Tuesday, 2 September 2014

Credit - The European Catharsis

"We can easily forgive a child who is afraid of the dark; the real tragedy of life is when men are afraid of the light." - Plato

Looking at the continuation in yield compression in the European government bond space, in conjunction with the deliquescence of French political parties with the Socialist party risking outright implosion with Fran├žois Hollande shifting towards "Macron-nomics" (Emmanuel Macron being a young  former investment banker and new French minister for the economy), we reminded ourselves for our chosen title of the definition of the Aristotelian "Catharsis", the dramatic art that describes the effect of tragedy. The German philosopher, dramatist, publicist and art critic Gotthold Ephraim Lessing translated "Catharsis as a purification, an experience that brings pity and fear into their proper balance: "In real life," he explained, "men are sometimes too much addicted to pity or fear, sometimes too little; tragedy brings them back to a virtuous and happy mean." Tragedy is then a corrective; through watching tragedy, the audience learns how to feel these emotions at proper levels.

In similar fashion we would argue that in real life, European politicians have been sometimes too much addicted to debt and popularity, indeed, one would hope that the European tragedy unfolding would bring them to more virtuous and happy mean, but, hearing the departing French minister of the economy Montebourg blaming entirely French woes on the implementation of "austerity", we thought this week's chosen title was appropriate given "Catharsis" can apply to both tragedy as well as comedy. Given, purgation and purification, used in previous centuries are still the common interpretations of catharsis and still in wide use today, we wonder when the purgation and purification of the European debt market will happen via "restructuring"? We reminded ourselves as well our January 2012 conversation "The European Overdiagnosis" where our friends from Rcube Global Asset Management pointed out the inherent flaws of the European currency construct when discussing "The likelihood of a Euro Breakup": "By eliminating currency crises, which were common until the mid-1990s (and at the same time preventing evil “speculators” from making billions on them), the Euro built an economic crisis of far larger proportions. Once again, economics provides a good illustration of the old proverb “the road to hell is paved with good intentions”.

In this week's conversation we will look at the prospect for the continuation of the performance of credit and the continuation in the contrarian tactical trade, namely being long European equities (playing the rebound or when "bad economic" news is "good market" news...) and short the Euro.

While Europe continues to go through "Catharsis" as indicated by the latest raft of economic data pointing to weaker growth, European credit continued to post strong performances so far in 2014 with Total Return for Investment Grade Credit at 6.5% and High Yield slightly behind at 5.5%. Talking about "Credit Bubble", Investment Grade did reach last week it's lowest historical yield at 1.55% validating our 2012 conversation "Deleveraging - Bad for equities but good for credit assets"but we ramble again...

The latest flows of funds indicate as reported by Deutsche Bank on the 1st of September in their report entitled "Investors return back to European equities on hopes of (private) QE":
"European funds attract solid inflows on hopes of (private) QE: A week after the Jackson Hole symposium, Total equity funds recorded the 3rd consecutive week of inflows (+0.1% as % of NAV), led by solid flows into Western European and Emerging Asia equity funds.
Following a stack of disappointing economic data releases in Europe over the last few weeks and subsequent outflows thereafter, Western Europe equity funds rebounded strongly with solid inflows (+0.2%, highest inflows in 11 weeks) in anticipation of a possible (private) QE announcement during this week’s ECB meeting. DB’s economists are bringing forward the timing of the announcement of private QE (ABS purchasing) to 4th Sep’14, though admitting it’s a very close call. They expect it not to be a generic QE with government bond purchases and expect ABS purchasing would act as a complement to the already announced TLTRO. What to make out of this?
Observing flows returning back to Europe, we think investors would play this trade mostly via ETFs (Europe ETFs had +0.4% of inflows last week). A basket of common names constituent to the ES50 and the DAX30 could benefit overproportionally as 1) these indices are by far the two largest targets to invest the region via ETFs and 2) where the share of equity held by ETFs is particularly pronounced for these names. This basket’s outperformance in Europe correlates well with flows (top below chart)."
- source Deutsche Bank

Another important point from Deutsche Bank's note relates to ETF flows becoming an increasingly important indicator:
"ETF flow has become an increasingly important driver of stock returns over the past years as the share of equity held by ETFs has gone up significantly. In case of the DAX, this share has increased to 6.2% from 0% 10-years ago (Figure 1)."
The two largest ETFs to invest Europe based on AuMs are those on the ES50 + DAX30.

