Macro and Credit - Le Chiffre

"If you spend a week at a casino you will very easily see that people have a certain way of behaving in a casino." - Mads Mikkelsen, Danish actor (who played Le Chiffre in the recent Casino Royale).

While observing the rapid, yet severe pain inflicted to the "short crowd" so far in October thanks to the "relief rally" in risky assets "High Yield" and equities included, supported as of late by the PBOC double rate cuts and the return to the front stage of our "Generous Gambler"  aka Mario Draghi, we decided this week given our eagerly anticipation of the release of the 24th opus of James Bond's adventure Spectre to steer towards a "Bond" related analogy when it comes to choosing this week's title for our musing. While we could have simply elected to go for "Casino Royale", the character Le Chiffre appears to us more interesting from a central banking "gambling" perspective given the latest actions of the PBOC and promises made by Mario Draghi. Le Chiffre after all was the main villain of the official 2006 James Bond film "Casino Royale". In order to win the money back lost during the summer, one could argue that Le Chiffre aka our main European central banker has indeed set up and entered a new high-stakes Texas hold 'em tournament in similar fashion he did at the Casino Royale in Montenegro in the movie. In the movie Casino Royale Bond eventually beats Le Chiffre in the game of poker by catching his bluff. In the start of the movie Bond tells Vesper: "in poker you never play your hand...you play the man across from you". 

While in the movie Le Chiffre pretty much made a game out of it with nothing on his cards in the first game, in similar fashion Mario Draghi made a game out of it with his "OMT" and "Whatever it takes" July 2012 moment. In the movie it made Bond surmise that Le Chiffre was in desperation to get the money and resorted to bluffing (It was exactly our thought at the time). Le Chiffre and Mario Draghi share the same trait, both are poker prodigies hence our title analogy.

Whereas in the last couple of weeks, we have mused around the deterioration of credit metrics particularly in High Yield land,  with renewed M&A marking what we think signs of exhaustion in the "credit cycle", in this week's conversation, we would like to highlight the weakening effects of the various iterations of QEs have had on risky assets, showing in essence that Le Chiffre is probably "overplaying" it particularly when one looks at the poor effects on "credit growth" in Europe and "inflation expectations".

Synopsis:

• QEs and the law of diminishing returns
• Europe's "Japanification" process is still supportive of European credit
• Final chart - Bonds have been the only game in town when it comes to "over-allocation"

• QEs and the law of diminishing returns

In last week's conversation we used Liebig's law of the minimum concept as an analogy for our title given it was originally applied to plant or crop growth, where it was found that increasing the amount of plentiful nutrients (liquidity via QEs) did not increase plant growth (Economic growth). Last week we read with interest that the ECB indicated Credit Standards improved as QE Program supported lending as reported by Bloomberg:

"Credit standards on loans to companies eased for the sixth consecutive quarter, the ECB’s Bank Lending Survey showed on Tuesday. Terms for mortgages tightened, with banks citing national regulation as the primary cause. A small majority of lenders reported an increase in profitability over the past six months as a result of the central bank’s quantitative-easing program, though a deterioration is seen over the next two quarters." - source Bloomberg

Obviously what we find of interest from Le Chiffre's team at the ECB is that, once more the reality of the data counters their wishful thinking as indicated by Reuters in their article from the 27th of October entitled "Euro zone bank lending sluggish despite tsunami of QE and cheap cash":

"Growth in loans to the private sector slipped to 0.6 percent in September on a year ago, lower than August’s 1 percent rate and nowhere close to the near double-digit numbers clocked before the global financial crisis.  Loans to non-financial corporations grew just 0.1 percent in September from 0.4 percent the month before, the first monthly slowdown since June 2014.That data also are at odds with ECB’s Bank Lending Survey findings released last week, which showed banks reported increasing demand for business loans." - source Reuters

QE on its own is not leading to credit growth, because as we have repeatedly pointed out in our musings, a lot of European banks, particularly in Southern Europe are capital constrained and have bloated balance sheet due to impaired assets.

We would have to agree with Reuters, namely that  no matter how charming Le Chiffre's bluff is, we are not falling for it and you should not. From the same Reuters article:

"ECB President Mario Draghi last week signaled more easing is coming in December, and that has already become the consensus among economists. 

But more than six months of QE – 60 billion euros of bond purchases in each – and years of cheap long-term cash auctioned by the ECB has so far yielded lacklustre results despite the extraordinary amount of stimulus along with interest rates at or below zero.

More stimulus will not necessarily give banks the incentive to start lending to businesses.

Instead, European banks are lending a lot for house purchases, which does not suggest there will be a spurt broader consumer prices, which the ECB targets.

Consensus forecasts for euro zone inflation at the end of 2015, 2016 and 2017 have either stayed constant or been downgraded in each Reuters poll since May, even as it slipped back below zero last month." - source Reuters

We will repeat ourselves again: QEs have no impact on the "real economy". This a subject we already discussed at length in our November 2014 "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

When it comes to the change in "credit growth", we agree with Kit Juckes from Société Générale in his recent takes on the impact of QE on lending growth in his View From The Hill from the 27th of October:

"QE doesn’t boost bank lending: I have two problems and one question. The first problem is economic: I can’t see how further ECB ‘QE’ can really help boost economic activity and specifically, how it can help boost loan growth. The second problem is a market one: I have no idea how to judge how far German Bund yields can fall as growth loses momentum and investors project zero (or negative) rates further onto the future and settle for less and less yield in their portfolios. The question, which I shall attempt to answer, is what that means for the Euro. Whatever else it means, of course, it isn’t good news.

The chart shows (In my opinion) the key part of the ECB’s monthly money supply release: the growth of loans, adjusted for securitisations. This slowed to an annual rate of just 0.4% in September, from 0.8% and from a recent peak of 1.4% in July. That’s a severe loss of momentum. I plotted it against the annual rate of change in the ECB’s balance sheet, although I could have plotted it against almost any other measure of QE and got the same answer – QE does not appear to be doing anything to boost loan growth in Europe.
We don’t know (what would have happened to bank lending or economic activity if the ECB hadn’t embarked on its bond-buying programme but ‘QE’ has supported peripheral bond markets, narrowing spreads and preventing a crisis of confidence, and it seems have supported equity and increasingly, property markets across Europe. But it hasn’t supported lending. QE + the shift to negative interest rates meanwhile, have as a combination weakened the Euro, which has hopefully helped exports (though a 9% year-to-date fall against the dollar is only a 5 ½% fall on a trade weighted basis).

