Tuesday, 19 August 2014

Credit - Thermocline - What lies beneath

"History has not dealt kindly with the aftermath of protracted periods of low risk premiums." - Alan Greenspan

Seeing finally that Germany entered the "below 1% yield club", in effect joining Japan and Switzerland in the process, (confirming indeed our deflation bias when it comes to assessing European woes in particular), as well as the low trajectory of bond yields with US 10 year at 2.37%, and the continuation of the lower risk premiums being seen in the credit market and "risks" not being detected, we reminded ourselves of the particularity of summer and its effect on the thermocline (negative refraction) when it came to choosing this week's title. No doubt it needs an explanation from our part for the aforementioned chosen title, and its relation to low risk premiums as quoted by the inept former central banker Alan Greenspan. 

Us being fans of all things maritime we thought this week we would use an analogy to the specific feature of thermocline and its major importance in submarine warfare. During the summer it gives a distinct advantage to submarines to stay undetected. In our case "lower risk premiums submarine" could torpedo rapidly the "economic ship" we are sailing on if there was a sudden rise of volatility due to increased geopolitical tensions in the near term.

But what is the thermocline?
The thermocline is a thin but distinct layer in a large body of water in which temperature changes more rapidly with depth than it does in the layers above or below. In the open ocean, the thermocline is characterized by a negative sound speed gradient, making the thermocline so important in submarine warfare because it can reflect active sonar and other acoustic signals, in effect providing stealth coating for submarines. Technically, this effect stems from a discontinuity in the acoustic impedance of water created by the sudden change in density. If a submarine is submerged at the layer of thermocline or immediate below the layer, the submarine (risk) will not be “captured” from the wave (market participants), and the submarine (risk) will stay undetected until it is too late.

There are usually two layers of a thermocline during summer. One layer is on about 15 to 20 metres of depth, and another one is about 150 meters of depth. Depth of 15 to 20 meters is the most important. During the summer, at afternoon, if weather conditions are good, a submarine cannot be detected from standard (hull mounted) ship’s sonar making the depth perfect for observing and torpedo launching. If the surface ship wishes to detect a submarine, the ship has to be fitted with towed sonar. In that case, the sonar must be submerged below the thermocline.

The thermocline and the impact of negative refraction: 
During the summer temperature of water decrease by depth of the water. Sound wave is bending towards the sea bottom. If submarine is on smaller depth, near the sea surface that is, our "economic" ship's sonar can’t detect the submarine (the risk that lies beneath). Range of the sonar is bigger if the submarine is merged on deeper depth (higher risk premiums):

In similar fashion to the actual record low yields and continued low volatility reached during the summer, the negative refraction seen in the markets means to us that "risk" is just below the surface, and it cannot be appropriately detected currently we think, hence our lengthy explanation and title.

In this week's conversation and in continuation to last week's post, we will put forward some of our short term views as well as other indicators pointing to risk that lies beneath in the coming months in similar fashion a submarine lurks below the thermocline in the summer, but we ramble again...

Interestingly we have been tracking over the summer months the growing divergence in the performance of the Standard and Poor's 500 index and the Eurostoxx in conjunction with the significant rally Italian 10 year government yields - source Bloomberg:
The lag in European stocks given the very recent negative tone in Europe due to the Russian sanctions have made them much more volatile. Should the "Risk-On" scenario persist in the coming weeks it should lead once again to an outperformance of European stocks versus US stocks.

We have seen today the start of this outperformance materializing in the pan-European Euro Stoxx 600 Index which was higher thanks to Danish shipping and oil group giant Moller-Maersk reporting better than expected net profit for its second quarter and indicating as well that demand for container transportation was set to grow. Its shares rose in sympathy by nearly 5 % leading European benchmarks higher in the process.

It is no secret to our readers that Moller-Maersk has been one of our favorite bellweather stock due to our affinity with all things maritime and the use of shipping as a leading credit/deflation indicator. In fact, we identified Moller-Maersk as the best candidate in the survival of the fittest contest happening in the shipping space when we wrote extensively on the link between consumer spending, housing, credit and shipping back in August 2012:
"If you want to pick winners in this survival of the fittest contest, you have A.P. Moeller-Maersk A/S investing in fast and fuel efficient vessels (Maersk vessels are designed to operate efficiently at both high and low speeds),  and so is Evergreen Group, owner of Asia's second biggest container line is as well adding more fuel efficient vessels to its fleet as well as Neptune Orient Lines Ltd" - Macronomics, August 2012.

