Macro - Ominous Decade

"Fascism is capitalism in decay." - Vladimir Lenin

Following Greek's submission and the acceptance by French Constitutional court of the controversial surveillance law aimed at broadening eavesdropping of terrorism suspects, despite protests from privacy advocates with France seeing at the same time a "farming revolt", in conjunction with Spain's new public security law introduced in July limiting freedom of speech and curbing the right to peacefully protest with the introduction of fines ranging between €100 ($111) and €600,000, we reminded ourselves of the "Ominous Decade" (Década Ominosa) when it came to choosing this week's analogy. 

The "Ominous Decade" was the traditional term used for the last 10 years of the reign of King Ferdinand VII of Spain dating from the abolition of the Spanish Constitution of 1812, from the 1st of October 1823 to his death on the 29th of September 1833. Following the liberation of Spain from Napoleonic domination, King Ferdinand VII first act on his return was the dissolution of the two chambers of the Spanish Parliament which marked the period of the "Ominous Decade" which saw harsh censorship re-established and the complete suppression of the liberal opposition (which fled the country). This "Ominous Decade" saw an endless series of riots and attempts of "revolutions", such as that of Torrijos, funded by English liberals on the 11th of December 1831. Given the turn taken by recent events in Europe and with European Commission president Jean-Claude Juncker quote in February this year: 

"There can be no democratic choice against the European treaties." - Jean-Claude Juncker

We are indeed wondering if, Europe has not entered its own "Ominous Decade" hence our chosen title. 

We are also wondering if, after all, Vladimir Lenin's quote was not correct, and we could opine in the light of recent laws passed in various countries that indeed, Joseph Schumpeter seminal 1942 book "Capitalism, Socialism and Democracy" was indeed right when assuming that the decay in capitalism is indeed somewhat leading to some new form of "fascism". Schumpeter argued that capitalism's collapse from within will come about as majorities vote for the creation of a welfare state and place restrictions upon entrepreneurship that will burden and eventually destroy the capitalist structure but we ramble again...

When it comes to forward returns and current valuations levels and the "rosy tainted" environment painted by some sell-side pundits, in this week's conversation we will discuss into further details the return of the deflationary forces (hence our recent return in taking a long US duration exposure partly via ETF ZROZ) and "Zemblanity", (Zemblanity being defined as the inexorable discovery of what we don't want to know). Back in September 2012 we asked ourselves at the time the following question:

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?" - Macronomics, September 2012.

Synopsis:

• Some "Zemblanity" facts in the transportation market
• Forget Greece, China is sending a weak global growth message
• If China is stalling then it makes sense to "short" exposed European car makers 
• Final chart: Credit and Equities parting ways

• Some "Zemblanity" facts in the transportation market

For those who have been following our musings, you will not be surprised that we view the transportation market, particularly shipping as a leading deflationary indicator as well as a credit indicator (lower shipping = credit tightening = deflationary trend). When it comes to the "real economy" and "Ominous Decade" risk, in true "Zemblanity" fashion, transportation is telling us that the much vaunted recovery story remains illusive and marks the return of the deflationary forces we think.

On that point we agree with Bank of America Merrill Lynch's take from their Cause and Effect note from the 13th of July entitled "Who do you believe?":

"Some inconvenient facts
The transportation market, which is more closely linked to the world economy, does not share this optimism. Global shipping freight rates, down 40% so far this year, are showing no signs of recovery. Our latest trucking survey shows sentiment at the year-low. Rail traffic remains very weak and rail stocks are down nearly 20% year to-date.
The million dollar question is whether what appears to be increasing growth optimism among rates investors is justified. The transportation market, which is much more closely linked to the global economy, apparently does not think so:
Global container freight rates, which have been falling this year, are showing few signs of stabilization, let alone recovery. The bellwether China export containerized freight index is down 40% so far this year (Chart 7) and is now below the trough associated with the height of the Eurozone crisis in 2012:

Falling freight rates seem to reflect more weak demand than excess capacity. World trade volume growth, which in Q1 contracted at the fastest pace since the end of the financial crisis, recovered weakly in April (Chart 8).

Inbound loaded containers into the Port of Los Angeles and Long Beach, having surged in March following the end of the strike, was down in April and flat in May (Chart 9).

Trucking is also faring poorly. The latest BofA Merrill Lynch proprietary biweekly Truck Shipper Survey shows shippers’ 3 month outlook falling below 60 for only the second time in 2015 (Truck Shipper Survey #78, 9 July). An increasing number of the respondents are citing weak demand.

If shipping and trucking are not doing well, rail is not doing much better. US rail traffic for intermodal units, which picked up in the spring after the end of the port strikes, is slowing again (Chart 10). 

Meanwhile, total carloads are contracting at an annualized rate of 10%. US rail stocks, already down 18% year-to-date, continue to underperform the broader index (Chart 11).

In sum, what the transportation market is telling us is that global trade growth is weak. This is consistent with the fact that in the June manufacturing PMI surveys released last week, new export orders were either declining or below 50 for most of the major economies (Chart 12). 

If global trade in manufactured goods is weak, it seems reasonable to think that global manufacturing is weak. Indeed, the new orders component of world manufacturing PMI has fallen in June to the lowest level in two years (Chart 13).

 - source Bank of America Merrill Lynch

To illustrate further the "illusory" recovery in 2015 we would like to add additional data, this time around coming from Deutsche Bank Freight Tracker note from the 21st of July. Truck Supply/Demand in 2015 is in fact weaker in 2015 than in 2014:

"Below we have illustrated the recent trends in TL dry van load-to-truck ratios (Figure 4 below) as well as dry van spot rates (Figure 5 below) in each of the past two years based on TransCore data.

 - source Deutsche Bank

If the economy is improving in 2015 compared to 2014, which would justify a "normalization" policy from the Fed, then we struggle in understanding the "dynamic" improvements so much vaunted by the "recovery" pundits...

This is leading us to our second point, namely that one should indeed focus less on Greece (a sideshow) but much more on the weaker global growth signs coming out of China.

• Forget Greece, China is sending a weak global growth message

Whereas the Greek soap opera has been gathering much of all the attention in recent weeks, the global growth seems to be heading like the proverbial bull in a China store. The preliminary PMI from Caixin Media and Markit Economics was at 48.2 for July from 49.4 the previous month, the lowest in 15 months, regardless of China's "engineered" 7% GDP growth.

Once again, shipping is leading us to some interesting indications when it comes to gauging the strength of the Chinese economy and the trajectory for world growth. If we look at the Shanghai-US Container Rates Overview from Deutsche Bank Freight Tracker note, one can clearly acknowledge the weaker tone in Chinese exports:

"SCFI spot rates declined 10.9% w/w as rates continued to fall across the board."

- source Deutsche Bank

Whereas we are talking West Coast Ports or East Coast Ports, the year on year change points to a clear weaker tone in exports towards the United States.

What we find of interest is the recent fall in consumer confidence which we think is indicative of the fragility of this much vaunted "recovery".  For instance, Consumer confidence in July dropped four points month-over-month to 45.2%, a low for 2015 but still higher than the 13 month low reported back in October (41.0%). But, "Confidence" among Small Business Owners is off as well at 53.8% (from 55.0% in June) which doesn't look great from an "employment" perspective.

As we pointed out in our 15th of August conversation "The link between consumer spending, housing , credit and shipping":

"Containerized traffic is dominated by the shipment of consumer products. A resurgence in international container volumes will be dependent on the housing markets improving. Furniture and appliances are some of the top freight categories imported into the U.S. and euro zone from Asia in containers. Furniture demand collapsed with the housing market." - source Bloomberg

The link between freight shipments and changes in housing start can be seen in the below graph coming from Deutsche Bank's most recent Freight Tracker report:

"Cass Freight Shipment Index Declines 3.4% Y/Y In June (+0.2% M/M). Last week, Cass Information Systems reported that the Cass Freight Shipment Index declined 3.4% y/y in June, which was an acceleration from down 1.3% y/y in May. Sequentially, the index was essentially flat (+0.2% m/m), which was worse than normal seasonality (June’s trailing five- and ten-year average m/m changes are up 1.8% and up 2.4%, respectively)."

 - source Deutsche Bank

Whereas housing starts have jumped in the U.S. in June to the second-highest level since November 2007 to  9.8 percent to a 1.17 million annualized rate from a revised 1.07 million in May, consumer confidence and shipping are yet to reflect this improvement so far. This is indeed depicting a conflicting picture when it comes to US growth particularly with the lack of acceleration in wages.

Moving back to China, not only does shipping and PMI points towards a slowdown but so does credit growth and passenger vehicle sales year on year as shown by Bank of America Merrill Lynch in their Cause and Effect note from the 13th of July entitled "Who do you believe?"

"The transfer of wealth from the people on the street to the wealthy who cashed out when the market was still going up is likely to hurt consumption. It is important to take note of the fact that in June, before the equity correction began, passenger vehicle sales fell for the first time since 2012 (Chart 16)."

It seems reasonable to think that a further moderation of Chinese growth will have global repercussions. On a Purchasing Power Parity basis, China is now the largest economy in the world, accounting for 16% of global GDP. More importantly, the IMF estimates that China accounted for one third of global GDP growth over the past three years (Chart 17).