The issue at stake is the different path taken between the Fed and the ECB when dealing with the impaired balance sheet of their respective banking sector. After all, the "Growth divergence between US and Europe? It's the credit conditions stupid...", it is all about Stocks versus Flows as we pointed out in May 2012:

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

What is depreciating at a very slow pace are the impaired liabilities on banks' bloated balance sheet hence the on-going support of the financial sector via LTROs first and then QEs, but in no way finding its way "meaningfuly" into the "real economy".

As a reminder, our take on QE in Europe from our "Chekhov's gun" can be summarized as follows:

"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?" - source Macronomics, November 2014

We also quoted at the time Nomura's Richard Koo on the subject of lending growth, QE and liquidity:

"Central bank-supplied liquidity has nowhere to go without real economy borrowingAs I have repeatedly pointed out, the central bank can supply as much base money (liquidity) as it wants simply by purchasing assets held by private-sector banks.But a private-sector bank cannot give away that liquidity, it must lend it to someone in the real economy for that liquidity to leave the banking sector." - Nomura, Richard Koo

If Le Chiffre is again promising more "generosity" it is because, contrary to some beliefs in its effectiveness in triggering "real economic" growth via the lending channel, all is not well in the European banking world.  We noticed that on the 12th of October, 3 small Italian banks Banca Marche, Banca Popolare dell'Etruria and Cassa di Risparmio di Ferrara (Carife) had to be bailed out by the Italian Central Bank due to a "small hole" of €2.2 billion euros. There are 650 small and medium banks in Italy, you  can therefore expect more consolidation and more "support" from the ECB.

Of course, when it comes as well to Le Chiffre and "inflation expectations", QE has been as well a failure as displayed in the below Bloomberg graph - H/T Holger Zschäpitz

- source Bloomberg / Holger Zschäpitz on Twitter

While Le Chiffre has been a prodigious  Poker player when it comes to "bluffing" his way out out of the "bond vigilantes" in Europe setting their sights on weaker European government bonds, when it comes to both "credit growth" and "inflation expectations", we think Le Chiffre has indeed been "overplaying" it.

In similar fashion to Liebig's law of the minimum, the law of diminishing return means that at some point, adding increasingly more fertilizer (liquidity via QE) improves the yield by less per unit of fertilizer (QE), and excessive quantities can even reduce the yield (check out 2 year Italian and Spanish government yields...). 

Back in December 2014  in our conversation "The QE MacGuffin" we quoted Société Générale in relation to the law of diminishing return from QE:

"Life below zero. At the ZLB, central banks do what they know: they print money. But such policy seems to follow a law of diminishing marginal returns. It has worked well for the US, because the Fed had a first-mover advantage, and the support from pro-growth fiscal policy and a swift clean-up of the household and bank balance sheet. The BoJ and ECB aren’t as lucky. Let’s consider three transmission channels: 1) The portfolio channel. By pushing yields lower, central banks force investors into riskier assets, boosting their prices. But trees don’t grow to the sky. And the wealth effect on spending is constrained by high private and public debt. 2) The latter also gravely impairs the lending channel. And with yields already so low, it’s questionable what sovereign QE can now achieve. 3) The FX channel. This is where the currency war starts, as central banks try to weaken their currency to boost exports and import inflation. It however is a zero-sum game that won’t boost world growth.-The battle to win market shares highlights a fierce competitive environment, which tends to depress global inflation. Adding insult to injury, oversupply in commodities, especially oil and agriculture, currently add to the deflationary pressure. That leads central banks to get ever bolder, when instead they’d need to be more creative (e.g. a bolder ABS plan from the ECB would be far more effective than covered and government bond purchases) and get proper support from governments (fiscal policy, structural reforms)." - source Société Générale, December 2014 - Macronomics

Indeed, in December we expect Le Chiffre to get even bolder.

When it comes to Le Chiffre and QE, we would have to agree with Société Générale's Forex Weekly note from the 22nd of October, "QE is losing is Mojo" and so is Le Chiffre:

"Dubious QE impactThere’s a belief in the foreign exchange market that ‘QE’ - bond-buying by central banks - can continue to weaken currencies and boost asset prices, pretty much ad infinitum. This argument feels more and more dubious to me. In particular, I am doubtful that increased conventional QE (bond-buying) by the ECB or the BOJ will weaken the yen or the euro significantly further from their recent lows. Indeed, I’m not sure how much of the weakness in either currency to date can really be attributed to QE in the first place. I think we have learnt enough from the experiment in glowing central banks’ balance sheets to understand more about how this works in practise. The Fed went first and, by buying bonds, forced a portfolio switch on US investors, out of Treasuries and into more exotic assets, first into mortgages, then corporate bonds and then on into domestic equities and foreign assets. Up went the S&P500 and down went the dollar as outflows to EM grew. US QE was turbocharged by intervention to limit the rise of the ruble, real and perhaps most of all the renminbi
(Chart 1). 

As central bank reserves grew across EM, which created more demand for Treasuries, magnifying the effect. And it also spilled over, through diversification, into demand for euros, Australian dollars and even sterling. I wouldn’t want to argue that Fed QE didn’t undermine the dollar. But what about BOJ and ECB action? Well, these moves weren’t turbo-charged in the same way, yet the yen and euro weakened. I put that down in large part to the other policies undertaken by these ‘excess saving’ central banks. The BOJ started with FX intervention after Mr Abe’s election and the next big phase of yen weakness came about as a result of a deliberate asset allocation switch into equities, including foreign equities by the public sector pension fund. The ECB generated euro weakness not through QE but later, when QE was compounded with negative interest rates in 2015. Driving yields down, on its own, isn’t always enough to persuade investors in savings-rich, low inflation countries to move money overseas - just look at the Swiss.

If conventional QE wasn’t what weakened the euro and yen as much as combining QE with other more potent policy adjustments, it seems to me wrong to assume that another simple round of QE by the ECB or BOJ will have much impact on the euro or yen in the coming days/weeks. Maybe there’s still an effect on peripheral bonds spreads in Europe, and perhaps on equities in both Europe and Japan. Or maybe, as in the UK, the most visible effect now will be on the property market. But in FX, perhaps not so much.

If words from the ECB and QQE from the BOJ this month fail to weaken the euro and the yen meaningfully, there’s a risk of the FX market adding two and two together and making four - concluding that QE ‘doesn’t work in FX’ and challenging the idea of a stronger dollar. EUR/USD at 1.20 and USD/JPY under 115 are not at all inconceivable outcomes this autumn. All it takes is for US Treasury yields to remain anchored." - source Société Générale

Combining QE with other more potent policy adjustments such as the ones described above in our "Hopeful equation" would have indeed a more meaningful impact on the "real economy", but, the free-ride given to European politicians by the ECB is ensuring that structural reforms are either postponed or not implemented. France for instance is a basket case for slack in implementing structural reforms.

