Thursday, 28 May 2015

Chart of the Day - S&P500 - Leverage and performance

"When you combine ignorance and leverage, you get some pretty interesting results." - Warren Buffett

This Exane BNP Paribas chart displaying the S&P 500 with the performance relative to the leverage summarizes clearly the current "releveraging" trend in the United States we think:
- Source Exane BNP Paribas

Some thoughts around the latest jumbo M&A deal of the day, namely the $37 billion Avago/Broadcom deal. Like in many recent deals in the cable industry or pharmaceutical industry, we note that the buyers who are Investment Grade/Low Investment Grade rated use current low rates/spreads to realize acquisitions which are financed by most part through significant debt issuance.

We have therefore the following "spicy" buybacks/M&A cocktail at the high of the cycle financed by debt. This is reminiscent of the M&A Telecommunications wave of 1999/2000 where buyers who had realized their acquisitions by paying mainly in shares (Vodafone) fared much better than those who used debt and leverage (France Telecom/Orange, Vivendi, etc.).

Our thoughts:
  1. If this trend continues, US Investment Grade credit will become less and less attractive from current levels of rates/spreads
  2. This might be a statement of the obvious but, this "releveraging" to finance buybacks/acquisitions is a "bullish" development from a "volatility" perspective at medium/long term. The correlation between credit spreads/equities is more likely to rise and "self-power" financial stress in a case of a "Macro" risk reversal.

"Fair play doesn't pertain in bargaining. What matters there is leverage." - Alan Rosenberg, American actor

Stay tuned! 

Saturday, 23 May 2015

Credit - Optimal bluffing

“It's funny. All you have to do is say something nobody understands and they'll do practically anything you want them to.” - J.D. Salinger, The Catcher in the Rye
Listening amusingly to the positive "spin" put by the French government on French economy smashing expectations, expanding by 0.6% in the first quarter following zero growth in the previous quarter, as well as learning about Benoit Coeuré from the ECB giving Hedge-Fund players an extra "edge" on the central bank's "front-loading" move, we reminded ourselves of  the "Optimal bluffing" strategy in the game card of poker for our chosen title analogy. David Sklansky, in his book The Theory of Poker, states "Mathematically, the optimal bluffing strategy is to bluff in such a way that the chances against your bluffing are identical to the pot odds your opponent is getting." 

We remembered the "whatever it takes" moment of our "Generous Gambler" aka Mario Draghi, which was no doubt a display of "Optimal bluffing" as it requires that the bluffs must be performed in such a manner that opponents cannot tell when a player is bluffing or not. To prevent bluffs from occurring in a predictable pattern, game theory suggests the use of a randomizing agent to determine whether to bluff. Of course, the continuation of the high stake Greek poker game, in our mind is yet another display of "Optimal bluffing". But, the on-going Greek saga is also a perfect illustration of our August 2012 conversation's analogy "Banker's Algorithm". In our computational reference previously used, "The Banker's algorithm" is run by the operating system (OS) whenever a process requests resources. The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state (one where deadlock could occur):
"When the system receives a request for resources, it runs the Banker's algorithm to determine if it is safe to grant the request. The algorithm is fairly straight forward once the distinction between safe and unsafe states is understood.
1. Can the request be granted? If not, the request is impossible and must either be denied or put on a waiting list
2. Assume that the request is granted
3. Is the new state safe?
-If so grant the request-If not, either deny the request or put it on a waiting list. Whether the system denies or postpones an impossible or unsafe request is a decision specific to the operating system."
Looking at the "modus operandi" of the European Commission, or put it simply it's OS, it appears that the Greek request will not be granted for the moment but we ramble again.

Rest assured that when it comes to applying "Optimal bluffing", the US Fed is as well an astute poker player as well in this high stake poker game with global investors, given their latest FOMC comment:
Perfect illustrations of "Optimal bluffing" given of the chances against the Fed's bluffing are identical to the pot odds the market is getting we think.

In this week's conversation we will look at the challenges facing the Euro area which are indeed more challenging that of the Japan of the 1990s. We will also look at the deterioration of all the indicators in the latest survey from French corporate treasurers, depicting yet another bleak picture for unemployment given the decay in the overall cash position which had been on an improving trend since 2011 but has now turned more negative overall. Finally, we will look at liquidity in US credit with clear signs of vacuum in unexpected places thanks to the effects of central banks meddling aka "Cushing's syndrome" and overmedication.

  • Euro-area is worse than the Japan of the 1990s.
  • The deterioration of the latest survey from French corporate treasurers warrants close monitoring
  • The liquidity in US credit markets shows clear signs of vacuum in unexpected places
  • Final note: Applying the US definition of U-6 under-employment shows Southern Europe is in the doldrums

  • Euro-area is worse than the Japan of the 1990s.
In our February 2015 conversation "The Pigou effect", we argued that government bonds had replaced private sector lending on European bank's balance sheet with the significant effect of "evergreening" bad loans in Europe à la Japan. We also touched recently in April 2015 in our conversation "The Secondguesser" on the unattractiveness of the European banking sector particularly Southern European banks due to extensive use of on DTAs (Deferred Tax Assets) in their capital base:
"When it comes to "capital", what matters therefore is the "quality" of the capital. In the case of some Spanish banks, the capital levels made up mostly by DTAs are not sufficient regardless of the AQR. Given in the case of Spain, these DTAs constitute a "credit" against the Spanish government and are exchangeable for Spanish public debt we doubt this marks the end of the banks/sovereign nexus" - source Macronomics, April 2015
In continuation to the Euro-area comparison to Japanese woes of the 1990s we read with interest Nomura's take from their 19th of May 2015 Economic Insight note entitled "Euro area outlook more challenging than that of Japan in the 1990s" showing that indeed the Euro-area failed to learn its fast enough its Japanese lessons compared to the United States:
"Contrary to the US, the euro area failed to draw early lessons from the Japanese experience as it continuously rejected the analogy. But what put the euro area in a more challenging situation to that of Japan is in our view related to factors which are more idiosyncratic to the region (Figure 2). 

