Credit - The Departed

"Faithless is he that says farewell when the road darkens." -  J. R. R. Tolkien 

We have long posited that by suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns. This week's chosen title is not only a reference to departing Fed chairman Ben Bernanke, but as well a reference to Martin Scorsese movie masterpiece "The Departed". In the final scene, a rat is seen on the window ledge, symbolizing according to Scorsese "the quest for the rat", which we can ascertain today in the strong sense of distrust towards the actions of the US central bank and in relation to our chosen analogy. We could ramble further and quote Don Delillo's 2003 Cosmopolis: "A rat became the unit of currency".

Under Ben Bernanke's guidance, there has been a growing disconnect between Wall Street and Main Street as displayed by Bank of America Merrill Lynch graph displaying the evolution of Wall Street versus Main Street:

From its 2009 lows the US economy has grown by $1.3 trillion while the US stock market has grown by $12.0 trillion.

No doubt to us that the 2013 performance of the US stock market has been artificially "boosted" by "de-equitization", namely the reduction of the number of shares courtesy of buybacks thanks to increase leverage given many corporates have issued bonds to finance their buybacks program as displayed by the graph below displaying the growing divergence between the S&P 500 and trailing PE since January 2012  - graph source Bloomberg:

 The S&P 500 trades at 25x cyclically adjusted PE ratio (CAPE), exceeding the highs reached in 1901 and 1966. In 1929 CAPE reached 33x and in 2000 44x. 

Our "Departed" strategy has relied heavily on the "Cantillon Effects". The rise of the Fed's Balance sheet coincided with the rise of the S&P 500, and boosted as well by the rise of buybacks. The greatest failure of "the Departed" can be clearly seen in the fall in the US labor participation rate (inversely plotted) - source Bloomberg:

In red: the Fed's balance sheet

In dark blue: the S&P 500
In light blue: S&P 500 buybacks
In purple: NYSE Margin debt
In green: inverse US labor participation rate.

What the "Departed" aka Ben Bernanke as achieved is as follows:

More liquidity = greater economic instability once QE ends

No surprise therefore that the $4 trillion of flows which have been going towards Emerging Markets have been impacted by the return of US rates into positive real yields territory as we have argued in our conversation "Osmotic pressure" back in August 2013:

"The effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - Macronomics, 24th of August 2013

The mechanical resonance of bond volatility in the bond market in 2013 started the biological process of the buildup in the "Osmotic pressure" we discussed at the time:

"In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment."

Of course, what we are seeing right now in Emerging Markets is the continuation of "reverse osmosis".

So in this week's conversation, we will look at the growing downside risk posed by some Emerging Markets, the implication for European stocks, and our growing uneasiness with the credit risks being taken and the deflation build-up we are seeing.

We already discussed EM troubles brewing in our conversation "Misstra Know-it-all" relating to the great work from Ben Bernanke aka "The Departed":

"Of course given volatility is on the rise and that VaR (Value at risk) has risen sharply from a risk management perspective, re-calibrating risk exposure could indeed accentuate the on-going pressure of reducing exposure to Emerging Markets, triggering to that affect additional outflows in difficult illiquid markets to make matters worse."

And as posited by Nomura at the time of our September 2013, the risk of the situation turning nasty for lack of liquidity is significant:

"Bad liquidity markets saw asset swaps widen considerably (making swap paying less of a hedge) and start to trade like credit products. This phenomenon, if it continues, could result in a lot of proxy hedging through FX, FX vol, buying CDS and, at a more serious stage, selling what investors could unwind."

We also added at the time:

"Misstra Know-it'all has indeed played a quick hand, lifting stock prices, playing on the wealth effect game and exporting "hot money" flows in Emerging Markets"

In the same conversation we also indicated an interesting trade we particularly like and enjoy today:

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up." - David Goldman's article about Gold and Treasuries and bonds in general written in August 2011 (the former global head of fixed income research for Bank of America)

This is exactly what is happening at the moment from a tactical point of view we think and at least the gold leg of the put-call parity, has indeed been performing in this fashion year to date while Emerging Markets currencies have been on the receiving end of the sell-off - graph source Bloomberg:

Interestingly, when it comes to Japan and the crowded trade in JPY (which we have been playing since late 2012) appears to us overly crowded and the risk of a strong reversal cannot be ignored anymore, making as well the Nikkei vulnerable in the short-term (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro). The USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:

When it comes to credit and spread tightening, the above significant correlation between rising equities and tighter credit spreads is clearly explained by the wealth effect induced by the Japanese QE.

But, the recent rise in the Nikkei 3 month 100% Moneyness Implied Volatility could indicate a potential near term rise in the Itraxx Japan, representative of the credit risk perception for corporate Japan. It has stayed at record low levels for many months and could easily climb back towards the 100 bps level we think - graph source Bloomberg:

Given the recent bout of volatility, which has been caused from the "Great Rotation" from Emerging Markets aka the "Tourist Trap" (a tourist trap being an establishment, that has been created or re-purposed with the aim of "attracting tourists" and their money), when it comes to playing "defense", Consumer staples offer partial crash protection. On that subject see our April 2013 post - "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option".  From a contrarian stand-point, Consumer Staples, as displayed by Bank of America Merrill Lynch January 2014 Long & Shorts summary, appears extremely underweight:

When it comes to equities and credit sensitivity to Emerging Markets turmoil, Europe is more sensitive to China/EM weakness as indicated by the below chart from Bank of America Merrill Lynch from their note from the 25th of January entitled "Love EM or Hate EM" displaying the massive underperformance in Europe main investment grade risk perception indicator namely Itraxx Main (125 European investment grade entities):

We already touched on the sensitivity of equity index earnings versus FX sensitivity on the 21st of March 2013 in our conversation "Have Emerging Equities been the victim of currency wars?":
"For some countries, the major equity indices can be much more heavily affected by foreign earnings than by domestic earnings." - source BNP Paribas

No wonder the IBEX is on clearly on the receiving end of the latest sell-off. In similar fashion peripheral issuers such as Santander, Mapfre and BBVA in the credit space have not been spared either. The underperformance of the IBEX - graph source - stockcharts.com:

Credit wise, "The Departed" has indeed pushed "mis-allocation" to deep instability level, you would have thought the prime role of a central bank was financial stability, but then again, looking at the recent developments, one might wonder about the "unintended consequences" which increased the instability of the system were worth the efforts put on in over-reflating financial markets.

Recent examples abound to show the increasing risks taken by brazen investors moving clearly outside there comfort zone.

For instance investors are dipping their toes back into illiquid investments as reported by Lisa Abramowicz in Bloomberg on the 23rd of January 2013 in her article "Hard-To-Sell Junk Debt Lure Oaktree to JP Morgan":
"Bond investors are losing their aversion to difficult-to-trade corporate debt that handed them some of the biggest losses in the credit crisis.
The extra yield note buyers demand to own older, smaller junk bonds that trade infrequently has shrunk to an average 0.25 percentage point this month from more than 1 percentage point a year ago, according to Barclays Plc data. JPMorgan Chase & Co. money manager Jim Shanahan said he’s preferring “good credit quality and less liquidity” when picking bonds, while Howard Marks, the head of distressed debt investor Oaktree Capital Group LLC, said he’s finding bigger potential gains in private, less-traded debt.
The evaporating premium for illiquid assets is showing the depths to which money managers are reaching to boost returns after a five-year rally that pushed relative yields on junk bonds to the least since August 2007. With Federal Reserve monetary policies suppressing interest-rate benchmarks for a sixth year, credit buyers are showing more concern that they’ll miss out on a continued rally than get stuck with debt that lost 26 percent during the market seizure in 2008.
“For the past several years, people have been concerned about liquidity,” said Eric Gross, a credit strategist at Barclays in New York. “Now we’re hearing more about people seeking out illiquid bonds.”