Hence, it doesn’t seem too far-fetched assuming that stocks constituent to both benchmarks could benefit/suffer over-proportionally depending on flow in and out of these vehicles. Figure 2 highlights the blend of stocks constituent to both indices.
We can show that ever since the Great Financial Crisis (GFC) hit markets and ETFs became common tools to implement (rather short-term oriented) market views, flows into Western European ETF funds correlate well with this basket’s outperformance in Europe, based on market cap weights (Figure 3).
The basket P/E ratio trades at a 20% premium to Europe (Stoxx600) and at a 10% discount using P/B (Figure 4). 
Since the basket comprises Financials as well as Industrials, we consider the P/B ratio as more meaningful in this context since Financials are generally valued over their book value of equity rather than earnings.
Should the money flow return to Europe (predominantly via ETFs) once positive economic surprises come through as implied by our credit impulse framework, we think the recent pull-back (and subsequent underperformance of the basket) should be seen as an attractive entry point." source Deutsche Bank

In similar fashion to Deutsche Bank our good friends at Rcube Global Asset Management in their latest note entitled "Is Europe's situation so bad that it is good?", posit the following:
"Global equities have reached a strong resistance level, sentiment is frothy (EM and US), breadth is poor, bearish technical divergence abound; all this makes a larger correction likely. This would create a great buying opportunity for European equities for a year end and H2 2015 rally. The periphery and banks should be the clear winners".

During this summer, European equities have indeed been punished due to the significant fall in European inflation expectations as shown as well by our friends in their note:
"European Inflation expectations have crashed this summer. French 3 year breakevens have lost 100 bps since April. This has worried equity investors who punished European equities both on absolute and relative basis
If left unanswered for too long by the ECB, the deflation scare could clearly trigger more selling pressure, this would be we think a major opportunity to play both a rebound on absolute terms and a catch up with US stocks from a relative perspective. When met with action by the European central bank, the European and US liquidity environment will look very different (QE ending in the US, starting in Europe; Monetary tightening in the US, Negative interest rates in Europe, EURUSD weakness).
In the very short term, the gap that has opened up between inflation expectations and equity prices is such that if deflation fear persist, the selloff could be more severe, or it is also possible that financial markets stress will be the trigger for the ECB to act, in which case lower equity prices are likely before the rebound set up gets clearer. In the past this is exactly what happened. Inflation expectations following a market shock would melt, prompting a response from the central bank. Hence this is why inflation expectations are such a good contrarian explanatory factor equities forward returns.
As the back test below shows, the lower the forward inflation rate, the higher the Stoxx 600 forward returns. This clearly makes the decision process harder this time around since there has not been any correction in equities following the crash in breakevens. This is explained by the high hopes over Quantitative easing by the ECB, the lower inflation expectations are falling the higher are the hopes for QE, and its positive impact on equities.


As explained below, in the medium term we strongly believe that European equities are going higher. So this is only a question of timing.

Our Equity model for European equities is sending its stronger buy signal since just after the 1987 crash

Valuations according to our methodology are the cheapest since March 2009 thanks to the yield meltdown
- source Rcube Global Asset Management

Where we slightly disagree with our friends is that should QE materialise banks should be the clear winners. We'd rather hold bank debt than bank equities given the upcoming AQR which should highlight the capital needs of some European banks. Given banks' stocks are a leverage play on the economy and looking at the weakening economic growth outlook, we would rather hold bank senior debt than their stocks from an investor point of view. We will in another post touch again on the European banking situation rest assured.

In similar fashion to Deutsche Bank and our friends at Rcube, Barclays as well on the 2nd of September also added to the contrarian views of a possible tactical rebound in European equities in their note entitled "Don't exit Europe":
"Recent trends suggest we are near a turning point for continental European equities.
While the poor performance of Continental European equities since May owes something to the ongoing conflict in Eastern Ukraine, the main cause is more fundamental.
Negative data surprises have now reached an extreme relative to those in the US with underperformance to match. History suggests such episodes have been turning points.
The weakening in the Euro should help revenue and earnings growth, while there is evidence that bottom-up earnings estimates are responding to a solid Q2 reporting season and no doubt the weaker Euro.
While we have cut our forecast for earnings growth in Continental Europe to 10% in 2014, this should accelerate to 17% in 2015. Both forecasts are slightly above the bottom-up consensus.
There is an increasing chance the ECB will ease monetary policy further with full blown QE becoming more likely. Such a move would represent a major regime change and echoes some past experiences such as the major ERM realignments of the early 1990s.
Finally, Europe’s underperformance has not been confined to domestically focused stocks. Several globally focused sectors such as Energy, Industrials and Healthcare are trading at multi-year lows compared with their US peers."
- source Barclays

This adds more ammunition to our views expressed in our 19th of August conversation "Thermocline - What lies beneath":
"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."