Of course they are buybacks at play which have just been announced by the company which will no doubt boost furthermore the stock price of the Danish giant, but more importantly, the fuel efficient company is benefiting more than others due to the deployment of it new fuel efficient fleet from the evolution of bunker prices which have fallen by 19% since the peak of 2012 for its margins - graph source Bloomberg:
The only issue will be coming from the continuous fall in oil prices which should impact the earnings of the oil group part of the Danish conglomerate.

When it comes to shipping and our survival of the fittest theory, back in March 2012 in our conversation "Shipping is leading deflationary indicator", we argued that shipping was in fact an important credit and growth indicator, but most importantly a clear deflationary indicator. We also indicated that consolidation, defaults and restructuring were going to happen, no matter what in the shipping industry. We discussed at the time the restructuring process involving one of the biggest container shipping companies of the world CMA CGM. We followed up on this shipping discussion in April in our conversation "Shipping is a leading credit indicator", where we indicated that the deterioration of credit would accelerate the demise of some shipping companies due to many banking institutions paring back drastically funding or pulling-off completely from structured finance operations such as shipping.

Given the worst U.S. drought in more than a half century in 2012 in conjunction with dry weather from Europe to Australia, the shipping market experienced the biggest contraction in grain cargoes for 19 years and unprofitable rates for owners of Supramax commodity carriers, it wasn't a surprise to hear about the demise of Eagle Bulk Shipping Inc., the largest US operator of the vessels filing for bankruptcy earlier in August. Rest assured some other operators will continue to struggle while some others, the fittest, such as Moller-Maersk will benefit. The fourth quarter is usually the most important for Supramaxes hauling grain as it coincides with the Northern Hemisphere’s harvests. Normally this period generates the best average returns in four of the past six years. With Soybeans on a roll with a four-session winning streak after USDA estimated this autumn's U.S. harvest could reach a record 3.82 billion bushels, roughly in line with analysts' estimates, some US Supramaxes carriers will strongly benefit from this record harvest.

Another clear indication of what lies beneath in the thermocline layer of shipping can be seen in the evolution of the Drewry Container prices. No matter how many successive rate increases (already 5 in 2014 and in continuation of what happened in 2012 and 2013), the industry has been struggling in counter balancing the "deflation" effect stemming from the credit bubble that plagued the industry with overcapacity. The effects have yet to be fully digested by the shipping industry - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark declined 4.6% to $2,075 a 40-foot container (FEU) in the week ended Aug. 13. Rates retreated after an Aug. 1 $600 general increase per FEU by the Transpacific Stabilization Agreement (TSA). Rates are only up 1.9% yoy and illustrate the effect slack capacity has on the industry's ability to raise rates. The TSA has implemented five general rate increases in 2014 totalling $1,800 per FEU." - source Bloomberg

Further away from the shipping industry, when it comes to being contrarian, we have been long US duration since early 2014 and continue to believe in the trade due to the continuous slack in economic data from the US, pointing towards continued accommodation by the Fed. The US economy is weaker than expected we think. It is muddling through rather than the strong economic recovery scenario put forward by some pundits. Until we see a significant rise in wages in the US, we won't be buying the story that the US economy has reached "escape velocity" speed from the deflationary forces.

When it comes to assessing currencies in general and the US dollar in particular, we have to agree with CITI's recent take on the subject in their note entitled "Lower Yields Delay USD upside" from the 18th of August:
"G10 FX continues to be driven by monetary “surprises”. Recent ambiguous US data have allowed 10y UST yields to break to one year lows, yet again disappointing extended fast money USD bulls. With shorts in the bond market still extended, a move to 2% is possible near term which would almost certainly entail further USD losses over 0-3m. Similarly, delayed tightening in the UK should set back GBP given extended long positioning. Meanwhile, lack of additional stimulus in both Japan and Europe should generate short term JPY and EUR gains." - source CITI

Given Europe's cumulative 12m Eurozone current account surplus was 2.4% of GDP in June 2014, up from 2.1% of GDP in June 2013, one should expect the Euro to strengthen in the near term unless of course our "Generous Gambler" aka Mario Draghi unleashes QE in Europe, but we think QE is not a done deal at the moment. In fact there is a risk that QE could be "torpedoed" by German's unwillingness in increasing its liabilities from being implicit to contingent and not tolerate that the ECB launches its own QE. As we previously wrote:
"By managing to keep Germany’s liabilities unchanged German Chancellor Angela Merkel has been in fact the clear "winner""

