Tuesday, 21 October 2014

Credit - A Descent into the Maelström

"You drown not by falling into a river, but by staying submerged in it." - Paulo Coelho

Looking at the massive intraday surge on the 15th of October on the 10 year US T-note, the most liquid asset in the world (as an example to what can happen in directional volatility going forward), this move relative to the asset class (around 5%) would equate in the equity space to a +10% intraday move on an equity index, highlighting in effect our liquidity concerns we have frequently voiced on this blog. 
- graph source Bloomberg

To that effect and in the search of this week's analogy we reminded ourselves of the Maelström, being a very powerful whirlpool, a free vortex with considerable downdraft. A whirlpool is produced by the meeting of opposing currents, therefore one can argue that the "asset inflationary" policies followed by central banks around the world are in direct confrontation with the tremendous deflationary powers we have described in our musings, triggering in effect potential huge downdraft (or gaps) on asset prices. The more powerful whirlpools are properly termed "Maelström". A "Maelström" is created in narrow (poor liquidity), shallow straits with fast flowing water (capital flows).

While looking for our title analogy, we remembered the work of one of our favorite writer Edgar Allan Poe and his short story "A Descent into the Maelström" written in 1841, where a man recounts how he survived a shipwreck and a whirlpool. The story is told by an old man who reveals that he only appears old—"You suppose me a very old man," he says, "but I am not. It took less than a single day to change these hairs from a jetty black to white, to weaken my limbs, and to unstring my nerves." 

The old man goes to tell the story of the shipwreck he and his brothers encountered in their journey: "Driven by "the most terrible hurricane that ever came out of the heavens", their ship was caught in the vortex. One brother was pulled into the waves; the other was driven mad by the horror of the spectacle, and drowned as the ship was pulled under. At first the narrator only saw hideous terror in the spectacle. In a moment of revelation, he saw that the Maelström is a beautiful and awesome creation. Observing how objects around him were pulled into it, he deduced that "the larger the bodies, the more rapid their descent" and that spherical-shaped objects were pulled in the fastest." - source Wikipedia

In this week's conversation, we will reflexionate around the latest bout of volatility and what we think it entails in terms of risk/reward ideas.

"The larger the body, the more rapid their descent", as one can vouch from observing the death of the $55 billion tax inversion AbbVie -Shire deal in the Merger Arbitrage world. Obviously, what appears interesting to us is the change in the rules announced by the U.S. Treasury Department to make tax inversion deal more difficult in conjunction with the European Commission being on the offensive about Irish  and Luxemburg Tax deals involving the likes of Apple and Fiat.

It makes even more likely that these companies tax advantages may vanish at some point in the near future, making it possible for a "Maelström" to occur, generating in the process a powerful "downdraft" on the stock price in the process.

The effect of the cancellation of the AbbVie-Shire deal on Shire's stock price - graph source Bloomberg:
A powerful downdraft in the Maelström...

Biotech stocks, one of the biggest winners of the five-year bull market in a context of increasing tax risk appears to us considerably vulnerable from the rapacious appetite of over-indebted governments we think. "Lower Liquidity" is already causing "Higher Volatility".

We think that the "too much liquidity" popular trades of biotech, internet, gaming and small cap are up for more pain in the future. Technology and Health Care Companies in the S&P 500 index are both heavy users of adjusted earnings measures in their financial statements: Of 69 technology companies in the index, 56 use non-GAAP earnings, of 56 Health Care companies, 45 use them. (source "Earnings, but Without the Bad Stuff", Gretchen Morgenson, November 9 2013 - New-York Times). The vast majority of public biotech companies in the U.S. (87%) do not pay taxes because they lose money as they pursue breakthrough therapies and cures as well as using non-GAAP metrics to boast are more "positive" accounting picture. Young high tech companies often end up paying less than 10% of income in taxes whereas old railroads and utilities often pay more than 25% and cannot easily "jump" countries using M&A for tax inversion purposes.

