Saturday, 20 April 2013

Credit - The Awful Truth

Lucy: It's enough to destroy one's faith, isn't it?
Jerry: Oh, I haven't any faith left in anyone.
The Awful Truth (1937)

Following up on last week conversation in relation to the deflationary forces at play and in continuation to last week's analogy to one of our favorite movies of all time, we thought this week we would as well use one in our title, this time 1937 classic starring Cary Grant, namely "The Awful Truth", which catapulted is career. 
In the movie, Lucy and Jerry Warriner having filed for divorce have to settle in court for the custody of their dog Mr Smith. Abandoning the law books, the judge leaves the "final decision" of custody up to the dog:  "The custody of the dog will depend upon his own desire"

In similar fashion, to last week's argument about inflation and deflation and the gold sell-off, in the movie, the dog, Mr Smith, swiveled his head back and forth between his two owners (inflation or deflation) unable to choose until Lucy lured him by cheating, surreptitiously with a glimpse of its favorite squeeze toy. 

All that glitters is not gold, and while some central bankers managed to trigger inflationary expectations with various QE programs, the recent sell-off in gold might indeed be the boogeyman in this deflationary environment. In similar fashion to QE2, QE3 triggered a significant rise in Inflation Expectations, but since the beginning of the year, 5 year forward breakeven rates have been falling, indicative of the strength of the deflationary forces at play - source Bloomberg:
The Fed’s five-year, five-year forward break-even rate, fell to 2.69% last week, the lowest since before the central bank said in December it would buy $45 billion of Treasuries a month on top of the $40 billion of mortgages it was already purchasing.

Yes, QE is supposed to create inflation and should be supportive of gold, but looking at this chart from a recent Bank of America Merrill Lynch report from the 16th of April entitled "The Curious Case of Stocks and Credit", as indicated above the recent fall in break-even inflation rates is a not a good sign:

In this week's conversation we will therefore look at various deflationary signs that signal caution in this very complacent environment, as displayed by the on-going disconnect between equities and bond yields.

As indicated by Bank of America Merrill Lynch's recent note, stocks should normally be reacting to an ease in inflation expectations:
"Everybody is getting worse but stocks and credit are getting better. US economic data is deteriorating, there are global growth concerns in Europe and most recently in China reflected in sharply dropping commodities, and inflation expectations are coming down hard. Yet stocks and credit are moving back toward their peaks. Every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully. But not this time. We continue to side with the weakening macro backdrop and retain our tactical (short-term) short positioning in investment grade credit. Perhaps stocks and credit are holding up on the perception that US and Japanese QE will push investors into US risk assets regardless of fundamental weakness – in other words, that strong technicals will overcome weak fundamentals. That appears uncharted territory, as what we have seen in the past is that QE can work to push investors into risk assets when perceived to boost economic activity and thus create inflation (Figure 3). We have little evidence that QE alone can do the job, without being perceived to improve fundamentals. Thus, again, we expect the weakening macro backdrop to prevail. However, in the meantime the technicals are undeniably strong despite the lack of retail inflows to long and intermediate high grade bond funds. Clearly we are seeing foreign institutional investors – especially from Asia – moving into US corporate bonds. However, this process has been ongoing for at least a year and is unrelated to the expansion of Japanese QE." - source Bank of America Merrill Lynch

For us the 5 most dangerous words have always been:
"It is different this time"

As we clearly indicated last week, in the US, High Yield credit has remained in line with equities since the beginning of the year. The de-correlation between credit and equities is nearly exclusively coming from Investment Grade credit and we indicated the relationship between High Yield and Consumer Staples in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option" how defensive the rally in the S&P500 has been so far - source Bloomberg:
While Bank of America Merrill Lynch's short term positioning in investment grade seemed obvious early April,  the recent weakness in both the S and P500 and High Yield, in conjunction to weaker macro data warrants caution we think. 