While we have long been ranting on our strong deflationary bias, nonetheless, the "japanification" process is still supportive of European credit.

• Europe's "Japanification" process is still supportive of European credit

In a market where recent bad news is still seen as good news (as it leads to more QE), the reality of QE’s failure will become at some point "bad news" as we once more lean towards deflation. While we have during the summer touched on the lateness in the US credit cycle and in particular through the view of our "CCC Credit Canary", European, which is still an expanding universe thanks to dis-intermediation from the banking sector and new players issuing bonds rather than loans, the on-going "Japanification" process and the increase in "Reverse Yankee" (US corporates issuing in EUR) is still supportive of the asset class, but, as we are indeed getting late in the credit cycle, there is limited upside we think.

As we indicated when quoting Nomura in April 2012, "Deleveraging - Bad for equities but good for credit assets":

"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns" - source Nomura

But, while Le Chiffre is promising some additional "unconventional" card tricks in December, the law of diminishing return means that as we are getting late in the credit game in the US, we could indeed have a spillover effect on European High Yield, should the Fed proceed with some form of normalization in December as expected by the markets following the latest FOMC statement.

When it comes to European High Yield, we would have to agree with Société Générale's take from their Credit Market Wrap up of today:

"Additionally, whatever (in)action the central bank takes today, the markets are likely to react one way or another. However, hike or no hike, we believe that the reality in Europe will remain largely the same. That means low inflation, poor economic growth, high unemployment and the need for more structural reforms and ongoing QE. In that environment, don’t expect corporates to start reckless releveraging processes any time soon, and that means, as we mentioned already this week, low to non-existent defaults and supportive credit metrics in general. The end result is a constant pressure on spreads to head tighter as credit, particularly HY, remains a more attractive alternative to other fixed income asset classes." - source Société Générale

Once more, Central Banks are indeed in the "driving seat" given the non-existing strong economic growth prospects, which makes this "Japanification" process "Goldilocks" period for "credit investors". Even more so in Europe if indeed Le Chiffre in December goes far more "unconventional and extending the already finite bond buying list of some Corporate issuers further. This would of course provide an additional "boost" to European credit. This was a well highlighted by Société Générale in their Credit Market Wrap up from the 25th of October entitled "Where did the defaults go?":

"Highlights: Credit yields are heading lower again, a trend that looks unstoppable for the coming months, even though they are much more attractive than equivalent sovereign bond yields. Still the upside of credit is again increasingly limited and the downside is growing. The good news is that spreads remain very wide by historical standards and compensate amply for the risk of defaults which are simply not happening. 

The ECB continues to prepare the ground for an increase in its QE program, most likely for the duration of it (extending it well beyond next September), but we suspect for the size and scope as well with the central bank gearing up to buy non-financial corporates next year. But even if the ECB confines its purchases to sovereign bonds, the ultra-low yield environment (not just sovereigns but corporates too) is set to remain in place for a very long time. And that means that funding conditions for both governments and corporates will remain extremely attractive for the time being. 

And we can already see some of the benefits of the favourable funding conditions. Coupons in IG of 1% are no longer rare, and only corporate hybrids offer 3%+. In HY, coupons can vary substantially depending on the rating but the average of new issues this year stands at 5.08% or 5.4% since the end of the summer. And this low funding, added to the ongoing disciplined approach to spending, means that defaults globally seem to be a negligible worry. As we can see in the chart below, it’s been around four years already with very low levels of defaults despite a very difficult recession and a very slow economic recovery.

In Europe there were only two defaults in September, Privatbank and Savings Bank of Ukraine, both Ukrainian banks, which is not too surprising given the situation in the country, and to a certain extent this pushes the European default rate higher than it should be under normal circumstances. Still, spreads continue to price in a higher level of defaults to come.
The iBoxx Corporates index is currently around B+157bp, better than where it ended September but still very wide compared to the current level of defaults. The iTraxx indices are a cleaner way to look at the pure credit risk which is in the end a reflection of the risk of default, given the greater liquidity in the synthetic contracts but even these continue to show a very high level of implied default rates. Currently, the iTraxx Main implies a default rate of 1.15% in a year’s time for IG which is excessive as the actual default rate remains at 0.0% and IG defaults tend to be very rare. The X-Over implied a default rate of 4.86% which also looks high versus current and forecast default levels.

Moody’s forecasts a speculative default rate of 3.2% in 12 months’ time, the highest forecast in a long time but even this is lower than what the X-Over is pricing. Furthermore, Moody’s universe is very broad and includes very vulnerable names (the two Ukrainian banks for instance), while the X-Over is made up of the 75 strongest names in the HY universe, companies that have easier access to the capital markets. Additionally, we believe funding conditions for corporates will remain very attractive throughout the life of the ECB’s QE as sovereign yields remain ultra low (and are probably falling) with spreads tightening gently in the coming months. With the economy growing even at a slow pace, it is difficult to see a wave of defaults on the way." - source Société Générale

What of course could but a "spanner" in the current "overconfidence" in Le Chiffre's ability in driving further "credit" into "overtime" for us are two factors, first one being a Fed December normalization process when liquidity will be very thin, second factor is that the EPS momentum continues to slump. As per our conclusion of last week's conversation,  companies overall remain extremely sensitive to revised guidance and earnings outlook. This was clearly illustrated in an another interesting note from Société Générale from their Global Equity Market Arithmetic series from the 26th of October entitled "While equities celebrate central bank actions, EPS momentum continues to slump":

• Global equity markets continued their resurgence with the MSCI World up 1.4% last week, up over 10% from the recent lows. Interest rate cuts from the PBOC and dovish comments from the ECB pointed to a continuing downward trend in global interest rates.
• The ECB's words undoubtedly had the intended effect of weakening the euro and as such, in local currency terms, it was the eurozone equity markets that were the better performers last week with the MSCI Eurozone index up 4.6% and the DAX gaining 6.8%. The DAX has rebounded strongly from the correction, having bounced back 14%, but it is still 8.0% off this year's high. With the Eurozone and Chinese central banks having made their intentions clear, all eyes will no doubt shift to Japan.
• Away from the central banks, the US reporting is in full swing and there have been some impressive price moves, particularly in the large cap tech stocks, in response to positive earnings surprises. The message remains the same though, revenues are disappointing and despite some Herculean efforts to deliver EPS surprises, US earnings momentum is awful, with 70% of all revisions to 2016 numbers coming through as downgrades. Interestingly European and Japan EPS momentum is suffering the same fate, with the direction firmly negative. Only Emerging Markets and Pacific ex Japan are seeing a rebound from lows.