Our analysis of how the euro area is faring in comparison to the challenges that Japan faced in the 1990s – which is presented in detail below – suggests that the magnitude of the shocks has been on average less pronounced than in the case of Japan (see Figure 1). 

The area where we find that the euro area has been particularly badly hit relative to Japan is the banking sector, where problems cumulated in a number of countries across the region have been worse than in Japan and the slow policy response in the euro area will likely be remembered as the most important failure to draw lessons from the Japanese crisis. Europe did have the lessons of Japan to draw upon which Japan never had. We believe that there are still major issues in the banking sector that need tackling in earnest if the region wants to turn the page decisively away from the NPL and DTA issues that continue to plague a large swathe of the sector.
On labour markets, while downward nominal rigidities might have prevented the region entering a deflationary spiral for now, the adjustment has taken place on the unemployment side with under-employment today in the region around 20%, twice as much as Japan and the US. On a multi-year basis this will exercise fundamental downward pressures on wage growth of an order of magnitude which we believe is still underestimated by policy makers (the so-called “pent-up” deflationary process as described by Akerlof et al and Daly et al). Some of the symptoms behind the breakdown in nominal rigidities that took place at the end of the 1990s in Japan are also present in the current labour market developments in the euro area, arguing that on the aspect of nominal wages, the jury is still out." - source Nomura
Of course the main reason we had a much vicious recession with an explosion in unemployment in Europe was the ill-fated decision of the EBA to impose banks to reach a core tier one level of 9% by June 2012 which led to an epic credit crunch in Southern Europe.

We have also long argued there was an on-going "japanification" process in Europe. This was as well highlighted by Nomura's report:
"The euro area’s major underperformance
There has been a lot of debate over the past few years on the potential Japanification of the euro area, but most observers and policymakers have concluded that the euro area was unlikely to face a repeat of Japan’s experience and that the region has a higher chance of lifting nominal growth than Japan did. The ECB in particular has provided reasons for thinking that the euro area is in a different place than Japan was in the 1990s and that, while Japan provided some important lessons, the euro area was unlikely to face a similar outturn to that of Japan1.
As shown in Figure 3, euro area GDP was about 2% below that of Q1 2008 at the end of 2014 while Japan was down less than 1%.

Also, when looking at Japanese performance in the seven years following its own banking crisis, which reached its peak in 1997, output was 3% higher than at the beginning of the period and so grew by 5 percentage points more than the euro area over a comparable period (see again Figure 3).
The underperformance is also apparent when looking at other economic measures over different time periods. Figure 4 provides a comparison of productivity growth in Japan and the Big-4 euro area countries as measured by GDP per capita. With the exception of the 1990s and of Germany, productivity growth has been higher in Japan since the beginning of the 2000s.

Consumption per capita (in real terms, see Figure 5) in Japan rose on average by 2.6% per year between 1970 and 2013, higher than any of the Big-4 euro area countries.

Since 2009, Japanese consumption per capita has increased by 1% per year on average in line with the German consumer and higher than the other three countries in the Big-4. The euro area has outperformed Japan to date on nominal variables such as nominal GDP or nominal wage growth, but that is no reason for optimism in our view.
Based on the recent underperformance of the euro area, we believe the question should not be about the risks of Japanification but about whether the euro area can return to a sustainable path of growth that would put it at least on a par with Japan." - source Nomura
Exactly, and we do not think the euro area can return to a sustainable path of growth particularly when one looks at France and the lack of structural reforms recently highlighted by the IMF. 

In earnest, do not expect any major changes given French President François Hollande is already on the campaign trail for 2017. 

France remains in our views the new barometer of risk for core Europe. Back in August 2014 in our conversation "Thermocline - What lies beneath", we discussed the "Optimal bluffing" of the French government in its forecasting skills:
"French Minister Sapin is talking about budget deficit being above 3.8% in 2014, rest assured it will be North of 4%. If you have 0.5% of growth it should equate to 4.3%" - Macronomics, August 2012
For 2014, the budget deficit for France was in fact 4% but debt to GDP increased from 92.3% to 95.6%. We were not that far off in our estimate. The issue in the game of poker when a player bluffs too frequently like French Minister of Finance Michel Sapin, at Macronomics we just had to "snap off" his bluffs by re-raising our budget deficit estimate.

A symptom of European woes has been the very weak aggregate demand caused by the European crisis and the credit crunch triggered by the EBA in 2012 which accelerated the deleveraging of European banks and the lack of credit transmission to the real economy. This can be ascertained by the different trajectory taken between the United States and Europe also highlighted in Nomura's report:
"Leaving aside the Japanese comparison, it is also worth emphasising the extraordinarily weak performance of final demand (as measured by real consumer spending + nonresidential capex) in the euro area both relative to its own past (Figure 6) and relative to the US (Figure 7).
Assuming that euro area private sector demand picks up from now on and follows an uninterrupted recovery path comparable to the one experienced by the US over the past six years (i.e. with the growth rate 16% higher than its previous trend rate), it would take seven years for the euro area to resorb part of the private sector gap that has built up since the onset of the crisis and shrink it to 7%. Even assuming an extraordinary deterioration on the supply side, it is hard not to believe that there is a substantial amount of slack in that economy." - source Nomura
In our conversation "The Secondguesser" we also highlighted the difference between Europe and the US:
"In the US QE was more effective for a simple reason: stocks vs flows as highlighted earlier. The problems facing Europe and Japan are driven by a demographic not financial cycle. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment." - source Macronomics
After all, credit growth is a stock variable and domestic demand is a flow variable. We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe:
"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.
Of course, the availability of credit is only beginning to be restored in Peripheral Europe and has been encouraged by the ECB's recent QE but it is by no means dealing with the stock on Southern European banks impaired balance sheets!