Maybe we ought to be worried that something not great is unfolding in Asia, probably the reason why the US is so nervous about Abenomics. Is China at risk of social unrest due to labor conditions and weaker inventories signaling a much weaker economic outlook than expected?

With Japan playing "beggar thy neighbor", it is risks stirring trouble in the entire Asian region which is already hurting badly South-Korea with companies like Bridgestone and Sumitomo Rubber being the biggest winner so far of the weaker yen - source Bloomberg:
"The CHART OF THE DAY shows the best and worst performers this year among 46 companies in the MSCI World/Automobiles & Components Index, with Japan’s Sumitomo and Bridgestone, the world’s largest tire maker, surpassed by only Mazda Motor Corp. Their rivals Milan-based Pirelli & C SpA and Michelin & Cie., which is headquartered in France and is Europe’s biggest tire producer, are among the worst performers. The euro-zone economy has contracted for five straight quarters and the jobless rate rose to a record in early 2013, crimping vehicle sales. Bridgestone, which had 77 percent of its sales from abroad last year, said in February profit would climb to a record high in 2013, even under the assumption the yen would average 89 per dollar. Japan’s currency slumped to 99.66 per dollar on April 9, the weakest level since April 2009, after the Bank of Japan took unprecedented stimulus last week to end 15 years of deflation." - source Bloomberg.

On top of that, the European automative market's weakness continued in March and new car registrations were down 10.3% YoY following a 10.2% decline in February and 8.5% decline in January. It marks the 18th consecutive months of YoY decline. European car sales are sliding to a 20 year low. Not even Germany is immune to the deflationary trend given its auto market plunged by 17%. European car sales are a clear indicator of deflation as we indicated in April 2012. Our concerns have unfortunately been confirmed by these latest figures and as indicated by Tommaso Ebhardt in Bloomberg on the 17th of April in his article - "Europe Car Sales Heading for 20-Year Low as Germany Plummets", not even mighty Germany is immune:
"The German car-sales drop was the steepest among Europe’s five biggest auto markets, and compared with an 11 percent fall in February. The U.K., where sales increased 5.9 percent, overtook Germany in deliveries in March, according to the ACEA. Spain, Italy and France all posted declines.
The western European passenger-car market is on track this year to hit levels last seen in 1993, and Germany seems to be in a free-fall,” Max Warburton, an analyst at Sanford C. Bernstein Ltd. in Singapore, wrote in a report to clients yesterday. “While unit profitability in Germany is not nearly as high as China, it’s still a critical driver of German carmakers’ earnings and the current trend is quite disturbing.” Deliveries at Wolfsburg-based VW, the regional market leader, dropped 9.3 percent, with the namesake brand posting a 15 percent decline. BMW, the world’s biggest luxury-car producer, sold 4.7 percent fewer vehicles in Europe last month." - source Bloomberg.

And if France is in trouble as we currently think it is, Germany will be too, very soon, given motor vehicles are Germany's biggest export to France as indicated by the below graph from Exane BNP Paribas:

As far as motor vehicles and China, should the Chinese economy weakens further, Germany will no doubt have issues:
- source Exane BNP Paribas - 28th of March 2013 report.

German exports and Chinese PMI showing a disconnect - source Exane BNP Paribas:

China accounts by the way 34% of global demand for rubber and inventories have climbed to 117,696 tons according to the Shanghai Futures Exchange, the highest in more than three years. 