A sharp Chinese slowdown in H2 (not the central scenario of our China economics team) would easily send world GDP growth to the lowest level since the recovery began.

That said, the impact of a Chinese slowdown on the rest of the world will be uneven. Countries like Korea and Australia whose exports to China account for a large share of their GDP will be especially vulnerable (Chart 18). 

Even Japan and Germany that have significant exposures to China will not be able to escape the implications of a sustained Chinese slowdown.

What about the US? US export exposure to China is modest, both in absolute and in relative terms. However, long-term Treasury yields have been more correlated with global growth outlook than US growth outlook over the past few years (Chart 19).

Moreover, further USD appreciation as other countries would be hurt more by the Chinese slowdown, by tightening US financial conditions, is likely to lead the Fed to go more slowly in the tightening cycle. The first batch of June data suggests that the momentum behind the US economy observed in late spring seems to be slowing. Aggregate payrolls in Q2 grew at the lowest rate in six quarters (Chart 20)."

- source Bank of America Merrill Lynch

 So if indeed China is slowing, then it makes sense to look at "shorting" the European Autos Sector (SXAP). This brings us to our third point namely never ending overoptimism from equity analysts...

• If China is stalling then it makes sense to short exposed European car makers 

If you buy into the story of an "Ominous Decade" and poor forward returns thanks to lofty valuations, Chinese slowdown and waning global demand (hence like us, sitting nicely in the "deflationary" camp), then we believe, it makes sense to look at over-exposed European car makers and to make a case for a "short" perspective we think.

On the subject of "deceleration" and cars in China, we read with interest Société Générale's note on Automobile and Components from the 15th of July:

"We see a margin issue in the Chinese premium car market: The market is crowded, not only on the roadway, where the number of premium cars has been growing fast, but also by the number of carmakers, who long for share in this formerly high-margin market. The “German big three” has 70-80% of the market, and the remainder is divided up among the Europeans, Japanese and Americans. Since H2 2014, these carmakers have started to see volume pressure owing to the economy’s slowdown, competition from local rivals, limits on car registrations in big cities, and pressure from a legitimized parallel premium car market. Official price cutting took place but turned out to be ineffective. Margin pressure was further aggravated by the rally in the A-share market in May that absorbed money from people who had delayed their car purchases. Despite these headwinds, we still see potential in the Chinese premium car market based on a growing middle class population because although the economy is slowing, the growth rate is still relatively high. Indeed, China’s economy historically has grown in the double-digits, but the market is now expected to experience a structural transition period where automobile financing (still low less than 20% in China vs. 50% in developed countries which reserves room for development) and electric cars (strong support from the government due to environmental concerns) could be a new growth impetus." - source Société Générale

While we agree from a long term perspective, there is further room for growth in the Chinese car market, the on-going pressure on the market is of particular interest as highlighted in Société Génerale's note:

"Premium carmakers have been forced to step into a tough price war since H2 2014, against the backdrop of China’s economic slowdown. Given the choice between market share and margins, carmakers chose to sacrifice margins temporarily in order to win and keep market share. Tier 1 premium brands have started to lower prices or decrease production in China. Audi is selling its two popular models, the A4L and A6L, at a 20-25% discount. BMW China’s CEO said that the group had already decreased its production in China as well as the supply to dealers (Source: Bloomberg 20 April). Going into the second quarter of 2015, new car sales have continued to shrink. The situation got even worse with the euphoria in the A-share market which absorbed the car budgets from a large number of people who were holding back on buying big-ticket items.
In our view, the other factors that are prompting a slowdown in premium car sales growth include but are not limited to: limits on new car registrations in big cities, pressure from a legitimized parallel car market, competition from local car brands, the government’s antiextravagance policies, consumption behaviour transformation (more mature customers) in the tier1 and tier 2 cities, an explosive second-hand car trade volume (9m units in 2014, over 10m expected in 2015), and a technology-driven growth model, which can be summarized as the Chinese automotive market’s “New Normal”.
In order to maintain margins and market share, we expect carmakers to cut costs, which
passes on pricing pressure to upstream auto parts makers and raw material providers. Thus, we believe the “German Big Three”, accounting for 70-80% of the premium car market, will leverage their negotiating power to lower production costs and save margins.

We expect a moderate premium car sales expansion in 2015, with a growth rate slightly higher than our forecasted 8% of passenger vehicle sales growth rate. The China Automobile Association forecasts that in 2015, the volume of sedans will increase slightly by 1% to 12.5m, SUVs will increase by 25% to 5.1m, MPVs will increase by 35% to 2.6m, and crossovers will decrease by 20% to 1.1m, which together represent passenger vehicle sales of 21.2m units and a 7.8% growth rate.
We expect three trends in the Chinese premium car market in 2015
1) The import growth rate to slow to the single-digits when premium carmakers focus on localisation: the high tax rate imposed on imported cars is one reason for customers’ move to localised cars, especially against the backdrop of the economic slowdown and customers’ high cost/performance preference. We expect more import models to be localised in the coming year.
2) SUVs to continue to be popular: the Chinese prefer large-sized cars and have a tendency to favour popular models, thus we expect premium carmakers to take action and make profits in this segment with new localised models." - source Société Générale

So the only way for the German Big Three to maintain further their margin will be to either force more deflationary pressure on their suppliers impacting furthermore the "commodity" sector in the process or to localize even more the production of cars in China to lessen the high tax rate imposed in imported cars which have been impacted by the bloodbath in the A-share market as of late.

What goes up must come down:

As per the conclusion of our "Ephedrine" conversation focusing on China in May this year, where we pointed out correctly that Dr Copper, the metal with the economics Ph.D was still in a bear market, we believe that European car makers in particular the German Big Three will soon have to adapt to the "new normal". This is clearly illustrated in Société Générale's note:

"The market for premium cars in China has expanded at an impressive rate of 36% per year over the past decade. Multinationals dominate China’s premium car market, with German carmakers accounting for 70-80% of market share.
Premium segment development is part of the change in passenger vehicle sales. From 2000 to 2010, the average passenger vehicle sales growth rate was 24%, and from 2010 to 2014, the growth rate slowed to 7%, which indicates that China’s automotive industry has stepped into a new growth period." - source Société Générale

The "goldilocks" period for the German Big Three, from a "short" perspective, seems to us an attractive proposal given their significant exposure to China. On that "short" interest, we agree with Louis Capital Markets recent take on this "trade idea" in their recent Cross Asset Strategy note from the 15th of July:

"The European Autos sector (SXAP) is fully driven by the German carmakers as Daimler, Volkswagen and BMW make more than 50% of the sector index. These global companies have a significant exposure to non-European markets and particularly, to China. The chart below shows the amazing increase of the profitability of the European Autos sector since the great crisis.

Despite a sluggish European economic environment, these European companies have benefited from their global exposure to record all-time high profits. In relative terms (below chart) the diagnosis is even more impressive and this explains why this sector has been a strong market leader since 2009.

The sector has been weak recently (2nd worst performer behind basic resources over the past 3 months). This is an interesting message as the profit dynamic seems intact. The direct consequence is that analysts have seen the recent correction as a buying opportunity given their unchanged earnings forecasts over the period. According to them, nothing has changed except the upside potential that is restored thanks to the decline of share prices. This differs from banks on which analysts remain cautious and do not expect a significant share price recovery.

We do not wish to treat analysts with disdain but there is clearly a risk that, once again, their expectations fall short of the reality. We do not see the latest correction as another opportunity but rather we see this correction as a warning for the sector similar to what banks experienced in the summer 2007.
The story of the Autos sector during the past decade looks like a “super cycle” and because we believe in cycles (i.e. ups and downs) we suspect that the nicest part of the story is far behind us and that difficulties can arise faster than expected.

We are beginning to see less positive stories coming from China regarding the Autos sector (price discount to revive sales, subsidies to affiliates) but these less positive aspects seem to have gone largely unnoticed by market commentators. It is typical to see some denial at the early stage of a new trend. The charts below shows the strong fundamentals of the “big three” – the 3 biggest components of the SXAP Autos sector – that have enjoyed a super-cycle over the past 5 years (average sales growth of 11.7% against average of 2.6% during the 2002-2007 cycle).

Also, perhaps the most impressive achievement is to see the structural improvement of margins since 2009. On the below chart we plot on the Y-axis the quarterly EBIT margin and on the X-axis the quarterly sales growth for the Big3. The blue dots represent the 2002-2008 cycle whilst the grey dots represent the 2010-21015 cycle. The message is crystal-clear here: despite some volatility of the business activity, the EBIT margin has remained resilient around 7%. This is a real performance that was flagged by analysts and this could explain why some investors play the “change of status of the sector” due to its new “growth status” (luxury goods + pricing power).

Its a nice story but too good to be true in our opinion and reminds us of our discussion with Banks’ analysts back in 2007 (see our European Equity Note No241 – 25 June 2007 – “The Valuation Principle”, CA Cheuvreux) when we told them that the specific risk premium that was emerging on financial stocks was worrying and that these stocks were expensive. We want to say the same thing today: despite apparent low valuation ratios, European carmakers are expensive because profits should revert soon and will reveal therefore that the profit trend growth of these companies is lower than expected.
We show on the following chart Global car sales growth and that of the Big 3. Obviously the correlation is strong between the two series but we see the significant outperformance of these winners in the aftermath of the Great crisis thanks to their Chinese exposure and their above-average pricing power.