Remember, on  the 18th of October 2012, Chancellor Merkel in her address to the German lower-house has indeed craftily defended again Germany's liabilities by declaring:

"Financial aid without conditions attached has in some cases frustrated the drive to streamline economies, and therefore joint liability is the wrong answer"

Another risk when it comes to our "submarine" analogy and what the Banco Espirito story has shown is the European banking sector. It is still an on-going story of deleveraging and never-ending recapitalization process. The ongoing AQR (Asset Quality Review) ambitions to reveal "what lies beneath" the European banking sector as the ECB is gradually becoming the sole supervisor. But it doesn't alleviate our concerns for additional provisioning and more goodwill writedowns which traditionally happen during the second semester. While financials in the credit space have been outperforming, being a pure beta play, banking stocks continue to struggle as displayed by the relative change in Bloomberg consensus 2015E EPS from Nomura's recent EU banks strategy note entitled "Taking stock of troubled earnings" published on the 13th of August:
"Earnings momentum: Retail upside vs IB and EM weakness
Within the sector, the best earnings momentum continues to come from northern European retail banks, driven by improving asset quality and cost control. Some of the Spanish banks also benefited from earnings upgrades as a lower cost of funding offset declining profits from the carry trade. By contrast, investment banks continued to suffer from weak top-line momentum and higher-than-expected litigation charges. Also weak were emerging-market exposed banks as well as some other Spanish banks on asset-quality concerns, although we expect revenue momentum to improve in Asia over the coming quarter". - source Nomura

Of course, as we pointed out last week, expecting the single European banking supervisor to be supportive of lending in peripheral countries amount to "wishful thinking we think":
"We beg to ask where the demand is going to come from? Yet another illustration of "Cognitive dissonance" from the ECB"

From Nomura's note, there are as well too many uncertainties when it comes to expect a pick-up in credit in Southern Europe:
"Southern Europe: Margin upside vs coverage adequacy
Southern European banks’ presence among the best and worst of the earnings momentum reflects on the one side better margin performance after a disappointing 1Q as retail funding costs improved and asset yields remained quite high, and on the other side a need to build coverage levels even as NPLs appear to be passing their peak. Looking forward, as we discuss in this note, maintaining asset yields could become increasingly difficult as securities portfolios mature and weak loan growth is weighing on overall NII. We caution that analysts still model a strong pickup in NIM in Iberia over the next two years in contrast with more cautious estimates, even in economies with more aggressive expected rate cycles.

Asset quality stabilising but some risks of additional provisioning
On a positive note monthly NPL data in Spain and Italy appears to be stabilising, which should fund improvements in profitability through 2015-16. However, despite pre-emptive action ahead of the AQR and stress test, NPL recognition and coverage still diverge widely across the sector. In many cases this is warranted by loss experience and business mix (e.g., a high level of mortgages at ING). In other cases capital deductions for expected loss would limit the impact of any increased coverage on capital ratios). However, we caution that banks with lower coverage (e.g., POP) could run a greater risk of additional provisioning needs in 2H." - source Nomura

Given we pointed out last week a change in the Business cycle in Europe turning South which we called a "Cognitive dissonance" indicator coming from a Bank of America Merrill Lynch note, we have a hard time believing in a credit-less recovery and that additional provisioning will be avoided as Europe struggles with lack of overall aggregate demand, particularly with Germany now being impacted and France sliding more into trouble. French Minister Sapin is talking about budget deficit being above 3.8% for 2014, rest assured it will be North of 4%. If you have 0.5% of growth it should equate to 4.3%.  We also expect additional goodwill writedowns happening for peripheral banks during the second part of the year, meaning once again some bank analysts earnings forecasts will be torpedoed thanks to the undetected "European banking submarine" resting in the thermocline.

If the European ship wishes to detect European bank submarine risk hiding in the thermocline, the ship has to be fitted with towed sonar. In that case, the sonar must be submerged below the thermocline:

One of the way to detect "risk" arising from a European bank submarine hiding in the thermocline which we pointed in October 2012 conversation "When causation implies correlation"  is to track the issuance of putable bond issuance from financials. It is a typical instrument used by financial institutions under stress. For us, a big red flag. Putable bonds are fixed-income securities which investors are able to redeem before maturity. It is a very dangerous option given the funding shock it could create should investors decide in concert to exercise their option.