Also, private demand due to high unemployment levels continue to weigh significantly in the euro area private sector as indicated by our musings from our November conversation "Chekhov's gun":
"If domestic demand is indeed a flow variable, the big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.
QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.
In textbook macroeconomics, an increase in AD can be triggered by increased consumption. In the mind of our "Generous Gamblers" (aka central bankers) an increase in consumer wealth (higher house prices, higher value of shares, the famous "wealth effect") should lead to a rise in AD.
Alternatively an increase in AD can be triggered by increased investment, given lower interest rates have made borrowing for investment cheaper, but this has not led to increase capacity or CAPEX investments which would increase economic growth thanks to increasing demand. On the contrary, lower interest rates have led to buybacks financed by cheap debt and speculation on a grand scale.
 In relation to Europe, the decrease in imports and lower GDP means consumer have indeed less money to spend. We cannot see how QE in Europe on its own can offset the deflationary forces at play." - source Macronomics, November 2014 
Put it simply, credit growth is a stock variable and domestic demand is a flow variable. Central-bank induced liquidity is pointless without the real economy borrowing and the issue at the heart of the problem is that most Southern European banks are in fact "capital constrained" and plagued by NPLs (Nonperforming loans) and artificially boosted capital by DTAs.

When it comes to the comparison with Japan in the 1990s, Nomura's report makes an important point relating to the size of the problem which has not been dealt with in Europe:
"Figure 14 shows that banks’ conditions in many euro area countries are significantly worse than at the worst point of the Japanese banking crisis between 1997 and 2002, when NPLs peaked at 8.4%.

In particular, NPLs in Cyprus, Greece and Ireland are above 20%, even higher than Japan’s NPLs subject to self-assessment and after the implementation of bad banks in some of these countries. More worryingly, NPLs in Italy and Spain are above the Japanese levels.
The IMF finds in its latest GFSR that banks with a higher ratio of non-performing loans have tended to lend less: for 60 euro area banks over 2010-13, those with the lowest NPLs (1st quantile) expanded their loan supply by six times the national average growth rate, while the credit of those with the highest NPLs (the 4th quantile) contracted at the pace of four times the national average growth rate. This negative relationship is believed to arise because the non-performing assets decrease banks’ profitability, use more capital (to absorb the bad assets), and damp banks’ intention to lend to borrowers with borderline credit quality.
DTA might be another potential risk to the banking sector
Bank equity, or net asset value (NAV), always acts as the first line to defend the financial entity in an adverse event. However, not all the equity is of the same quality as some can quickly lose their value in face of negative shocks and pose significant risks to the financial system. One example is a bank’s “goodwill”. Another important asset whose quality is generally recognised of being of a lower standard is the “deferred tax assets” (DTAs).
A deferred tax asset is an asset used to reduce the amount of tax due in the future. It mostly arises when a bank makes losses, for example by writing off bad loans. The losses, although processed as expenses in corporate accounting, are not tax deductible under tax law. As such, an “overpayment” of taxes emerges. It is then booked under deferred tax assets in the assets section, which correspondingly requires an increase in the bank’s equity. In theory, DTAs can reduce banks’ liability in the future but this only materialises if the bank can make enough taxable profits. That said, for banks that overestimate future earnings, their equity is inclined to be overvalued by DTAs.
This was the case for Japan back in the late 1990s: in 1998 when banks’ other sources of regulatory capital had been depleted, Japan introduced the rule of deferred tax assets and allowed them to be accounted for as regulatory capital. DTAs then became an important source of regulatory capital for Japanese banks. For example, in 2002 the major banks’ DTAs totalled 60% of bank equity (Skinner, 2008), rising quickly from 45% in 2001 and from 29% in 1998. This increase in weak forms of capital is thought to have prolonged the financial crisis (Skinner, 2008).
In the euro area, currently the CRR (Credit Requirements Regulation) allows competent authorities to set the percentage for the deduction of DTAs relying on future profitability at 10% in 2015 for DTAs that existed before 1 January 2014. The deduction rate will increase by 10% each year until 2023. For DTAs created after 1 January 2014 and relying on future profitability, a phase-in approach is applied, i.e. minimum of 20% in 2014, 40% in 2015, 60% in 2016 and 80% in 2017 and 100% in 2018.
For the moment, the ratios of net DTAs to bank equity in some countries are at similarly high levels as in Japan back in 2001-02 (Figure 15).

In particular, the ratio in Greece is higher than the peak level in Japan and that in Portugal is above Japan’s 2001 level. Although for Spain and Italy DTAs have a lower share in total bank equity, 30% is still big enough to pose significant risks in adverse scenarios, in our view." - source Nomura
Exactly! DTA amounts to us as "dubious" capital. As we have shown in our conversation "The Secondguesser" many Southern European banks are still capital impaired  and their banks' capital basis are made up for a large part of Deferred Tax Assets (DTAs).

  • The deterioration of the latest survey from French corporate treasurers warrants close monitoring
One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest survey published on the 18th of May points to a deterioration in the Terms of Payments, which indicates that the improving trend since mid 2012 has turned decisively negative:

The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in receiving payments from your clients tend to fall, remain stable or rise?

Delays in "Terms of Payment" as indicated in their May survey have reported an increase by corporate treasurers. Overall +18% of corporate treasurers reported an increase compared to the previous month (+22.8%), bringing it back to the level reached in October 2014 (17.9%). The record in 2008 was 40%.

Overall, according to the same monthly survey from the AFTE, large French corporate treasurers indicated that they are still facing an increase in delays in getting paid by their clients. It is therefore not a surprise to see that the overall cash position of French Corporate Treasurers which had been on an improving trend since 2011 has now turned more negative overall according to the survey:
The monthly question asked to French Corporate Treasurers is as follows:
"Is your overall cash position compared to last month falling, remains stable or rising?"
Whereas the balance for positive opinions was 17.9% in November 2014 and still at 6.3% in January 2015, February saw it dip to -5.2% and March's came at -13%, April at -0.5% but provisional May came at -9.5%.

We will restate what we mentioned back in our March 2015 conversation "Zugzwang":
"This warrants significant monitoring in the coming months we think from a "corporate monitoring health" perspective."
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.