However, talking about the past will not help us in forecasting the market behaviour of these names in the coming weeks so the latest data are more interesting and they show a very significant slowdown of the sales dynamic. In China, June was a negative month, for the first time since 2013. The 3-month moving average is at 0.5%, the lowest level since Q1 2012 which was at that moment only temporary.

We think that the current weakness will not be transitory and reflects the start of the down cycle for the European car makers exposed to China. The rationale is simple: generating growth is a tough task as for a carmaker it implies selling more cars each year. The strong growth rate achieved by the European carmakers in China was the result of the concurrency of several factors: low base effect (low starting equipment rate), strong growth of income and strong growth of the potential client base (emergence of the middle class). Today these factors have not disappeared but have strongly diminished. The number of cars in use compared to the size of the urban middle/upper class in China is no longer extreme. The catch-up process from this point of view is over and now, the demand for cars should be driven by more classic factors like the vehicle age (implicitly the average life expectancy of cars) and the size of the middle class.
In the short term, the excesses have to be clear and this implies a decline in units sold in China by the European leaders of the car industry. Thus, the investment risk is very high for the Big 3 as investors are not ready for this outcome. They will be reluctant to sell them because of some sentiment towards stocks that have done so well in their portfolios in this cycle. We understand that but investors have to set aside “affect” and be pragmatic as downs follow ups and China will not be an exception." - source Louis Capital Markets

Of course from a long term perspective China and Asia will continue to be important drivers for European car makers but, we do have to agree with LCM's tactical view on this interesting "short" contrarian proposal, which we think is enticing.

China, it’s still a critical driver of German carmakers’ earnings and the current trend is quite disturbing, therefore we think shorting the German Big Three from a valuation perspective could be an interesting proposal should China worries persist.

German exports and Chinese PMI are still showing a disconnect which we think is not justified. Car sales in Europe during the first six months of 2015 are down 14% compared with the same period in 2007. In Germany, car sales are up by only 3% in the same period whereas Italy is down by a cool 38% and Spain is down 35% back to 90s levels (for more on cars sales and trends see our 21st of April conversation "The European Clunker - European car sales, a clear indicator of deflation").

So even the mighty German can't really look West to find some Chinese solace...

Does a Chinese slowdown spell an "Ominous Decade" for German car makers? We wonder...

• Final chart: Credit and Equities parting ways

Whereas in 2014 the much vaunted story of  the "Great Rotation" from "Bonds3 to "Equities" failed to materialize, in 2015 it seems indeed there has been some rotation at least in European towards equities as depicted by Bank of America Merrill Lynch in their Follow The Flow note from the 17th of July entitled "June'15 Flows: biggest outflow for fixed income funds since the tape tantrum":

"Credit and equities: parting ways
Flows remain on the negative side for both high-grade and high-yield funds, despite strong risk-on sentiment. Outflows from high-grade credit funds were the third largest this year, at $2.1bn, and ~$10bn has departed from the asset class in the past six weeks. Outflows from high-yield credit funds were marginal, however, marking the sixth consecutive week of withdrawals from the asset class.
On the other side of the fixed income world, government bond funds followed an opposite course from credit: the asset class recorded an inflow of +$1.4bn during the last week, the first in seven weeks and the highest in 18 weeks, dating back to the pre-bundshock period. Money market fund flows went back to negative territory.
But the picture is different in the equity land. European equity funds have seen inflows doubling that of the previous week, getting very close to $3bn. Equities have now had a nine week streak of positive inflows, against six weeks of consecutive outflows from high-grade and high-yield credit funds combined.

 - source Bank of America Merrill Lynch

"Where wealth accumulates, men decay." - Oliver Goldsmith, Irish poet

Stay tuned!

Credit - The Secondguesser

"Do not try to second-guess or master-mind our military officials. Leave this for established military analysts and experts, who are experienced enough to await the facts before drawing conclusions." - Broadcasting magazine, December 1941

While playing with interest the Hang Seng Index rally game given we have taken some exposure since the 30th of March and enjoying the ride so far, we reminded ourselves the definition of "second-guess" for our title analogy, as it can be of two folds:

1. To criticize and offer advice, with the benefit of hindsight.
2. To foresee the actions of others, before they have come to a decision themselves.

Of course when it comes to our "Asian allocation", we have indeed played number two and decided to "front-run" somewhat the appetite for Chinese investors moving from Shanghai towards Hong-Kong when it comes to their regional "appetite". As far as our title is concern and the choice of allocation, it stems from learning from the wise Charles Gave of Gavekal research for whom we have great respect: 

"if there is more money than fools then market rise, and if there are more fools than money markets fall"

In the case of the HSI, there is indeed more money than fools, whereas when one look at the European government bond markets and in particular the state of the corporate Hybrid debt market we touched on last week, there are indeed more fools than money in Europe. This ties up nicely to definition number 1 for "second-guess" and the benefit of hindsight, given that the "bond" risk in Europe doesn't justify anymore the reward we think.

A commonly used meaning of "to second-guess" is to criticize the actions of others, after the event. On this blog, we try to criticize the actions before the events. When it comes to choosing our title we also reflexionated around the meaning and the origin of the expression as defined by Gary Martin:

The umpire in a baseball game used to be called, rather unkindly, 'the guesser'. People who were continually telling the guesser, the manager or the players what they were doing wrong were known as 'secondguessers' and were so defined in the Sporting News Record Book, 1937:
"Secondguesser, one who is continually criticizing moves of players and manager."

Therefore one could unkindly define us as being "Seconguesser" when it comes to assessing the macro and credit environment and the decisions taken by our brazen central bankers, but we ramble again. Although one could indeed unkindly defined as "Secondguessers" with these few examples:

• we have been short yen since November 2012 when the Japanese yen was trading around 80 as described in our conversation "Cold Turkey" (partly via ETF YCS) guessing that the Bank of Japan had a lot of catch-up to do when it came to QEs and expanding its balance sheet .
• Following the BOJ move, in early 2013 we went long Nikkei but in "Euros" via a quanto ETF (currency hedged).
• Of course our biggest 2014 call has been to go long US duration in January (partially via ETF ZROZ).

As per our January 2013 conversation, "If at first you don't succeed...", we have repeatedly broken our 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."

We have to confide, that we have continued to become clear "Seconguessers" as per definition number 2 above when it comes to "second-guessing" the "Black Magic" practices of our magicians of central bankers and their "secret illusions".

So never mind the practices of our "dark sorcerers apprentice", as in this week conversation, while we will briefly touch on the attractiveness of Asia versus Europe, we will look at the supposed end of the European banks/sovereign nexus particularly in the light of the latest Icelandic proposal, namely the Sovereign money proposal which we think is a must read.

Synopsis:

• Yes, for now Asia is a buy and it will continue to be so
• A large number of European banks still destroy value
• Many Southern European banks are still capital impaired
• Don't count on the end of the banks/sovereign nexus in Europe
• Final note: Flows have lagged performance in EM

• Yes, for now Asia is a buy and it will continue to be so

As me mentioned, playing our "Secondguesser" role has meant we have gotten on the HSI exposure since the 30th of March and we do believe in the compelling valuation story in Asia, regardless of the recent parabolic rise in the equity space.

So one might wonder why there has been such a rally in the equity space. It all has to do with the collapse in China money market rates as displayed by Bank of America Merrill Lynch in their recent Liquid Insight note from the 15th of April 2015 entitled "What's driving China rates":

"More to lower rates than just policy easing
The rally in the China stock market since March has been significant and in our view at least partly related to expectations of policy stimulus, as reflected in lower rates (Chart of the Day). In particular, there has been a lot of focus on China’s money market rate – the 7-day repo – which has dropped about 200bp to 3.0%. The decline should come as no surprise as market rates were high relative to inflation, and high real rates were probably the last thing the government wanted to see given the slowdown in investment and economic growth. The market move has been consistent with our view that 7d repo should come off to 3.0-3.5% in the short term.

But a closer analysis suggests banks’ liquidity management also played an important role in the decline of repo rates, over and above the PBoC’s policy guidance. The question is how fast and to what extent can money market rates fall from the current low level, in particular after the latest weaker-than-expected financing and economic data. We argue that the 7d repo rate could fall moderately further to an average of 2.5-3.0% in the coming months, but that the sharp decline of recent months seems unlikely to repeat itself." - Bank of America Merrill Lynch.

We are not the only one thinking about the China "reflation" trade as we see maverick money manager Stanley Druckenmiller recently commenting on this very subject on April 15th in Bloomberg article from Katherine Burton and Stephanie Ruhle entitled "Druckenmiller Bets on Market Surprise With China Boom, Oil Rise":

"Chinese stocks have soared with the Shanghai Composite Index doubling in the last 12 months.
“Whenever I see a stock market explode, six to 12 months later you are in a full blown recovery,” he said.
A recovery in China, the world’s second-biggest economy, would influence securities and commodities prices around the globe, said Druckenmiller. For instance, it would send German government bond prices lower, boost European exporters and lift the price of oil, he said in a separate interview." - source Bloomberg

When it comes to valuation, while the rally in Asia has been epic, when it comes to Europe, we would rather "cash in" given current valuation levels as displayed in the latest note by Louis Capital Markets from the 13th of April entitled "Three For The Price Of One" where one can see in their bonus chart the percentage of Stoxx Europe 600 members trading above their 200-day Moving Average:

 - source Louis Capital Markets

With the liberalization of personal account rules in China and a forward PE around half of the S&P500 and a free cash flow yield or around 20% according to Asia Times, Hong-Kong appears to us a better "value proposition" in these global inflated markets if we would need to second-guess investors' appetite.