- source Société Générale

So while Société Générale is right in pointing out the "low default rate" in Europe, it is we think "oversimplistic", leverage matters more and so does earnings when it comes to High Yield. Looking at default rates is like looking at the rear view mirror. It tells you what has happened, not what is going to happen and maybe indeed looking at the iTraxx CDS credit indices is a cleaner way to look at the pure credit risk, given the greater liquidity in these synthetic contracts versus cash. We like mostly as an early indicator, the ability of our "CCC credit canary" to tap the primary market when it comes to using an early warning indicator in rising default risk and exhaustion in the credit cycle.

As we posited in our September conversation "The overconfidence effect", when it comes to credit spreads and default risks and leverage, end of the day, earnings matter!

Finally, for our final chart, we would like to point out that both the Fed and Le Chiffre have been great benefactors to bond speculators who continue to have a field day. Bonds have been the only game in town when it comes to "over-allocation".

• Final chart - Bonds have been the only game in town when it comes to "over-allocation"

The big benefactors of the Fed and Le Chiffre's gaming style, particularly since is brilliant 2012 bluff in the European Government bond poker game have been bonds. We came across this very interesting chart from Deutsche Bank (h/t Tracy Alloway from Bloomberg on Twitter) which clearly illustrates "overconfidence" and "over-allocation" to the bonds relative to the trend which are $755bn above the normal trend. This is entirely attributable to the distortions created by QEs:

- source Deutsche Bank (h/t Tracy Alloway).

But of course there is a caveat to the Fed and Le Chiffre "overplaying" it in this monumental poker game.  On that specific matter we will simply quote again Antal Fekete from our July 2014 conversation entitled "Perpetual Motion":

"Moving back to the important notion of the difference between stocks and flows we do agree with Antal Fekete's take in May 2010 in his article "Hyperinflation or Hyperdeflation" being akin to a Black Hole and the possibility of capital being destroyed thanks to ZIRP (as it is mis-allocated towards speculative endeavors) hence the risk of pushing too far the "Perpetual Motion" experience":
"Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it the Black Hole of Zero Interest. When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction -- wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators." - Antal Fekete

While Le Chiffre is indeed in the process of trying to mesmerize us once more in December with his astute poker abilities, if bond investors continue to observe Le Chiffre, they will at some point find out his physical tell (A tell in poker is a change in a player's behavior or demeanor that is claimed by some to give clues to that player's assessment of their hand).

In the movie Casino Royale, Bond knew he could beat Le Chiffre as he was confident that he would catch his tell and get an insight into his game and strategy (bluffs included). This is what happens at the end!

Why? Because Le Chiffre used to place his left hand near his wounded eye at times during play. That was his physical tell. It ended up very badly for Le Chiffre but that's another story...

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald

Stay tuned!

Credit - Eternal Return

"There are no eternal facts, as there are no absolute truths." - Friedrich Nietzsche

Watching with interest the renewed gyrations in the bond markets rendering balanced funds "unbalanced", with the continuing Greek tragedy in true Nash equilibrium fashion wondering if indeed the Euro prisoner will eventually defect, we reminded ourselves of the "Eternal Return" concept when choosing this week's title analogy. Eternal Return is a concept of eternal recurrence, where time is viewed as being not linear but cyclical. The concept of cyclical patterns is very prominent in various religions and philosophy throughout history. In addition to religion and philosophy, the concept of "Eternal Return" can be found in French mathematician Henri Poincaré "recurrence theorem", a harmonic oscillator being a good illustration of his theory. His theory states that a system whose dynamics are volume-preserving and which is confined to a finite spatial volume will, after a sufficiently long time, return to an arbitrarily small neighborhood of its initial state. "A sufficiently long time" could be much longer than the predicted lifetime of the observable universe or current "credit cycle" which has been prolonged by central banks' liquidity induced "overmedication" we would argue.

On a side note, we will at the end of this week delve into more details into the US dollar upside risk and underpriced financial risks courtesy of our friends at Rcube Asset Management in another post. We will as well be travelling to Hong-Kong between the 23rd of June and 30th of June and won't be posting at this time. If you would like to meet up with us in Hong-Kong, get in touch.

The current gyration and volatility in interest rates is a reminder as well of our fear linked to "Aerolastic Flutter" which we touched in our conversation "The European Flutter" back in December 2011:

"An Aerolastic Flutter is a self-feeding and potentially destructive vibration where aerodynamic forces on an object couple with a structure's natural mode of vibration to produce rapid periodic motion. Flutter can occur in any object within a strong fluid flow, under the conditions that a positive feedback occurs between the structure's natural vibration and the aerodynamic forces. That is, the vibrational movement of the object increases an aerodynamic load, which in turn drives the object to move further. If the energy input by the aerodynamic excitation in a cycle is larger than that dissipated by the damping in the system, the amplitude of vibration will increase, resulting in self-exciting oscillation. The amplitude can thus build up and is only limited when the energy dissipated by aerodynamic and mechanical damping matches the energy input, which can result in large amplitude vibration and potentially lead to rapid failure." - source Wikipedia

Also, in our previous "Hooke's law" conversation, (when it comes to oscillation analogies), we argued:

"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates."

In similar fashion to Poincaré's recurrence theorem, in mechanics and physics, the return to the mean in financial markets is a given as displayed in Hooke's law of elasticity:

"In mechanics and physics, Hooke's law of elasticity is an approximation that states that the extension of a spring is in direct proportion with the Load applied to it. Many materials obey this law as long as the load does not exceed the material's elastic limit. Materials for which Hooke's law is a useful approximation are known as linear-elastic or "Hookean" materials. Hooke's law in simple terms says that strain is directly proportional to stress." - source Wikipedia.

Therefore it appears to us that it validates the concept of cyclical patterns hence our title "Eternal Return" as an appropriate title for this week's chosen analogy.

In this week's conversation we will look again at what can be learned from the ongoing "japanification" process for credit markets as well as why convexity is starting to bite credit and why M&A marks the end of the "goldilocks" period for Investment Grade credit. We will also look at the ongoing "de-equitisation" process through leverage and buybacks and the instability it creates.

Synopsis:

• The "japanification" process and its impact on credit markets
• Credit - When convexity is starting to bite credit
• Investment Grade is becoming less and less attractive courtesy of M&A
• The ongoing "de-equitisation" process through leverage and buybacks
• Final chart: QE has been a "high beta game" in credit

• The "japanification" process and its impact on credit markets

While we have discussed in numerous posts the "japanification" process in Europe, particularly within the financial sector, we read with interest the latest Société Générale Cross Asset note from the 2nd of June 2015 entitled "What global markets can learn from Japan". Similar to what we posited in various conversations the on-going "japanification" process has been a "goldilock" period for credit as an asset class:

"Can Europe’s credit market turn more Japanese?
Lowflation environment to remain supportive for European credit. 