Fragile Market

Such debt tends to be more vulnerable to price swings when market sentiment deteriorates, because there are fewer buyers to bid on it when investor withdrawals force money managers to sell. Those risks intensified after stricter banking rules accelerated a pullback by Wall Street dealers that used their own money to facilitate trading.
Primary dealers that trade directly with the Fed cut their holdings of corporate bonds by 76 percent to $56 billion after peaking at $235 billion in 2007, Fed data through March show. After the central bank changed the way it reported the holdings in April, net speculative-grade bond holdings fell as much as 24 percent to a low of $5.63 billion in May before rising to $7.7 billion on Jan. 8.
Investors are demanding an average yield of 5.94 percent to own bonds sold at least 18 months ago in batches of less than $250 million, Barclays data show. That compares with an average 5.7 percent for newer debt offerings of at least $500 million.
The gap, which averaged 0.5 percentage point last year and 0.92 percentage point in 2012, reached as much as 1.95 percentage points at the peak of the financial crisis in March 2009."  - source Bloomberg.

Just a thought for our confident credit investors:
"Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth - - they trust, instead, on their supposed ability to exit."
Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” - "Corzine Forgot Lessons of Long-Term Capital"

Another example as well to the extreme the "Departed" has pushed investors is the return of the old credit binge instruments such as "PIKs" bonds (Payment in Kind) as discussed by Sarika Gangar in Bloomberg on the 24th of January in her article "No-interest Junk Bonds Make Comeback With Twist":
"The riskiest types of corporate bonds are getting a makeover, providing more protection for investors while showing the limits of a rally in junk-rated debt that pushed yields to a record low.
Issuers from Neiman Marcus Group Ltd., which sold $600 million of notes in October that allow it to make interest payments in more debt instead of cash, to Jacksonville, Florida-based Bi-Lo Holdings LLC led $14.8 billion of payment-in-kind offerings in the U.S. last year, the most since 2008, according to data compiled by Bloomberg and Fitch Ratings. The 36 issues were a record.
While the bonds became popular during the last credit boom before the downturn, the new generation of securities are smaller in size, come from companies with less leverage and some compel borrowers to pay interest in cash unless they violate certain financial targets. These protections show that investors are treading carefully even as they search for additional yield amid unprecedented central bank stimulus measures that pushed interest rates to all-time lows.
“The issuance of PIK tends to move the same way as the credit cycle and credit has been loosening,” Sharon Bonelli, a managing director at Fitch in New York, said in a telephone interview. Still, “the market is not as aggressive as it was.” Sales of PIK-bonds were the third most on record last year, behind the $16.2 billion in 2007 and $14.9 billion in 2008." - source Bloomberg.

Kuddos to the "Departed", the Fed's ZIRP since 2008 has forced investors into riskier securities to get extra payouts. But, there is a catch we have repeatedly pointed out:
Definition of Credit Market insanity - "Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

When it comes to credit risk and luck, recently some investors in hybrid securities learned the hard way when ArcelorMittal called early some subordinated bonds at 101 when they had been trading recently around 108.96 cents, a good sucker punch for some unwary investors as indicated by Alastair March in Bloomberg on the 21st of January in his article entitled "Arcelor Mittal's Hybrid Bonds Slump on Early Redemption Call":
"ArcelorMittal’s $650 million of hybrid bonds slumped 6.8 percent after the steelmaker said it would redeem the notes early because of changes to the way the securities are treated by Moody’s Investors Service.
ArcelorMittal will buy back the subordinated securities on Feb. 20 and pay investors 101 percent of their principal, the Luxembourg-based company said in a statement. The notes, which combine elements of debt and equity, were trading at 101.55 cents on the dollar at 11:05 a.m. in London after closing on Friday at 108.96 cents. Moody’s said on July 31 that it would consider hybrids of speculative-grade companies to be entirely debt, rather than half equity as is now the case for all issuers. ArcelorMittal’s move to call the securities early “shocked the market” and highlights the vulnerability of hybrid bonds to ratings changes, ING Groep NV analysts led by Mark Harmer wrote in a note to investors." - source Bloomberg

When the facts change, which they did in July last year, as a credit investor, change your facts or face the consequences.

We are nearing a top in the gentle credit cycle and no doubt there will be a second distressed wave in the not so distant future, rest assured.

This is what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, wrote back in 2011 - Corporate Subprime - The default crisis that never happened:
"Armageddon never arrived. The Federal Reserve slashed interest rates, helping to spark a huge rebound in the price of risky debt. According to S&P, during the past five years cov-lite debt returned a total of 33 percent, versus 31 percent for standard loans with covenants. Companies that were running into trouble were able to raise more money in the markets. Corporate default rates stayed very low. And it all happened so quickly that the protection afforded by the covenants, or the lack thereof, never seriously got tested." - Bethany McLean - The default crisis that never happened.

She also added in her 2011article:
"The fact that the Fed rode to the rescue doesn't necessarily mean that cov-lite loans were a good risk to begin with."

Another interesting development in the desperate search for yields at any risk by credit investors, has been in the the speculative loan space as indicated by Sridhar Natarajan in Bloomberg on the 22nd of January in his article "Loan Surge Above Par Putting Investors at Risk":
"More speculative-grade U.S. loans are trading above par than at any time since May, exposing investors who are funneling record amounts of cash into the debt to greater risks as rising prices encourage borrowers to refinance at lower interest rates. 
Spanish-language broadcaster Univision Communications Inc. and KKR & Co.-controlled First Data Corp. are among at least 30 companies seeking to reduce rates on $31 billion of bank debt as more than 80 percent of leveraged-loan prices exceed 100 cents on the dollar, according to JPMorgan Chase & Co. That’s up from 40 percent at the beginning of October, according to a report from the New York-based lender last week. “Loans are trading well above their call prices because the investor community is reaching out for existing loans, "Jonathan Kitei, head of U.S. loan distribution at Barclays Plc in New York, said in a telephone interview. “You will see more loans getting repriced.”
Investors last year deposited about $63 billion into loan funds that invest in debt with rates that rise with benchmarks and have limited restrictions on early repayment. Banks from Barclays Plc to JPMorgan and Citigroup Inc. expect loans to underperform compared with 2013 as the Federal Reserve begins to taper its bond purchases, paving the way for an increase in rates that have been kept near zero for the last five years.

Limited ‘Protection’

“Whenever loans are trading above par, you introduce an additional risk element as there is limited call protection,” David Breazzano, president of DDJ Capital Management LLC, which manages more than $7 billion in high yield assets, said in a telephone interview. “Value in loans has dissipated a bit in the last couple of months.” Companies reduced borrowing costs on $281 billion of speculative-grade loans last year, or almost 4 times more than 2012, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data." - source Bloomberg.