• A large number of European banks still destroy value

When it comes to Europe and in particular many points to cheap valuation in the European banking space. As we have argued in our conversation "The Pigou effect" in February this year, we have argued around the "japanification" process of Europe:

"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe."

This "japanification process can be seen with the rapid disappearance of "positive" yields in the European Government space with German Bunds closing on the zero bound.

We have also long argued that regardless of QE, ZIRP and AQR, European banks would be facing continued deleveraging and that both bondholders and shareholders alike would in many instances get punished for their holdings. The reason is that European banks, in many cases still destroy value. On this subject, we read with interest Nomura's EU banks strategy note from the 10th of April entitled "Why European banks still destroy value":

"Why do half Europe's banks not make a 10% cost of equity?
Even by 2016, Bloomberg consensus implies that half of Europe’s larger banks will not make a return on tangible equity above their historical 10% cost of equity. This contrasts with US banks where almost all exceed the hurdle.
In this report, we decompose profitability to identify the main drivers. Low ROE banks are mainly a result of higher costs, and to a lesser extent higher provisions and higher taxes. Margins (mix) and leverage together account for less variation between high and low ROE banks. Nordic and Benelux banks show the highest ROEs, while German and Italian banks are lowest, with UK, France and Spain around the 10% hurdle.
How and where can banks improve their profitability?
We show that cutting costs would deliver the biggest improvements in ROE, but given the consistency of national cost/income ratios, much of the differences in costs appear to be structural. Although most banks have some form of cost reduction plan in place, few target an absolute reduction in the cost base, suggesting it will take some time for banks in the least profitable countries to converge their ROEs (hence valuations) with the best in class." - source Nomura

Truth is most European banks offer poor value in terms of returns as shown in Nomura's report:

"Even by 2016, Bloomberg consensus implies that half of Europe’s larger banks will not make a return on tangible equity above their historical 10% cost of equity. This contrasts with US banks where the average ROTE of banks in the BKX index is just over 13% and where almost all exceed the10% hurdle."

- source Nomura

As pointed out by Nomura's note we were note surprise to read that US banks higher ROE was driven by fewer lower risk mortgages on balance sheets:

"The higher ROE of US banks is driven by higher revenue margins given fewer low risk mortgages on balance sheet. This (and to a lesser extent a lower cost of risk) helps compensate for a considerably better leverage (equity/assets), as well as a slightly higher cost/income ratio and tax rate."

This is not a surprise for a "secondguesser" as we have highlighted on numerous occasions the very important concept namely the accounting principles of "stocks" versus "flows":

"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."

After all, credit growth is a stock variable and domestic demand is a flow variable. We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe:

"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012.

Of course, the availability of credit is only beginning to be restored in Peripheral Europe and has been encouraged by the ECB's recent QE.

The core of our macro thought process is based upon the difference between "stocks" and "flows", which we highlighted when discussing the growing difference between Europe and US growth (see our post "Shipping is a leading deflationary indicator"). The same approach can be applied in relation to the growing divergence between US banks versus European banks we think. 

This difference can be ascertained from the difference in return on assets for EU banks versus US banks as displayed in Nomura's recent report:

- source Nomura

Given the amount of deleveraging that still needs to occur in the European banking space, this divergence will continue to grow.

Although European banks have risen 16% YTD, they are still underperforming the market and when it comes to their peers in the global space they do stand out less cheap as indicated by Nomura in their report:

"EU banks stand out less as cheap vs global peers …
With the 16% rise in European banks YTD, the market capitalization weighted SX7P banks index trades at 1.2x 2015E TBV for a consensus 2016E ROTE of 11.7%, which limits aggregate re-rating opportunities (absent a sustained fall in the cost of equity).
At a global level within the banking sector, European valuations generally appear proportionate to forward ROE expectations, with some countries already implying further profitability improvements." 

- source Nomura

When it comes to a better "value" proposal, China stands out as having much better 12m forward ROE. It is also not a surprise for a "Secondguesser" to see Chinese banks listed on the Hang Seng China entreprises index rallying hard as well as indicated by Asia Times in their article from the 15th of April entitled "Chinese bank soar on valuations":

"Industrial and Commercial Bank of China led gains on the Hang Sang China Enterprises Index overnight, up 4.86%, followed by China Construction Bank (+4.39%), Bank of Communications (+4.31%), China Minsheng Bank (+3.93%), Bank of China (+3.56%) and Agricultural Bank of China (+3.50%). Banks rallied after ICBC reported mediocre 4th quarter earnings, with a big pop in loan loss provisions and a modest decline in YOY net revenue.
Mediocre is beautiful when stocks are cheap. Chinese banks non-performing loans were a mystery wrapped in an enigma wrapped in plastic explosive, and the market bid down bank stocks because of uncertainty about future write-offs. A year ago, ICBC traded at a multiple of just 4 to earnings. Now investors are convinced that banks can earn their way out their bad loss positions over time, and bank multiples have recovered–to just one-third their pre-2008 levels.
At the peak of the 2007 China equity boom ICBC traded at 21 times earnings, or three times its present valuation. The bank stock recovery reflects greater confidence in regulatory transparency under the ongoing financial reform regime. The banks have gone from distressed valuations to merely low valuations.
As global managers pile into the China trade, moreover, bank stocks are among the few vehicles with enough market capitalization and liquidity to meet the requirements of large portfolio managers." - source Asia Times

From a "second-guesser" perspective, there is indeed better value in Asia at the moment and particularly in the banking space we think whereas European banks doesn't offer that much value particularly when one takes into account the quality of capital in Southern European banks. This brings us to our next item

• Many Southern European banks are still capital impaired

Many Southern European banks' capital basis are made up for a large part of Deferred Tax Assets (DTAs) as reported by Nomura in their Southern European Banks report of the 7th of April entitled "Quality of Capital":

"Deferred tax assets (DTAs) under the microscope
European authorities are reported to be considering whether or not the legislation and guarantees on DTAs in southern Europe can be considered state aid (FT, 7 April 2015). This is in addition to the ECB looking for greater harmonisation of European capital ratios by attempting to correct for some of the different national definitions.

How big an issue are DTAs for southern Europe?
DTAs have increased significantly in southern Europe over the past few years (generated by the significant losses incurred by many of the banks). However, under Basel III’s definition, the bulk of the DTAs will be deducted from capital ratios (a change vs the previous regulatory environment). To minimise the impact of this regulatory treatment, many countries in southern Europe enacted legislation to limit the impact of this deduction. DTAs currently represent c42% of tangible equity in southern Europe and contribute a median of c300bp to core capital ratios.

Raise capital or improve quality over time? 

Given the extent and the size of the DTAs in southern Europe, and taking into account political considerations, we think it unlikely that the banks will be forced to raise capital specifically to address this issue. However, with the ECB increasingly looking to harmonise capital ratios, the banks could be required to continue to build and strengthen capital ratios over time. This issue could also be a hurdle to those banks looking to significantly increase dividends or payout ratios. For the moment though, the majority of dividend policies for southern European banks target moderate payout ratios of c40%- 50% (with Intesa the one major exception – targeting a payout ratio of c70% in 2015 and c82% in 2016)." - source Nomura

Hence our negative stance on European Banks and Southern European Banks in particular given the additional "real capital" that is needed to compensate for the "favorable" DTA treatment offered by the local regulators.

The exposure to DTAs while often overlooked when it comes to the quality of capital is not trivial as per the same report and is very significant in the Spanish banking system as indicated by Nomura in their report:

"Exposure to DTAs
As we can see from Fig. 1 banks in southern Europe have built up significant amounts of DTAs. In Spain alone total DTAs reached cEUR 77bn in 2013, although net DTAs (ie, net of tax liabilities) were cEUR 68bn. Low levels of profitability have meant that for the moment the amount of DTAs continues to increase.
Under Basel III, the treatment of DTAs is harsher vs the previous regulatory regime. However, in an effort to minimise the negative impact on capital from holding large levels of DTAs, governments in southern Europe have enacted legislation to reduce some, if not most, of this impact. In Spain, for example, the value of the DTAs is underwritten by the Spanish government. The DTAs that are not used up within 18 years are considered a credit against the Spanish government and exchangeable for Spanish public debt. Of the total amount of net DTAs in Spain, the government has guaranteed c 60% or cEUR 40bn. As we can see in Fig. 2, DTAs account for a significant part of the current capital ratios for the banks.

