think our title, and our analogy to the crash of "Czar 52" is this time around very appropriate, but once again our thoughts keep wandering.
In this week's conversation, we would like to look at the binary risks posed by not only rising rates and the pain that can be inflicted in the investment grade space, in conjunction with the rising tide of corporate impairments and write-downs (goodwill being one of our long standing pet subject) and its implications but, looking as well into the rising risks in the credit space with the returns of all the riskiest structures of the recent 2007-2008 credit crisis. First a quick credit overview.
The divergence between the performance in US equities (S and P500) and the Eurostoxx 50 has been clearly growing in early February, the red line in the graph being Italian 10 year yields - source Bloomberg:
As displayed by BNP Paribas in their February Credit Markets conference called entitled "Giving Equities too much Credit", as far as the Corporate Credit Cycle is concerned, the US is ahead of the games:
This distinction clearly explains the outperformance of European High Yield Credit in 2012 versus US High Yield. In the deleveraging process, US Households have indeed been able to deleverage more as indicated in the below graph from the same BNP Paribas note:
But, for the "Great Rotation" theory put forward by many pundits such as Bank of America Merrill Lynch, to play out, much more deleveraging is needed.
As far as Europe is concerned and the Eurostoxx 50, we think European stock analysts should be seen as having an established reputation for being "hot sticks" in similar fashion to Colonel Bud Holland, given they are still expecting double digit EPS growth in the European space as per BNP Paribas' note:
And we know that "Great Expectations" can lead to huge disappointments, when ones looks at Economic consensus continuing to be revised down in Europe:
So "mind the gap", because, one the indicator we have been following, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes. This correlation is rising. In "Risk Off" periods we have noticed that the 120 days correlation had been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level. Currently the correlation is rising towards 78%, albeit at small pace, but it warrants caution we think - source Bloomberg:
"•The Spanish government is confident that it will deliver on its 6.3% 2012 deficit target, only missing the target by roughly one percentage point of GDP due to the 4Q12 bank bailouts.
•But meeting the 6.3% target (excluding bank bailout cost), would mean the government balanced the budget in the fourth quarter. The government last ran a balanced budget in the first quarter of 2008 when the economy grew at 2% on an annualised basis. The economy shrank by 1.7% on an annualised basis in the fourth quarter last year.
•What's more, a one point cost for the bank bailouts might be too low. Bank bailouts contribute to the deficit to the extent that the values of the stakes received by the government are deemed to be worth less than the price the government paid.
•The three main bailouts that are so far included in the economic accounts (worth a combined €14 bn) appear to have been ascribed very little value. If the government's stakes from the 4Q12 bailouts are treated as harshly, then the deficit will incorporate the full €34 bn cost (nearly 3.5% of GDP).
•We believe investors should consider lightening up on Spanish government and credit risk, especially beyond the 3-year horizon of the ECB's bond purchases going into late February when the deficit numbers will be announced. If the government misses its target it is likely to undermine confidence in the sovereign. Whereas the government hitting the target is largely priced in." - source CreditSights
Moving to the subject of binary risks posed by rising rates and the pain that can be inflicted in the investment grade space, higher mark-to-market losses could prompt investment grade credit to come under pressure, which has been the case in January in Europe, when Investment Grade credit was hurt in total returns terms by a rising bund (-1.20%). The hunt for yield has, no doubt increased the risk for pain for low coupon, long duration credit investors given a small surge in yields could inflict some significant losses due to bond convexity. For instance a US rate hike in similar fashion to 1994, could inflict considerable pain to bondholders as indicated by the previously mentioned Exane BNP Paribas note above:
The US asset Class performance through 1994 is indicative of the level of peak to through adjustment that Investment Grade credit could face, should a similar risk scenario plays out, as indicative in the below graph from Exane BNP Paribas:
But if you think bondholders would be in their own world of pain, think again, given that the European equity space wasn't spared either in 1994 as indicated below by Exane BNP Paribas graph:
The rising tide of Corporate Impairments and Write-downs, which has been a pet subject of ours, have, we think, serious implications from an earnings point of view. If ones look at a graph displaying stock prices, impairments and purchases in terms of M&A activity as displayed in Fitch's recent report entitled Corporate Impairments and Write-downs:
To combat negative pressure, corporate issuers have been taking stock and refocusing operations on core assets in an effort to conserve cash. Management strategies centred on disposing of marginal / non-core assets in an attempt to weather weaker demand. Weaker growth forecasts, higher cost of capital in certain markets and increasingly uncertain cash flow projections led to the revaluation of assets held for sale as weighted average cost of capital increased across underperforming sectors, reducing the values realised in disposals." - source Fitch
The current level of European equities, do not reflect these growing risks we think, particularly in the light of accounting changes which have been taking place when it comes to the amortization process which had previously prevailed, meaning that now, the risk for earnings, as we have seen recently is binary.
What are Impairments?
"An asset becomes impaired when the company holding the asset is unable to recover the carrying value of the asset either through the use (cash generated over the usable life) or the sale of the asset. An accounting impairment would occur if the carrying amount of the asset is considered to be less than the intrinsic value management believe it can get from the asset, or the price, less selling costs of the asset.