The divergence of growth between the US economy and the European economy has been indeed reflected in credit prices such as the US leveraged loan cash price index versus its European peer. - source Bloomberg:

While both the PMIs and Leveraged loan prices cratered in 2008, you can see the impressive rebound in 2009, leading in the rapid surge in cash prices for leveraged loans and the increasing divergence in cash prices as indicated by the growing spread between US leveraged loan prices and European leveraged loan prices now at only 3 points apart.

The divergence of loan growth has indeed explained the divergence of economic expansion between Europe and the US. The divergence between US and European PMI indexes - source Bloomberg:

The growth differential between both economies is due to credit conditions. You can clearly notice the uncanning similarity with leveraged loans prices in both regions.

Moving on to the growing deflationary risk we have been warning about for some time, Europe seems indeed to be sleepwalking into a deflationary trap as pointed at recently by Christopher Woods from CLSA in his recent Greed & Fear note:
"At some point the equity market must surely focus on the reality that this market action reflects an increasingly deflationary environment in the Eurozone which is fundamentally equity negative. In this respect it is worth noting that 20% of the items in the Eurozone’s CPI inflation basket are now in deflation, with an average 2.2%YoY decline in December, contributing a negative 45bps to the Eurozone CPI inflation." - CLSA, Christopher Woods

Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes going down again and indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

In similar fashion to QE2, QE3 triggered a significant rise in Inflation Expectations, since the beginning of the year, 5 year forward breakeven rates have been falling, indicative of the strength of the deflationary forces at play - source Bloomberg

Every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully.

Another sign of the many failures of the "Departed": Inflation is nowhere to be seen but in rising asset prices, which are more and more grossly disconnected from reality. QE was supposed to create inflation. It hasn't been the kind of inflation the "Departed" was hoping for.

On a final note, of course one of the main culprits in 2013 which we have discussed at length has been Japan which has been exporting deflation on a large scale and the US has not been immune. It is still the "D" world (Deflation - Deleveraging). On that point we agree with Albert Edwards from Société Générale on the deflation risk, as displayed in a recent Chart of the Day graph from Bloomberg:

"The CHART OF THE DAY shows annual rates of inflation excluding food and energy, based on indicators that Edwards cited in a similar chart two days ago. It tracks the monthly changes in a consumer-spending deflator compiled by the U.S. Commerce Department and a price index from Eurostat.
The U.S. deflator rose 1.1 percent for the 12 months ended in November. The increase was smaller than the 1.7 percent gain for the core consumer price index that month, which was matched in December. Last month’s reading for the euro-region gauge was 0.7 percent, the lowest on record.
“Investors have yet to react to the deflationary threat,” wrote Edwards, a London-based strategist who says stocks are in a multiyear bear market that he calls the Ice Age. “They simply do not believe a recession that would trigger outright deflation is on the horizon.”
International Monetary Fund Managing Director Christine Lagarde highlighted the risk of falling prices two days ago during a speech in Washington. She urged policy makers in the U.S. and other advanced economies to avert deflation, which would hamper a “feeble” economic recovery.
“If U.S. growth in 2014 proves as disappointing as in previous years, then there should be a large market reaction as inflation expectations get pegged back closer to euro-zone levels,” Edwards wrote.
Economists expect gross domestic product to rise this year by 2.8 percent, exceeding last year’s 1.9 percent, according to the average estimate in a Bloomberg survey. They also expect a bigger increase in the deflator for core consumer spending, to 1.6 percent from 1.3 percent." - source Bloomberg.

To conclude on Ben Bernanke's legacy, we quite enjoyed Doug Noland recent take on the subject in his column entitled "The Departing Bernanke on Macro-Prudential":
Q&A from the National Association of Business Economics conference, Philadelphia, January 3, 2014: William Nordhaus, Yale University economics professor and chairman of the Federal Reserve Bank of Boston: “I asked my students if they had a question for [Bernanke]. And there were a number of them, one which I won’t ask is ‘what about bitcoin?’ – which I know he knows about. But I thought a really interesting one was this: ‘If you knew in 2006 what you know now, what step or steps would you have taken then to prevent or ameliorate the financial crisis and subsequent severe downturn?’” 

Bernanke: “Well that’s a really unfair question. I mean, the reality is that everybody – every policymaker has to make – this is the nature of policy – it has to be made in very, very foggy conditions with very imperfect information – a lot of uncertainty. So, in order to do anything, I think I would not only have to know everything in advance, everyone else would have to know I knew everything in advance. In other words, if I went out and started saying – all of the sudden I’m arbitrarily raising capital requirements by five percentage points, the banks would say ‘What!’ and it would be very difficult to get Congress and the other regulators and so on and so on to agree. I mean I think the crisis was very complex, involved many many issues. One of the concerns, I want to respond indirectly to a point…, the usefulness of macro-prudential-type measures. I think one of the practical questions is, even if you think you’ve got macro-prudential measures that work, can you put them in place quickly enough and responsibly enough, preemptively enough.

"To know and not to act is not to know." - Cosmopolis - Don Delillo

So long "Departed".

Stay tuned!

Credit - Cold Turkey

"Every form of addiction is bad, no matter whether the narcotic be alcohol or morphine or idealism." - Carl Jung 

While listening to future Fed in Chief Janet Yellen first public appearance as nominee to succeed Fed Chairman Ben Bernanke in front of the Senate Banking committee, who:

-could "see no evil" when questioned about the housing market:

"a rational response by the market" - Janet Yellen

- source Bank of America Merrill Lynch - The Thundering Word - 13th of November 2013.

and also added:

“I don’t see evidence at this point, in major sectors of asset prices, misalignments,”- Janet Yellen

- could "hear no evil" about QE being an elitist policy, favoring those holding financial assets failing to trickle down to Main Street:

“Stock prices have risen pretty robustly but if you look at traditional measures,” such as price-earnings ratios, “you would not see stock prices in territory that suggests bubble-like conditions,” - Janet Yellen

"Global stocks are annualizing 22% gains in 2013 (versus -2% for bonds, and -6% for commodities). Wall Street's boom in recent years has been caused by Main Street's bust and a “High Liquidity-Low Growth” regime." - source Bank of America Merrill Lynch - The Thundering Word - 13th of November 2013.

- could "speak no evil":

“Although there is limited evidence of reach for yield, we don’t see a broad buildup in leverage, where the development of risks that I think at this stage poses a risk to financial stability.” 

and added:
"It could be costly to fail to provide accommodation (to the market)". - Janet Yellen

- source Bank of America Merrill Lynch - The Thundering Word - 13th of November 2013.

she also said:

"I don’t think the Fed should be a prisoner of the market," - Janet Yellen

Given we are coming closer to "Thanksgiving Day" which is a national holiday to celebrate primarily in the United States and Canada as a day of "giving thanks" for the blessing of the harvest and of the preceding year, no doubt Wall Street could indeed be giving thanks for the blessing of QE and the Fed's unaltered generosity, which will of course continue in the near future, be rest assured.

So you might already see the relationship with this week chosen title in relation to upcoming "Thanksgiving Day". 