Our base-case scenario is that the banks do not have to raise capital to specifically address this issue. However, we do believe capital ratios could be raised to higher levels. The level of DTAs could also affect banks looking to raise payout ratios to high levels or significantly increase dividends, although most dividend policies are targeting a moderate payout ratio of c40%-50% (which we believe is achievable)." - source Nomura

When it comes to "capital", what matters therefore is the "quality" of the capital. In the case of some Spanish banks, the capital levels made up mostly by DTAs are not sufficient regardless of the AQR. Given in the case of Spain, these DTAs constitute a "credit" against the Spanish government and are exchangeable for Spanish public debt we doubt this marks the end of the banks/sovereign nexus discussed in our next bullet point.

• Don't count on the end of the banks/sovereign nexus in Europe

As highlighted by the DTAs issue in our last bullet point, the last couple of years have seen the banks/sovereign nexus increasing thanks to the "carry trade" financed by cheap LTROs allowing Peripheral banks to gorge on the domestic debt of their country (Italy and Spain). On the subject of the banks/sovereign loop in Europe we read with interest Bank of America's take on the subject in their Euro Area Economic Viewpoint from the 13th of April entitled "Towards the end of the banks/sovereign nexus":

"Banks/sovereign loop in the EA was worse, absent QEIn the Euro area, the impact of the banks/sovereign negative feedback loop was even more acute than in the rest of the developed world, given the tardiness in addressing the structural issues of the banking sector and more fundamentally because, in the absence of QE, banks played the role of marginal lender to the government - thanks to the ECB's generous liquidity policy - at the expense of funding the private sector.

But things are improvingHowever, thanks to progress in the capital position of banks and the new "presumption of bail-in" - which in our view could only come after the most acute systemic banking risks were actually alleviated thanks to government support (e.g. in Spain) - member states' exposure to the financial sector has now fallen. This liberates more room for manoeuvre for counter-cyclical fiscal policy. The recent shift, in the Euro area, from all-out austerity to a neutral, or even slightly stimulative, fiscal stance would not be sustainable, in our view, if government faced massive contingent liabilities.

And QE will help reduce the loop even further
At the same time, to wean banks off lending to the governments at the expense of the private sector without jeopardizing the governments' funding capacity - which would be equally detrimental to economic growth - the Euro area needed to find an alternative marginal lender. This is achieved by QE. In a nutshell, QE is the necessary complement to banking union and the Single Resolution Mechanism to break the banks/sovereign nexus. This is another, indirect, transmission mechanism of QE to the real economy. Under cover of QE, we think that the regulatory authorities will try to incentivize banks to reduce their exposure to sovereigns. This is the message that Daniele Nouy, head of SSM, sent in a recent interview in the Handelsblatt, in which she opined that holdings of government bonds should be limited to a quarter of banks' equity." - source Bank of America Merrill Lynch

We disagree with the aforementioned progress made in the capital position of banks, particularly in the light of the DTAs for Southern European banks. While QE will certainly try to incentivize banks to reduce somewhat their exposure to sovereigns, we have a hard time seeing most of these banks part with some of their highly collateral such as German government bonds due to bond scarcity with the German budget being balanced and the reduction in their debt to GDP level.

In the US the problem were dealt swiftly and differently as highlighted by Bank of America Merrill Lynch's note:

"In the US, vigorous monetary policy action - in the form of early QE - managed to offset much of the fiscal drag. To put things simply, if fiscal support is unavailable and sensitivity to interest rates is lower, then monetary policy needs to "go an extra-mile'. In our view, QE in the US has been instrumental in making sure the economy remained on the recovery track in spite of a i) effective fiscal drag and ii) unprecedented threats of "catastrophic withdrawals" in public spending, with the various "debt ceiling" and sequester episodes. The UK is another example of a country which managed to control the impact of a major fiscal drag - after a just as major public bailout of the financial system - thanks to extraordinary monetary support.

In the Euro area, in our view, the "banks/sovereign" nexus played a more acute role than in the US and the UK, not simply because monetary policy did not offer as much support, at least until very recently, but more fundamentally because the "banking issue" had a more durable, complex and pervasive effect on the economy and policy-making.

The banks/sovereign nexus is bad everywhere, but it's even worse in Europe
The reaction of the US authorities - after the initial "bail in" temptation on Lehman Brothers - was remarkably swift. Forcing a recapitalisation and imposing management decisions on banks complemented state support on liquidity. In Europe, while support came very quickly, there was comparatively little attempt at dealing with the structural issues surrounding the national banking systems. Probably to some extent because European policy-makers considered that this was primarily an "Anglo-Saxon crisis", the onus was on dampening the contagion effects of a New York born financial meltdown, without necessarily a clear awareness of the depth of the local difficulties.

This timing difference is plain to see in banks’ capital to asset ratio across the regions (see Table 3).

For simplicity of analysis, we look here at total assets, not risk weighted assets. This measure, which we take from the IMF’s financial stability report, is therefore close to a leverage ratio. Before the Great Recession, the ratio was already much higher in the US than in Europe (roughly twice as large), but what is striking is that within only three years, it had already improved by more than 2 percentage points. The best European performer during this period (France) managed an increase of only 1.2 pp, from a very low starting point.
The irony, then, is that the Europeans ended up spending slightly more government money on their banks than the Americans (4.9% of GDP instead of 4.5% of GDP for on-balance sheet expenditure alone) while triggering a much smaller improvement in their banks' capital position. To some extent, this mechanically reflects the difference in size between the two banking systems - the same public spending in % of GDP has a much lower impact on the financial position of the much larger European banking sector - but we also consider that, at least at the onset of the crisis, European governments failed to emulate their US counterpart in making public support conditional on significant and rapid efforts from banks under their jurisdiction to deal with their underlying problems.
Europe’s tardiness in dealing with the structural issues of the banking sector proved particularly toxic given the much more central role it plays in funding the economy, relative to the US. Indeed, in the US bank loans accounted for only 20% of the total liabilities of the corporate sector before the Great Recession, roughly half the proportion found in the Euro area (see Chart 2). 

It was not only a matter of quantities but also, as suggested above, of price. As we have argued before (see EEW), the health of the demand and particularly the supply of credit are key to understand the broken transmission of monetary policy, the very limited sensitivity of lending rates to policy rates in most of the periphery for most of the post-crisis period and the increased sensitivity of lending rates to sovereign yields.

Another consequence of the belated reaction of the European public sector was, that by the time the banking sector was blatantly on the brink of collapse in number of countries, the governments there had already lost market access – or at the very least was already paying crippling interest rates – precisely on account of the market’s anticipation of the bailout costs. Spain probably is the best example of this type of behaviour. Exactly at the time public sector support became crucial, its cost was impossible to shoulder.
This gets us to the second significant difference between the US and the Euro area as far as the "banks/sovereign nexus" is concerned: the "imperfect mutualization issue". In the US, even if various bodies compete in the regulation of the banking industry, two centers of decision matter: the White House and Congress, as it is ultimately a federal issue. In the Euro area, a major difficulty arose from a discrepancy, across member states, between banks' need for funds and fiscal capabilities. Ireland is the best example of this. As it can be seen in Table 2, the total of approved support to the financial sector there - on and offbalance sheet potential liabilities - amounted to 500% of GDP, while the effective cost of support exceeded twice local GDP."

   - source Bank of America Merrill Lynch

In the US QE was more effective for a simple reason: stocks vs flows as highlighted earlier. The problems facing Europe and Japan are driven by a demographic not financial cycle. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment. As shown above in our post in Nomura's chart,  the difference in return on assets for EU banks versus US banks improved much faster in the US thanks to the swift approach by the US in dealing with the crisis as well as their existing resolution framework absent in Europe at the time.

The main reason we had recession and credit crunch in Europe was the ill-fated decision of the EBA to impose banks to reach a core tier one level of 9% by June 2012.

Of course the 2011 debacle was avoided by LTRO 1 and 2 but what the "geniuses" at the EBA did not understand was that European banks were "capital" constrained hence the speed of the deleveraging and the epic credit crunch (Italy/Spain) that followed which led to a fall in "Aggregate Demand" a point which we agree with Bank of America Merrill Lynch:

"The political balance within the central bank - compounded by, until recently, the absence of clear deflationary pressure at the aggregate regional level - made it impossible to break this negative feedback loop via direct purchases of government bonds, which at the very least would have isolated sovereign funding costs from the consequences of the banking crisis.
Instead, the ECB approach - understandable from an emergency management point of view - added another layer to the banks/sovereign nexus by turning the banks into the lender of last resort of their local sovereign. Indeed, the ECB, by allowing access to long term cheap liquidity, through the LTROs, allowed banks to engage in safe carry-trade, parking liquidity into government bonds at a time when non-residents were leaving the periphery in droves.

Banks always tend to skew their asset allocation towards government bonds in bad cyclical times, as the demand for credit from the private sector diminishes while the quality of the banks' loan books deteriorates. Still, the ECB's generous approach to liquidity clearly was a facilitator. Italy in our view managed to avoid a recourse to the EFSF/ESM only because banks, which in 2009 held only 14% of the stock of public debt, ended up absorbing 75% of the increase in public debt between 2009 and 2014.

This was probably an acceptable "second best" to QE in terms of maintaining some funding capacity for embattled governments, as well as keeping the banking sector alive in the absence of clear progress on recapitalisation and balance sheet clean-up, but such approach presented the major risk of keeping the real economy into a recessive regime. Indeed, in this configuration, peripheral banks could make a more than decent living purely on the carry-trade, with little incentives for them to try to re-start lending to the private sector." - Bank of America Merrill Lynch

And of course the above approach, for any reasonable "Secondguesser" led the real economy into recessive regime thanks to the "crowding-out" effect mentioned in numerous conversations.