Furthermore, in our March conversation, we indicated the following:
"While the international scene is watching with caution the rise of the French National Front, the political story, we think is the slow dislocation of the unity of the left." 
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. The slow dislocation of the unity of the left is currently being tested given there was a significant demonstration of teachers in France this week. French teachers’ unions, which routinely protest any changes, complained about reforms relating to secondary education. France’s 840,000 teachers have traditionally been a strong base of support for President François Hollande, but the proposed reform has turned many against him and his ruling Socialists. Furthermore the growing rift has been increasing given the proposed reforms where pushed through a decree without consultation during the night, following the day of the demonstration. Given President François Hollande is already on the campaign trail for 2017, it will be interesting to see most of structural reforms requested by the IMF put on the sideline.

Given the on-going negative trend from the AFTE surveys, it will be interesting to both monitor the micro data from a corporate health perspective as well as the evolution of the political mood in France and the lack of progress in the unemployment front in the coming months.

  • The liquidity in US credit shows clear signs of vacuum in unexpected places
We share the growing concerns of the lack of liquidity in the fixed income space. On numerous occasions we have indicated our uneasiness with the "yield hunt" and dwindling liquidity in the secondary space thanks to banks deleveraging as well as mounting regulatory pressure on market makers.

A good illustration for the hunt for yield has been happening in the high yielding space such as MLPs, REITS, dividend funds and High Yield as displayed in Bank of America Merrill Lynch's chart from their Thundering Word note from the 17th of May entitled "The Twilight Zone":
"High Yield
Investors are positioned heavily in high yield, high dividend yield and high PE strategies (Chart 15). The quest for high yield (relentless multi-year inflows to dividend funds, MLPs, REITS & HY bonds - $415bn inflows since Mar’09) remains the biggest Achilles’ Heel for positioning, in our view." - source Bank of America Merrill Lynch
What we find of interest from a "Twilight Zone" perspective is that when it comes to the Fixed Income space, the liquidity deterioration is not what it seems and has not been where one would have expected it to be. On this specific matter we read with interest Deutsche Bank's US Credit Strategy note from the 20th of May entitled "Signs of Liquidity Vacuum in Unexpected places":
"Liquidity deterioration has not been uniform across fixed income
While liquidity has deteriorated in all parts of fixed income, the extent of such deterioration has not been uniform, and this represents another area where consensus view is often misguided, in our opinion. Figures 1 and 2 below present trading volumes in HY, IG, and Treasury markets, expressed in a percent of market size terms. 

The scale here is showing us the proportion of each respective market that changes hands on a daily basis, measured as a trailing 12-month average value. In other words, HY traded 0.7% of its market size on an average day in the past year; IG traded 0.4%, and Treasuries traded 4.0%. The degree of deterioration in these metrics since their pre-crisis levels amounted to a 30% loss of trading depth in HY, 50% in IG, and 70% in Treasuries! We are doubtful that most investors realize the presence of this distribution in that the higher quality segments of the fixed income universe have in fact been impacted by liquidity withdrawal to a greater extent. Treasuries still maintain their position as the most liquid set of securities in the world; they are just not nearly as liquid as they used to be pre-crisis.
This last point is critical to properly understanding the current liquidity environment and its implications. While most investors perceive HY liquidity as being inherently poor, and drying up even more around turning points in the market, this in fact has been the normal state of affairs in our asset class. Few investors realize that IG has become a more illiquid portion of the credit universe, even though somewhat misleadingly a given IG cusip usually trades more deeply than a given HY one.Deutsche Bank Securities Inc. Page 3
These findings have significant implications as to how investors should be positioning themselves to take advantage of liquidity vacuum points that undoubtedly await us in the future. Instead of watching HY market for the signs of cracks, they should be spending more time monitoring higher quality portions of the market going all the way up to Treasuries. The experience of last year’s October 15 is very important in this respect in that it serves as a preview of what a liquidity vacuum experience is likely to feel like. The 10yr Treasury yield experienced a seven-sigma intraday move during that session, triggered by temporarily thin volume at some point, and exacerbated by dealers pulling a plug on their electronic trading systems on early signs of volatility. While that particular experience has not registered as much in credit, given its extremely short duration measured in minutes, it is reasonable to assume that it could have more pronounced implications in the future, if it lasts longer than that or repeats itself more frequently.
Furthermore, and we cannot overemphasize the importance of this point, most investors tend to think about the potential impact from reduced liquidity in the context of Fed’s raising of short-term rates and a resulting back up in longer-term Treasury yields. The key lesson from October 15 however is that Treasury yields gapped down, and not up, in seven sigma moves in a perfect example that illiquidity-driven volatility could happen on lower rates as well. We could not have come up with a better example than this to drive home our most important point: it is a point of debate how far and how fast the Fed is going to be able to raise short-term rates, given the prevailing weak macro environment and a potential for negative side-effects of higher volatility. But volatility itself could, and most likely will, materialize from their attempt of doing so, even if a lesson from this experience is that six-plus years of zero rates would make it incredibly difficult to raise rates in early stages of a liftoff without disrupting the market. The point is that failure to raise rates materially does not by itself protect us from higher volatility impacting the Treasury market first and IG/HY market next. In fact such a failure would probably mean that volatility was just too high for the market and the economy to be able to cope with it." - source Deutsche Bank
In this high stake poker game with investors, we hope the Fed will be able to play its "Optimal bluffing" strategy given its bloated balanced sheet and reduced liquidity in the Treasury market.