Our title is a clear reference to the addiction to QE as it seems the current Fed leadership and the future Fed leadership has no "appetite" for "cold turkey" as posited by the astute Christopher Wood from CLSA:

"There is no benign exit from QE and that the Fed is in a trap of its own making in the sense that stronger data will lead to renewed tapering concerns, leading to a tightening in financial conditions and a resulting reluctance on the part of the central bank to taper. In this respect, the correct analogue remains that of a heroin addict. The tapering concerns are the equivalent of withdrawal symptoms. Obviously, it is possible to exit an addiction if the addict is willing to go through “cold turkey”. But GREED & fear’s base case is that the current Fed leadership has no stomach for “cold turkey”." - CLSA - Christopher Wood - Greed and Fear - 14th of November 2013

Nota bene: "Cold turkey" describes the actions of a person who abruptly gives up a habit or addiction rather than gradually easing the process through gradual reduction or by using replacement medication." 

In the case of dependence upon certain drugs, including opiates such as heroin, going cold turkey may be extremely unpleasant, but less dangerous. Life-threatening issues are unlikely without a pre-existing medical condition." - source Wikipedia.

On a side note we chuckled when the future of the Fed stated the following in relation to Gold:

“Well, I don’t think anybody has a very good model of what makes gold prices go up or down,” - Janet Yellen.

It seems to us that Janet Yellen seems oblivious to "Cantillon Effects", and the return of the Gibson paradox, and as far as "tapering" is concerned we think that "the Buying will continue until moral improves" but we ramble again:

“A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases” - Janet Yellen

While everyone has been focusing on the Fed's "tapering" stance since May 2013, for us the "real game changer" in 2013 has no doubt been the true elephant in the room, namely Japan's truly aggressive reflation policy. Therefore this week, we will focus our attention back to Japan.

Japan has already been the subject of numerous posts already on Macronomics, such as "Big in Japan", "Japan - the rise of the Kagemusha", "If at first you don't succeed..." or  "Have Emerging Equities been the victims of currency wars?".

Of course when one looks at the relative performance of the MSCI Emerging versus the S&P 500, one can easily see that EM equities have been clearly lagging. Emerging markets (MXEF) have underperformed the S&P 500 - source Bloomberg:

But as we posited in early 2013, Emerging Markets have indeed been the victim of "Abenomics" given in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off.

It has clearly been the case for Emerging Markets which have been lagging as well the surge in the Nikkei index - graph source Bloomberg:

The aggressiveness in the reflation trade has once again been further illustrated by Friday's price action, which saw the Nikkei surge by 1.95% and the Topix by 1.68% - graph source Barclays / Bloomberg:

"UNSTOPPABLE! NKY went up another 2% pushed by USDJPY going through 100. Intraday was one way: NKY opened up 75bps to close up 1.95%. With realized volatility going higher and high demands for options from clients, VNKY remained elevated at 25.6. The volatility curve went up sharply today again with high correlation to the cash spot. 1Y +1.2% 5Y +0.5%. Option market was very busy as each move up of spot was triggering volatility moves. We saw a lot of interests on calendar spreads, call ratios and skew. Long term volatility remained well bid as Structured Products desks are looking to buy back volatility in the rally. Client flows were active: lot of interests in 2014 upside calls from Jan14 to Dec14. We saw a lot of risk reversal crossed on the exchange for clients getting exposure on the upside. At this level even if Bollinger bands & RSI suggest NKY is overbought, we should expect NKY to go higher and test the 16,000 level again very soon. Interesting to notice the dynamic between rates, FX and Equities at the moment. We saw a large drop in JGB around the close, triggering some weakness in USDJPY (yield adjustment)." - Barclays 

Dynamic between FX and Equities? Of course there is! As illustrated by this Bloomberg graph displaying the not only the surge of the Nikkei and the weakness in the USD/JPY but also the reverse Itraxx Japan CDS index:

And went it comes to expect more from the Nikkei until at least the end of the year, this is as well validated by the fall in the Nikkei 3 month 100% Moneyness Implied Volatility and the fall in the Itraxx Japan, representative of the credit risk perception for corporate Japan - graph source Bloomberg:

As per our January conversation, "If at first you don't succeed...", once again we will slightly break our Magician's Oath.
As a reminder on the Magician's Oath:
"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

Back in January we argued:
"We have to confide, that since our October post, we have continued "practicing" the effect of our magicians "secret illusions" by having been short JPY against USD (via proshare ETF YCS) and we have been as well long Nikkei but in Euros via a quanto ETF (currency hedged) but until you all become magicians, we have to stop revealing tricks unless, of course, dear readers, you all swear to uphold the Magician's Oath in turn*, but we ramble again..."

When it comes to going long Nikkei but in Euros, we must confess, we have been adding again. Reason being, and on that point we agree with Exane's note from the 8th of November entitled "The end", is that Japan might be high risk but worth it for now:

"Overweight Japan- but currency hedged

If markets have at times fought the Fed this year, and driven Treasury yields up, it looks very unwise to fight the Bank of Japan – that is busy hoovering up 70% of JGB issuance. Economic momentum in Japan looks robust – with little real obvious test to that momentum prior to the sales tax increase in April. If the economy suffers as a result of April’s tax change, the BoJ has stated its intention to respond with increased monetary stimulus.

Looking into Q1, if the USD strengthens as a result of tapering, the Yen looks one of the currencies liable to weaken as a result. A fall in the real effective exchange rate should feed back into more supportive domestic liquidity conditions. For us, the Yen still looks materially overvalued.

While the Japanese equity market has re-rated significantly over the last year, it still does not look particularly expensive and remains on course to provide one of the big earnings growth stories of 2014. We like the market on a currency-hedged basis." - source Exane

While Exane like the Japanese market on a currency-hedged basis, we like it too as the Nikkei keeps going one way with higher conviction, more volumes (highest in last 3 months) and more inclusive client/investor participation. JPY cemented 100 level as a strong support and went as high as 100.4 in the evening session. We have been liking it since January this year.

Furthermore Exane added on Japan the following points:
"After 6-months consolidation, corporate earnings have grown into share prices. Valuations are reasonable, and there is still plenty of upside to the earnings base. We see the Yen headed south and equity prices north.

From setting the investment world on fire in the first 5-months of the year, Japan has morphed into something of a forgotten story over the last 5-months. USDJPY has traded sideways over this period, as has the Nikkei. And after May’s spike higher, the 10-year JGB yield is back at April’s levels too.

After such an aggressive price move earlier in the year, a period of consolidation is understandable. But this has allowed the Japanese market’s earnings base to grow into the pricing move. EPS for the MSCI Japan is on course to advance almost 60% in 2013.

The dynamics of the Japanese equity market, as they stand on consensus numbers looking into 2014 are summarised in the following table:

Of course a large component of the Japanese policy framework involves weakening the Yen. This is an obvious and clear benefit to the Japanese corporate sector with a positive direct translation impact on overseas earnings and also potentially the secondary transaction impact – whereby improved Japanese competitiveness leads to market share gains. The following chart shows that the Japanese equity market’s EPS forecast has followed the path of USDJPY over the course of the last year:

The currency support for the Japanese economy, Japanese stock prices and for the earning base of Japanese companies is unequivocal. And in our view this is likely to go materially further than we have seen to date.
As the US cycle matures the downward pressure on the Yen is likely to intensify. The BoJ is likely to hold bond yields lower via direct asset purchases at a time when the US backs out of QE. Further as the Japanese start to have some success in creating a degree of inflation, the real yield on Japanese government debt is likely to fall.

