"The worst pain a man can suffer: to have insight into much and power over nothing." - Herodotus, Greek historian
"In 149 BC, Rome declared war against Carthage. The Carthaginians made a series of attempts to appease Rome, and received a promise that if three hundred children of well-born Carthaginians were sent as hostages to Rome the Carthaginians would keep the rights to their land and self-government. Even after this was done the allied Punic city of Utica defected to Rome, and a Roman army of 80,000 men gathered there. The consuls then demanded that Carthage hand over all weapons and armour. After those had been handed over, Rome additionally demanded that the Carthaginians move at least sixteen kilometers inland, while the city itself was to be burned. When the Carthaginians learned of this they abandoned negotiations and the city was immediately besieged, beginning the Third Punic War." - source Wikipedia
"Given France has now postponed any chance of meaningful structural reforms until 2017 with the complicity of the Europe Commission, (again a complete sign of lack of credibility while imposing harsh austerity measures on others), and that the government will face an electoral onslaught in the upcoming local elections which will see yet another significant progress of the French National Front, we are convinced the"Current European equation" will breed more instability and not the safer road longer term."
"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 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?"
"All the investors that piled in "high beta trade", namely our "tourist trap", in the form of Asian High Yield, Emerging Debt Bonds and Equities as well as Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play courtesy of repressed volatility thanks to central bank meddling due to negative real US interest rates." - Macronomics, September 2013Therefore in this week's conversation, rather than focusing on the Greek tragedy, we would rather focus our attention to some macro and micro aspects that warrants, we think a closer attention.
- Bear markets for US equities generally coincide with a tick up in core inflation
- France from a "corporate monitoring health" is deteriorating "slowly" but "surely"
- Beware of the Repo drought
- US Interest Rates and the US Corporate pensions gap
- Final chart: In High Grade Credit, liquidity is coming fast at a premium
"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008" - Macronomics, 5th of June 2014
- France from a "corporate monitoring health" is deteriorating "slowly" but "surely"
"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."
"The French government policy is based on "hope" and their strategy is based on "wishful thinking". No matter what, we do not see unemployment falling with these deteriorating conditions."
As we indicated in our conversation as well is that there was a large contingent of public servants supporting François Hollande representing 22% of the working population compared to 11% in Germany. To validate our prognosis, we find it amusing that Public Service Minister Marylise Lebranchu has announced on the 16th of June 2015 that public servants would see their salary increases as of 2017 without any mention of course of the budgetary impact it would have! Also, she mentioned that while salaries have been currently frozen thanks the stability of the index used for deciding on salary increases which depends on the economic situation, it is a possibility that in spring 2016, there could be an increase prior to the 2017 presidential elections....
The impact of a 1% increase would cost an additional €1.8 billion euros according to the Court of Auditors.
"The Court of Auditors (in French Cour des comptes) is a quasi-judicial body of the French government charged with conducting financial and legislative audits of most public institutions and some private institutions, including the central Government, national public corporations, social security agencies (since 1950), and public services (since 1976).)" - source Wikipedia
Whereas the Third Punic War is coming to a close, we still believe that France warrants close monitoring given its impossibility to reform. Whereas Rome was having none of it with Carthage like Germany with Greece, the current indulgence displayed with French's lack of progress is reminiscent of Rome's attitude towards Numibia we think.
Moving on to our next point, which deals once more with credit in general and repo in particular, we think it is an important point to follow when it comes to assessing the dwindling "liquidity" picture.
- Beware of the Repo drought
"Repo Under Pressure — Repo markets are often considered the “oil that greases the financial markets”. The leverage ratio has become the binding constraint for many wholesale banks, which have pulled back from balance-sheet-intensive, low-return repo. We estimate gross repo at global wholesale and custody banks has declined by c11% over 2012-14, with European banks bearing the brunt (down 16%, Figure 1).
This broadly matches the c13% decline in total repo (Figure 3).