  • Final note: Applying the US definition of U-6 under-employment shows Southern Europe is in the doldrums

Whereas many pundits are expecting a gradual recovery in Europe thanks to the ECB's QE support, we beg to differ and as we indicated previously, in our conversation "Chekhov's gun" back in November 2014:
Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).
“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)
When it comes to the damages inflicted by the "credit crunch" in Europe, again as a final point, we would like to point out Nomura's interesting replication of the US BLS methodology to construct broader measures of unemployment in the euro area focusing on the so-called U-6 from their 19th of May 2015 Economic Insight note entitled "Euro area outlook more challenging than that of Japan in the 1990s":

"We also believe that the level of so-called labour under-utilisation, a concept which has recently attracted a large amount of attention in the US, is in the euro area at levels that no advanced economy has seen since the great depression. The rising share of nonregular contracts has been a feature of the Japanese (see Kuroda & Yamamoto 2013) and German (see Toshihiko, 2013) labour markets. This structural change is generally understood as having helped diminish the bargaining power of wage-setters and thus to the surprisingly low wage dynamics in those economies.
Measures of labour under-utilisation in the euro area are not readily available, which is probably the reason why there so little attention has been devoted to this topic.
We have replicated the US BLS methodology to construct broader measures of unemployment in the euro area focusing on the so-called U-6 definition of unemployment (a measure that includes people marginally attached to the labour force, part-time employment for economic reasons, and unemployed).
The results shown in Figure 23 indicate that the euro area U-6 rate averaged slightly above 20% in 2013 (the latest year we have) compared with 13.6% in the US. The last reading for the US which is available on a monthly frequency was 10.9% in March 2015, down from its March 2010 cyclical peak of 17.1%.
The picture across the region is extraordinarily varied, with the German U-6 already below 10% in 2013 and below its 2002-04 average and countries like Spain, Greece and Italy with U-6 levels at or above 30% and more than twice their 2002-04 averages." - source Nomura
QE on its own, rest assured will not cure European woes and particularly the difficult employment situation in Southern Europe, no matter how "Optimal" the ECB thinks it is "bluffing".
"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

Stay tuned! 

Thursday, 14 May 2015

Credit - Cushing's syndrome

"Ninety-nine percent of the people in the world are fools and the rest of us are in great danger of contagion." - Thornton Wilder, American novelist
Looking at the dizzying volatility in the government bond space and in continuation of our recent theme dealing with "alkaloids", we remembered Cushing's syndrome when choosing our title analogy, also known as "hypercortisolism" which is a collection of signs and symptoms due to prolonged exposure to cortisol (or QEs). Cushing's syndrome is generally associated with rapid weight gain (bond prices), moodiness, irritability or depression to name a few. The most common cause of Cushing's syndrome is "exogenous" administration of glucortocoides prescribed by a health practitioner to treat other diseases such as asthma and rheumatoid arthritis. In our "market case", one could argue that the most common cause of the sudden rise in government bond yields could be linked to the exogenous administration of "QEs" prescribed by central bankers in order to treat weak aggregate demand (AD). Strictly, Cushing's syndrome refers to excess cortisol of any etiology (as syndrome means a group of symptoms). 

When it comes to QE and its impact on asset prices, we have largely discussed its effect in our September 2013 conversation "The Cantillon Effects":

"Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with an increasing "exogenous" (central bank) money supply.

We also commented at the time about the increase of money supply on the art market as posited by our friend Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":
"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.
In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.
Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

It is was therefore not a surprise for us  to hear that yet another record in the art market has been broken with a Picasso painting "Les femmes d'Alger" selling for $179.4 million, smashing the previous record of Francis Bacon's triptych "Three Studies of Lucian Freud," which sold for $142.4 million at Christie's in November 2013.

The only "rational" explanation coming from the impressive surge in asset prices (stocks, art, classic cars, etc.) has been "Cushing's syndrome aka monetary base expansion and the belief that indeed, our central bankers are "Gods" which by the way is a clear application of "Pascal's Wager".

In the classical equation of exchange, MV = PQ, also known as the quantity theory of money. we have: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.
-Endogenous money, PQ => MV (Hume, Wicksell, Marx)
-Exogenous money, MV => PQ (Keynes, Monetarist)

Of course, "Cushing's syndrome" is "exogenous" thanks to our Keynesian/Monetarist central bankers practitioners but we ramble again. 

In this week's conversation we will look at the gyrations in the government bond markets and the worrying trend of rising "positive correlations" courtesy of central banks meddling, or put it bluntly "excess" medication. 

  • "Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations"
  • The interest of balanced fund management in a ZIRP world.
  • Credit CDS market is under-pricing volatility in the rates space
  • "Overmedication" has created an abnormally long credit cycle
  • Final note: True health of the US economy - Where is the CAPEX recovery?

  • "Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations"
There is a growing systemic risk posed by rising "positive correlations". 

Since the GFC (Great Financial Crisis), as indicated by the IMF in their latest Financial Stability report, correlations have been getting more positive which, is a cause for concern:
- source IMF, April 2015
This "overmedication" thanks to central banks meddling with interest rates level is leading to what we are seeing in terms of volatility and "positive correlations", where the only "safe haven" left it seems, is cash given than in the latest market turmoils, bond prices and equities are all moving in concert.

"Positive Correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:
"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 
Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson

We could not agree more with the above. Regardless of their "overstated" godly status, central bankers are still at the mercy of macro factors and credit (hence the title of our blog). When it comes to rising risk and the threat of "positive correlations" and Cushing's syndrome we read with interest Nomura European Strategy note from the 6th of May 2015 entitled "At the mercy of macro":
  • "The correlation between macro variables (eg, bund yields, FX and oil) and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. This is the first time this has happened since 2006 and the difference between the two correlations is the largest than at any point in the post 2000 era.
  • The average pairwise correlation between stocks in Europe is close to its post Lehman low. However, we do not think that this heralds the return to some kind of stock-picking nirvana (if such a thing exists).
  • The rapid move up in bund yields and EUR-USD reversals of recent weeks has been felt in some sharp factor reversals, most notably an underperformance of Momentum both across the market and within sectors.
  • We have moved away from a world where changes in macro variables cause short-term rallies and corrections in the overall index level, to a situation where the same macro variables are the driving force for groups of stocks within the market. So understanding the macro risks is no less important. This perhaps represents a market where the main focus is on the nature of the recovery and the timing and type of earnings growth rather than macro developments prompting a continuous existential crisis as we have seen in recent years. We take this as a positive development." - source Nomura
No offense to Nomura but, we do not take it at all as a "positive development". On the contrary, we think it is representative of the excess of "alkaloids" use leading to Cushing's syndrome and rising instability as posited by the great Hyman Minsky. From the same Nomura note:
"In Fig 1 we show the absolute correlation of the European (ex UK) market with a range of macro variables (bund yields, EUR-USD exchange rate and oil); we also show the absolute average pairwise correlation of long-short factors with the same macro variables (using Momentum, Value, Growth and Risk as our factor set). It is unsurprising that the market-macro correlation is usually the stronger of the two. However, now the factor-macro correlation is stronger than the market-macro correlation for the first time since 3Q06.
Moreover, the degree to which the factor-macro correlation exceeds market factor correlation is greater than at any point in the post 2000 era. We show the spread between the factor-macro and market-macro correlation in Figure 2.
Although it is not shown here we also note that the correlation between factors and these macro variables is greater than the correlation between sectors and macro variables at present." - source Nomura