Europe is still in the middle of the credit cycle: Like for Japan, investment is still low. GDP growth is likely to stay near its long-term potential rate at a low level. As a result, we don’t expect strong inflation pressure in the next 12 month, and with the help of the ECB, interest rates are thus going to remain lower for longer.

Corporate behaviour similar to Japanese firms: default rates to stay low

The recent behaviour of European companies has been similar to that of Japanese firms during the lost decades. European companies, faced with limited growth prospects, have cut capex, so leverage has declined. Cash as a percentage of assets has risen. The combination means that default probabilities have fallen, and default rates are well below long-term averages. This should continue to be a positive driver for European credit in the next 12 months, as lending conditions should remain easy (cf April 2015 bank lending survey).

Comparison with Japanese spreads: further tightening possible

European spreads to benchmark remain wider than the pre-2007 average. Japan shows how much tighter European spreads can go if this environment of low growth/low capex/low inflation/low rates persists. In the report “What turning Japanese actually means for European credit”, our credit strategists highlight that European credit could see a further decline in spreads (left chart), but also a tightening in the range of spreads (right chart).

- source Société Générale

Of course we are not surprised by this analysis given this is exactly with what Nomura discussed at the time which we agreed with in our April 6th 2012 conversation entitled "Deleveraging - Bad for equities but good for credit assets", particularly in the financial sector space:

"-Deleveraging is generally bad for equities, but good for credit assets.
-In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute).
-As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities." - source Nomura.

We even played the "high beta" game of going long on some subordinated French BPCE Tier 1 debt bonds paying a coupon of 12.5% in October 2011 as confided in April 2014 in our conversation "The Shrinking pie mentality":

"When it comes playing credit, we have to confide that, indeed we did participate and bought some junior subordinated debt from a French bank in October 2011 at a cash price of around 94.5 for a perpetual bond paying a nice 12.5% coupon seeing it rise meteorically to 138 cash price, a 46% appreciation with limited volatility, hence applying our lesson learned from the Japanese experience thanks to our continued study of central bank magic...

In the case of credit, if indeed the ECB does indeed embark on QE, another big beneficiary will no doubt be in the financial bond space " - Macronomics, April 2014

Indeed QE has provided additional support to the High Yield/High Beta space in Europe providing much more "stability" in 2015 than in the Investment Grade space, which as of late has been on the receiving end of the volatility in the European Government bond space as indicated by Société Générale in their weekly credit strategy note from the 5th of June. The latest bout of volatility has finally shown signed of fatigue in the credit space:

"Uncertainty and fears of the worst will not leave credit unscathed:

The credit markets, both cash and synthetics, have put in a very resilient performance over the past few weeks despite increasing volatility in the rates world. This week however, credit has come under slight pressure. The primary markets have been disappointing (unsurprising given the sharp swings in the swaps market) and the iTraxx indices broke through the ceiling of the recent trading range, with the X-Over rising above 300bp and cash starting to feel soft towards the end of the week. Worst of all, total returns turned negative as stability in spreads and carry earned was not enough to offset the sharp Bund yield swings. Going forward the market has little else to focus on but Greece. In our view, if the worst comes to pass, all markets will come under pressure but we suspect credit will be among the most resilient and the first to recover. After all, even a Greek exit will do little to change corporates’ ability to service their debt and we believe high beta (and high yield) will post the best performance albeit after a period of high volatility." - source Société Générale

Of course it is not yet a case of "Eternal Return" being put to the mean reversion test, but, should the volatility continue in the Government bond space, it will in the near term put upward pressure on credit spreads for both cash and synthetic indices such as the Itraxx Crossover (High Yield) 5 year CDS index taking the brunt of the widening stance we think as long as the GREXIT is "avoided".

Should the GREXIT materialise, given the Itraxx Main Europe 5 year CDS index is the proxy for investment grade and includes 21 banks out of 125 names, it would then face "harmonic oscillations" in the process.

On a side note, the Itraxx Crossover 5 year CDS index, the "proxy" for High Yield, does includes two Greek companies, OTE and Hellenic Petroleum out of 75 entities within the Series 23 index which was implemented in March this year and rolls every 6 months. Also the US equivalent to the European CDS investment Grade index, namely the CDX, does not include banks. The Itraxx Main Europe 5 year index is therefore a good "macro" hedge instrument for investment grade exposure to a potential GREXIT scenario playing out à la Poincaré...

Moving back to the impact of QE in Europe on credit investors, in similar fashion than it did in the US it will push investors down the "quality" spectrum further as indicated in Société Générale recent Cross-asset note:

 "QE will push investors lower down the quality curve

• Disappointing Q1 due to heavy supply: The outperformance of the sovereign benchmark vs. credit in Q1 15 reflects the huge change in the supply/demand balance of sovereign bonds that ECB QE created vs. heavy credit issuance levels.

• The QE rebalancing effect will support higher-yielding, lower-rated credit: High-yield bonds should be boosted by QE rebalancing effect, which intensifies the search for yield. EUR BBBs have tightened the most in percentage terms this year, and our credit strategists believe high yield has strong potential to improve. In particular, demand for yield should extend to single-Bs this year and make them outperform.

• Is the IG honeymoon over? In March 2015, over €1trn of European investment grade corporate debt was yielding less than 1%, and over €500bn yields less than 50bp. Since June 2014, IG spreads have tightened in Europe vs. the US, the UK and EM. This trend may now have run its course as some investors could start rebalancing overseas if yields diverge further. In addition, given the low level of sovereign yields, highly-rated credit could suffer from wider spreads due to the zero lower bound constraints (see “A corporate is not a custodian: how falling government yields could hurt credit”) and the return of very high levels of issuance remains a risk. Additionally, while spreads have been resilient in recent weeks, the sovereign bond sell-off has affected IG total returns which turned negative in May, while HY remained resilient." - source Société Générale.

As we pointed out in our conversation of October 2014 "Actus Tragicus", from an "interest rate buffer perspective" and  "credit risk", though the releveraging has been more advanced in the US. US Investment Grade has so far been a "better" defensive play than European Investment Grade. Dollar credit was hugely popular with European investors in January and February this year, but, with the on-going Greek tragedy playing out, fund flows have slowed significantly for both High Yield and Investment Grade as indicated by Bank of America Merrill Lynch Follow the Flow note from the 5th of June entitled "No Flow":

"More uncertainty, weaker flows
Fund flows have slowed down significantly recently. The Greek debt saga and the recent bund sell-off, mixed with challenging market liquidity, have put a strain on fund flows into risky assets. Fund flows have been relatively muted over the past week with high-yield fund flows at the lowest - in absolute value terms - in 32 weeks. A similar picture is seen for high-grade, equity and commodity funds. Only government bond funds have seen some pick up on their (outflow) pace.
Investors have taken a wait-and-see stance amid Greece. Our “flows strength” indicator below shows lethargic flows over the last few weeks. In our opinion, should the recent rates moves and risks around Greece not abate, flows will struggle to gain momentum despite the ECB QE."

