Thursday, 10 March 2016

Macro and Credit - The Paradox of value

"Every positive value has its price in negative terms... the genius of Einstein leads to Hiroshima." - Pablo Picasso
Looking at the dramatic fall in the yield of Japanese 40 year government bonds (JGB) racing towards negative territory faster than a rat on roller skates thanks to NIRP, gaining 26% in price terms and yielding around 0.5%, we reminded ourselves of the Paradox of value also known as the diamond-water paradox when thinking about our new title analogy. While water is on the whole more useful than diamonds, yet diamonds do command a higher price in the market such as JGB these days. Adam Smith is often considered to be the classic presenter of this paradox while it had already appeared in Plato's Euthydemus. Many brilliant minds such as Nicolaus Copernicus, John Locke, John Law and others had previously tried to explain the disparity. The concept of value was discussed in Adam Smith seminal book "An Inquiry into the Nature and Causes of the Wealth of Nations". In his book, Adam Smith argued the concept of value in use and value in exchange and how they differ:
"What are the rules which men naturally observe in exchanging them [goods] for money or for one another, I shall now proceed to examine. These rules determine what may be called the relative or exchangeable value of goods. The word VALUE, it is to be observed, has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys. The one may be called "value in use;" the other, "value in exchange." The things which have the greatest value in use have frequently little or no value in exchange; on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarcely anything; scarcely anything can be had in exchange for it. A diamond, on the contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had in exchange for it". - Adam Smith, "An Inquiry into the Nature and Causes of the Wealth of Nations"
In his book Adam Smith denied the necessary relationship between price and utility. Price for him was related to labor and not to the point of view of the consumer. Yet, saffron being the most expensive spice, most of its value is derived from the low yield growing it and the disproportionate amount of labor required to extract it.  One could argue in a NIRP world that most of the value of the 40 year Japanese Government Bonds come from its low yield:
- graph source Thomson Reuters - WSJ

Proponents of the labor theory of value argued that "saffron" was indeed a resolution of the paradox before the theory was replaced by the theory of marginal utility: 
"In explaining the diamond-water paradox, marginalists explain that it is not the total usefulness of diamonds or water that matters, but the usefulness of each unit of water or diamonds. It is true that the total utility of water to people is tremendous, because they need it to survive. However, since water is in such large supply in the world, the marginal utility of water is low. In other words, each additional unit of water that becomes available can be applied to less urgent uses as more urgent uses for water are satisfied.
Therefore, any particular unit of water becomes worth less to people as the supply of water increases. On the other hand, diamonds are in much lower supply. They are of such low supply that the usefulness of one additional diamond is greater than the usefulness of one additional glass of water, which is in abundant supply. Thus, diamonds are worth more to people. Therefore, those who want diamonds are willing to pay a higher price for one diamond than for one glass of water, and sellers of diamonds ask a price for one diamond that is higher than for one glass of water.
Conversely, a man dying of thirst in a desert would have greater marginal use for water than for diamonds so would pay more for water, perhaps up to the point at which he was no longer dying." - source Wikipedia
What we find of interest is indeed the Paradox of value in a NIRP world is that the lower the yield of the governement bond, the greater it's value in terms of price thanks to financial repression. Arguably the greatest bubble of the world is no doubt residing in the bond market hence our growing discomfort with government bonds yielding more and more into negative territory, leading to balanced funds becoming more and more "unbalanced" (a subject we discussed previously). One could argue today that indeed any particular unit of liquidity injected becomes worth less to the real economy as the supply increases. Those who want government bonds today are willing to pay a higher price for JGBs, thinking they have real value in their hand akin to some diamond. This is probably due to the fact that higher yielding government bonds are in such low supply because of central banks having vacuumed the lot (ECB, Bank of Japan, etc.). So, we are left with our Paradox of value, because it seems to us that JGBs are no diamonds, rest assured, but we are ranting again...

In this week's conversation we would like to focus once more on what Japanese investors will be doing and the attractiveness of US Investment Grade Credit in that context.