In August 2013 in our conversation "Alive and Kicking" we argued the following:
For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 
However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 
Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

What we are currently seeing is a repricing of bond volatility which had been "anesthetized" by central bankers leading to Cushing's syndrome. Central bankers meddling with interest rates levels have led investors to get out of their comfort zone and extend both their risk exposure and duration, taking the repressed volatility regime as an empirical factor in their VaR related allocation risk process. Now they are rediscovering in the ongoing turmoil that, yes indeed long duration exposure is more volatile than shorter ones. They are also rediscovering "convexity" with artificially repressed yields. They are being significantly punished the more exposed to "credit" duration they are. When looking at the average maturity of new issues in the Euro Investment Grade Credit market one can see it has jumped to 10.4 years in March as displayed by Bank of America Merrill Lynch in their European Credit Strategist note of the 22nd of April entitled "The Time for Duration":

- source Bank of America Merrill Lynch
Obviously, flow wise, Investment Grade Credit long term exposure has seen less significant inflows since January 2012 than short term fund as displayed in Bank of America Merrill Lynch Follow the Flow graph from their 8th of May note entitled "the wrath of the Bund" but, nevertheless, overall many pundits have been playing the "beta" game of increasing duration exposure courtesy of new issues and the hunt for yield:
- source Bank of America Merrill Lynch
This brings us to our second point, the interest of balanced fund management in a ZIRP world.

  • The interest of balanced fund management in a ZIRP world.
We remind ourselves when it comes to our musings from our previous conversation entitled "Misstra Know-it-all" that, when it comes to undoing the great "destabilizing" work from Ben Bernanke (aka "The Departed"), rising volatility would lead to re-calibration of risk exposure:
"Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse."

The issue with so many pundits following "similar strategies" and chasing the "same assets" in a growing "illiquid" fixed income world is a Cushing's syndrome impact. Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain.

The growing issue with VaR (Value at risk) and bond volatility is that it has risen sharply from a risk management perspective. This could lead to a sell-fulfilling "sell-off" prophecy of having too many pundits looking for the exit as the same time, namely "de-risking".

To that effect and in continuation to Martin Hutchinson's LTCM reference, we would like to repeat the quote used in the conversation "The Unbearable Lightness of Credit":
Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital
Today investors face the same "optimism bias" namely that they overstate their ability to exit. We share our concerns with Matt King from CITI which was quoted in a recent post on FT Alphaville entitled "Der Bundshock, revisited" on the 11th of May:
"To date, the air pockets and flash crashes represent little more than a curiosity, having mostly been resolved very quickly, and having had little or no obvious feed- through to longer-term market dynamics, never mind to the real economy. But we think ignoring them would be a mistake. Each has occurred against a largely benign economic backdrop, with little by way of a fundamental driver. And yet with each one, investors’ nervousness about the risk of illiquidity is likely to have been reinforced. When the time comes that investors do see a fundamental reason all to sell – most obviously because they start to doubt the extent of central banks’ support – their desire to be first through the exit is liable to be even greater."- source CITI Matt King via FT Alphaville.
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. On this subject we read with interest Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net":
"Balanced fund managers are the “stars” of this market cycle as they exhibit excellent performances. We would not say that they are smarter than other fund managers, but would like to remind rather how lucky they have been to have lived in an investable universe of two asset classes that have never stopped rising since 2009. Below, we show the equity and government bonds asset classes for France since 1992.
In theory in period of economic recovery/expansion, the ratio of equities to bonds tends to rise as equities are bought for their leverage on this economic growth and bonds are sold due to increasing expectations of higher interest rates. From this perspective, this cycle is – as we all know – unusual.
Balanced portfolio management, also named diversified portfolio management, comes from the mantra “do not put all your eggs in one basket”. Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle.
The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle. Meanwhile, on the equity market, the high economic uncertainty has maintained a high level of preference for investors in terms of quality-defensive stocks. We summarize these two regimes on the chart below:
The correlation between bonds and equities, which was rather negative in “normal times”, has become neutral or slightly positive in this market cycle. So diversified portfolio managers have dealt with two asset classes whose market’s behaviour has been quite similar. The diversification argument has lost some of its power, but up to now no asset manager has sought reason for complaint as they have made a lot of money. In fact, they have enjoyed the biggest “benchmark bull market” of their life, explaining why they are quite happy these days. 
There is a limit to the appreciation of any financial assets. We do not know the level for equities, but for bonds, when the coupon they will detach for the next 10 years is around 0, we can say without taking too much risk that their potential to increase further is not very high. This is not a crazy statement that we are making. As we can see it has become a consensus on financial markets. We show below the implicit probability of a 3%+ rise of 10y government bonds in Germany within 6 months extracted from the derivatives markets and it is historically low.
 At the same time, the probability of seeing the equity market declining by 10% in the next 6 months has remained more or less the same around 25%.
For all these reasons, it becomes obvious that a diversified PM should expect a far less effective bond buffer in case of an equity correction. The “raison d’être” of the balanced fund management is fading and should therefore reinvent itself, trying to find what kind of assets could truly reduce the volatility of a 50/50 equity/bond portfolio in case of an accident on the equity market.
Many investors are ready to return to gold these days following its significant underperformance and its theoretical capacity to safely navigate through periods of uncertainty. We have previously discussed gold investment and remain convinced that gold is a good hedge against a US$-centric crisis, but not against a non-US economy related crisis.
Furthermore, investors have to understand that gold is above all else a commodity. Its underperformance over the past months is not only due to factors affecting the price of gold, but is also due to factors affecting the whole commodity asset class. Thus, we have to look at the relative performance of gold against other commodities. This is what we show on the following chart and the message appears very different. The ratio of gold prices over commodity prices is trading at an all-time high.

