Macro and Credit - The Law of the Maximum

"Capitalism believes that its remit is exclusively to make maximum short-term profits." -  Jeremy Grantham

While watching "market's gyrations" in anticipation of the gathering of "The Cult of the Supreme Beings" aka central bankers at Jackson Hole and the much anticipated speech of Janet Yellen in conjunction with French dairy farmers protesting against low prices and their fight with industry giant Lactalis, we decided we would make yet again a reference to the French Revolution as per our latest musings when it came to choosing this week's title analogy. The Law of the Maximum was a law created during the course of the French Revolution as an extension of the Law of Suspects on 29 September 1793. It succeeded the 4 May 1793 "loi du maximum" which had the same purpose: setting price limits, deterring price gouging, and allowing for the continued flow of food supply to the people of France. Numerous food crisis during the French Revolution which led to speculation on a grand scale were linked to the "inflationary" bias of the much dreaded heavy issuance of "assignats" which lost rapidly their value, a subject we discussed in our previous conversations. According to Andrew Dickson White, Professor of History at Cornell, the ever greater and ultimately uncontrolled issuance of paper money authorized by the National Assembly was at the root of France's economic failure and most certainly the cause of its increasingly rampant inflation. This is as well confirmed by French economist Florin Aftalion 1987 in his seminal book entitled "The French Revolution - An Economic Interpretation" we have been quoting as of late.  What we find of interest with our title, from a historical perspective is that with the repeal of "The Law of The Maximum" in December of 1794 came inflation, mass economic strife and riots that ultimately lead to the rise of the Directory and the end of the Thermidorian period. As per our last conversation, not only did "The Cult of the Supreme Being" contributed to the Thermidorian Reaction and the ultimate demise of Maximilien Robespierre, its instigator, but, "The Law of the Maximum" was as well an important factor. By now, you probably understand our "pre-revolutionary" mindset when it comes to the selection of our recent title analogies. We would posit that NIRP, to some extent is akin to "The Law of the Maximum" and creating as such a very strong "hoarding" mentality leading to the unintended consequence for some consumers to increase their savings and company to delay "investing". In our last conversation we argued, while as well the Law of the Maximum encourages even more the search for short-term profits as highlighted above in our introductory Jeremy Grantham quote:

"No offense to the Supreme Being Cult members out there, but, in our book, NIRP is insanity as there cannot be productivity and economic growth without accumulation of capital, because simply put, NIRP is killing capital (savings)." - source Macronomics, August 2016.

In this week's conversation we will revisit again the lack of "credit impulse" and "credit growth" in Southern Europe in conjunction with our "japanification" theme given that the "capitalization weakness of some European banks have yet to be addressed.

Synopsis:

• Macro and Credit - Thanks to NIRP, for European banks, "japanification" is at play
• Macro and Credit  - ECB and NPLs? Either put up or shut up
• Final chart: US Investment Grade credit, great returns for less risk, we told you so...

• Macro and Credit - Thanks to NIRP, for European banks, "japanification" is at play

While like many pundits we have repeatedly pointed out that the credit transmission mechanism was broken in Southern Europe because these specific European banks were capital constrained. Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity":

"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."

Back in September 2015, we pointed out the following in our long conversation "Availability heuristic":

Before we delve more into the nitty-gritty of our second point, it is important, we think to remind our readers of what is behind our thought process of the "stocks" versus "flows" macro approach.

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on voxeu.org entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: 

"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 

We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on voxeu.org

We have always wondered in relation to the global rounds of quantitative easings the following:

"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.

As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think." - source Macronomics, September 2015

What is very clear to us is that the Fed and the ECB have been following different path, which obviously have led to different "growth" outcomes in recent years. The lack of "credit impulse" in Italy for instance, leading to lack of economic growth is entirely due to the capital constraints put on already stretched balance sheets of Southern European banks which had no choice but to collapse their loan books, in effect, the credit crunch in Europe was a self-inflicting wound. The "japanification" outcome of the European banking sector is well described by Deutsche Bank in their European Banks Strategy note from the 25th of August entitled "More Japan than US playbook":

"Our core investment thesis for European banks remains unchanged: the net interest income outlook remains at the forefront; litigation and regulation are more idiosyncratic while politics remains an unknown. In this context, we continue to favour Nordic, Benelux and French banks, remain Underweight Italian banks and avoid UK and Spanish banks, as well as Wealth Managers.