High grade fared slightly better than other asset classes but flows still halved from last week to $256mn. The same went for equities, with its inflows also halving to $781mn, mimicking the behaviour at the beginning of the sell-off in April. Government bond funds registered outflows at $730mn, the largest in three weeks. Money market fund outflows also soared to a three week high. Fixed income fund flows were down by over $1bn.
On the flip side, ETF fund flows fared better, both in high-grade and high-yield credit." - source Bank of America Merrill Lynch

Another case of cyclical pattern in the current "Eternal Return" environment we think.

As we pointed out in our conversation "The camel's nose" in March this year, in the credit space, it has indeed been back to "beta" and QE will no doubt accentuate this trend (provided a GREXIT is avoided...):

"The clearly undesirable actions of the ECB from their QE have indeed pushed back European investors in the "BETA" play or to put it simply, given the disappearance of the "interest rate buffer" in the Investment Grade space, "bad" namely lesser quality bonds have indeed become "good", more appealing than "quality" bonds such as Investment Grade in the European space." - Macronomics, March 2015

In terms of "Total Return", this trend has been confirmed by Société Générale from their latest cross-asset note with High Yield faring much better than Sovereigns with the on-going volatility:

- source Société Générale

The weaker macro outlook as part of the "Japanification" process has been highly supportive of credit and the continuation of lower yields and a continuation of the "High beta" game. When it comes to High Yield price behavior CCCs continue to be the canary in the credit coal mine as they were in 2014 during the second semester as we pointed out in our conversation "Wall of Voodoo", (even single Bs weren't spared). So, you should watch closely this "rating" bucket as a "risk indicator".

Given the recent "weakness" in credit as indicated above, this brings us to our second point relating to convexity and of course bond volatility

Credit - When convexity is starting to bite credit

Obviously, the mechanical resonance of bond volatility in the bond market, is indicative of the "Eternal Return" concept and mathematically of Poincaré's "recurrence theorem" in the sense that  "convexity" is becoming a sell-fulfilling prophecy issue. We discussed that very subject in our June 2013 in our post tapering" conversation "Singin' in the Rain"  relating to the sell-off in EM.

Let's move on to the underlying issue of "convexity":

Like a spring severely coiled, when volatility is released, the destructive energy is massive because of convexity as indicated by our friend Martin Sibileau on his Popular Macro blog which unfortunately was turned off:

"Technical aspects that may matter tomorrow: While the Bank of Japan seems to have failed to control market forces, the Fed appears to have won the repression battle. However, there is an aspect that may be out of their reach: Convexity. The reach for yield (i.e. greed) has been such a powerful force that the rumor is that approx. only 15% in High Yield and 50% in Investment Grade portfolios are rate hedged.
Remember: When an investor wants to be long credit risk only, as the yield is driven by: US Treasury yield + swap rate + credit spread or Libor+ credit spread, said investor will buy the credit (i.e. bond, loan) and sell the rate, to keep only the credit spread. 
But if only 15% and 50% of positions in HY and IG are rate hedged, if Ben triggers a sell off in credit with the insinuation of tapering, the dealers on the other side, making the bid for the investors, will be forced to do the rate hedge their investors did not do, because they must be interest rate neutral! That means selling US Tsys for an average of 85% and 50% of positions in HY and IG respectively! In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?" - Martin Sibileau, Popular Macro blog

So all in all this is the perfect storm because market makers are running inventories at 2002 levels and they are always interest rates neutral...You buy a bond from a mutual fund, you sell treasuries, feeding even more the rising pressure on treasuries yield to rise further if there is a sell-off in credit funds...
There is no place to hide except cash at the moment and in dollars...(or shorting treasuries for the  short term tactical braves out there...we like the ETF TBT out there as of late...)." - Macronomics, June 2013

Of course, what we are seeing as of late is exactly what has been playing out in the rates space, hence the recent "performance" of the ETF TBT and our nose bleed on our long duration exposure (attenuated by our short JPY stance...). 

As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower will be larger because to avoid paying negative rates, investors have either taken more duration risk or more credit risk!

So, should the volatility in the bond space continue in conjunction with a materialisation of a GREXIT, you could indeed face Poincaré's "recurrence theorem" and a vicious risk-reversal in illiquid secondary markets.

As we posited in our conversation on the 13th of June 2013 "The end of the goldilocks period of low rates volatility / stable carry trade environment?":

"The huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space."

It looks like we could face both possibilities.

When it comes to "balanced funds", due to rising correlations, you have both core European Government bonds and equities getting punished at the same time these days.

In addition to what we posited in our last conversation "Optimal bluffing", when it comes to liquidity and US treasuries, there is a case of "Eternal Return" aka "mean reversion in US Treasury liquidity ratio which is creating this mechanical resonance of bond volatility in the bond market. This is also ascertained in Socété Générale cross-asset note:

"Liquidity decline: a factor of volatility in global bond markets

• A structural decline in liquidity… Since 2008, liquidity conditions deteriorated markedly in sovereign markets. This results in part from the changes in the structure of financial markets, including the impact of tougher regulations for banks and institutional investors, and the growing share of mutual funds. One measure of liquidity, the “liquidity ratio”, declined sharply in major bond markets, including the US. For instance, the liquidity ratio of US Treasuries (measured as the annual volume traded by US primary dealers, divided by total outstanding amounts of US Treasuries) declined sharply (see chart below from our Quant analysts).

Moreover, liquidity in bond futures has also declined.

• ...reinforced by unconventional monetary policy: As a result of central bank asset purchases, the liquidity of these markets has been further impaired (via a reduction in net supply and the implementation of one-way trades). For example, a study from the BoJ shows that liquidity in the JGB market has been declining since autumn 2014 (when the BoJ stepped up its QQE).

• Lack of liquidity to amplify future volatility spikes: Shallow market depth could cause sharper volatility spikes in the future, echoing the Japanese bond crash in 2013 and the flash crash on USTs last autumn." - source Société Générale

 - source Société Générale

Indeed a clear case of "overmedication" courtesy of central banks meddling with liquidity, in conjunction with much tighter regulations and their "unintended consequences".

This overmedication has come hand in hand with a case of "indigestion" as of late when it comes to new issuance activity. The "indigestion" has been indicated in Société Générale's Credit Market wrap-up from the 26th of May in their note entitled "The risks to the credit markets":

"We’ve written before about how €48bn in a month is an extremely high figure for the euro IG markets and has only been seen before in January 2009, the best month on record so far. But at the time, coupons were around 6%+, while now they are generally around the 1% mark, and volumes have been very high in recent years. As the chart below shows, a high level of net issuance has not been an obstacle for spreads until now.