We do not think that gold can be a genuine hedge against a rising risk aversion on the equity market. Until the Fed implements QE4, gold prices will remain capped." - source Louis Capital Markets.
For us gold is not an inflation hedge, it is an inflation signal; it is a hedge against the end of the dollar’s status as a reserve currency, a deep out-of-the-money put against the US currency as a whole.

  • Credit CDS market is under-pricing volatility in the rates space
On numerous occasions we looked at the CDS market as proxy of the built up in instability in the financial markets, the widening in credit spreads in 2007 and 2011 were good early warning signals of the rising tension in the markets. In similar fashion credit spreads widened in sympathy with the 2013 taper tantrum. What we find of interest is while Cushing's syndrome has indeed been as of late reflected in the acute volatility in government bond yields, so far the reaction in the CDS credit space has been so far fairly muted in Europe in the Itraxx Main 5 year CDS index, a proxy for investment grade credit.

On this muted volatility we read with interest Bank of America Merrill Lynch's Credit Derivatives Wrap note from the 13th of May entitled "Hedging rates volatility":
"Credit CDS market under-pricing rising rates volatility
We think the CDS market is currently under-pricing the high levels of volatility currently being seen in the rates space. iTraxx Main has widened 6% since rate volatility started moving higher (April-16th). But looking back at the 2013 taper tantrum in the US, we can see that CDX.IG had already widened by almost 40% at this point (chart 1). 

Admittedly the drivers were different (end of QE in US, a host of fundamental and technical reasons in Europe), but nonetheless iTraxx Main appears tight relative to rates volatility.
What’s the downside? We think iTraxx Main could potentially reach 80bp should CDS better reflect the current level of rates volatility. Risks to spread widening are also clear should Greece volatility linger. Yet, moderate widening remain our base case amid the powerful backdrop of ECB QE." - source Bank of America Merrill Lynch.
The Cushing's syndrome effect on credit spreads thanks to major central banks meddling has indeed "neutered" the CDS market in its role as an early indicator of systemic risks during the sovereign crisis as described by Bank of America Merrill Lynch:
"Is the CDS market too complacent over the underlying risks or is the ECB backstop simply too strong? It seems both…
Once upon a time, the CDS market mirrored the rise of systemic risks. iTraxx Main used to be well correlated to moves in Greek stocks (ASE index). This was the case up until mid-2014.
However since then, even though Greek stocks continued to trade lower, iTraxx Main kept moving tighter, on anticipation of an ECB QE moment.
Actually, when the ECB announced the QE program, spreads broke the long-standing resistance point of 55bp. Despite risks around Greece, spreads have not repriced wider.
Clearly the CDS market is pricing little of the potential risks around Greece, simply on the back of the backstop provided by the ECB QE.
Historically, index and single-name CDS has been the liquid way to protect cash portfolios. In periods of significant stress, the CDS/cash basis would have widened, with the CDS market pricing-in more risk than the cash market. That would simply reflect CDS market insurance premium.
However, with the ECB in the driving seat, CDS did not decouple to cash spreads, keeping the CDS/cash basis close to historical lows, and below long term averages.
The CDS market is also underpricing the rising volatility in the rates market. 10y yields move higher; rates volatility rise; credit spreads on an upward trend. This is a familiar pattern for credit investors who saw CDX.IG selling off during rising treasuries volatility in May’13.
This time around European bond markets are in the driving seat. While European CDS indices (iTraxx Main) had initially embarked on an identical market reaction to that of CDX.IG back in May’13, they recently have outperformed.
At these levels credit spreads are underpricing the rising volatility in the bond market. We expect European CDS indices to track closer the move higher in rates volatility. iTraxx Main could potentially reach 80bp should we have a repetition of the previous patterns seen back in May’13. (see chart 1 above)
Nowadays, credit spreads seem to be short-term volatile and long-term range-bound. Spreads are volatile within relatively tight ranges, simply because of the absence of a strong catalyst. We think this is more apparent recently, when looking at the intra-day volatility in the CDS market. This has been mainly driven by headlines around Greece, on the 14th to 17th of April, (same in December last year), but also the strong bund moves recently.

However, we increasingly think that these ranges will break in the near-term and most likely on the downside. 

Risks around Greece still remain to the downside, till an agreement is reached, and thus spreads could back out further. Additionally, the recent spike in rates volatility will put an upward pressure on the CDS market, we think.
Undoubtedly, the credit index vol market has been the sole pocket in the credit space that has been tracking risks around Greece. Over the last 4 years credit implied vols have been tracking moves in the Greek equity market surprisingly closely, in contrast to the underlying credit spread levels.
- source Bank of America Merrill Lynch

Rising positive correlations and dwindling liquidity in the credit market making space in both cash and CDS, with the major withdrawal of Deutsche Bank in single name CDS trading will no doubt weight in the future in the ability for fund managers to protect their cash positions and mitigate rapid redemptions in their funds rest assured. This is the result of the"exogenous" administration of liquidity as posited by our Cushing's syndrome analogy.

  • "Overmedication" has created an abnormally long credit cycle
What credit investors forget is that in a deflationary environment, as we argued in November 2011 in a low yield environment, defaults tend to spike and it should be normally be your concern credit wise (in relation to upcoming defaults) for High Yield. But, due to the "overmedication" thanks to our central bankers "market health" practitioners, the long credit cycle has indeed been extended into "overtime".