The impact of the tax inversion related M&A 2014 frenzy on the Biotechnology and Drugs Industry - source CSIMarket:
- source CISMarket.com

From a credit perspective, spreads in Merger Arbitrage situation widened on the back of risk adjustments spillover from the ABBV-Shire situation as portrayed in a note from the 16th of October from the UBS Special Situation team:
"Merger arbitrage spreads continued to widen:

o    Spreads are widening as a result of market volatility and now also as a result of risk adjustments arising from new developments in ABBV- Shire

o    The median annualized spread for definitive deals late in the day on October 15 was 11.0%, as compared with 9.6% on October 14, 8.0% on October 10 and an average level of 6.5% during the eight week period preceding the market stress period (restricting the sample to spreads between 0 and 30% annualized)

o    If we restrict the sample to spreads between 0% and 50% annualized, the median annualized spread late in the day on October 15 was 11.7%, as compared with 9.9% on October 14, 8.8% on October 10 and an average level of 6.8% during the eight week period preceding the market stress period

o    If we look at spreads on a non-annualized basis, the average level on October 15 was about 150 basis points wider than the average level in the preceding weeks (widening from ~2.9% to 4.4%)

o    This 450-500 basis point widening in annualized spreads and ~150 basis point widening in non-annualized spreads relative to pre-stress levels are comparable to maximum spread widening in prior market stress episodes" - source UBS

Please note the US convertibles space is more and more made up of tech/biotech new issues but in terms of Merger Arbitrage, the convertibles space is less concerned by the tax inversion trend.

In continuation to our recent conversation highlighting the relative protection offered by Investment Credit, the market changes since the 8th of October as displayed in Bank of America Merrill Lynch's note from the 17th of October entitled "Macro policy: no room for error" clearly indicates the relative protection offered by the asset class:
- source Bank of America Merrill Lynch.

No surprise as well that when it comes to "capital inflows" and our "Maelström", flows have indeed been driven towards safer asset as indicated by Bank of America Merrill Lynch's recent Flow Show note entitled "Crash Flows & Feedback" from the 16th of October:
"Equity stabilization ($2bn of redemptions) after big risk-off flows past 2 weeks
($23bn redemptions)
Big caveat: huge inflows to small cap (14% of IWM float) & energy (10% of XLE float) probable “ETF-creation” for new shorts
Note Aug’11 equity plunge coincided with much larger $42bn redemptions European capitulation: biggest outflows from EU equities ever ($5.7bn – Chart 1)
Quality king: Treasury & IG bond funds big winners with $10bn inflows combined
Risk out of favor: HY, floating-rate debt and EM equities extend outflow streak"
Fixed Income Flows
43 straight weeks of inflows to IG bond funds ($5.6bn)
Big $3.9bn inflows to govt/tsy funds (largest in 10 weeks) (Chart 2)
7 straight weeks of outflows from HY bond funds ($2.0bn)
14 straight weeks of outflows from floating-rate debt ($1.0bn)
6 straight weeks of outflows from TIPS" - source Bank of America Merrill Lynch

Go with the flow and don't fight the "Maelström"....

Of course, as we pointed out in our conversation "Wall of Voodoo" on the 23rd of September, CCCs in credit  have indeed been the canaries in the risky asset coal mine. When it comes to the "credit whirlpool" created by the meeting of opposing forces (aka our "Maelström"), we could not agree more with Bank of America Merrill Lynch's comments from their 17th of October note entitled "Zero rates vs Zero growth":
"The bond market’s great tug-of-war
Yet asset markets are really reflecting a tug-of-war between the conflicting forces of “zero rates” and “zero growth” in Europe. Nowhere can this be seen more clearly than in credit where high-grade and high-yield markets have totally decoupled. The chronic shortage of yield is – and will stay – the dominant force for high-grade tightening, we believe. But we think the growth downturn in Europe needs to be addressed (by central banks or policy makers) for high-yield to rally decisively." - source Bank of America Merrill Lynch.

Hence our comment in last week's conversation "Actus Tragicus" in relation to the appeal of Investment Grade credit in a deleveraging/Japanification world:
"While it is true that the "interest rate buffer" in case of a surge in rates is nearly exhausted in the current low yield environment, but the environment for investment grade credit is still favorable"

We also added:
"While the "Actus Tragicus" continues to play out in the deterioration in Europe of economic fundamentals putting additional stain on stretched equities valuation. In the credit space, at least in investment grade, thanks to the "Japanification" process, it continues to be "goldilocks" we think."

From a risk positioning perspective, we agree with our cross-asset friend and fellow "Macronomics" blogger "Sormiou" in the sense that given the relative recent moves, getting exposure to US High Yield via selling the CDX CDS index HY 5 year versus Short S&P 500 via long puts 3 to 6 months seems relatively enticing - graph source Bloomberg SPX vs CDX HY:
We have move back towards relatively high implicit probability of default on US High Yield whereas the S&P 500 remains close to the highest levels. If we do indeed move lower, being short US equities versus being long US High Yield could be of interest. If there is a rebound, the exposure of being long equity put options limits the downside and High Yield could potentially retrace towards the 300 bps mark. If you calibrate the trade to be carry flat/slightly positive, the risk/reward seems of interest we think.