Another towed sonar that needs to be used for high yielding credit investors in corporate high yield is the call risk, which we pointed out in our conversation "The Departed" in January 2014:
"When it comes to credit risk and luck, recently some investors in hybrid securities learned the hard way when ArcelorMittal called early some subordinated bonds at 101 when they had been trading recently around 108.96 cents, a good sucker punch for some unwary investors."

We could also recommend using the towed sonar analogy for the CDS orphaning risk which was so clearly illustrated in the SNS case and the Banco Espirito story, but, as we pointed out in our conversation "The Week That Changed the CDS World" in May 2013, hopefully the new CDS contracts due to be launched in September should suppress this "submarine" risk of orphaning for financial subordinated debt CDS.

Also, whenever loans of corporate high yield bonds are trading above par, you introduce an additional risk element as there is limited call protection, hence the need to switch on your "towed sonar" for call risk should you decide to navigate further on the treacherous credit seas where submarines are lurching and defaults can easily torpedo your credit exposure.

For those that need to seek comfort in a safe haven, we believe Investment Grade credit while tight from an historical point of view, still benefits from positive exposure thanks to the Japanification process. In that sense, we expect the Fed to keep a dovish tone in this muddling through economic situation in the US meaning that the releveraging process taking place in the US is still positive for credit. From that perspective, we would like to point out to Morgan Stanley's recent take on the subject from their note Credit Continuum note entitled "Rationalizing the Resilience" published on the 18th of August:
"What Are the Rates Markets Telling Us About
We think a rates rally may not result in a severe spread widening for credit. Interestingly, the correlation between the two markets has changed markedly. Typically spreads are inversely correlated to government yields, but recently rates returns and credit excess returns have moved together as both credit spreads and rates have tightened during a large part of the past twelve months. The main reasons for this coupling are complex and not entirely related. The credit reasons were listed earlier. On the rates side, weaker than expected US growth in 1Q14, weak European economic data, and a flight to quality over global conflicts have been the primary drivers (Waiting for Godot, Aug 1, 2014). But in a bear case scenario, if we assume that correlation falls further into negative territory (as it has recently), then this spread widening episode would only get marginally worse. Our Rates Strategy bull case (our bear case) for 4Q14 is 2.15% or roughly ~20bps tightening from here. Using our simple -4:1 rates:credit spread change ratio, the rates rally may result in a ~5bps widening in credit, which would result in a total incremental increase of ~13bps from this episode’s tights. Although this outcome is certainly not desirable, it is better than the post-crisis average mentioned earlier of 36bps." - source Morgan Stanley

This somewhat validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"-Corporates around the world have been deleveraging for longer than most people realise, starting around the time of the tech bubble in 2000.
-Deleveraging is generally bad for equities, but good for credit assets.
-In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute).
-As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities." - source Nomura

On another note what has clearly torpedoed the short US treasuries stance as of late has been the continuous appetite from Japanese Life Insurers for foreign bond investments as depicted in the below graph from Nomura's recent Japan Navigator note number 583 posted on the 18th of August:

"At the Jackson Hole meeting over the weekend, Fed chair Janet Yellen and ECB President Mario Draghi will give speeches.
As concerns over geopolitical risks subside in the near term, we believe investor focus will shift onto ECB easing and/or the potential of central banks turning more dovish. We do not expect the Fed to send any message at the Jackson Hole meeting that may prompt the market to bring forward its expected timing of a rate hike. Instead, we believe the ECB will speak in such a way as to suggest its intention to take further easing action. In this environment, we expect the Goldilocks market to continue (strong bonds and stocks coupled with low volatility), barring a sharp fall in macro indicators and/or a more imminent risk of a credit crunch.
We note that, since geopolitical tensions over Ukraine heightened, G3 bond yields have fallen globally in tenors longer than 10yrs. Looking at each of these markets, we find that the yield curve has flattened beyond the 10yr in the euro area, steepened in the US and shifted down parallel in Japan. We believe these moves reflect the conditions of these economies, which have translated into their respective monetary policy outlook.
We believe the steepening of the UST curve reflects the relative strength of the US economy, which leads the others in a recovery cycle. Faced with this, we believe few investors are likely to price in a dovish shift by the Fed. Rather, they may be looking at the risk of Fed policy falling behind the curve, in our view. In this respect, we will watch to see when volatility begins to rise in the UST market.
When the Fed policy outlook changes next, we would expect it to be either changes in the FOMC statement “maintain the current target range for the federal funds rate for a considerable time” or FOMC members’ expectations of rate hike in mid-2015. As the “considerable time” is widely believed to suggest at least six months, the statement will be inconsistent with a forecast rate-hike by end-2014." - source Nomura

We agree with the above, the Fed is far from normalizing its interest rate policy hence our positive stance on investment grade credit. As a side note, investing in long dated Apple corporate bonds following the taper tantrum has been a good strategy, we believe keeping a long duration exposure on quality investment grade credit is still a valuable trade.