Velocity But No Depth — Although market ‘velocity’ (traded volume) has increased, market ‘depth’ has declined. For example, the market depth of 10yr UST is US$125m vs peak levels of US$500m in 2007, while the US Treasury market is nearly three-fold over the same period:
Increasing frequency of “flash crashes” and “air pockets” may be here to stay (see The liquidity paradox). Whilst the strongest declines in repo books have come from DBK, UBS and RBS, the likes of the major French banks, HSBC and Barclays look less efficient even if the latter has made significant progress over the past 3 years.
- Global wholesale and custody banks have reduced their gross repo books by c11% between end-2012 and end-2014. European banks’ repo outstandings fell by 16% vs US banks’ by 6%, mirroring the shift in FICC market share in favour of US banks.
- In USD-terms, DB has downsized most aggressively (c40% in USD or c34% EUR) and is looking to further optimise its Prime Finance business, per its recently announced Strategy 2020.
- The French banks are the notable exceptions amongst European banks. BNPP and SOGN in particular have grown their repo books by 41% and 13%, respectively, which has not necessarily translated to higher sales & trading revenue market share over the same period
The decline in US repo may also be driven by greater rationalisation by European banks, partly in response to stringent upcoming US FBO requirements. Repo or ’financial grease’ is likely to fall further & correspondingly, risks are likely to increase, in our view." - source Citi
"When it comes to Europe and in particular many points to cheap valuation in the European banking space. As we have argued in our conversation "The Pigou effect" in February this year, we have argued around the "japanification" process of Europe:
This "japanification process can be seen with the rapid disappearance of "positive" yields in the European Government space with German Bunds closing on the zero bound.
We have also long argued that regardless of QE, ZIRP and AQR, European banks would be facing continued deleveraging and that both bondholders and shareholders alike would in many instances get punished for their holdings. The reason is that European banks, in many cases still destroy value." - source Macronomics, April 2015
"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe."
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."
"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012.
Banks’ trading market share appears to be reasonably well correlated with repo, as highlighted in the above charts.
European banks have already lost market share in Sales & Trading, particularly in FICC but also in Equities. Although we do not discount the effects of re-pricing and optimisation, as banks continue to increase balance sheet efficiency, further reductions in repo (as well as in other products) may drive further consolidation." - Source Citi
"•A significant maturity mismatch exists between the short-term repos, over 70% of which mature in 5 days or less, and the long-term corporate bonds being financed. This could create risks as a withdrawal of repo funding can lead to the forced selling of collateral.
•Dealers post a significant amount of bank and other financial institution notes and bonds as collateral, exposing them to wrong way risk. About 29% of the corporate collateral that Fitch studied was from banks and other financial institutions.
•Liquidity is low in some of the bonds posted as collateral, as determined by trading frequency. Almost 30% of the bonds in the Fitch study traded on less than half of trading days in 2014." - source Fitch
- US Interest Rates and the US Corporate pensions gap
"What our "wealth effect" planners at the Fed should take into account is that rising stock prices may do relatively little to bolster the finances of corporate pension funds. Bonds matter because increases in projected distributions put even more pressure on yield hunting leading to an increase in duration risk exposure and high yield exposure. Volatility in funds’ asset value and relatively low interest rates have made managing pensions increasingly difficult for corporate managers, one of the solution they have found is shifting into bonds and away from stocks. Of course if the "magicians" at the Fed had respected the "Golden Mean" and prevented past and present excesses, funding gaps and overall pension pressures would have been avoided in the first place, but we are ranting again..." - source Macronomics
As indicated by CreditSights in their 29th of May 2013 Asset Allocation Trends - 2012 Pension Review:
"Key among the prevailing market realities in the post-financial crisis environment has been the extended period Quantitative Easing and the continuation of the Fed's prevailing zero interest rate policy and in the latest year's plan asset allocation data there was evidence of the effect this was having. As noted above, historically low interest rates have not only inflated the calculated liabilities of pension plans via the downward pressure on interest rates, they have also deflated assumed plan asset return rates as fixed income has increased as a percentage of plan assets." - source CreditSights.