Where we slightly disagree with Bank of America Merrill Lynch is that while QE seems to be a necessary condition to alleviate the distortion created on Peripheral banks' balance sheet when it comes to their overall exposure to their sovereign, it is creating yet another distortion in "valuations" triggering in effect financial instability on a grand scale:

"Beyond institutional progress on banking union, QE is the necessary condition for breaking the banks/sovereign nexus
The two key institutional elements allowing the Euro area to deal with the banks/sovereign nexus are i) the Single Resolution Fund, funded by the banks and ii) the possibility, finally adopted on 8 December 2014, for the ESM to recapitalize banks directly, i.e. without leaving the financial cost, ultimately, on the balance sheet of the sovereign in the concerned banks' jurisdiction. These two instruments' capability is limited (1% of insured deposits for the first one and EUR 60bn for the second) but this is a first, important step towards a mutualization of the banking risk across the Euro area, which is in our view made possible by the federalization of banking supervision under the SSM framework.
In both cases, however, in principle mutualized support can be triggered only after a bail-in of the private creditors. This leaves the "financial stability" issue unanswered. Indeed, if the Euro area was faced with a major banking incident in which "burning" private shareholders and bondholders would trigger an unstoppable, generalized crisis, it remains unclear how a collective response would be organized." - source Bank of America Merrill Lynch

QE on its owned as we have argued recently is not enough to put Europe on the right track as we pointed out in our conversation "Chekhov's gun":

"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 

QE without private demand for funds only generates bubbles. The liquidity it supplies will not enter the real economy as long as there are no private sector borrowers. From our take, as "secondguessers" the Icelandic proposal of Sovereign money would break this toxic nexus between banks and sovereigns. To explain further why the Icelandic proposal is very appealing we would like to re-quote Dr Jochen Felsenheimer from asset management XIAI we used in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!" in September 2011:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy." - Dr Jochen Felsenheimer

Looking at the current stalemate surrounding Greece in particular and Europe in general nothing has really changed from our "secondguesser" perspective.

• Final note: Flows have lagged performance in EM

While some EM markets have continued to post on stellar performances, there is indeed a disconnect between EM equity flows and EM equity performance as displayed in Bank of America Merrill Lynch's recent Flow Show note from the 9th of April entitled "EM Disconnect":

"Europe hogs the spotlight: $3.9bn inflows this week, extending inflow streak to 13…
…meanwhile EM can’t catch a bid: flows have lagged performance (Chart 3); 8 straight weeks of outflows from China equity funds (despite her being the best performing global market past 12 months) and LatAm equity funds only see a tiny $37mn after 9 straight weeks of outflows" - source Bank of America Merrill Lynch

As "secondguessers", we would expect flows to resume in the coming weeks/months.

"Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcome after-effects. Their precise nature is anyone's guess, though one likely consequence is an onslaught of inflation." - Warren Buffett

Stay tuned!

Credit - Information cascade

"Every market is in transition." - Kenneth Lay, former CEO of Enron

Watching with interest the impressive melt up in European equities during the month of February (with French index CAC40 up close 14% since the beginning of the year), in conjunction with continuous credit and rates compression, marking the return of leverage structured credit as the hunt of yield runs unabated, we reminded ourselves of the "information cascade" model when choosing our title analogy:

"An information (or informational) cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts. A cascade develops, then, when people “abandon their own information in favor of inferences based on earlier people’s actions”." - source Wikipedia

In the specific case of the current equity melt-up helped recently in Europe supported as well by "better" economic data, no doubt that some investors have abandoned their own information in favor of inferences based on earlier central bankers actions when it comes to implementing QE, with Europe on the verge of launching a program of its own.

When it comes to assessing the on-going lift-off in European equities, it follows the lift-off we have seen in the US as well as in Japan, following the various rounds of QEs. 

In the "Information cascade model", there are four key conditions:

"1. Agents make decisions sequentially
2. Agents make decisions rationally based on the information they have
3. Agents do not have access to the private information of others
4. A limited action space exists (e.g. an adopt/reject decision).
One assumption of Information Cascades which has been challenged is the concept that agents always make rational decisions. More social perspectives of cascades, which suggest that agents may act irrationally (e.g., against what they think is optimal) when social pressures are great, exist as complements to the concept of Information Cascades." - source Wikipedia

Of course we agree with point number 2. When it comes to financial markets, agents often seems to act "irrationally", and display what former Fed Chairman Alan Greenspan called "Irrational exuberance" but then again, as we posited in our conversation "Pascal's Wager" investors are indeed making a "rational" decision based on the premises that central bankers are "deities":

"In the investment world, we think investors are betting with their "life savings" that central bankers are either gods or not."

Obviously investors that believed that the SNB's had a "godly' status met their makers when the SNB finally pulled the plug on the Euro peg but we ramble again...

When it comes to markets and the choice of our specific title, no doubt that the current "euphoric" environment is a clear display of "Information cascades being at work:

"Information cascades have become one of the topics of behavioral economics, as they are often seen in financial markets where they can feed speculation and create cumulative and excessive price moves, either for the whole market (market bubble...) or a specific asset, like a stock that becomes overly popular among investors." - source Wikipedia

What we also find of interest is that marketers also use the idea of cascades to attempt to get a buying cascade started for a new product:

"If they can induce an initial set of people to adopt the new product, then those who make purchasing decisions later on may also adopt the product even if it is no better than, or perhaps even worse than, competing products. This is most effective if these later consumers are able to observe the adoption decisions, but not how satisfied the early customers actually were with the choice. This is consistent with the idea that cascades arise naturally when people can see what others do but not what they know." - source Wikipedia

In similar fashion, central bankers around the world have done the same "marketing" exercise. They have induced other central bankers to adopt QE, although it is fairly clear that the real economic benefits of QE are dubious at best.

Therefore this week will review the current "risk-on" information cascade environment given, we think it is entirely flow driven with one of the main culprit being Japan's GPIF and we will also muse around the utility of a European QE in the current context.

Synopsis

• Under a dovish monetary global policy, both stock and bond markets will strengthen concurrently
• In the equity space, it's "party on" with a caveat
• We have moved from a low volatility regime to a higher volatility regime
• QE + Austerity = road to growth disillusion/social tensions but road for heaven for financial assets
• 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
• Final note: Why European banks deleveraging has much further to go and why it means more pain for shareholders and bondholders

• Under a dovish monetary global policy, both stock and bond markets will strengthen concurrently. 

The current European "melt-up" in European equities is driven by investors' flows and in particular by Japan's GPIF allocations. As reported by Nomura in their 2nd of March note entitled "GPIF Q3 FY14 investment results", there has been significant progress in portfolio rebalancing from the GPIF:

"The Government Pension Investment Fund (GPIF) released its investment results for Q3FY14 and reported that investment income totalled JPY6,623.3bn for a total return of
5.16%.
Beginning this quarter, the GPIF adopted a new method for announcing the amount of its investment assets – it no longer discloses investment assets by asset.
By making certain assumptions, we estimate the GPIF reduced its domestic bond holdings by JPY6.4trn, added JPY1.9trn in domestic stocks and shed JPY0.8trn short term investment. It increased its investments in international bonds and international stocks by JPY0.7trn and JPY1.9trn, respectively.
Compared with the JPY3.3trn reduction in Q2, the GPIF accelerated its domestic bond selling significantly in Q3 (JPY6.4trn reduction including matured investments). This is consistent with October-December JSDA data showing that trust banks were net sellers of yen bonds by a total of JPY3.1trn (vs. JPY0.5trn net buying in July-September).
By comparing the asset mix at end-December and the new Basic Portfolio, we have estimated how much GPIF assets need to increase or decrease to achieve the target median weightings. According to our calculations, GPIF should shed JPY13.3trn in domestic bonds, and increase domestic stocks by JPY5.7trn, international bonds by JPY1.7trn and international stocks by JPY5.9trn.
Assuming the GPIF reduces domestic bonds at a similar pace to Q3, it could achieve the target weighting in six months. Similarly, it would achieve the target weighting in 12 months if the reduction continues at a pace on par with Q2, and eight months if it proceeds at the Q2-Q3 average pace (Case [1] in Figure 2). The amount of portfolio shift necessary would be smaller if we reflect mark-to-market changes since end-December (i.e., higher stock prices, etc.; Case [2] in Figure 2). We will monitor how market movements affect the GPIF’s portfolio shift.
Looking at supply and demand factors alone, the GPIF’s portfolio shift should cause stock prices and yen bond rates to rise and JPY to weaken further. In our view, however, JGB investors may highlight the fact that the GPIF has made significant progress in its yen bond selling, and gradually shift their focus to when it is completed, as well as subsequent supply and demand dynamics.
We also note that public pensions other than the GPIF appear to have lagged in their portfolio shifts, and may begin to accelerate yen bond selling. In this case, the portfolio shift by public pension funds as a whole would be a longer process. However, we believe the market will begin to wonder if the BOJ can continue QQE2 purchases as it heads toward end-FY15, when the GPIF is likely to complete its rebalancing." - source Nomura

And as we posited in our post "The Vortex Ring", the re-allocation process from Japanese behemoth GPIF, has continued to put additional downward pressure on core government bonds:

"It is important to note as well that for the Japanese investors, adjusted for living expenses, US treasuries still yield more this year than Japanese government debt than at any time since 1998". - source Macronomics, 26th of May 2014

Go with the flow:
One should closely watch Japan's GPIF (Government Pension Investment Fund) and its $1.26 trillion firepower. Key investor types such as insurance companies, pension funds and toshin companies have been significant net buyers of foreign assets.