As we show in the following chart the yield premium on 2-year JGBs deflated by CPI over the 2-year Treasury deflated by US CPI has captured pretty well the big directional moves in USDJPY. With the ‘real yield’ on 2-year JGBs likely to fall and the real yield on 2Y US bonds potentially rising this clearly points to downward pressure on the Japanese currency. That should feed straight back in to supporting Japanese shares.

Put simplistically we fail to understand how a 20% fall in trade-weighted Yen fully reflects the central bank’s commitment to double the monetary base. There must be, to our minds at least, further to go in this trade.

From a valuation standpoint, the rehabilitation of the Japanese economy combined with the boost to export earnings is helping the Japanese corporate sector lift ROE. The 12- month forward ROE – using consensus forecasts – has now reached nearly 9%. The uplift in the price-to-book value has been substantive – and now stands at around 1.2x 2014F." - source Exane

While some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we think that we are in an early second stage for the Multistage Japan rocket:
"A multistage (or multi-stage) rocket is a rocket that uses two or more stages, each of which contains its own engines and propellant. A tandem or serial stage is mounted on top of another stage; a parallel stage is attached alongside another stage. The result is effectively two or more rockets stacked on top of or attached next to each other. Taken together these are sometimes called a launch vehicle. Two stage rockets are quite common, but rockets with as many as five separate stages have been successfully launched. By jettisoning stages when they run out of propellant, the mass of the remaining rocket is decreased. This staging allows the thrust of the remaining stages to more easily accelerate the rocket to its final speed and height." - source Wikipedia

On that point we agree with Exane's take for more Japanese upside:
"Potential catalysts
The underpinnings of the Japanese equity story are still there. It seems to us more likely the market has just got a little trade fatigue. In this respect, there are potential catalysts on the horizon that can re-create a degree of enthusiasm.
First, most clearly the sales tax increase of next April is seen by many economists as likely to prompt an acceleration in the pace of central bank asset purchases. That should clearly be helpful for the assets bought directly – but also in suppressing bond yields and forcing yield-seeking investors up the risk curve. Furthermore, this is likely to put more downward pressure on the Yen that should feed back into enthusiasm for the earnings prospect of Japanese companies. The stock market should respond.
Second, the missing link in the Japanese story this year has been some evidence that labour market reforms – a key component of PM Abe’s third arrow – can be pushed through the Japanese parliament. This is clearly the most controversial and politically difficult element of the policy suite. While so far Mr Abe has chosen to use his bullets on politically easier reform measures, progress on labour markets would be seen as a particularly important development by international investors." - source Exane

We don't see Japanese going "cold turkey" for the time being hence our stance.

Of course given everyone and his dog has been focused as of late on the "magician tricks" from the Fed, we would have to agree with David Bowers take in the Financial Times in his article from the 13th of November entitled - Monetary shock from Japan eclipses Fed taper concerns :
"If you cannot see the wood for the trees, then how do you expect to see the elephant in the room? One of the casualties of the market’s obsession with the Federal Reserve’s monetary easing “non-taper” has been a loss of perspective. The world has forgotten that the real monetary shock of 2013 has been the change in policy by the Bank of Japan. 

In the words of the Bank for International Settlements’ annual report, when the world’s third-largest central bank decides “to double the size of its monetary base, double its holdings of Japanese government bonds and exchange traded funds and more than double the average maturity of its government bond purchases”, investors ought to sit up and take note, especially when it comes with a 20 per cent currency depreciation. 

This is “unilateral QE” with a vengeance – of a similar magnitude to the Fed’s QE3 but applied to an economy a third the size of the US. Japanese monetary policy is never going to be the same again, with consequences that will extend beyond Japan’s borders. 

The main reason why Japan is still a sideshow in the minds of investors is because that is exactly where it has been for the past 20 years. Many asset managers have only known Japan as a taker, rather than a maker, of the global narrative. The sharp rise in the Nikkei in the first few months of this year may have been impressive, but it is the seventh occasion in 21 years when the market delivered six-month returns in excess of 30 per cent; the previous six were all false dawns." - source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.

"Have Emerging Equities been the victims of currency wars?" we wondered in March 2013:

"If Mr Kuroda is indeed serious about "reflating" in this on-going currency wars, the "rise of the Kagemusha", no doubt, represents a serious headwind for some Emerging Markets in general and their equities in particular."

It seems that David Bowers is indeed confirming our Pareto efficient economic allocation concept where no one can be made better off without making at least one individual worse off, in that case Emerging Markets:

"This year, many investors have chosen to focus on the strategic risks facing emerging markets instead. Over the past three years, EM equities have underperformed the global benchmark by almost 30 per cent, confounding the conventional wisdom. Fed tapering has been the catalyst for this soul-searching. But this year’s underperformance is in part due to Japan. 

One of the consequences of the BoJ’s policy shift has been to weaken the yen and boost the dollar. In recent years, dollar strength has been associated with soft commodity prices and weak pricing power in the traded goods sector. That has hurt emerging markets with their high exposure to commodities and global supply chains. 

In short, the initial impact of Abenomics has been to export deflation to the rest of the world. This can also be seen in the lower-than-expected inflation rates in the US and eurozone. These are the unintended consequences of the BoJ’s actions. You may not want to invest in Japan, but you do have to understand that it matters enormously whether Abenomics succeeds or fails. 

The initial shock may have been deflationary; but it could yet turn out to be reflationary if Japan succeeds in getting companies to save less and invest more. Japanese corporates have run themselves for cash rather than for growth; their saving has been the counterpart to the government’s borrowing. Were we to see double-digit capex growth next year – led by the non-manufacturing sector – the labour market would tighten to a point where real wage growth returns." - source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.

We also have to agree with David Bowers from Absolute Strategy Research, Japan is the real elephant in the room:
"For the past quarter of a century monetary policy has been run for creditors, not debtors. That favoured instruments such as Japanese government bonds. But if the BoJ succeeds in generating sustained inflation then the asset allocations of the past 20 years could quickly become obsolete. The launch of the Nippon Individual Savings Accounts, and the review of public pension funds’ asset allocation, are important developments. 

Japan has been practically invisible for the past two decades, a passive bystander to China’s rise. But Japan’s moves clearly have the potential to disrupt the Asian narrative. If Japan recovers, it would provide a new source of final demand for the region; if it fails, then the risk is it exports more deflation via further yen depreciation. It would be ironic if Japan’s attempt to reform ended up destabilising China’s own reform process. The stakes could not be higher."  - source David Bowers Financial Times - Monetary shock from Japan eclipses Fed taper concerns.