  • Macro and Credit - US Investment Grade - Go with the Japanese flow?
  • Macro and Credit  - NIRP finally put a nail in the coffin of Japanese Money Market Funds
  • Final chart:  A strengthening Yen will weigh heavily on the future earnings of corporate Japan

  • Macro and Credit - US Investment Grade - Go with the Japanese flow?
In our recent conversation "The Monkey and banana problem", we mused around the importance of the Japanese Yen and the relationship between FX and credit spreads as well as the importance of tracking "flows":
"Whereas everyone has been focusing on the importance of the strength of US dollar in relation to corporate earnings and in similar fashion in Europe previously the focused had been on the strength of the Euro, we think, from a credit perspective, the focus should rather be on the Japanese yen going forward." - source Macronomics
 We also added more recently in our conversation "The Ninth Wave" the following:
"So, moving on to why US high quality Investment Grade credit is a good defensive play? Because of attractiveness from a relative value perspective versus Europe and as well from a flow perspective. The implementation of NIRP by the Bank of Japan will induced more foreign bonds buying by the Japanese Government Pension Investment Fund (GPIF) as well as Mrs Watanabe (analogy for the retail investors) through their Toshin funds. These external source of flows will induce more "financial repression" on European government yield curves, pushing most likely in the first place German Bund and French OATs more towards negative territory à la Swiss yield curve, now negative up to the 10 year tenor." - source Macronomics, January 2016
As we pointed out, from a relative value perspective and given the better tone so far in the credit space, we continue to see more value in US Investment Grade as indicated by Bank of America Merrill Lynch in their Credit Market Strategist note from the 4th of March 2016 entitled "Morning after the dawn":
"Second phase of rally
We now enter the second phase of the rally in high grade where spreads tighten significantly due to the combination of catch up tightening in bonds, as our market has lagged the retracement in stocks and high yield (see section below), and the market finally beginning to respond to the three factors that make us bullish on spreads this year.
These are 1) Technicals: big foreign inflows of $400-500bn this year as with ultralow foreign interest rates the US investment grade market is the only game in town (Figure 9). 

2) Valuations: near recessionary spreads but no recession (Figure 10) 

and 3)
Fundamentals: we expect leverage to decline a bit in 2016, and then more in 2017 (see graph below).

What more can you ask for (apart from a favorable macro environment)? Remain overweight high grade, recommend 5s/10s spread curve flattener, overweight Autos, Energy, Life Insurance, underweight Banks" - source Bank of America Merrill Lynch

When it comes to "fundamentals", we disagree with Bank of America Merrill Lynch's take as we think that in recent years the credit clock in the US has been ticking faster than in Europe and leverage has gone up significantly, hence our more defensive, yet still constructive approach in relation to US Investment Grade. When it comes to "fundamentals" and the Paradox of value, we read with interest JP Morgan High Grade Credit Fundamentals review for the 4th quarter 2015 published on the 4th of March:
"Revenue and EBITDA growth is quite weak and interest coverage weakened as well, but leverage (ex the Commodity sectors) stabilized this quarter
4Q Revenue and EBITDA trends deteriorated vs 3Q (based on last twelve month figures) due to weakness in commodity issuers and also slowing growth from noncommodity companies, in part due to the strong dollar in 2015. Profit margins remain strong, however, and the cash going to shareholders (ex Commodity issuers) was slightly down on the year. Leverage outside of the Commodity sectors was stable compared to last quarter, which is encouraging after several quarters of rising ex-Commodity leverage. Interest coverage weakened, however, as did the earnings payout ratio (calculated as dividends plus share buybacks / EBITDA).
Revenue in 4Q15 declined 9.2% y/y (LTM basis) which was the worst y/y revenue performance since 4Q09. Excluding the Metals/Mining (-21% y/y) and Energy (- 36% y/y) sectors revenue grew 1.8%, however. This figure was also down from last quarter (+3.3%) and is the slowest growth since 3Q14. The trade weighted dollar appreciated 10% from 4Q14-4Q15 which held back the earnings of exporters and contributed to the weak revenue results.