More Japanese, than US Playbook

The lower-for-even-longer rate environment remains a critical headwind with the sector. Margin compression over the past year should be seen in the context of a multi-year trend similar to Japan and the US through extended QE. Indeed, our economists anticipate a 9-12 month extension of QE in September and complementary moves to ensure a sufficient supply of bonds.

Indeed, a 5% change in NII has a 10% impact on PBT ie amplified by a factor of c2x, all else being equal. Our Margin Monitor continues to demonstrate a steady grind of back-book (ie stock) spreads (4bps pq) implying NIM erosion of c7% pa. Moreover, front-book (ie flow) spread compression accelerated to 8bps pq.

Recent credit impulse metrics do not suggest a meaningful pick-up in credit growth (see Figures 32 and 33).

With euro area credit growth of ‘only’ c1%, further NII pressure seems inevitable. In other words, the euro area experience appears much more like the Japanese than the US playbook where loan growth compensated for NIM pressure.

More Value Trap, Than Value

Year-to-date, the sector is down c25% vs earnings downgrades of c23%. In other words, the sector performance predominantly reflects earnings trends rather than a valuation de-rating. Furthermore, relative sector performance continues to demonstrate a strong correlation with 10yr Bund yields, or the rate environment more broadly. The decline in swap rates will also continue to have implications for pension deficits and capital ratios.

Following c6% decline in 2016E, consensus expectations are for c1-2% pa NII growth over 2017-18E. Thus, further reductions in consensus earnings expectations seem inevitable. Hence, we continue to believe that the sector – despite trading at an optically cheap PTBV multiple of 0.8x – is more value trap, than value.

Risks Rising for the UK; Nordic and Benelux Offer US Playbook

Much of European banking reflects the Japanese playbook namely ongoing margin compression only partly offset by credit growth. If anything, we believe that the recent combo of 25bps rate cut and launch of Term Funding Scheme by the Bank of England could imply that the UK may follow the euro area experience of TLTRO. Beyond the near-term positive of deposit and funding costs decline, asset spread compression and lack of meaningful credit pick-up has weighed. Hence, we continue to avoid the UK with earnings risks rising." - source Deutsche Bank

We could not agree more, in our "playbook" European Bank stocks are more a trap than a value play hence our continue distaste for the sector. We would stick to "credit" when it comes to banks, rather than side with the many sell-side pundits that keep trying to sell us the "optically cheap" fallacious argument.

Furthermore, the growth outlook for Southern Europe is much more linked to the ability for their banks to provide credit to corporates and in particular Small to Medium Enterprises (SMEs). This is as well clearly illustrated in the below Deutsche Bank chart from their report:

- source Deutsche Bank

This leads us to our second point about the need to deal swiftly with Nonperforming loans and "capital constrained" banks (the politically correct of describing them...).

• Macro and Credit  - ECB and NPLs? Either put up or shut up

In our previous conversation and in relation to the aforementioned different growth outcome and trajectories between Europe and the United States, we indicated the following:

"We keep hammering this, but, our "core" macro approach lies in distinguishing "stocks" from "flows". When it comes to dealing swiftly with "stocks" of Nonperforming loans (NPLs) such as in Italy via "flows" of liquidity, it looks to us that the "Supreme Beings" do not understand that "liquidity" doesn't equate solvency.", source Macronomics, August 2016

Yet, the Nonperforming loans issues (NPLs) which are particularly acute in Italy have yet to be addressed, making it difficult for the "credit impulse" to be restored and therefore hindering any significant positive growth outcome for the likes of Italy and even Portugal. This is clearly indicated as well by Société Générale from their "On Our Minds" note from the 26th of August entitled "Bank loan take-up shows weak transmission of monetary policy":

"There have been encouraging signs in the growth in euro area lending to the private sector – with acceleration to 1.4% yoy in July from 0.6% the previous year. Interest rate spreads have narrowed materially, but signs of financial fragmentation remain in the volume of new bank loans. The bulk of the flow of loans to households and firms comes from the two largest countries, Germany and France. The transmission of monetary policy is thus not yet sufficiently uniform. Unsurprisingly, the countries where banks are struggling to increase their net lending also have the highest NPL ratios. Hence, fixing these weaknesses should be a key priority for euro area policymakers (SSM, EC and national authorities) in the coming years. All this could help rebuild some confidence in the euro area banking sector, although we still believe that credit demand will continue to be dampened by high political uncertainty (e.g. referendum in Italy this autumn, political gridlock in Spain, elections in France and Germany), low growth prospects and necessary deleveraging in some countries. Moreover, the process of disintermediation is accelerating: this weighs on bank profitability, while SMEs have little access to credit. To our minds, the need for government actions remains decisive: reforms capable of boosting potential growth and communication aimed at reducing policy uncertainty.