"Economic growth in a society based on consumption requires credit. In order for credit to grow, or in other words banks to lend, collateral must be available. Since the 2007-2008 financial crisis, high quality collateral has slowly but surely become less available. If Central Banks continue to buy various government bonds (and US Treasuries are among those bonds), the available collateral will trend lower and the economy will stall, or worst spiral down as a credit crunch will occur at some point. So the FED has no other choice than to slow and even stop its QE if it wants the game to go on."
"What could curtail outflows from pension funds from Equities to Fixed Income could come from Updated Mortality Tables according to another CITI report from the 10th of April:
"The Society of Actuaries released drafts of proposed new mortality tables (RP- 2014) and mortality improvement scales (MP-2014) that provide the basis for determining pension liabilities. These are significant updates.-The new tables and schedules increase life expectancy at age 65 by 2.0 years for males (from 84.6 years to 86.6 years) and by 2.4 years for females (from 86.4 years to 88.8 years).-The previous set of mortality tables was published in 2000 (RP-2000), and the most widely used mortality improvement scale (Scale AA) dates back to 1995.We have estimates that longer life expectancies resulting from the updated mortality tables will increase the value of pension liabilities by 3% to 10% depending on the nature of the plan and prior assumptions.-If we take Aon Hewitt's estimate of a 7% increase in plan liabilities, that would reduce funded status by approximately 6%, or about half of the improvement experienced in 2013.-Plan durations should extend, but we do not have good estimates of how much.With lower funded statuses using the updated tables, it is likely that de-risking flows from equities to fixed income will be lower than they otherwise would have been under the previous mortality regime." - source CITI" - Macronomics, February 2015
- "Despite the S&P 500’s 11.4% gain in 2014, low interest rates and higher longevity tables pressured corporate pension and Other Post-Employment Benefits (OPEB) funding status in 2014. Notwithstanding the S&P 500 tripling off of its 2009 lows, corporate pension funds remain underfunded with a $389 billion underfunded status in 2014, still fairly close to 2012’s peak of $452 billion. Surprisingly, pension funding dropped to 81% of obligations at the end of 2014, down from 88% in 2013, but it was up from 77% in 2012.
- Funding status comparisons are not apples-to-apples in 2014. The Society of Actuaries’ update to private pension plan mortality tables (Retirement Plan-2014 “RP-2014”) led to a one-time significant increase in pension liabilities. While adoption of RP-2014 is at the discretion of the plan sponsor, US GAAP requires a “best estimate” for assumptions and the current tables were well accepted. Accordingly, this “one-time” hit to funded status aligned liabilities with the actuarial organization’s best estimates.
- Robust free cash flow, earnings and cash holdings alleviate some of the unease surrounding pension funding. Investors have been concerned about pension funding levels since 2007-08, but corporate cash flows provide comfort as companies have the ability to make large contributions to pension funds.
- After edging higher in 2013, the discount rate fell back to 3.92% in 2014, causing pension obligations to swell. The present value of corporate pension obligations is heavily influenced by interest rates and thus lower yields typically cause deterioration in funding status. While forecasts for higher yields in the future should lead to decreased concerns over the underfunded status of US pensions, OPEB accounts remain significantly underfunded as corporations attempt to shift these costs on to individuals. The value of OPEB underfunding at the end of 2014 grew to $196 billion vs. $181 billion in 2013.
- All ten S&P 500 sectors remain underfunded, with Energy continuing to be the least funded sector. Health Care and Industrials saw the largest drop in funding status amongst the sectors. As the overall S&P 500 pension funding status has declined, it is worth noting that only 21 companies within the S&P 500 were fully funded at year-end 2014, with nearly half of the overfunded companies coming from the Financials sector. Notably, the number of fully funded companies was down sharply from 51 companies in 2013.
- S&P 500 pension plans’ allocation to equities slid down to 44.5% in 2014 from 46.9% in 2013. The equity allocation increased most within the Consumer Discretionary and Utilities sectors in 2014, while Consumer Staples, Health Care, and Telecom Services saw a sharp pullback along with Industrials and Energy.