EBITDA declined 7.2% y/y, also the weakest result since 4Q09, but excluding Metals/Mining (-27% y/y) and Energy (-34% y/y) it grew 1.5%. This is down from 2.4% growth last quarter, driven by similar trends as Revenues.
Profit Margins as measured by LTM EBITDA/Revenue have been remarkably stable in the 28-30% range since 4Q11. They ended 4Q15 at 28.9%, near the middle of this range. Perhaps surprisingly, Energy profitability is up 0.2% y/y at 27% as the sector continues to successfully achieve cost efficiencies despite the challenging revenue trends and has been able to maintain profitability in the 26%-28% range.

Total Debt increased 11% y/y, down from the trend of 12% growth y/y in the previous two quarters, so a modest change in the trend, but still a very strong increase, especially with EBITDA down 7.2% over the same period. M&A has been an important driver of issuance with $280bn of M&A related issuance in 2015 and a pipeline of $158bn for the remainder of 2016, based on publically announced

The largest increase in debt y/y was in Technology, where debt increased by $65bn, driven by Apple (+$27bn) and Microsoft (+$16bn). The second largest increase was in Energy (+$60bn). Pharmaceuticals come next with a $48bn increase y/y driven by M&A as industry consolidation continues in the sector. Net debt is also increasing and is up 16% y/y as cash levels declined modestly y/y.
Gross leverage continues its upward trend, reaching 2.76x in 4Q15, the highest level in our analysis. Ex commodity issuers, however, leverage actually declined slightly, to 2.32x from the peak of 2.37x last quarter. In part, this was helped by issuers who are deleveraging post M&A. These names contributed to almost half of the decline from 3Q15 to 4Q15. Net leverage has increased slightly to 2.23x from 2.18x last quarter but the trend is not the same ex commodities, where leverage fell to 2.19x from 2.21x. For both Gross and Net leverage, ex commodities, these declines were the first since 3Q14 and 4Q13, respectively.

Interest coverage has been deteriorating since 2Q13 and is now 10.94x, down from 11.27x last quarter and 12.82x one year ago. It is the weakest since 2009. Ex commodities, interest coverage has also been declining. It is at 10.56x, down from 10.77x last quarter and 11.16x one year ago.
Cash to Shareholders is down 2.2% y/y but is up 1.5% y/y excluding Metals/Mining and Energy. The Energy sector in particular is down $30bn (-29%). Energy companies have substantially cut share buybacks and some are now cutting their dividend, including significant dividend cuts from several large energy companies recently, which will show in lower cash to shareholders in future quarters. Cash to shareholders has stabilized in the past two quarters, but is still rising ex commodity issuers.
The Earnings Payout Ratio (Cash to shareholders / EBITDA) increased 2.1% y/y to 39%, which is a high since 2000. The increase is driven by declining EBITDA and lagging responses of companies to adjust shareholder friendly activities accordingly. Excluding Commodity issuers the Earnings Payout Ratio was up 1.4%." - source JP Morgan
Whereas in High Yield, EBITDA and other measures continue to point out to more caution, US Investment Grade credits apart from the usual suspects in the commodity space continue to hold their ground fairly well for now.

So what is going to be driving more yield compression apart from the fundamentals, you might rightly ask? 