In terms of additional risk positioning, a thematic trade idea based on Japan's latest pension allocation reforms and put forward by JP Morgan on the 21st of October in their note entitled "Thematic Trade Ideas on GPIF Reform Update" is interesting we think:
"Government Pension Investment Fund (GPIF) reportedly to boost domestic stock allocation to 25%. According to the Nikkei newspaper, GPIF is considering increasing its allocation target for domestic equities to about 25% as well as raising the allocation of foreign stocks and bonds. We concede there is a large amount of uncertainty about the composition of GPIF reform, but the much stronger potential allocation ratio for domestic equities versus our pervious expectation of 20% leads us to think that results of the GPIF reform could surprise positively and add to the gains of Japanese equities.

Implementation could occur before announcement of the new investment strategy. The Nikkei article also suggested GPIF will update its portfolio allocation targets later this month, although the timing of implementation is unclear. Nonetheless, advisors to GPIF are well aware of the adverse market impact of publishing target weightings beforehand. In fact, recent interviews with Professor Ito, the government’s top adviser on GPIF reform, suggest that the implementation could happen even before the announcement.

The allocation increase could spur buying of c.¥10 trillion of domestic stocks. We analyze the flow implication under the scenario suggested by the Nikkei newspaper. Due to the uncertainties on asset returns and fund redemption schedule, our analysis is solely based on the expected change in the allocation ratios and investment results at the end of June 2014. Our calculation suggests additional purchases of domestic stocks will be ¥9.8 trillion if the domestic stock allocation is boosted to 25%. After examining flows data, we believe positioning in Japan is light, and any surprise could easily lead the price action to change very quickly.

Bullish index options strategies: In view of renewed attention towards GPIF reform and an eventful Japan in the next few months, we recommend that investors add upside exposure in Japanese equities for the remainder of the year. In addition to outright calls and call spreads, investors may want to consider structures that take advantage of the current elevated skew, such as risk reversals (buying calls and selling puts, and possibly with knock-in barriers embedded in the puts). JPX-Nikkei 400 is our preferred underlying index among major Japanese benchmarks due to its lower volatility and direct linkage to the corporate governance reform theme." - source JP Morgan

Given the Nikkei index is particularly more sensitive to away earnings, than by domestic earnings, going long again on the Nikkei currency hedged (Euro hedged) could make sense if ones would like to front-run again the Bank of Japan and their GPIF friends (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro).

On a final note, Bloomberg's latest Chart of the Day, shows that the Yen's real effective exchange rate has fallen to the weakest since 1982 - graph source Bloomberg:
"The yen’s purchasing power is eroding to an unprecedented level with Japan’s trade deficit poised to increase from the widest on record, according to Mitsubishi UFJ Morgan Stanley Securities Co. 

The CHART OF THE DAY shows the Bank of Japan’s calculation of the yen’s real effective exchange rate against 59 trading peers fell last month to the weakest since 1982, as the nation posted an unprecedented 26th-straight month of trade shortfalls in August. Historically, a weaker currency boosted exports and squeezed imports, though that hasn’t happened this time, indicating a “structural shift” has taken place, said Daisaku Ueno, the brokerage’s Tokyo-based chief currency strategist. 

“If the trade deficit doesn’t noticeably narrow from here, the yen’s real effective rate could fall to levels never seen before,” he said. “From a supply and demand perspective, yen selling for foreign currency by Japanese importers will just continue endlessly.” 

A 26 percent decline in the yen versus the dollar over the past two years has left it 20 percent undervalued, the most among developed-market peers, according to a gauge of purchasing-power parity based on consumer prices. Japanese visiting the U.S. would have to pay 71 percent more for a McDonald’s Corp. Big Mac than at home, according to Bloomberg calculations based on the Economist magazine’s Big Mac index. The yen traded at 106.95 per dollar yesterday in New York.

Japan’s currency was at its weakest in the early 1970s, according to the BOJ’s measure. It was pegged at 360 to the dollar until President Richard Nixon broke the U.S. currency’s last link to gold in August 1971, ending the ability of foreign central banks to convert dollars into a fixed quantity of the precious metal. 

The yen’s real effective exchange rate is now in the range that the market considers “extremely cheap,” Ueno said. “In Japan’s post-float history, the strength of demand for dollars and other foreign currencies among importers has never been higher.” - source Bloomberg 

Of course we expect further downside to the Japanese currency in the medium term, in fact a much weaker levels hence our short positioning since late 2012 but that's another story...

"The depth of darkness to which you can descend and still live is an exact measure of the height to which you can aspire to reach." - Pliny the Elder, Roman author

Stay tuned!

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