"Pension under-funding continues to be a major issue for S&P 500 constituents even after some of the intense investor scrutiny back in 2008 and 2009 softened to some extent in 2011 as markets improved. Nonetheless, very respectable equity market gains over the last six years have not substantially alleviated pension pressures.
The S&P 500 was up more than 201% at the end of 2014 since the low in 2009 but the aggregate underfunded status of $389 billion in December 2014 is now 26% higher than the $308 billion under-funding peak seen in December 2008 (see Figure 1).
While the funding status in 2013 improved by more than $225 billion versus 2012 alongside strengthening equity market performance and a higher discount rate, this trend reversed in 2014. Specifically, revised longevity tables and lower interest rates contributed to the reduction in 2014’s pension funding status." - source CITI
"Pension funds have been unwilling to allocate assets towards stocks after two major equity pullbacks in the past 15 years clobbered pension programs leaving allocators and consultants relatively risk averse with liability driven investing taking over the mindset. Moreover, current ERISA requirements call for companies to keep enough short-term cash and equivalents available to pay out current pension liabilities. Fortunately, corporate cash flow, free-cash flow, earnings and cash holdings are at or near record highs making required cash contributions to pension funds a much more manageable expense for S&P 500 constituents. Note that the funding status at 81.2% declined from the 87.9% level seen in 2013, which was the best reading in six years, but remained markedly better than 2012’s 77.3%, which was the weakest point since 1991." source CITI
"Meanwhile, persistently low interest rates on long-term bonds translate into lower discount rates for determining pension obligations, making the actuarial assumptions for the present value of these obligations appear larger than if discount rates were more in-line with the long-term average." - source CITIExactly, with updated mortality tables and continued ZIRP, US corporate pension plans are struggling in achieving their targeted rates.
"S&P 500 constituents’ pension plan allocations to equities edged down to 44.5% in 2014 from 46.9% in 2013, yet remain better than 2008’s 43.7% (see Figure 8) and far below 2007 levels of 61.3%.
However, much of the gains from 2008 would have been attributable to the increased value of equity assets within corporate pension portfolios relative to overall holdings rather than new equity-oriented allocations. Interestingly, flows returned to bond mutual funds, as released by ICI, which saw more than $43 billion flow into bond funds last year (and inflows of roughly $40 billion so far this year), US pension funds followed suit with fixed income allocation increasing by more than 3% (see Figure 9).
Moreover, defined benefit plan managers were net buyers of bonds in the last three quarters in 2014 but they have not started to buy equities just yet (see Figure 10).
The shift to equities increased most notably within the Consumer Discretionary and Utilities sectors in 2014, while Consumer Staples, Health Care, and Telecom Services saw a steep decline in allocation along with Industrials and Energy over the past year. Fascinatingly, the funded status deteriorated for every sector in 2014, with Health Care and Industrials highlighting the weakest sectors but once again, the actuarial adjustments may be playing a role here as well. The 2014 data compares unfavorably to 2013 data, where the funded status for all ten sectors improved. However, the key difference may have been the effect of the near 30% return for the S&P 500 in 2013 versus the more modest 11.4% gain experienced last year.
As Figure 11 shows, the greatest under-funding can be found in the Energy sector followed by Telecom Services and Materials as well as old-line Industrial/manufacturing equities that have accrued large pension obligations due to long-term operations. However, in order to fund pension obligations, these companies must begin to get pension expenses under control lest their products lose competitiveness versus international peers due to higher prices.
The expected pension return rate for S&P 500 constituents continued to decrease in 2014 (see Figure 12), sustaining the trend which has been in place since 2001.
We are not that surprised by the continued decrease in pension return rate expectations in 2014 given low yields from “safe” Treasury instruments which are looking riskier now." - source CITIThe law of diminishing returns it seems...Note as well the impact the Great Financial Crisis (GFC) has had on the funding status for Telecom Services. One word: brutal.
"Bear in mind that the stock market is crucial to the asset side of the pension story (see Figure 18).