As we pointed out in our conversation "The Ninth Wave" back in January you want to continue to front run Mrs Watanabe, the GPIF and their friends in their search for the Paradox of value and their unquenchable search for yield:
"Because GPIF and other large Japanese pension funds as well as retail investors such as Mrs Watanabe are likely to increase their portfolios into foreign assets, you can expect them to keep shifting their portfolios into foreign assets, meaning more support for US Investment Grade credit, more negative yields in the European Government bonds space with renewed buying thanks to a weaker "USD/JPY" courtesy of NIRP." - Macronomics, January 2016
When it comes to credit, don't fight the flow, run with it. And when it comes to "flows" we told you before that we do monitor closely what the Japanese are doing. On that matter we read with interest Nomura's latest Flow Monitor report from the 8th of March 2016 entitled "Negative rates accelerate foreign investment":
"Japanese investors’ foreign portfolio investment accelerated in February. Excluding the banking sector, whose foreign investment tends to be FX-neutral, Japanese investors were net buyers of foreign securities to the tune of JPY2829bn ($25.0bn), the biggest net purchases since at least 2005. As expected, pension funds re-accelerated their foreign investment, while lifers purchased foreign bonds at the highest pace since 2008. Lifers’ foreign bond investment is likely more on an FX-hedged basis at the moment though. Toshin companies also increased their foreign investment slightly. January BoP data showed strong investment in the French bond market. Japanese investors sold GBP denominated bonds in January, but only by a relatively muted amount. Japanese corporates’ repatriation from FDI profits in January slowed to the smallest since 2009." - source Nomura
In our "The Monkey and banana problem" we voiced our concern on "liquidation" and "repatriation risk" from a strengthening Japanese yen. The latest Nomura report alleviated somewhat our concerns:
"The BOJ announced the introduction of negative interest rates on 29 January, which led to a decline in JGB yields overall (see “BOJ negative rate policy to reaccelerate JPY depreciation trend”, 1 February 2016). Only 30% of JGBs still offer positive yields now, making it difficult for lifers to manage their portfolios. As a result of the lower domestic yields, lifers needed to look for investment opportunities outside Japan.
That said, we expect that most of their foreign bond investments would be hedged, ahead of the fiscal year-end. The outlook for the global economy remained uncertain in February, and life insurers became more skeptical about the prospects for JPY depreciation going forward, although major lifers expected USD/JPY to trade between 115 and 130 (see “JPY: Lifers still look for foreign bond investment opportunities”, 26 October 2015). Moreover, while hedged foreign bonds are essentially an extension of yen bonds, unhedged foreign bonds differ considerably in terms of risk weighting. We expect hedged foreign bonds to account for the majority of their investments for now.
At the same time, as hedge costs for USD assets have risen, FX-hedged UST investment has become less attractive for Japanese investors. Lifers likely need to consider investment in US corporate bonds or euro area bonds going forward, if they continue to prefer hedged investments. We will take a closer look at life insurers’ FY16 investment plans, due to be announced at end-April, to assess their preference for unhedged foreign bonds." - source Nomura
Of course this will have some implications in terms of investment hence our close monitoring on everything Yen related. What was as well of interest from the same Nomura report was the data from the Balance of Payment for January:
"January BoP data show that Japanese investors bought more EUR-denominated securities than USD-denominated securities (Figure 6).

They purchased JPY919bn ($8.1bn) of EUR-denominated securities, while their investment in USD-denominated securities was JPY405bn ($3.6bn). Although Japanese investors purchased USD denominated equities aggressively (JPY892bn or $7.9bn), they sold USD-denominated LT bonds (JPY693bn or $6.1bn). While selling USD-denominated bonds, Japanese investors purchased EUR-denominated bonds aggressively (JPY723bn or $6.4bn). A country breakdown shows Japanese investors purchased French LT bonds especially aggressively, to the tune of JPY974bn ($8.6bn). Japanese investors were net sellers of German LT bonds (JPY196bn or $1.7bn) and investment in other euro area bond markets was not strong. Higher hedge costs for USD assets likely encouraged lifers to shift into French bonds from US bonds." - source Nomura
Once more the French government with the clear deterioration of French economic fundamentals can thank the Japanese falling for the Paradox of value and embracing French government bonds (OATs) as if they were some kind of diamonds but we are ranting again...

When it comes to Bank of Japan versus the ECB and the Paradox of value, we do agree with Bank of America Merrill Lynch's take from their Liquid Insight note from the 7th of March entitled "Trading QE flows", not all easing is equal:
"BoJ easing vs ECB easing: Not all easing is equal
 BoJ easing means lower US yields
While the impact of the BoJ’s January actions on JGBs/JPY has been discussed, its impact outside the borders is only becoming apparent over the last two weeks (after its clarification/toning down of the negative rate language). Japanese private investors have purchased nearly $26bn in foreign bonds since mid-February, their largest two-week purchases since mid-2012. This is not a recent phenomenon, but a consistent trend since the launch of QQE. As we have detailed, our analysis suggests Japanese private investors purchased nearly $120bn of USTs last year (despite the TIC data showing a $100bn decline in Japanese holdings of USTs) and the US rates market consistently rallied in Japanese trading hours in 2015. Clearly the lack of higher yielding alternatives domestically (BAML Japan corporate index yielding 22bp) has meant the portfolio balance channel in Japan translates to larger purchases of foreign bonds. The flow impact of these purchases is clearly bullish for USTs, all else equal.