The standard IAS 36 accounting treatment considers there to be several explicit triggers which could lead to an impairment event.
Significant decline in assets market value.
Indication that expected performance of the asset is reduced.
Increase in market interest rates (as seen in Europe during 2011).
Cash flows from the asset are significantly different from what was originally budgeted.
All, or part of the above, have occurred to varying degrees across different market since the onset of the financial crisis in 2008. This has, however, been more prevalent in more capital intensive sectors, or sectors with weaker fundamentals (such as nickel and pig iron) or competitive pressures (notably telecoms), have reduced profitability expectations.
A recent example is Peugeot, who in Feb 2013 announced that it would write-down the value of its automotive and financial assets in Europe by EUR4.13 billion. This reflects the extent Europe's economic woes are affecting some of the region's biggest companies, particularly in the auto industry. The write-down is a noncash charge, and its timing is partially driven by European regulators, who have urged companies to adjust the valuation of their assets to reflect prospective business more realistically." - source Fitch
For instance BNP Paribas posted a 33% decline in its fourth quarter profit, missing estimates, on a goodwill writedown at its Italian branch network BNL of 298 millions euros on and due to an accounting charge tied to its own debt (see our post: Credit Value Adjustment and the boomerang effect of FAS 159 accounting rules on Banks earnings). French bank Societe Generale posted a fourth-quarter loss on a goodwill write-down in its stake in broker Newedge as well as taking a hit courtesy of 686 million euros courtesy of debt value adjustments.
Why does goodwill represent nowadays a binary risk to corporate earnings?
"Under IFRS goodwill is no longer amortised. Pre-IFRS, goodwill was amortised and faded over time - now it remains at the original level and it is likely that it may have to be impaired in a weaker economic / cash flow environment." - source Fitch
Goodwill: "When a firm makes an acquisition for more than the fair value of identifiable assets acquired, the additional value is held in the form of goodwill on the balance sheet. Should the value of the purchased asset become permanently less than its initial value, then the asset must be written down." - source Fitch
What are the risks and consequences of low growth / low yields on impairments and the volatility of earnings?
"Old Acquisitions and Investments, New Economic Reality:
Before 2008, many firms in Europe purchased assets, or invested heavily, with the expectation of continued strong growth. There was a belief that high cash flow projections were acceptable considering the boom period preceding the downturn. Acquisitions reached their height in 2007, leaving companies. balance sheets reflecting large amounts of goodwill. However, as the economy soured, many firms were left with assets which were unlikely to produce the significant cash flows which had been projected previously, forcing revaluations and in some cases asset disposals at prices well below original acquisition costs and multiples. Similarly, corporate capex relative to sales reached a peak in 2008 (7.52% capex/revenue). Nominal capex however continued to rise in 2011 and 2012, notably in the utilities and industrial sectors, peaking at USD503.6bn in 2012. This, coupled with weaker growth expectations, may drive increased levels of impairments over the next two years to end-2014." - source Fitch
"Capital invested and large acquisitions pre-crisis in 2007 and 2008 have in some cases been on the premise that cash flows would continue in line with, or even accelerate, compared with historical performance. Firms which acquired or invested heavily in assets pre the 2008 financial crisis saw a significant fall in CFO return relative to the amount of capital employed.
Following acquisitions at inflated prices and money ill-spent on significant capex, economic reality hit hard between 2009 and 2012, requiring these assets to be written-down as its value in use decreased significantly, along with market value, leading to lower market and sale values of these underperforming assets.
The chart below highlights the sectors that had the largest impairments in 2011, with the telecoms sector recording by far the largest impairments, followed by the retail and technology sectors."
"Judging Impairments by Market Sentiment:
Market capitalisation is driven partially by market sentiment and, although typically volatile and pro-cyclical, includes an expectation of future cash generation and returns on assets. When a firm's market capitalisation falls below its equity value, it may indicate that assets are overvalued relative to market expectations." - source Fitch
The ESMA study (January 2013) found that 47% of issuers whose equity exceeded market cap recognised impairment losses.
On top of the rising risks in corporate earnings courtesy of our "bold bankers" repeated intervention and distortions, the rising risks in the credit space with the returns of all the riskiest structures of the recent 2007-2008 credit crisis is a clear signal that in similar fashion to "hot stick" Colonel Bud Holland, our central bankers have decided to "push it to the limit".
Maybe our "bold bankers should reflexionate on the quote below:
"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."
When one looks at the return of Cov-lite loans to the fore front, no doubt to us we are entering, once again bubble territory in the credit space. In May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz...":
So we might have some "hot sticks" in the credit cockpit at the moment but at least, one member of the pilot crew at the Fed is getting jittery like us: "You're a little low. You're a little low. Come on, buddy, pull up. Pull up, Cougar." Top Gun - Maverick to Cougar
Deutsche Bank concluded their note with the following comment:
"The credit markets and financial stability are not the key concern of the Fed right now but there is clearly someone on the Board watching credit markets with policy implications on his mind so we will do the same."
Watching credit markets: this is exactly what we have been doing for a while...