Evolution of rubber in the largest exchanges in China and Japan since March 2010 - source Bloomberg:
"The CHART OF THE DAY tracks rubber on the largest exchanges in China and Japan since March 2010, with the gap reaching a 27-month high on Feb. 20 amid a weakening yen and strengthening yuan. The material used in tires and medical gloves traded at an  equivalent of about 404 yen in Shanghai on Feb. 11, the most  since September 2011. The Tokyo price had an 11-month peak of  334 yen per kilogram on Feb. 6, data compiled by Bloomberg show.  The Tokyo price last exceeded the Shanghai price in May 2011, the data show. Japanese Prime Minister Shinzo Abe’s monetary easing, dubbed “Abenomics,” has contributed to the yen’s more than 15 percent decline since mid-November. The yen fetched 93.50 per dollar as of 7 p.m. in Tokyo yesterday. By contrast, the yuan rose to a 19-year high of 6.2073 per dollar. Even as rubber futures in Tokyo fell 2.6 percent yesterday into a bear market, the most active contract in Shanghai lost 3.2 percent. Along with the currency market, China’s efforts to boost stockpiles in the world’s largest rubber market had contributed to the premium. With the inventory program set to decelerate, prices in Shanghai could fall, particularly as Southeast Asian producers have stepped up shipments to China to take advantage of the price differential, Tang said. Inventories in the Shanghai Futures Exchange were the most in about three years as of March 29, at 117,696 tons, according to the bourse. “Buying in Tokyo and selling in Shanghai may be the most profitable trade to get exposure.” Tang said." - source Bloomberg.

As we indicated in our conversation Pareto Efficiency:
"In a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off. Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement." - source Bloomberg.

In true Pareto efficient economic allocation, while some pundits wager about simultaneous developments having contributed to the weakness in Emerging Market equities, for us Emerging Markets have been simply the victims of currency wars and "Abenomics", a subject we approached in last month conversation "Have Emerging Equities been the victims of currency wars?" - MSCI EM versus Nikkei - source Bloomberg:

If you look again at the Bloomberg table displaying the worst performers this year among 46 companies in the MSCI World/Automobiles & Components Index, the most affected, in true Pareto efficient allocation process are the Europeans, sinking deeper in a secondary depression.

While the strength of the Euro has been supported by the FOMC's January 2012's decision to maintain US rates low until late 2014, has in effect prolonged the European recession, delaying in effect a painful adjustment in Europe and to make matters worse, Europe is facing prolonged agony, with now Japanese joining the party with "Abenomics".

Like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content, and using another analogy, Europe is now facing pressure from two tectonics plates, initially pressure from the US and now Japan.

We always thought that the on-going crisis had a path similar to a particular type of "rogue waves" called "three sisters" ("three sisters" rogue waves sank SS Edmund Fitzgerald - Big Fitz) which were used as a comparable analogy by Grant Williams in November 2011.

We are witnessing three sisters rogue waves in our European crisis, namely:
Wave number 1 - Financial crisis
Wave number 2 - Sovereign crisis
Wave number 3 - Currency crisis

Another sign of the deflationary forces at play is the Euro-zone Corporate Credit Supply which continues to be elusive - source Bloomberg:
"A lack of corporate loan supply continues to hamper economic recovery across the euro zone. Lending to non-financial corporates (NFCs) fell in 11 of the 17 euro area countries in early 2013, with the Netherlands the sole large economy to show an increase in loans outstanding. Unless there is a pick-up in supply, growth forecasts will likely remain anemic and recovery slow." - source Bloomberg.

In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced. The decline in the oil price to a nine-month low may prove to be another sign of deflationary pressure and present itself as a big headwind. Why is so?

Whereas oil demand in the US is independent from oil prices and completely inelastic, it is nevertheless  a very important weight in GDP (imports) for many countries. Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.

Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.  As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets.