ECB easing more likely a risk-on trade
In contrast, the flow impact of ECB easing on USTs is not the same. The last five meetings where the ECB has positively surprised (Table 1), peripheral spreads have tightened in every episode while the belly of the US rates curve has sold-off in three of the five episodes. 
This supports the view that the European private investor is more likely to move to the periphery in “search for yield” as opposed to USTs. This preferred home bias is likely a combination of the availability of higher yielding assets and a preference for spread risk over currency risk (given onerous capital charges under Solvency II for FX unhedged positions). Irrespective of the motivation, the resulting "risk-on" trade from the tightening of peripheral spreads puts in great risk premium in the US curve, more often than not.
The differential impact of the BoJ vs the ECB is also apparent in the cross currency basis swap market. Since 2013, the yen/dollar basis swap has tightened much more significantly than the EUR/USD basis. This indicates the demand for dollars from the Japanese investor base (to fund US asset buying) has been greater than that of the European investor base.
The implications of this for the upcoming week are simple:
• If the ECB over-delivers on the rate cut, focus on trading local front end rates instead of global QE flows.
• If the ECB surprises to the upside on QE, while there may be other reasons to be bullish USTs, buying Treasuries on the sole hope of European investor diversification is probably the wrong trade." - source Bank of America Merrill Lynch
One thing for sure, regardless of "Le Chiffre" aka Mario Draghi's new tricks, when it comes to looking for "diamonds" and compressing even further government bond yields, Japan's foreign investment is indeed in the driving seat.

Also, thanks to the Paradox value, one thing fairly clear is that the Japanese NIRP will be driving even more flows from Japan into foreign securities as Money Markets Funds in Japan are clearly decimated by the policy as per our next point.

  • Macro and Credit  - NIRP finally put a nail in the coffin of Japanese Money Market Funds
One thing for certain is that NIRP in Japan is forcing massive fund moves from Money Market funds towards Money Reserve Funds according to Deutsche Bank Japan Securities sector note from the 8th of March 2016:
"Temporary retreat by short-term invested funds into bank deposits
Substantial portions of funds invested in the call market (end-January: ¥6.8trn unsecured, ¥14.1trn secured) and the ¥17trn in short-term invested assets in brokerage accounts (¥1.6trn Money Market Fund, ¥10.4trn Money Reserve Fund, ¥4.6trn deposits received) are effectively shifting to bank deposits. JGB redemptions are slated to reach ¥24trn in March. 
Short-term investment market in negative territory
We expect a heavy flow of funds seeking to avoid negative interest rates, such as JGB redemption funds, into bank deposits under the current conditions. We think banks could ultimately place restrictions on large corporate deposits and money trusts. We believe the size of the call market and other at negative interest rates will depend on the scale of deposit withdrawals requested by banks to customer companies and on JGB yields.
Impact on brokerage firm earnings
We believe the redemptions of MMFs and MRFs (unless the BoJ adopts special measures) might flow into the deposits received of brokers as well. We expect brokerage firms to provide deposits received at a zero interest rate as a customer service, mainly for individual investors, and believe they (in other words, their shareholders) will cover costs related to trusts and other products. Short-term invested assets in brokerage accounts total ¥17trn, including MMF, MRF and deposits received. Daiwa Next Bank's yen-based ordinary deposits, which serve as an MRF alternative via the sweep function, separately totaled ¥2.7trn at the end of December. We estimate that the annual pretax cost is ¥20bn if a 10bp cost is applied to the combined total of ¥20trn from above.
Sharing costs related negative interest rate
The negative interest rates applied to short-term managed assets are shared between financial institutions and cash-rich companies. We expect life insurers to shoulder the negative rate on investment for required liquidity funds and brokers to absorb the rate for managing sideline funds of individual customers. We believe declining investment yields will be transferred to policyholders through steep reductions in assumed rates of return (funding costs) starting in April 2017. We think brokerage firms will attempt to offset investment costs for sideline funds via reductions in their funding costs and buildup of sales commissions and management fees for risk products and others.
Disruption of corporate fundraising market
At this point, the adoption of the negative interest rate is adversely affecting corporate bond issuance activity through wider credit spreads. While issuance yields have been dropping closer to 0%, downward rigidity is resulting in wider credit spreads (spreads to JGBs of the same duration). Some companies with an aversion to wider issuance spreads are likely to delay corporate bond issues.
One way of avoiding wider credit spreads is to lengthen corporate bond duration (because of higher-reference JGB yields). However, the longer duration of bond holdings could result in excessive term risk (risk of declining prices when yields rise) for ordinary companies, banks, and individuals (via investment trusts and other products)