Of course all eyes are on the ECB and expectations are high the ECB will sooner rather than later unleash a QE of its own. On that matter we agree with Bank of America Merrill Lynch's take from their Liquid Insight note of the 1st of September entitled "Muddle-nomics", that, QE won't happen just yet:
"No QE, yet
Draghi’s speech at Jackson Hole was dovish enough to confirm our view that small scale ABS purchases will take place, very likely before year-end, but not to change our view that QE is unlikely to happen within 12 months (a close call and in contrast to our view that more aggressive action by the ECB is warranted).
For this week’s meeting, we do not rule out smaller measures, such as fine-tuning the upcoming TLTROs or a detailed timeline of how and when ABS purchases could take place, given the need to deliver after the market’s reaction to Draghi’s speech. However, in our view, none of these would change the outlook substantially. The key issue will be to understand how many members of the governing council share Draghi’s latest concerns, particularly since his comments on inflation expectations were not included in the original text posted on the ECB website. We believe Draghi will not be able to convince the governing council to adopt broad-based QE just yet. But we think further disappointments in inflation data could do the trick." - source Bank of America Merrill Lynch

We also agree with Bank of America Merrill Lynch when it comes to further yield compression in our "Japanification process":
"Rates: Trade the journey not the destination
The reaction in the rates market will not just be a function of what specific measures the ECB announces, but also the extent to which the ECB lays out the conditions for future action. Even if the market would arguably be disappointed by our central scenario, a dovish press conference would still be possible. We have argued here that rates are not pricing in a significant QE probability. Following the Jackson hole repricing, we would argue this statement generally still holds. We remain constructive European rates and express that by being long duration in the periphery." - source Bank of America Merrill Lynch

Moving on to the subject of the Euro, with the on-going "Japanification" process, what appears clear to us is that you can expect significant rise in volatility in the FX space particularly with EUR/USD, in similar fashion you had significant volatility throughout the years in USD/JPY. On that note Mohamed El-Erian's recent comments in the Financial Times in his article "Foreign exchange volatility is the risk to watch" are worth mentioning:
"The biggest threat to investors may come from the foreign exchange market rather than directly from the stretched prices of equity and bond markets. Judging by recent policy and technical signals, the forex market may be about to exit an unusual phase of low volatility." - Mohamed El-Erian - FT.

We expect a "regime change" in FX volatility as well. In fact we voiced our concern with the impact the end of tapering would have in terms of dollar liquidity in June 2013 in our conversation "Singin' in the Rain":
"If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?

It is a possibility we fathom." - Macronomics, June 2013 

We also reminded ourselves in this particular conversation the following: 
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given 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
if the dollar goes even more in short supply courtesy of Bernanke's "Tap dancing" with his "Singin' in the Rain", could it mean we will have wave number 3 namely a currency crisis on our hands? We wonder..."

Rest assured that higher real yield on US debt will continue to attract foreign investors towards US Treasuries hence our continued expectations for lower US long term yields. We have made no secret that we have been riding the long duration trade since early January 2014 via ETF ZROZ has a good proxy exposure to long US duration with some success...

When it comes to net USD buying the trend has continued as displayed by Bank of America Merrill Lynch in their CFTC FX Futures Watch from the 29th of August entitled "Largest USD longs in a year":
"EUR selling continues; short positioning stretched
Speculators this week sold $1.7bn of EUR contracts, increasing net short positioning to $24.8bn. Speculators have sold $30.5bn of EUR contracts since the dovish ECB meeting in May. Net short EUR positioning is beginning to look stretched (Chart 2). 
Technicals suggest the near term trend is pointing to a maturing decline and a range trade, while our positioning models suggest a medium risk of reversal in the EUR/USD downtrend. - source Bank of America Merrill Lynch

On a final note and from a contrarian point of view, should the ECB disappoint there is potential for some heightened volatility and reversal given the short consensus trade on the Euro we think. What has been driving the move have been flows and QE expectations rather than "fundamentals" which can be seen when one looks at the forward curve at the 5 year point (we look at the 5 year point because for the ECB the five-year forward break-even in five years is certainly one of the important indicator) - table source Bloomberg - EURO/USD Forward Curve:
Flow matters...but the stock of European debt too.

When it comes to our European Catharsis, being the prelude to the European tragedy and the current high expectations of QE we think our final quotes resonate well with our sentiment on European woes and QE:

"There are only two tragedies in life: one is not getting what one wants, and the other is getting it." - Oscar Wilde

Stay tuned!

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