Investment Grade credit is a more interest rate volatility sensitive asset, High Yield is a more default sensitive asset. What warrant caution for both we think are, the risk of rising interest rates for the former as per our previous bullet point and the risk of rising default rates for the latter. For more on credit returns we suggest reading our March 2013guest post from our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns" as they indicated the following in their very interesting previous note:
"Credit investors have a very weak predictive power on future default rates. Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates. " - source Rcube

On the subject of "Overmedication", for us it means that the fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets meaning that in the next downturn, we expect the recovery rates to be much lower than in previous cycles!

On the subject of the "extended credit cycle", we read with interest Bank of America Merrill Lynch's  recent HY Wire note from the 6th of May entitled "Collateral Damage Part I : A recovery recession":
"Recovery drudgeryRejoice! Low default ratesWith the low-rate environment causing the extension of cheap credit to hundreds of high yield companies, we are currently bearing witness to what we believe will be an abnormally long credit cycle. As we noted last week, with default rates below historical levels, investor cash balances high, and little yield globally, Q1 saw the third most issuance in US high yield history. And with central banks continuing to provide unprecedented stimulus, with little end in sight, we don’t expect a meaningful increase in defaults for several years to come. In fact, we wrote last fall that we believe this cycle will be much like that of the late 1990s, with defaults increasing to mid-single digits for a period of time before spiking significantly. Over the past 43 years, the average length of time it takes to go from the height of defaults to the lows has been about 5.5 years- the exact amount of time since the peak of bankruptcies in late 2009- but we believe there is runway for this cycle to extend several years more before we see double digit default rates.
In fact, given the availability of cheap credit, the lack of an imminent maturity wall and the increase in interest coverage, high yield corporates could currently appear as a safe haven. After all, where else in the world can an investor receive a yield of nearly 6% for a 2% default rate? Consequently coupons have decreased from 8.5% to under 7% and the maturity wall has been pushed out to 2019. Note, we caution our readers to not read too much into the wall itself, as debt tends to default 12-18 months prior to maturity. The wall, therefore, always appears in the distant future. However, even if defaults meaningfully increase a year to a year and a half earlier, in 2017-2018, this cycle will be in line with the longest in history.
But it’s not necessarily all about defaultsOn the surface, investors should welcome such news. However, default rates are in and of themselves not the only measure financiers should be concerned with. In fact, if our estimate is correct about an elongated cycle, we think bond holders should be just as concerned, if not more so, about recovery rates. Last year we coined the phrase “zombie companies” to characterize those issuers able to survive longer than they would otherwise be able to- either as a consequence of looser covenants or simply due to the willingness for investors to search for yield and fund nearly any high yield corporate at any cost (see above decline in coupon). In an environment where earnings and revenue are growing at a healthy clip, such reach for yield behavior could perhaps be tolerated. However, fundamentals have not improved significantly, and up until recently, clients adopted a kick the can down the road mentality. Additionally, we are in the midst of witnessing CEO decisions (buybacks/dividends) that erode value rather than create it, in our opinion, further fostering an environment where the formation of long-lasting asset wealth has been supplanted by the formation of short-term financial wealth. This transformation will have a long lasting impact on recoveries, we think, likely causing investors to recoup fewer pennies on the dollar than any time in the last 30 years.
So far recent history has corroborated this view, as recovery rates have been very low during the last several years. In this two part series we examine the many factors that determine recoveries, focusing in this publication on some of the macro variables that have traditionally been good indicators. As we will see below, however, this cycle is unlike any other; with losses given default much higher so far despite what the “literature” and conventional wisdom may otherwise imply." - source Bank of America Merrill Lynch

For us and our good friends at Rcube Global Asset Management, the most predictive variable for default rates remains credit availability.  Availability of credit can be tracked via the ECB lending surveys in Europe as well as the  Senior Loan Officer Survey (SLOSurvey).

One key aspect of later stages in the cycle is unlikely to recur this time – liquidity. In the new regulatory environment dealers hold less than one percent of the corporate bond market. Previously dealer inventories grew to almost 5% of the market through the cycle. 

  • Final note: True health of the US economy - Where is the CAPEX recovery?
Many pundits argue that the US consumer should finally start to realize the benefits of lower oil prices, a healthier job market, and with an increase in financial asset valuations, it should lead to a healthier economy. Given Retail sales barely budged in April, why on earth would corporate CEOs invest in CAPEX if demand in the US will continue to remain anemic thanks to Cushing's syndrome?

On the subject of seeing the true health of the US economy, we agree with Bank of America Merrill Lynch's recent HY Wire note from the 6th of May entitled "Collateral Damage Part I", that indeed CAPEX matters and will continue to be absent in this "recovery recession":
"Perhaps a better place to see the true health of the US economy, and further see the psychological impact of the Great Recession, is by looking at the behavior of corporate CEOs. We wrote last March our expectation for CAPEX to remain deflated for the foreseeable future. Why spend on the potential for growth when you can acquire proven growth? Why increase costs when you can realize cost efficiencies through a merger? In our view the thought process behind this behavior is one of the reasons we have not had a pickup in wages and investment in the future. It also could be one of the key reasons that recovery rates are lower this cycle than during any other period in history- there is little investment in tangible assets. Furthermore, not only are CEOs not investing in growth, but by returning capital to shareholders in order to boost stock returns, they’re inherently diminishing their own recovery values should the business experience trouble. As Chart 9 below shows, as a percentage of operating cash flow, S&P 500 companies today are spending at historically low levels on CAPEX while are near historical highs for dividends and buy backs."
- source Bank of America Merrill Lynch
No matter how you want to spin it but given the lack of investment in tangible assets, in the next downturn, recovery rates will be much lower. It is a given.

"Criticism may not be agreeable, but it is necessary. It fulfils the same function as pain in the human body. It calls attention to an unhealthy state of things." - Winston Churchill
Stay tuned!

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