Yen-dominated MMFs: Headed for redemptions
All domestic companies have already halted new MMF purchases. While MMFs offer slightly higher yields than MRFs, combined value fell to ¥1.6trn at end-January due to yield declines. MMFs also invest funds in short-term bonds and thus might be forced to invest at negative interest rates and run the risk of slipping below principal value in the future if they continue investing. Some asset management companies have already decided to redeem MMFs. We expect other companies to follow as well. - source Deutsche Bank
So no doubt Japanese investors will be frantically searching for overseas yielding assets given NIRP in Japan has finally put a final nail in the coffin of their Money Market Fund industry and will entice further reach for duration and credit risk. When it comes to the bond bubble, it keeps inflating thanks to flows, clearly not macro fundamentals. This brings us to our final point, namely that the strengthening of the Japanese yen is indeed weighting heavily on the profitability of corporate Japan, given the "shrinking pie mentality" which is prevailing in this global currency NIRP induced war.

  • Final chart:  A strengthening Yen will weigh heavily on the future earnings of corporate Japan
Whereas Japan's NIRP venture on the 29th of January has indeed put a spanner into its currency depreciation plan leading to a "sucker punch" type of risk reversal on the Japanese yen versus the US dollar, the sudden implementation of this policy has not only put a final nail in the coffin of its Money Market Funds (MMFs) industry but, is likely to affect its domestic equity market via a weakening of future earnings as displayed in our final chart from Société Générale Asia Pacific Market Arithmetic note from the 1st of March entitled "Japan sinks as Yen strengthens":
  • "Despite efforts by the Bank of Japan to weaken the Yen, including a surprising move to negative interest rates announced on 29 January, the Yen strengthened to a 15 month high against the US dollar and ended the month at 112.69/$. This adversely affected the Japanese equity market making it the worst performing market in the region in February.
  • A strengthening Yen will weigh heavily on the future earnings of corporate Japan with earnings forecasts for exporters likely seeing downgrades. Earnings momentum, measured as 4 week rolling upgrades vs total estimated changes, deteriorated sharply over the month. Bottom up consensus FY 16 estimate for MSCI Japan fell by 8.3% over the past 3 months while the FY 17 estimate slipped 3.4% over the same period. In contrast, FY 16 estimates for MSCI US and Europe have come down a more modest 4.8% over the past 3 months. Then again, on a 12 month horizon, Japan has seen the least amount of consensus earnings downgrades globally.
  • Japan has also given up most of its gains, as measured in terms of its 12-month forecast price to earnings ratio, since the start of Abenomics in December 2012. The MSCI Japan index has fallen to 12 times forecast earnings as of the end of February, close to the lows seen during the Euro crisis of 2012 and well below its 5 year average of 13.4x and 10 year average of 15.5x. The market is currently pricing in EPS of ¥58.6 assuming a fair PER of 13.4x (based on the 5 year average), while consensus bottom-up February EPS for 2016 and 2017 are ¥58 and ¥65.6.
 - source Société Générale

It looks to us that if indeed Le Chiffre aka Mario Draghi delivers, Bank of Japan and Kuroda will most likely come back again at the QE table. For now it's the "Paradox of value" and the continuation of a rally in credit thanks partly to large inflows from Japan and a bubble that keeps growing for sure...
"To invent, you need a good imagination and a pile of junk." - Thomas A. Edison
Stay tuned!

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