As we mentioned last Friday, even with IG issuance currently €45bn+ ahead of last year, we do not expect a very large widening on account of very high levels of issuance. These strong volumes may come as US corporates continue to flood the euro markets (today it was Eli Lilly’s turn – see below) and other non-eurozone corporates also come to raise funds. But we suspect that levels of issuance would have to be extremely high for a long time to trigger a sustainable and substantial widening trend.
Further down the line, there are more risks such as higher M&A activity, especially from US corporates targeting euro corporates. There is the risk of rising releveraging as the economy strengthens, and there is the prospect of the lower limit problem, although that has faded.
There is the risk of an EM sell-off, and there is still the unresolved situation between Russia and the Ukraine as well as an economy that remains fragile with very low levels of inflation and high unemployment. But these are risks to be explored another day." - source Société Générale

In our recent "Chart of the Day - S&P500 - Leverage and performance", we mused around the "spicy" cocktail of buybacks/M&A at the high of the cycle financed by debt in true "Eternal Return' fashion.
This is indeed a sign for us that the Investment Grade rally of the last few years is getting exhausted we think. We will look at this in our next bullet point.

• Investment Grade is becoming less and less attractive courtesy of M&A

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Asset Management:

Looking back on how our Rcube friends' "Global Credit Channel Clock" operates, it does seem indeed that the US has been moving faster towards the upper left quadrant of the clock, namely re-leveraging and weakening balance sheets overall. While buybacks are great at driving multiple expansions as we have argued, the overall objective and courtesy of the "wealth effect" thanks to central bankers' generosity, is of course to enable CEOs to reach for incentive-based pay structures, it is human nature after all. And what has happened in the last few years courtesy of Central banks generosity has been the multiplication of carry trades in various segments of the market. The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years is coming to an end.

 

Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is  the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...). With rising interest rate volatility, you can expect leveraged players, carry traders and tourists alike to start feeling rather nervous.

Another "great anomaly" that investors should take into account is that low volatility stocks have provided the best long-term returns such as "Consumer Staples".

The releveraging of US corporates means it is getting more and more late in the credit game, M&A being the last manifestation that we are indeed entering the last inning of the play we think as indicated by Société Générale in their June 2015 M&A update entitled "A powerful M&A wave":

"One of the main surprises for investors is that M&A generally happens when valuations are high. Unfortunately, when valuations are very attractive, companies, investors and banks are not comfortable enough to face M&A risks despite the attractive prices. M&A tends to happen close to the peak of the cycle, when confidence is high among investors and companies are struggling to organically deliver the solid EPS growth expected by the market." - source Société Générale

Eternal Return at play and usual "cyclical" behavior we would argue.

When it comes to "releveraging" and has per the "Global Credit Channel Clock" of our friends, US companies are moving firmly into the upper left quadrant meaning to US that one can expect US M&A activity to pick-up following the "exhaustion" of multiple expansions through buybacks financed by cheap credit. This is also Société Générale's take from their latest bespoke M&A June 2015 report:

"US companies look set to be particularly active.
As described later in this report, we believe US profits have probably peaked and EPS will fall this year. Earnings pressure is intensifying on the back of rising wages and slower top-line growth. In 2014, companies mainly resorted to share buybacks to continue to generate EPS growth. But there is a limit to how much of that they can do, since the buybacks are financed via debt, as SG’s Global Head of Quant Research Andy Lapthorne has demonstrated. Companies are now seeking out transformational deals and also are keen to use their sky-high valuations to efficiently finance deals. We think this should prompt more US acquisitions, including acquisitions in Europe. In our view, the time is ripe for M&A activity in light of where we are in the profit cycle, as US companies have an opportunity to benefit from the recovery in European profits, starting from weak levels. According to Moody’s, US companies have over $1.7trn in cash, $1.1bn of which of which is sitting in Europe and cannot be brought back to the US as it would be taxed upon repatriation. These assets offer a very low yield in cash and any acquisition should improve their returns.
The main factors that could potentially reduce the strength of this M&A wave are, in order

• A stock market downturn, particularly in the US, where the market looks at risk because of stretched valuations.

• A slowdown in the major economies.

• A sharp rise in interest rates, making financing more difficult and the deals less attractive."

 - source Société Générale

Of course, most acquisitions are often over-valued as they are often made at the top of the cycle, when valuations are excessive and when stocks already include hefty premiums. When companies have access to plentiful and historically cheap funding there is a risk that they use it in ways that support shareholders while making their credit profiles more risky. This is the case today.

You cannot escape the cyclicality of the "Eternal Return":
There are trends occurring in the US credit markets that have historically been associated with a credit cycle that is reaching maturity:

• significant bond issuance
• low spreads 
• weakening of covenants, 
• declining credit ratings, 
• increase in M&A activity, 
• less favorable use of proceeds from issuance

As pointed out by JP Morgan in our conversation of October 2014 "Actus Tragicus":

"-In US High Grade markets the credit cycle is the most advanced, with increasing cash going to shareholders, rising leverage and increasing M&A.-In US High Yield credit metrics are eroding modestly alongside new-issue quality, but robust corporate liquidity supports continued low default rates.
-In European HG leverage remains near historical highs, as the economic recovery has struggled to gain momentum. Companies are being conservative with dividends and M&A.
-In European HY markets companies are reducing debt but revenue is declining at about a similar rate, such that credit metrics are struggling to improve.-In EM HG the rise in leverage has been driven by quasi-sovereigns where government policy remains a variable, but non-quasis have been stable.
-In EM HY credit fundamentals have weakened with slow GDP growth. There is still some pressure from commodity sectors, but maturities are light near-term.
-In Japan credit metrics are improving sharply with the pickup in growth and weak Yen. Companies are using the improved cash flow to pay down debt." - source JP Morgan

Also as indicated in our May conversation "Cushing's syndrome", we believe that the Investment Grade market, particularly in the US, with the start of this M&A wave is moving clearly into the final inning given the lack of investment in CAPEX means that corporate CEOs are using M&A following multiple expansions through buybacks as indicated by Bank of America Merrill Lynch's recent HY Wire note from the 6th of May entitled "Collateral Damage Part I":

"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

We concluded at the time:

"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."

Given Investment Grade bonds generally assume a 40% recovery rate for Senior Unsecured bonds when valuing CDS trades, you can probably conclude that CDS levels are somewhat "mispriced", but we ramble again...