Over the past few months, there have been two noteworthy trends. First, loan take-up is highly fragmented. The bulk of the flow of loans to households and firms comes from the two largest countries, Germany and France. In some smaller countries (Portugal, Austria) loan take-up by SMEs has actually fallen, despite lower interest rates.

Second, the ECB CSPP has triggered a strong recovery in corporate bond issuance and this is weighing on the flow of bank credit to large firms.

Fragmentation still there in loan take-up

Since 2012, ECB policy has eased bank funding conditions (e.g. low money market rates, QE,TLTRO I and II). Between 2012 and 2014, the pass-through to end-customers was disappointing. Since 2014, however, the improvement in peripheral country bank lending costs has been very impressive (chart 1).

Interest rates paid by end-consumers and corporates have fallen markedly, including for peripheral banks. Discrepancies in lending rates between core and peripheral countries have narrowed significantly. There is no doubt that the transmission of monetary policy through the euro banking channel has improved.

In terms of loan take-up, the outcome is less clear. While growth in lending to the private sector recovered gradually in 2015-16 and stood at 1.7% yoy in July, this recovery has been more heterogeneous and has come mainly from core banks, German and French institutions in particular (chart 4).

For instance, small loan volumes to non-financial corporations (NFCs, <€1m) have decreased in Portugal, Italy and Austria, despite large drops in interest rates in Portugal and Austria (chart 2). In contrast, this flow of credit to SMEs has experienced double-digit growth in France, Germany and Ireland, and this despite unchanged interest rates.

High NPLs still a hurdle for supply of loans

Part of this fragmentation reflects various credit risks, and these are unlikely to decline in the near term. The heterogeneity in bank strength is illustrated by comparing NPLs. For a number of member states, a still-large stock of NPLs and weak profitability remain headwinds to credit supply in an operating environment of low interest rates and low nominal economic growth. NPL figures support the view that the banking systems in Greece, Italy and Portugal are still unsound, whereas recent developments have been encouraging in Spain and Ireland. Italian banks represent 31.7% of the euro area total stock of NPLs, twice the size of Italy in euro area GDP. Greece (1.7% of euro area GDP) also represents 8.9% of euro area NPLs. Austrian banks (4.2% of euro area NPLs vs 3.0% of euro area GDP) and Portugal (3.9% of NPLs vs 1.7% of GDP) are also overrepresented.

During the latest ECB press conference, President Mario Draghi spent some time discussing his views on a better framework for dealing with NPLs. Firstly, there needs to be a strong supervisory approach; secondly, a fully functional NPL market; and thirdly, more government action (legislation that promotes securitisation, review of bankruptcy laws and, interestingly, a public backstop). However, the time horizon for these changes is several years. Hence, the SSM and national regulators will have to implement a comprehensive approach to deal with the banking fragilities in the coming months." - source Société Générale

Back in July we re-iterated our stance in relation to what the ECB should do in order to restore the credit transmission mechanism to Southern Europe in our conversation "Confusion":

"The only way, we think is for the ECB to monetize NPLs to restore the credit transmission mechanism, because without growth, there is no reduction in both NPLs and budget deficits, that simple.
We also made a more in depth analysis of the Italian NPLs problem back in April in our conversation "Shrugging Atlas":

"Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercise of dubious intellectual utility." - source Macronomics, April 2016

 As highlighted above by Société Générale, time is running out and we do not think the ECB has several years when looking at the situation in Italy or the recent cash injection by Portugal in its ailing CGD bank of €2.7 billion. While the Italian situation has been well commented and documented including by ourselves in April this year, Banco Novo situation has yet to be resolved. This is clearly indicated by credit markets in both cash prices and synthetic (CDS) prices as described by Datagrapple in their 26th of August post:

"After Portugal’s state-owned bank Caixa Geral de Depositos’ recapitalization plan early in the week, we had a brief respite on the Portuguese banks. However, the situation at Banco Novo is unclear. Banco Novo is the good bank created in August 2014 out of Banco Espirito Santo (BES) - transferring BES’s good assets. Two years later, Banco Novo’s short dated senior debt is now trading at distressed levels - around 70cts on the dollar. The CDS is trading at 30% upfront plus 5% for a one year protection. This CDS is one of the most technical and, let’s say, controversial special situations of the CDS market, with contracts outstanding under 2 different rules (2003 and 2014) already offering different definitions of what constitutes a credit event not to mention the further complication even if under 2014 rules of what is determined to be a Government intervention or not (ref Banco Novo transfer of bonds announced end-15). According to the attached Grapple, the probability of a credit event within a year has moved from 25% to 50% over the last month. The situation is turning sour. For an outsider, buying a pool of assets from a distressed bank is an investment decision whilst buying a distressed bank’s stress resilience could be more like an act of faith." - source Datagrapple

So either "Le Chiffre" aka Mario Draghi put up, meaning monetizing the lot, or he should shut up because in our book, no matter how charming the bluff he has pulled in the past with his July 2012 "whatever it takes" moment and his OMT, when it comes to ailing Southern Europe banks, it is decision time. The members of "The Cult of the Supreme Beings" might be numerous, but, saving Southern Europe banks requires more than an act of faith we think and haven't even mentioned German banks with some of their struggle with shipping loans such as HSH Nordbank, do not get us started....

As we posited in our conversation "Le Chiffre" aka Mario Draghi and given the market's anticipation for the ECB's next moves:

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

Le Chiffre is probably "overplaying" it particularly when one looks at the poor effects on "credit growth" in Europe and "inflation expectations". - source Macronomics, October 2015

So all in all, from an allocation perspective we continue to favor style over substance, namely Investment Grade credit and particularly US over High Yield, this has bee, our call since late 2015. As well when it comes to Investment Grade, we favor nonfinancials and it isn't a question of volatility but, more and more a question of recovery value in the end. When it comes to sleeping well at night we prefer the comfort of "smart alpha" rather than "dumb beta" as per our final chart.

• Final chart: US Investment Grade credit, great returns for less risk, we told you so...

When it comes to the Law of the Maximum, in our investment book we prefer sticking with the most favorable risk/return asset class when it comes to credit. We were not surprised to see in Société Générale's Credit Strategy Weekly note from the 26th of August entitled "The five things that credit investors need to do this autumn" that indeed, when it comes to risk and returns US Investment Grade continues to be enticing in a lower for longer world (no matter how charming the Fed's bluff is these days...):

"Risk/return performance is impressive: Chart 11 plots the returns (horizontal axis) against the risk (vertical axis) of IG and HY credit, equities and sovereigns in the US, Europe and EM. The best performers have been sterling IG and US high yield this year. EM stocks have generated as much return, but with four times as much risk. IG returns in either US domestic bonds or EM corporates in USD have been close to the performance of the US stock market, but again with less risk. European returns have been the lowest, and close to sovereigns, but much better than European stocks, which are still posting losses for the year.

- source Société Générale

Credit wise, we do indeed continue to like US Investment Grade, at least US Investors do not have to compete with the likes of the ECB and the Bank of England for now...This for us is the Law of the Maximum until the Fed jumps in that is...

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

Stay tuned!

Macro and Credit - The fourth wall

"It is only with the heart that one can see rightly; what is essential is invisible to the eye." - Antoine de Saint-Exupery, French pilot and writer

While enjoying the festive season in Paris, we watched with interest a couple of interesting credit and market events that made us think about a theatrical reference which we decided to use as our title analogy. The fourth wall is the imaginary "wall" at the front of the stage in a traditional three-walled box set in a proscenium theatre, through which the audience sees the action in the world of the play (or markets). Speaking directly to, otherwise acknowledging or doing something to the audience through this imaginary wall – or, in film and television, through a camera – is known as "breaking the fourth wall" (think Ferris Bueller's day off...). The fourth wall being an established convention and given our disregard for conventions (us being contrarian), we will, therefore, in this first of the year conversation "break the fourth wall". The acceptance of the transparency of the fourth wall is part of the suspension of disbelief (or delusion) between the "fictional" recovery we have commented on numerous occasions and you, the audience.