We would recommend you closely monitor Japan's foreign bond buying spree. Nomura in their 14th of November note indicated the following when it comes to foreign bond buying:

"Japanese investors were net buyers of foreign bonds last week for the fifth consecutive week. Net buying totalled JPY357bn (USD3.6bn), increasing slightly from JPY277bn the previous week. The strong US NFP data and following rises in US yields are likely to have increased expectations of a weaker JPY, encouraging Japanese investors to invest in foreign bonds" - source Nomura

Also, Nomura added:

"Retail investment in domestic and foreign assets via toshins remains stronger than the past five-year average, according to NRI"

- source Nomura

Furthermore, in another report Nomura also made the following points:

"Retail investors. risky asset investment activities via toshins have accelerated since the early 2000s, and they have preferred foreign assets to domestic assets owing to higher income returns. The foreign asset share of total toshin outstanding is now above 50%, but it was below 20% in 2000 (Figure 2). 

Thus, it is unsurprising that the liquidation of toshins before the capital gains tax hike is a bit concentrated in foreign assets selling. As a result, net purchases of foreign securities via toshins may continue to lag net buying of domestic assets by year-end.

At the same time, foreign investment activity via toshins has not been meaningfully weaker than the previous five-year average, even though the scheduled capital gains tax hike may be depressing momentum. Furthermore, total buying of domestic and foreign securities via toshins remains net positive, showing strong underlying momentum of toshin investment. The job market remains strong, while winter bonuses at large Japanese companies are estimated to have risen by 5.8% from a year ago, the biggest increase since 1990, according to a survey by business lobby Keidanren. Strong risk appetite supported by better income conditions, combined with the introduction of NISA next January, is likely to accelerate foreign investment activity via toshin next year." 

- source Nomura

As we posited in the "Coffin Corner" back in Europe, the aggressiveness of the Japanese reflationary stance spells indeed more deflation for Europe and we think the US will as well withhold its tapering stance, spelling more trouble ahead, unless the ECB of course decides to engage as well in a QE of its own:

"Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think." - Macronomics - 27th of April 2013.

On a final note the Euro curse is clearly illustrated by Bloomberg's recent Chart of the Day showing that the Euro remains the best performer this year:

"The European Central Bank’s surprise cut in interest rates last week failed to dislodge the euro from its position as 2013’s best-performing major currency, a potential blow to the region’s nascent recovery.

The CHART OF THE DAY shows the euro strengthened 6.2 percent this year, the biggest gain among 10 developed-nation currencies tracked by Bloomberg Correlation-Weighted Indexes.

That’s a reversal from four years of declines as the sovereign debt crisis engulfed the 17-nation currency bloc. The dollar appreciated 4.4 percent this year, while the yen slumped more than 10 percent, the indexes show.

The euro surged as the region exited its longest recession on record and central banks in the U.S. and Japan pursued bond-buying programs that tend to debase their currencies. While ECB President Mario Draghi said the exchange rate wasn’t part of the ECB’s decision to lower its main refinancing rate, French Industry Minister Arnaud Montebourg said on France Inter radio yesterday the currency is too strong. Inflation fell to the least in almost four years last month.

“Draghi knows his ability to control and steer the euro is woolly at best,” said Jane Foley, a senior currency strategist at Rabobank International in London. “Although he did say that the euro was not discussed in the policy meeting, it’s very clear that when you fight disinflation you really do want a weaker currency. The relief that the crisis is over has created another problem, which is a better euro.”

The euro traded at $1.3417 as of 4:14 p.m. London time on the 13th of November, after climbing to $1.3832 on Oct. 25, the highest since November 2011. The correlation-weighted indexes show the currency gained 1 percent since Nov. 7, the day the ECB cut its benchmark rate to a record 0.25 percent as predicted by only three of 70 economists in a Bloomberg News survey." - source Bloomberg

"A moderate addiction to money may not always be hurtful; but when taken in excess it is nearly always bad for the health." - Clarence Day, American author.

Stay tuned!

Credit - Lucas critique

"Excess generally causes reaction, and produces a change in the opposite direction, whether it be in the seasons, or in individuals, or in governments." - Plato 

While we mused around Goodhart's law, prior to taking a much needed break, unfortunately interrupted by the unavoidable and repetitive French strikes, we thought this week, on the back of a friend's recommendation, we would make a reference to Lucas critique, named after Robert Lucas' work on macroeconomic policymaking. Robet Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:

"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes.

For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. But a change in security policy, such as eliminating the guards for example, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies." - source Wikipedia

So, as one can infer from the point made above and in continuation to the points made in our conversation "Goodhart's law", Ben Bernanke's policy of driving unemployment rate lower is likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  

In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:

"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - source Wikipedia

In similar fashion to what we posited in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is as we recently discussed.

The issue with NAIRU:

"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed." - source Wikipedia

In respect to our chosen title, and looking at the evolution of inflation expectations, via TIPS, we still believe deflation is currently the on-going problem, not inflation as indicated by Bloomberg's chart displaying 10-year TIPS which have turned positive:

"Treasuries have dropped far enough during the past six weeks that investors no longer have to pay for the privilege of guarding against inflation when they buy 10-year notes.

As the CHART OF THE DAY illustrates, 10-year Treasury Inflation-Protected Securities yielded more than zero for the past two days. The last time that happened was in November 2011, according to data compiled by Bloomberg. Yields on the notes, known as TIPS, fell as low as minus 0.93 percent last December. Investors who bought the securities and held them to maturity were assured of receiving less than they paid before any adjustments to principal and interest payments, reflecting changes in consumer prices. “The idea that you’re going to have inflation, I think, is coming off,” Ira F. Jersey, director of U.S. rates strategy in New York at Credit Suisse AG, said yesterday in an interview on Bloomberg Radio.

The Federal Reserve’s preferred inflation gauge shows the pace of price increases has slowed even though the central bank is buying bonds and holding its key interest rate near zero to aid the U.S. economy. The indicator, the personal consumption expenditure deflator, rose 0.7 percent in April from a year earlier. The increase was the smallest since 2009.

Lower prices for Treasuries may do more to explain the above-zero yield for 10-year TIPS than the inflation outlook, Jersey said. Ten-year notes that aren’t indexed had a negative return of 4.2 percent from May 1 through yesterday, according to data compiled by Bloomberg."  - source Bloomberg

As a reminder in relation to the Taylor Rule and inflation expectations, as indicated in a Bloomberg article from the 15th of November 2012 by John Detrixhe entitled "Citigroup Seeing FX Signals of Early End to Stimulus: Currencies":

"Traditional measures of monetary policy such as the Taylor Rule that are based on growth and inflation suggest the Fed should end its stimulus efforts. John Taylor, an economist at Stanford University, published the formula in 1993. It signals the Fed’s benchmark should be 0.65 percent, or 40 basis points above the upper range of the current target interest rate for overnight loans between banks, assuming an inflation of 1.7 percent, unemployment of 7.9 percent and a nonaccelerating inflation rate of unemployment, or NAIRU, of 5 percent. NAIRU is the lowest unemployment rate an economy can sustain without spurring inflation.

About a year ago, the Taylor Rule model indicated policy rates should be minus 0.47 percent. The Fed has a target for price increases of 2 percent. The consumer-price index increased by that much in October 2012 from a year earlier, the Labor Department said on November 14. If “unemployment rate gets below 7 percent, you could have a Taylor Rule that suggests rates should go up and the question becomes do they overturn the Taylor Rule?” Steven Englander, Citigroup’s New York-based global head of G-10 strategy said. “When perceived commitments are at stake, it’s a nightmare.” - source Bloomberg

As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion, but we ramble again

Therefore in this week's conversation, after a quick market overview, we would like to touch again on the deflationary forces at play, given, as Plato's quote rightly said, excess generally causes reaction, and produces a change in the opposite direction .Our "omnipotent" central bankers, and investors alike should pay more attention to this quote...