When it comes to Toshin funds, as reported as well by Nomura in their 4th of March note entitled "Toshin momentum remains strong", retail investors are also piling in international markets:

"Retail investors accelerated their investment in foreign assets via toshins last week, according to NRI (Figure 1). They bought JPY136bn ($1.1bn) of foreign securities, the highest pace in three weeks. This was the 14th week in a row of net purchases, and retail investors' cumulative foreign security buying via toshins this year has reached JPY1.2trn ($10bn), about JPY856bn ($7.2bn) bigger than for the same period in 2014
(Figure 2). 

Toshin momentum remains relatively strong, as risk sentiment among retail investors has improved gradually.
Retail investors continue to prefer foreign equities to other asset classes. They are estimated to have purchased JPY56bn ($0.5bn) of foreign equities via toshins, while purchasing JPY27bn ($0.2bn) of foreign bonds and JPY52bn ($0.4bn) of foreign hybrid securities. They continued to sell domestic assets via toshins for the third week in a row, while the pace of selling slowed to JPY60bn ($0.5bn) from JPY98bn the previous week. Japanese equity prices have been performing well since mid-January, and this likely encourages retail investors to book profits. Retail investors’ expectations for USDJPY appreciation have also led to stronger investment in foreign equities than in domestic assets via toshins (see "Retail investors still see USD/JPY upside", 12 February 2015). Lower yields globally may reduce the appeal of foreign bonds to retail investors. We expect toshin momentum to remain strong, because of better risk sentiment and expectations for JPY weakness, while their preference for foreign equities relative to bonds will remain strong for the time being." - source Nomura

Arguably, the GPIF has not been the only game in town with the pending European QE which, in terms of flows has driven them into overdrive when it comes to European markets as indicated by Bank of America Merrill Lynch Flow Show note from the 5th of March entitled "Carry On Risk":

"Risk-On: cash down for 3rd straight week to fund $7bn into equity funds and $6bn into bond funds Europe the Consensus Darling: euphoric 99th percentile inflows over past 8 weeks ($31bn)…heaviest since Dec'08 (Chart 1)

Retail loves Income: chunky $2.8bn inflows to equity income funds this week; note BofAML private clients have significantly raised allocation to equity income ETF’s past 24 months (Chart 2)

Carry On Risk: incessant central bank rate cuts + rising macro optimism = risk taking on the rise...our Bull and Bear Index (flashed contrarian “buy” in Jan) up to 4.3 (Chart 3); 

big payroll/strong avg hourly earnings would cause risk to pause but Feb small biz hiring intentions today was not strong." - source Bank of America Merrill Lynch

The sentiment of bullishness in February has run unabated but, once again the "strong" NFP data in the US came back to spoil somewhat the party in the US equity space has "good" news once again meant "bad" news and increasing the possibility of a rate hike by the Fed in the near future (we still very much doubt about this).

• In the equity space, it's "party on" with a caveat, 

Not only have foreign flows and the ECB QE path pushed equities into overdrive, but the renewed appetite for buybacks in conjunction with a rise in M&aA operations have also been supportive of the aforementioned rally. But there is indeed a caveat, because while the party is going strong, earnings have reverted in the US and remain flat in Europe. On that note we agree with Louis Capital Markets Cross Asset Strategy note from the 2nd of March, that fundamentals do not seem to matter in this market cycle when it comes to equities behavior to say the least:

"The reading of financial markets has been an understandable process when regarding the bond, the currency and the commodity markets. The equity market however has been a real enigma and its recent behaviour has not helped to better our comprehension of it. What is the driver of equity indices??? We thought that the expected stream of companies’ earnings was the main driver however this market cycle has demonstrated that this assumption is a false one. Subsequently, we are having significant difficulty in identifying the main drivers of the market.

Equity indices are reaching new highs in this cycle contrary to earnings that have reverted in the US and that remain flat in Europe. The P/E expansion has been very strong as a consequence and its limit is unknown. The current level of investor confidence is amazingly high and it contrasts strongly with the business climate in the real sphere that has not shown similar signs of overheating.
This kind of context is obviously very positive for equity investors. Some will say “it’s crazy, it’s going to crash”. However, history has repeatedly proven that high-levels of hubris often take a while before inevitably ending in tears. We did not expect to live through another mania in our life after the one experienced at the end of the 90’s, but we were wrong. This cycle is even more impressive that the one at the end of the 90’s, because it has come from nowhere and has so far lasted longer.

These days many commentators are explaining that, contrary to the TMT bubble, as profits are rising on this occasion current circumstances cannot be diagnosed as a “bubble”. We do not believe the current context constitutes a bubble. However, we were more comfortable in paying Cisco 100x expected earnings in 2000 than paying today 18x the earnings for Endesa or 20x for Belgacom. In the 2000’s the story was a strong one. A sort of revolution was taking place and it was consistent from a market perspective to dream of a new world emerging. Today, we are failing to find a similar story for Endesa and Belgacom, and our dreams are not stimulated when listening to the IR’s presentation of Belgacom.
The “low interest rates environment” are the words that can be found in every mouth during this cycle. The argument appears so obvious that everybody embraces the idea that the influence of central banks on the bond market also impacts the equity market through the discount factor mechanism. If profits of Belgacom remain flat for the next 20 years, paying the stock 20x current earnings roughly implies the recovery of its investment in 20 years. This is a long period of time, but the 20-year government bond yield of Belgium is close to 1%, thus implying a 100 year time horizon needed to recover its investment. 20 years vs. 100 years would represent the “equity risk premium”.
We fully disagree with this rationale, because it implies a “by default” investment. The pricing of equities is not driven by the pricing of bonds. Their underlying drivers are too different to think there are spill-over effects that inflate “naturally” equities. The Japanese experience has been crystal clear on this subject: long term bond yields have oscillated between 1% and 2% between 1998 and 2008, and despite this low remuneration of the bond asset class, the performance of the Nikkei was null during this period of time.We do not want harp-on regarding this subject as it one of weak importance for many PMs. The long only PMs are fighting against a benchmark regardless of the global mood of the equity market, whilst macro traders focus on relative value trades. The main beneficiaries of this equity mania are diversified PMs, because they have the choice between two asset classes that have been in a bullish mood for 6 years now. So even if they are wrong in their assets’ selection, they have not lost money in absolute terms." - source Louis Capital Markets

For us, and as per our title, the "Information cascade is at play and feeding speculation and create cumulative and excessive price moves on a grand scale for the whole market (market bubble...).

• We have moved from a low volatility regime to a higher volatility regime

As per our title analogy, the more central banks meddle with asset prices, the more disconnected and unstable markets are becoming.

On the subject of a higher volatility regime which was discussed in our previous conversation by our friends at Rcube Global Asset Management , European equities have started 2015 on very strong note as highlighted above by the amount of flows in the asset class, but implied volatility have risen across financial markets as depicted by Louis Capital Markets in their monthly report entitled "Europe In Sight":

"The European equity market has been very strong since the beginning of the year, outpacing most equity indices. It is difficult to find a tangible and credible reason behind this move because nothing has really changed in the real economy. It seems it is first of all “sentiment driven” and that the perspective of an aggressive central bank has helped to lift this sentiment.We are surprised by this reaction because the “central bank” argument remains by nature fragile and because we had previously signs of cautiousness with the rising implied volatility across financial markets (see chart below).

In the previous cycle, the 2002-2007 cycle, the rising volatility coincided with the end of the bull market. Although we do not call for the end of this bull market, we thought that the rising volatility since last summer would have prevented an “upward crash” like we got in January/February (15%+ for the Eurostoxx50 in less than 2 months). The chart below shows to what extent this move is unusual.

The sector hierarchy shows that this move corresponds to a pure re-rating as all sectors, with a small dispersion, benefited from this euphoria. The consumer segment has led a little thanks to the decline of oil prices but this is not the whole story. The median 12m Fwd PER of the Stoxx Europe 600 universe stands now at 16.8 and it is well above the top of 2007. That’s the most important story because it questions the valuation regime of European equities. Is this level exaggerated or will we see a median PER at 20 before the end of the year (implying an additional upside potential of 20%+)??? This context is perturbing for investors because it blurs the notion of “cheap” and “expensive” stocks, and lowers in the end, the relevance of the valuation factor." - source Louis Capital Markets

As far as the Information cascade is concerned and the on-going "melt-up" we would repeat what we indicated back in January 2012 in our conversation "Bayesian thoughts" when we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":

"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

Bayesian learning today is indeed leading towards an acceleration in the rise in asset prices, while the end of the low volatility regime in conjunction with the rise in the US dollar (meaning a global tightening from a pure "macro" perspective) indicate we are indeed in the final innings of the game we think.