We believe that the current disconnect between oil prices, the Standard and Poor's index and the US 10 year Treasury yield warrants caution, as it seems to us that the divergence is very significant as displayed in this graph from Bloomberg from the 12th of April:

In a recent note entitled "The asymmetric beta of credit spreads" , Bank of America Merrill Lynch points as well to a weakness of oil prices which might be indicative of weaker growth expectations:

"Is oil re-pricing growth expectations?
A slowing economy could push Brent down below $95/bbl Brent prices have declined by almost $20/bbl on a combination of seasonal and cyclical headwinds. Some of these cyclical pressures are too large to ignore, such as China’s drop in energy demand growth or Europe’s sharp contraction in credit supply. In addition, emerging and developed markets face mounting structural challenges. To name a few, energy importing countries like China, Japan or India are seeing $15/MMBtu nat gas prices at the margin, while others like Brazil are struggling with high labor costs and rising inflation. In Italy or Spain, a high cost of capital poses a major challenge to a recovery. Should the global economic recovery stall further, Brent oil prices could fall below $95/bbl in the near-term.  
Our economists see few downside risks to EM growth…
At any rate, our economists still expect China to post GDP growth of 8.0% in 2013 and 7.7% in 2014. These numbers are consistent with our expectations of 360 and 485 thousand b/d in oil demand growth, respectively. A robust China outlook should translate into strong EM growth and hence oil demand. Having said that, Chinese oil demand in March grew by just 255 thousand b/d, consistent with average GDP growth of around 5 to 6%. Surely, solid EM demand has been a constant in the oil market for decades, so a structural slowdown in economic activity would not bode well for global crude oil prices."
 …so we keep our $112/bbl Brent forecast in 2014 for now
For now, we stick to our 2014 Brent forecast of $112/bbl despite the weaker data, as OECD ex-US inventories remain low. But we are concerned about the structural headwinds facing many economies. Whether it is high energy costs, expensive labor costs, a rising cost of capital, declining profitability, or misdirected investment into unproductive assets, the dislocations created by five years of zero interest rate policy in DMs will likely have some negative consequences in EMs. With oil demand growth exclusively supported by buoyant EM growth for years, lower global GDP trend growth (say from 4% down to 3%) could push Brent firmly out of the recent $100-120/bbl band into a lower $90-100/bbl range." -source Bank of America Merrill Lynch  - 17th of April 2013.

The issue of course is that we believe that "Abenomics" is a game changer from a pareto efficient allocation approach and that Emerging Markets in the vicinity of Japan which are already suffering, will be facing even more suffering in the second quarter hence our negative stance on emerging market equities, and on commodities as well.

On a final note, the latest hedge fund monitor from Bank of America Merrill Lynch from the 19th of April shows that they are positioning for a market correction:
"Based on our exposure analysis, macro hedge funds sold the S&P 500, NASDAQ 100, and commodities to a net short while increasing long exposure to the US Dollar Index. This suggests that macro funds are positioning for a market correction. Macros also sold 10-year T-notes to a net short. Within equities they switched to favor small caps from size neutral but are not at an extreme reading." - source Bank of America Merrill Lynch.

And as we posited before, if it is time for a pullback, get some greenbacks, at least that's what Dr Copper,  the metal with the economics Ph.D, is telling us given that as per a graph from Barclays, CFTC Comex positioning is the shortest on record:
"Copper plunged through $7,000 a metric ton in London for the first time in almost 18 months and
headed for a bear market on concern that demand from China to the U.S. and Europe may falter. Tin was also poised to enter a bear market. Copper for delivery in three months on the London Metal Exchange slumped as much as 4 percent to $6,800 a ton, the lowest level since October 2011, and was at $6,850.50 at 2:56 p.m. Seoul time. A close at the current level would be more than 20 percent below the metal’s last bull market peak in February 2012." - source Bloomberg, 18th of April 2013, Copper Poised to Enter Bear Market as Industrial Metals Slide.

Is Copper finally is telling us something about the real world, which equity markets are not currently focused on in true Zemblanity fashion, Zemblanity being "The inexorable discovery of what we don't want to know"? We wonder...

And, what if the trigger will be in Asia like in 1997 (as suggested by Albert Edwards recently) and not Europe after all? We wonder as well...

"Wonder rather than doubt is the root of all knowledge." - Abraham Joshua Heschel, Polish educator.

Stay tuned!

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