Also the weaker tone of the US economic strength can be ascertained from the breakdown of the remaining reliable pair, namely the 2 year treasury yield relationship with the S&P500 as displayed by Bank of America Merrill Lynch in their recent  Credit Market Strategy note entitled "Oh rates" published on the 15th of August 2014:
"Oh rates
The two key developments this week were declining geopolitical risks – even with today’s escalation between Russia and Ukraine - and interest rates taking another leg significantly lower on a couple of softer than expect data readings on Retail Sales and Jobless Claims, strong demand in auctions, as well as today’s geopolitical tensions. Declining uncertainties compared with last week – measured by implied volatilities ) – and a slower moving Fed, should we continue to see softer data, finally broke the lone relation between rates and stocks that has held up this year, as stocks have risen significantly since Thursday last week while 2-year Treasury yields continued to decline (Figure 6)." - source Bank of America Merrill Lynch

Another chart worth mentioning as a "towed sonar" we think and showing that the market has been getting wrong signals from the thermocline, can be seen in the below chart from Bank of America Merrill Lynch displaying TIPS forward real and BE rates being consistent with renewed QE:
"Forward yields move into QE territory
The bull flattening of the Treasury yield curve has been remarkably persistent. When we look at the move in terms of forward rates of TIPS real yields and forward breakevens, the current environment resembles early 2012, when the Fed was undertaking Operation Twist and preparing the market for QE3. The Chart of the day shows a time series of these 5y5y forward real and breakeven inflation rates.

In the last several years, the relationship between real rate and breakeven inflation forwards has described several QE-based regimes. When anticipation and expectations for QE3 were most intense, in late 2012 and early 2013, BE forwards were high and real yields were low, with the former driven by expectations of higher inflation from debt monetization and the latter by the Fed's demand for Treasuries.

From mid-2013 to early 2014, we see the effects of the taper tantrum, when forward real yields rose and forward breakevens fell. At the moment, we seem to be in a middle state between these two extremes, with real rates falling back down but forward breakevens holding roughly steady since March. However, the rally in real rates has occurred without any corresponding shift in the Fed balance sheet, other than the actual implementation of the taper. Something is causing the market to behave in a manner in some ways similar to an expansion of QE." - source Bank of America Merrill Lynch

On a final note, the reason we believe far more into a sluggish recovery than an outright recovery as vaunted by many can be seen in the Capital spending by US companies as displayed by Bloomberg in its recent Chart of the Day:
"Capital spending by U.S. companies has been hampered by “a traumatized economy” and will require more time to rebound, according to Milton Ezrati, a partner at Lord Abbett & Co.
The CHART OF THE DAY illustrates how Ezrati drew his conclusion, presented in a note two days ago. He tracked the percentage gap between outlays and depreciation expenses among domestic businesses, as compiled by the Commerce Department.
Last quarter’s spread, 27.7 percent, was the widest since the current economic expansion started five years ago. Even so, it was only 0.2 percentage point higher than the average during the previous period of growth, from 2002 to 2007.
“This is a very different and much less robust picture than in the economy’s past,” Ezrati wrote. The shift reflects the legacy of the 2007-2009 recession and financial crisis and the federal government’s policy response, the note said.
“These retarding forces will change only slowly at best,” the Jersey City, New Jersey-based senior economist and market strategist wrote. In the meantime, capital spending may expand no faster than it has in recent years, he wrote.
Spending on buildings, equipment and other capital items during the second quarter totaled $2.24 trillion at an annual rate. Depreciation, an accounting charge taken to reflect thewear and tear on assets, amounted to $1.75 trillion." - source Bloomberg.

"Beware of little demand for lending. Lack of demand for lending due to weak aggregate demand will eventually sink the great European ship." - Martin T. - Macronomics

Stay tuned!

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