M&A is indeed the last US corporate CEOs' "gameplay". US buy-backs have been financed by cheap credit and large debt issuance as displayed by Société Générale in their M&A report:

"At this stage companies have used their cash flows for capex and dividends. And their buybacks have been financed by debt.

This is not sustainable, as it leads to rising indebtedness.

But we believe we are reaching the limits of this process as companies do not want to endanger their credit ratings and interest rates are starting to rise. Companies are now turning to M&A to boost their EPS. Given today’s interest rates and high valuation levels, to issue more equity companies are traversing a period when M&A has become pretty fashionable.
This is especially true when the target is a European company, as a US predator benefits from:

• Top of the cycle valuation levels to issue shares
• Solid earnings recovery prospects in Europe
• A strong US dollar
• Significant cash positions. US companies have rising debt levels but also large cash positions (estimated at $1.7trn). The top 50 cash positions account for around 2/3 of this amount. This largely comes from the technology sectors with the top 5 cash positions (Apple, Microsoft, Google, Pfizer and Cisco) accounting for 25% of the total. These cash positions currently offer very low yields versus what could possibly be obtained from an acquisition.

The acquisition of truck and logistics company Norbert Dentressangle is an interesting case in point. Norbert Dentressangle and its acquirer, XPO, started discussions very recently as the stronger dollar and weaker US economic prospects prompted XPO to explore a potential acquisition, one that was negotiated in a record time. The surprise is that Norbert Dentressangle is twice as big as XPO and more profitable (XPO incurred a $64m loss in 2014), but currency swings and a-synchronised business cycles created an opportunity." - source Société Générale.

For those who still believe in a US recovery without significant CAPEX, regardless of the latest Nonfarm payroll number of 280 K, we still believe the recovery in the US is tepid yet, the wage "pressure" from the last unemployment report warrants monitoring. Until it materialises significantly we remain "unconvinced" in the recovery story much vaunted by so many pundits.

 "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?" - Bank of America Merrill Lynch

Indeed, the significant increase to expect in M&A in the US will continue to even more weaken US corporate balance sheets as indicated in the upper left quadrant of the "Global Credit Channel Clock" of our friends. This brings us to a phenomenon we have already discussed briefly, namely the "de-equitisation" process and the instability it entails as we will see in our next bullet point.

• The ongoing "de-equitisation" process through leverage and buybacks

The "de-equitisation" process is a cause for concern as it creates increasing instability in the financial system. It will as well reduce significantly the recovery value in the next credit downturn with rising defaults we think.

The issue of corporate balance sheet leverage was discussed in February 2015 in a guest post from good friends at Rcube Asset Management in their post entitled "Equity volatility - Going Higher":

"Corporate balance sheet leverage
When corporate balance sheet leverage rises, default probability increases down the line.

The FED only looks at the difference between internal funds and capital spending. We prefer adding to that equation the net amount of equity issuance (positive when issuance > shares buyback and negative when it is the opposite). The logic is straightforward. Shares buybacks drain liquidity away from balance sheets while share issuance replenishes coffers. When, like in 2007 or today, debt issuance is used to buy back shares, the impact on leverage is very substantial." - source Rcube Asset Management

Of course we agree with the above debilitating effect on corporate balance sheets. Back in October 2013 in our conversation "Credit versus Equities - a farming analogy" we indicated the following:

"The increasing recourse towards bond issuing by companies will be increasing "difficulties" at the end of the on-going credit cycle, when entering a recession or depression.
What has made the resounding success of the US economy throughout many decades was its capitalistic approach and recourse to equities issuance for financing purposes rather than bonds.
We believe the global declines in listings is indicative of growing instability in the financial system and increasing risk as a whole" - Macronomics, October 2013.

What is concerning is that ZIRP has accentuated the "de-equitisation process fuelled by "cheap credit". This has also been indicated as well by CITI in their Globaliser Chartpack from the 25th of May 2015:

"Global equities: more de-equitisation?

The cost of equity remains high relative to the cost of debt, so it makes sense for companies to de-equitise – use cheap financing to buy back their own shares; our Global Buyback screen features names like L’Oreal, IBM, Apple, Allstate, Boeing, FedEx, Viacom, Aon, and Yahoo!
‘De-equitisation is one of the key global investment themes for the next 12-18 months’, avows Global Strategist Robert Buckland, ‘for the cost of equity remains high relative to the cost of debt, so it makes sense for companies to de-equitise – use cheap financing to buy back their own shares. Since 2011, global non-financial corporates have bought back over $2.2trn of their own shares, equivalent to 9% of average market cap over the period. Companies doing buybacks have tended to be strong performers. Our global buyback screen has returned ~14% p.a. since 2000 and is up 3.7% YTD (vs. the MSCI World High Dividend Yield Index (+5.6%) and the MSCI AC World Index (+7.3%). The most represented sector in the screen is Consumer Discretionary (14 out of 50), followed by Industrials (9) and Financials (7). Names like L’Oreal, IBM, Apple, Allstate, Boeing, FedEx, Viacom, Aon, and Yahoo! currently feature’."

- source CITI

 When it comes to this week analogy and Poincaré's theorem, we concluded our 2013 conversation as follows:

"We can therefore make this over-simplistic yet provocative conclusion that:
Equities = Freedom
Debt = Road to serfdom
And as we argued before, "there is life (and value) after default!", there is freedom as well.
So we will eagerly wait for "the mother of all equities bull market" after some much needed "debt" defaults..." - Macronomics, October 2013.

If there is indeed a GREXIT, no doubt in our mind that after a painful currency adjustment, the Greek equity index will prove to be a return to an arbitrarily small neighborhood of its initial state à la Poincaré, and that hopefully equities will be the road to freedom in a debt liberated economy like Greece, but that is another story.  

• Final chart: QE has been a "high beta game" in credit

The "Japanification" process has been highly supportive of credit and "High beta" game in the credit space has indicated by Bank of America Merrill Lynch' annualized total return graph from their Glow Show note from the 4th of June entitled "The Flow Tantrum":

"Summer Bear Case: growth stall or higher inflation expectations cause markets to rebel against CBs...reversal of performance in HY, high DY, high PE assets causes flash crashes; credit returns have weakened most since taper tantrum - negative (Chart 6); 

and huge investor fear of illiquidity...the biggest gains in era of excess liquidity have been made in very illiquid assets (Chart 8)"

 - source Bank of America Merrill Lynch

We believe the US Investment Grade credit game is entering its final inning, as the leveraged players and carry traders are starting to be hurt by the rising volatility in the rates space. It marks the beginning of the end of the "goldilocks" period for credit. Caveat creditor...

"The glory that goes with wealth is fleeting and fragile; virtue is a possession glorious and eternal." - Sallust, Roman historian

Stay tuned!