Since we envision only modest mid-single digit gains from current levels through mid-2015, it will not close the gap entirely. The most significant impact on pensions will come when interest rates move higher, thus reducing the present value of future pension obligations, which will accelerate the timeline of fully funded status. With roughly $755.1 billion of pension assets in stocks currently (assuming the year-end 2014 figure appreciated by roughly 1% thus far in 2015 using the S&P 500 Index as a benchmark), there would need to be a more than 50% upward move in equity markets to close the $390 billion funding gap without an increase in discount rates to decrease the pension obligation. Thus, it will be more of a gradual move even as significant progress has been made in spite of investor anxiety over the pension issue from time to time." - source CITI
- Final chart: In High Grade, liquidity is coming fast at a premium
With Repo levels falling and liquidity concerns in conjunction with oversupply in the primary markets, US Investment Grade Credit as we posited in our last conversation "Eternal return" is fast becoming a "crowded" trade we think and we are not the only one given's Bank of America Merrill Lynch's take from their Situation Room note from the 15th of June entitled "Bonds 0 - CDS 1":
"Liquidity at a premium
With Fed liftoff fast approaching and increasing long term interest rates, liquidity conditions in the high grade corporate market are worsening. Our view remains that the unintended consequence of the intended consequence of financial regulation (the decline in dealer balance sheets, Figure 10) is that liquidity conditions in the market deteriorate.
However, so far this effect has been masked by inflows – hence the change as this year the credit market makes the transition from inflows to outflows. We are about to feel the true extent of the unintended consequence of financial regulation – namely the collapse in liquidity." - source Bank of America Merrill Lynch
"On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured.
In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out." - Macronomics, May 2015
"BlackRock is testing how risky its holdings are by running them through new worst-case scenarios that assume more volatility and varying correlation among asset classes. And strategists at JPMorgan Chase & Co., the world’s biggest debt underwriter, now see the need to calculate a “liquidity premium” for top-rated, longer-maturity government bonds in Europe, a new wrinkle for benchmark securities that are considered the safest assets available because of their deep markets.
The selloff is “questioning what is the right price given the current illiquidity in these asset classes,” said Nandini Srivastava, a global market strategist at JPMorgan in London. The difficulty in assessing the amount of risk “exacerbates the problem as you have investors on the sidelines thinking ‘Are these really the right prices and yield levels?’”
Yield volatility on 10-year bunds has climbed to nine-times its average during the past 15 years, giving traders a taste of the turbulence European Central Bank President Mario Draghi said June 3 they should get used to as the byproduct of record monetary stimulus.
A measure of 30-day volatility on bunds surged to 300 percent in May. It hadn’t gone above 100 before this year, in data compiled by Bloomberg going back to the middle of 2005. The market’s gyrations are being magnified by record-low yields: In the week of Draghi’s remarks, yields soared 0.36 percentage point, the biggest jump since 1998. The yield was at 0.82 percent on Monday at 1:30 p.m. in New York, up from a record of 0.049 percent on April 17.
“Investors should be pricing in more risk,” said Grant Peterkin, a money manager at Lombard Odier Investment Managers, which oversees 161 billion Swiss francs ($172 billion). “Given bonds steadily rallied for a long period of time, the low volatility suggested they were low risk, which potentially forced investors to buy more of them.”The danger is that this kind of instability may seep into other assets, he said. This could pressure companies as well as governments with rising borrowing costs. Yields on junk bonds around the world have collapsed to about 6.6 percent, versus their average of 9.7 percent since the end of 1997, according to Bank of America Merrill Lynch index data.
Citigroup strategists are recommending investors measure their vulnerability by placing more emphasis on duration -- a gauge of a bond’s sensitivity to interest-rate changes -- and the amount a country has borrowed, in addition to volatility, according to Alessandro Tentori, head of international rates strategy.
BlackRock is testing how its holdings would perform in scenarios like the dislocation in peripheral debt in 2011 and 2013’s taper tantrum. It’s also looking at how they’d react to sharp moves in the Standard & Poor’s 500 Index.
“It’s challenging, particularly when the correlations change, that’s the most difficult thing,” Thiel said." - Source Bloomberg
"The only good is knowledge, and the only evil is ignorance." - Herodotus, Greek historian