• QE + Austerity = road to growth disillusion/social tensions but road for heaven for financial assets

In our November 12 2014 conversation "Chekhov's gun" we put forward our take on QE in Europe:

"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 12th of November 2014

We also indicated at the time:

"Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)"

Given France has now postponed any chance of meaningful structural reforms until 2017 with the complicity of the Europe Commission, (again a complete sign of lack of credibility while imposing harsh austerity measures on others), and that the government will face an electoral onslaught in the upcoming local elections which will see yet another significant progress of the French National Front, we are convinced the"Current European equation" will breed more instability and not the safer road longer term.

This brings us to a subject we have already tackled when it comes to differentiating QE in Europe versus QE in the US. It is all about Stocks versus Flows:

"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."

"Credit growth is a stock variable and domestic demand is a flow variable" as indicated by Michael Biggs and Thomas Mayer in voxeu.org entitled - How central banks contributed to the financial crisis.

On that essential difference we came across a very interesting note from BNP Paribas from the 6th of March entitled "The ECB wants to buy but who wants to sell?"where they highlight 3 main differences between QE in Europe versus QE in the US which we summarized below:

1. Size matters: the corporate credit market/ABS market in Europe is not as deep as in the US. It is very difficult for institutional investors in Europe to switch from holding government bonds to corporate credit/ABS.
2. Timing: QE 1,2,3 in the US were done when the amount of US Treasuries issued was rising due to the US budget deficit! In Europe, QE is being launched when there is a very weak net issuance level due to austerity measures being implemented.
3. Liquidity constraints for Banks and Insurers are much more harsher than in 2010/20111, meaning that these institutions will hang onto their holdings, negative yields or not.

Stocks versus Flows, is for us a key element in terms of the macro understanding of the ECB's position versus the Fed as highlighted in BNP Paribas's note:

"The stock of bonds versus the flow
Over the past few weeks, much has been written about the risk that the ECB may not be able to find all the bonds it is intending to buy. This seems a strange predicament, since not so long ago many people were worried about the eurozone having too much debt. Before we go into more detail, it is worth remembering that someone’s debt is somebody else’s asset, so saying that there is too much debt would be equivalent to saying that there are too many assets, which we never hear (and for good reason). The main focus should rather be more on the quality of the debt (and how it would be repaid) instead of the size.
Why is there such a worry about the execution of QE? As we have pointed out several times, the size of the buying is relative to the size of bonds for sale. We show in Table 1, that the net issuance for 2015 is negative by EUR 200bn after taking into account the bonds bought under QE. This is the major difference with the US and the UK, as QE in those countries were done at a time of greater budget deficit, therefore limiting the concern about supply.

Other differences and specific points about European QE
When the FED was buying T-Notes, sellers had the opportunity to re-invest in the US fixed
income markets. They could also re-invest the proceeds into corporate bonds or in the mortgage markets, where the liquidity was enough to absorb part of the money that used to be in US government bonds. Investors could also choose lower quality bonds, investing some proceeds into municipal bonds for example. Obviously, it is unlikely that holders of AAA-rated US government bonds bought a lot of lower quality US paper (but some spillover must have taken place as we can see in Chart 1 and chart 2), and at the very least they were not penalised by negative deposit rates if the cash was not re-deployed immediately. So if they were not able to extend the duration or go lower into credit quality, they always had the choice to park (at least momentarily) some of the cash into very short-dated bonds at zero.

This is not the case in Europe today. When holders of a government bond from a eurozone country sell a bond, they do not have much of an alternative in the fixed income markets for reinvestment. The European corporate bond market is not liquid enough, the ABS market is too small and the ECB also has a programme to buy covered bonds. So unlike in the US, once a bond is sold to the ECB, the buyer is likely to look for another … government bond. So in the context where the offer of bonds is less (because deficits are lower) and there is a large marginal buyer, there is upward pressure on prices.
There are other differences. QE in the US and UK was done when the rules for liquidity constraints were easier. As regulation pushes banks to hold large amounts of collateral in order to comply with stricter liquidity rules, there is a natural extra bid for short-dated bonds. These bonds are also supported by the fact that the overnight rate is negative (unlike in the US) and as large investment funds do not have access to the deposit facility of the ECB, they have no choice but to buy short-dated bonds. This is why there are so many bonds with negative yields (up to 25% of the outstanding bond market size) – another significant difference with the US.

A word of caution
We should keep in mind that the ECB is officially trying hard to create inflation in line with its mandate. In that context the very long-dated bonds remain particularly vulnerable if CPI inflation numbers start to pick up. Nobody is expecting a bounce anytime soon, but when the base effect of oil fades (towards the end of 2015) and the weaker euro eventually lets some imported inflation in the eurozone, the picture could be very different. Also when QE started in the US, the economic situation was deteriorating following the 2008 crisis, which is not the case in Europe, where some early signs are that the situation is at the very least stabilising or getting slightly better. Forward inflation expectations in the eurozone have already corrected higher at 1.77% (5-year, 5 years forward implied inflation expectations) and are not far off from the ECB’s target, hinting that QE will be successful over the medium term, (Chart 6). 

Such high inflation anticipations combined with the suppression of nominal yields means that investors going into the long end are forced to accept very negative real returns (Chart 7). 

This is a highly unusual situation, which cannot be sustained over the medium term, hinting that at some stage the long end of bond prices will drop." - source BNP Paribas

Caveat creditor...as we posited in our September 2014 conversation "Sympathy for the Devil":

"The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.

"Investors have indeed Sympathy for the Devil we think, as they continue to pile up with much abandon and more and more getting "carried away" in their insatiable hunt for yield. In that sense Baudelaire's 1869 poem rings eerily familiar with the current investment situation in the sense that investors have been giving our "Generous Gambler" the benefit of the doubt (OMT - and now full blown QE) and shown their sympathy and their blind beliefs in "implicit" guarantees, rather than "explicit" (such as the German Constitution as we argued in various conversations)" - source Macronomics, September 2014

As we indicated in our conversation "Eastern promises" on the 9th of June 2012 we continue to think Germany could be the prime suspect in triggering a breakup (Greece being the perfect scapegoat):
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

Keep in mind that Angela Merkel while only appearing to be making material sacrifices has managed to keep Germany's liabilities unchanged so far.

• 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"

We will never understand why the European QE is not made alongside some form of New Deal with massive infrastructures in Europe, which would put people back to work and improve the odds of a self-sustaining economic model with better preservation of social cohesion.

On a side note, if you are fans of the US TV series "House of Cards", you will have noted that in season 3, Frank Underwood (Kevin Spacey) now president of the United States is fighting against an hostile US Congress. In terms of his proposed economic policies, President Underwood wants a hostile Congress to cut Social Security and appropriate $500 billion on public spending to boost jobs in infrastructure, government and the private sector.

In the "real world", as reported by Bloomberg  on the 4th of March, "U.S. Companies Are Stashing $2.1 Trillion Overseas to Avoid Taxes":

"Obama earlier this year proposed applying a 14 percent mandatory tax on the stockpiled profits and a 19 percent minimum tax on foreign earnings going forward.
The one-time tax would generate $268 billion over six years, which Obama wants to use for infrastructure." - source Bloomberg

We find this interesting particularly around the discussions about "Biotechs" current valuations, which for us are clearly representative of their "tax advantage" compared to the "Utilities" sector for example. We touched on this subject in our October conversation "A Descent into the Maelström":

"We think that the "too much liquidity" popular trades of biotech, internet, gaming and small cap are up for more pain in the future. Technology and Health Care Companies in the S&P 500 index are both heavy users of adjusted earnings measures in their financial statements: Of 69 technology companies in the index, 56 use non-GAAP earnings, of 56 Health Care companies, 45 use them. (source "Earnings, but Without the Bad Stuff", Gretchen Morgenson, November 9 2013 - New-York Times). The vast majority of public biotech companies in the U.S. (87%) do not pay taxes because they lose money as they pursue breakthrough therapies and cures as well as using non-GAAP metrics to boast are more "positive" accounting picture. Young high tech companies often end up paying less than 10% of income in taxes whereas old railroads and utilities often pay more than 25% and cannot easily "jump" countries using M&A for tax inversion purposes"

Should the US administration decide to "close the tax gap", rest assured that your "Biotech Bubble" would burst in an instant, but, that's another subject...

• Final note: Why European banks deleveraging has much further to go and why it means more pain for shareholders and bondholders

While the Hypo Alpe Aldria drama is unfolding in Austria with additional losses of €5.1bn to €8.7bn meaning more pain to come for bondholders  (€9.8bn senior and sub, €1.2bn Pfandbriefe), we leave you with Louis Capital Market chart displaying the relative performance of the the STOXX Banks sector (SX7P) versus SXXP:

- source Louis Capital Market

As a reminder, US banks have increased their capital basis by 57% since 2007 until 2012 while Western European banks by only 37% on the same period as per our conversation "Sympathy for the Devil". So keep on playing the "Dead Cat Bounce" game in European banks stocks the on-going "Information Cascade", rest assured that when it comes to European banks, the trend is indeed your friend...

Sic transit gloria mundi -  "Thus passes the glory of the world." 

Stay tuned!