In our quick market overview, we will not delve too much into the recent surge in rates volatility which has spilled over other asset classes given we have tackle this issue in our post from the 13th of June entitled "The end of the goldilocks period of low rates volatility / stable carry trade environment". 

The recent move in the MOVE and CVIX indices are now starting to spillover to the equities sphere. We have added the VIX index to our previous chart - source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

The spike in volatility in Japan has been preceding the widening move in CDS Spreads of the Itraxx Japan, a move we saw coming:

"Should the volatility in the Japanese space continue to trend higher, which is currently the case, we would expect credit spreads to continue to widen, particularly for Japanese financials." - Macronomics, Japanese Whispers, 25th of May 2013.

Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Itraxx Japan 5 year CDS since January 2010 until today - source Bloomberg:

Back on the 25th of May the Itraxx Japan CDS, we indicated that a surge in volatility in Japan would lead to a surge of Japanese credit risk. The Itraxx Japan has surged from 82 bps to 111 bps in the continuation of this surge in equity volatility.

More interestingly the surge in bond volatility has led to some serious outflows in the fixed income space. For instance, as indicated by Credit Suisse, the ICI fund flow data which was out for week ended June 5; showed equity mutual fund outflow of -$942m;  the big number was bond outflow of - $10.9bn. It was second-largest bond mutual fund outflow in history of weekly ICI series, which extends back to Jan 2007:

"The Investment Company Institute estimated that bond mutual funds posted a huge net outflow of $10.9bn in the week ended June 5. This was the second largest weekly outflow in the history of this series, which extends back through 2007. The largest outflow recorded was during the darkest days of the financial crisis, in the week ended October 15, 2008 (-$17.6bn). Investors apparently didn’t rotate into equity mutual funds in early June, as equities also saw a net outflow, albeit a much smaller one. In the week ended June 5, investors withdrew a net of $942mn from equity mutual funds.  Hybrid mutual funds posted a small net inflow of $347mn in that week." - source Credit Suisse

So much for the "great rotation" story: 

"Since the beginning of the year we have not bought into the story of the "Great Rotation" from bonds to equities. One of the reason being on one hand demography with the growing numbers of baby boomers retiring, the other one being pension asset allocation trends." - Macronomics, "Goodhart's law".

We will touch more on the deflationary forces at play and the importance of demography after our overview.

When one looks at the relative performance of the S&P 500 versus MSCI Emerging, one can easily see EM equities have been clearly lagging. Emerging markets (MXEF) continue to underperform developed markets  - source Bloomberg:

The absolute spread between the S&P 500 and MSCI Emerging Markets has touched a record low level.

"QE tapering"soon? We do not think so. Markets participants have had much lower inflation expectations in the world, leading to a significantly growing divergence between the S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play,  graph source Bloomberg (5th of June 2013):

While some central bankers are busy trying to ignite inflationary expectations with various QE programs, the YTD movements in 5year forward breakeven rates which have been falling are indicative of the strength of the deflationary forces at play - source Bloomberg:

We recently commented that Investment Grade is a more volatility sensitive asset to interest rate changes meaning a surge in the MOVE index is leading to increasing volatility in the investment grade bond space where record lows yields on long bonds can lead to some vicious losses on highly interest sensitive long bonds (Apple 30 year bond being a good example of the repricing risk)., High Yield is a more default sensitive asset. The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has weakened dramatically recently. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:

We recently commented on the latest sell-off in the ETF High Yield credit space with our good cross asset  friend in our conversation "High Yield ETF - The Fast and The Furious":

"If you do not believe in the "tapering QE" scenario, which led to a recent surge in US yields on government bonds and this recent sell-off on credit, then the relative value of High Yield, is starting to be compelling again (6.50% in YTM - yield to maturity versus S&P 500)." - source Bloomberg.

So if you do not believe in the "tapering", like ourselves, and like Mr. Jeff Gundlach, maybe at these levels the ETF HYG is starting to be compelling again. Mr Gundlach's opinion is that the Fed is likely to step in and actually increase QE to try and hold rates down, given mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3% today.

Moving on to the subject of the deflationary forces at play, shipping has always been for us, the best significant example of the reflationary attempts of our "omnipotent" central bankers. For instance, containership lines have announced eight rate increases, totaling $3,650, but have failed to maintain the momentum because of the weak global economy and the excess capacity which has yet to be cleared in similar fashion to the housing shadow inventory plaguing US banks balance sheet, graph source Bloomberg:

"Containership lines have announced eight rate increases, totaling $3,650, on Asia-U.S. routes since the beginning of 2012. The increases have largely failed to hold because of excess capacity and a weak global economy. As such, benchmark Hong Kong-Los Angeles rates have only risen by 36% since the end of 2011 and are down 11.6% ytd. In a Bear Case scenario, operators will continue struggling to sustain rate increases. The Drewry Hong Kong-Los Angeles 40-foot container rate benchmark was broadly unchanged in the week ending June 12, remaining below the $2,000 mark for the third time in 2013. Rates are down 27.5% yoy and 11.6% ytd, even with three rate increases, as slack capacity pressures pricing. Carriers are expected to raise rates by $400 per 40-foot equivalent on containers from Asia to the U.S. West Coast, and by $600 to all other destinations, effective July 1. " - source Bloomberg.

Of course high unemployment which continues to plague developed economies will continue to weight on the economic recovery in general and shipping in particular, graph source Bloomberg:

"Unemployment within the euro zone is expected to increase to 12.2% in 2013 from 11.4% in 2012, and remain broadly unchanged at 12.4% in 2015, according to consensus forecasts. Falling unemployment is crucial for expanding global demand for goods, soaking up excess capacity and firming shipping rates. The recovery in the shipping industry will not be fully realized without improving unemployment trends." - source Bloomberg.

Deflationary forces at play in the shipping space? You bet!

This is what was indicated by Rob Sheridan and Isaac Arnsdorf in their Bloomberg article from the 7th of June - Panamaxes Have Longest Losing Streak as Glut Magnifies Downturn:

"Rates for ships hauling coal and grains posted the longest losing streak on record as the merchant fleet’s largest glut magnified seasonal declines in demand from South America and India.

Earnings for Panamaxes fell 0.1 percent to $6,078 a day, the 32nd drop in a row and the longest stretch in data going back to 1999, according to the Baltic Exchange, the London-based publisher of shipping costs on more than 50 trade routes. Panamaxes can carry about 75,000 metric tons of dry-bulk commodities." - source Bloomberg.

We still are seeing creative destruction at play and deflationary forces in the shipping space as the gradual excesses of too many ships built on ship credit are being dealt with, graph source Bloomberg:

"Excess capacity and depressed charter rates have increased the number of container ships sent to be scrapped by 538% since June 2005. This is creating a more efficient fleet as older ships are replaced by newer models. For instance, Maersk is set to introduce triple-E ships that consume about 35% less fuel per container and are able to carry 16% more boxes. In May, the total number of scrapped container vessels surpassed tankers." - source Bloomberg

Global Economic growth remains weak and vulnerable as indicated by the dry bulk market:

"The dry bulk market continued to show weakness, as time charter rates fell for most carriers in 1Q. Dry bulk rates declined 36% yoy on average and were down 10% sequentially. Torm (down 14.2% yoy) and D/S Norden's (20.2% lower yoy) dry bulk rates decreased the least. D/S Norden noted dry bulk fleet growth has moderated, and scrapping will continue as long as rates remain low. The Baltic Dry Index declined 8.2% yoy in 1Q, and fell 16.5% from 4Q." - source Bloomberg.

In similar fashion to the extend and pretend game being played by banks relating to their real estate exposure and negative equity, some German banks, which total exposure to shipping loans amount to 125 billion USD with a nonperforming ratio of 65%, have resorted to avoid recognizing the losses by acquiring some ships in a bid to salvage their bad loans as reported by Nicholas Brautlecht in Bloomberg on June 13 in his article "Commerzbank Acquires First Ships in Bid to Salvage Bad Loans":

"Commerzbank AG, the German lender whose soured shipping loans prompted a ratings downgrade by Standard & Poor’s last month, is taking the helm as it tries to salvage some of the 4.5 billion euros ($6 billion) it holds in bad debt from the crisis-hit industry.

It plans to take over two feeder ships from debtors this month, holding off on a sale until values recover, said Stefan Otto, 42, the head of the shipping unit. The vessels, which can transport as many as 3,000 standard 20-foot containers, or TEU, are the first the Frankfurt-based bank will actively manage as part of a goal to reduce shipping losses and exit ship financing.

“We focus on ships where we see significantly more upside than downside in the future, and where it seems smarter to hold them for a limited time period and wait with the divestment until the value has increased,” said Otto in an interview, declining to reveal the value or the names of the ships.

The collapse of Lehman Brothers Holdings Inc. in September 2008 and the ensuing sovereign-debt crisis propelled the shipping industry into a slump from which it has yet to recover, suffocating demand and generating a glut of vessels. Commerzbank decided a year ago to wind down its shipping portfolio to stem the losses.

The company, which had shipping loans of 18 billion euros in the first quarter, became the world’s second-biggest financier of ships with the 2009 acquisition of Dresdner Bank. Norddeutsche Landesbank Girozentrale has a similar-sized loan portfolio, while leader HSH Nordbank AG’s ship loans stood at 27 billion euros in the first quarter." - source Bloomberg

Given that Container ships make up more than one-third of Commerzbank’s 18 billion-euro shipping loan portfolio and looking at the trend in Dry Bulk Cargo described above, and that Commerzbank has had its 5th capital increase in four years, you can expect additional pressure to come for Germany's second largest bank. By 2016, Commerzbank wants to further reduce its portfolio by 4 billion euros to about 14 billion euros, while a date for a complete exit is too difficult to predict according to Stefan Otto. Exit? What exit?

As we have argued in our conversation "Dumb buffers", taking ownership from debtors will not change the fact that Commerzbank's outlook due to its shipping exposure remains deeply concerning:

"Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book".

Size matters? In shipping it does as indicated by Deutsche Bank in their 7th of June report on the Container Shipping industry, (a point we had made back in August 2012 in our conversation "The link between consumer spending, housing, credit and shipping"):

What are the competitive advantages of the ultra-large vessels?

"Breakeven point is substantially lower in the ultra-large vessels

Container ships have become larger because they can take advantage of economies of scale, diluting the operating costs of the vessel among a larger number of containers. We estimate the freight rates at which a 18k TEU vessels could reach cash breakeven in Asia-Europe trades (USD916) is 21% lower than a 8.5k TEU vessel (USD1,160) and 28% lower than a 6.5k TEU vessel (USD1,268) (calculations made at 18 knot speed, 90% load factor and bunker price USD650/ton)."  - Source Deutsche Bank.

In this deflationary environment, as we repeatedly pointed out, only the strongest will survive. In the shipping space,  Maersk Line, will be the biggest beneficiary we think and agree with Deutsche Bank:

"Given the current order book for new vessels in the sector, the operation of truly ultra large vessels, those larger than 14k TEU, looks almost like a de-facto oligopoly mainly in the hands of Maersk Line, MSC and CSCL, which together will have 78% of the capacity in the segment by 2016, versus a total market share of 33%. This data is based on the global order book as of 11 January 2013 (source Alphaliner) and it does not include the latest order for five 18,000TEU vessels made by CSCL, on which we comment in the specific company pages below in this report." - source Bloomberg

What are "inflationistas" of the world and "tapering believers" fail to take into account in their analysis is the importance of demography we think in true Lucas critique fashion. Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":

"The older a country’s population, the lower its inflation rate, posing a challenge for central banks in the world’s industrial nations, according to a UBS AG report.

Singapore-based economist Andrew Cates of the Swiss bank’s global macro team plotted average inflation levels over the last five years against changes in the dependency ratio, which compares the very old and very young to the working-age population.

The resulting chart showed nations that have aged in recent years typically faced very low inflation and, in the case of Japan, deflation. By contrast, those that have been getting younger, such as India, Turkey and Brazil, have relatively strong price pressures.

“Since ageing demographics will now start to feature more prominently in the outlook for many major developed and developing countries this is clearly of some significance for how inflation might evolve,” said Cates in a May 30 report.

The finding clashes with the view of economics textbooks, according to Cates, which tend to say a slowdown in population growth should put upward pressure on wages -- and therefore inflation -- as labor supply shrinks. Still, this ignores how demographics influence demand for durable goods and property, Cates said.

He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.

By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.

“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg

On a final note, dormant inflation in the US is giving plenty of time to the Fed, as indicated as well by the current trajectory of TIPS, graph source Bloomberg:

"The Federal Reserve may be able to take its time in adopting a more restrictive monetary policy because inflation is relatively tame, according to Pavilion Global Markets Ltd.

As the CHART OF THE DAY illustrates, the U.S. core consumer price index’s increase since the latest recession ended in June 2009 is the smallest for any multiyear recovery since the 1970s. The gauge of prices excluding food and energy rose 6.3 percent through April, according to the Labor Department.

“There is no pressure on inflation that could lead the Fed to act more quickly than it would like” in scaling back a bond-buying program and raising interest rates, Pierre Lapointe, the Montreal-based head of global strategy and research at Pavilion, and two colleagues wrote yesterday in a report.

Core consumer prices were 7 percent higher at the same point in the previous recovery, which started in December 2001, as the chart shows. The biggest increase in the inflation gauge was 29 percent, posted in a recovery that began in April 1975.

These and other inflation statistics are at odds with the magnitude of losses in U.S. bonds, according to David R. Kotok, chief investment officer at Cumberland Advisors. The decline in 10-year Treasury notes sent their yield surging 60 basis points from this year’s low, reached on May 2, through yesterday. Each

basis point amounts to 0.01 percentage point. “The bond-market adjustment is too extreme and has created

bargains,” Kotok wrote. He added that Cumberland, a firm that’s based in Sarasota, Florida, is buying tax-free bonds and taking more interest-rate risk with its holdings." - source Bloomberg.

"We are not retreating - we are advancing in another direction." - Douglas MacArthur 

Stay tuned!