Before we dive more into our first conversation of the year, which will relate once more to the state of affairs in the credit and macro space, we would like to make a quick parenthesis on two subjects of interest of ours, namely idiosyncratic risks in credit markets and the state of shipping (given for us it is not only a deflationary indicator, but a credit indicator as per our past conversations).

A good illustration of the idiosyncratic risk in the credit space was once more illustrated on the 29th of December by the price action relating to the "sucker punch" delivered to the senior bond holders of Novo Banco, the supposedly "good part" of former Portuguese bank Banco Espirito Santo - graph source Bloomberg:

- graph source Bloomberg

So what happened on the 29th of December that spooked the "innocent" senior financial bond holders you might rightly ask dear audience? Well, Bank of America Merrill Lynch in their note on Novo Banco from the 4th of January tells it all:

"The Bank of Portugal announced that, as part of the resolution of BES, it was transferring five bonds from Novo, back to the ‘bad bank’, BES. We believe that the resolution of BES could be viewed as a process and not a discrete series of events, since Novo is still a ‘bridge’ institution (the intention is that the resolution of Novo is complete when it is sold, although the deadline for the sale now appears to be indefinite). In our view, recovery on these securities should be viewed as uncertain as BES’s total assets were only €197m at end-2014 compared to a negative net asset position of €2.7bn, before the transfer of a further €2bn of senior bonds. It is our understanding that the senior bonds’ Governing Law is Portuguese. We note that in the original resolution of BES, the Bank of Portugal, as resolution authority, has reserved the right to move assets and liabilities between ‘bad’ bank and ‘bridge’ bank. In addition, the BoP appears to have chosen large denomination seniors, to avoid imposing losses on retail bondholders. In any case, with the transferred securities trading at ~€11, and BES now to be liquidated. 

Further losses could lie ahead 

Novo has in effect been given a further €2bn in capital post-transfer which, according to the company, means that its CET1 ratio has now increased to 13%. However, Negocios, at the end of 2015, reported that a further €2bn of ‘irregular’ loans linked to the ancien regime of the bank had been discovered (the newspaper adduces these irregular loans as the reason for the senior bail-in). The newspaper reports that the provisions relating to these exposures may be taken in 4Q15 (and beyond) leading to a significant deterioration in the accounts of the bank. Note Novo Bank did not comment on the press reports. The June report already detailed a loss of €252m. We would expect this to deepen through year end as provisioning likely catches up with the asset quality decline we saw at the bank in 2015. 

Cheap but we await clarity 

In our view the 5% bonds are quite cheap, with yields of nearly 10%. However, many erstwhile bondholders of Novo are now nursing substantial losses from their senior exposures – we assume this could lead to a degree of reluctance to take exposure on the name, at least for a while, which could mean poor technicals for the bonds. We understand that Novo is now better capitalised. However, this capital could come under pressure in the coming quarters if more losses are recognised. Events of the past few weeks have highlighted Novo’s problems and the fact that the deadline for its sale is no longer subject to public disclosure suggests a drawn-out sales process, especially as Santander has just bought Banif, so arguably does not necessarily need to add to its Portuguese assets." - source Bank of America Merrill Lynch

No, these bonds are not "cheap" and should be avoided. 

In addition to senior bond holders nurturing their losses, as of the 1st of January, depositors are now "pari passu" with senior creditors and are indeed next in the line of fire should additional "hidden losses" materialize (they will). When it comes to recovery assumption, we read with interest CMA (now part of Capital IQ)'s take on the estimated recovery value. They estimate it to be at 1%. You read that correctly. So much for an assumed recovery value of 40% for senior CDS. 

We might be sounding yet again in 2016 as a broken record but, we told you before dear readers, in the next downturn in credit, recovery values, rest assured, will be much lower. That's a given.

Moving on to the second part of our parenthesis namely "shipping", and "cheap credit", we read with interest the FT's recent article on the subject from the 3rd of January entitled "Cash burning up for shipowners as finance runs dry":

"The challenges facing DryShips are among the most acute of those facing nearly all dry bulk shipping companies after a slump in earnings drove most owners’ revenues well below their operating costs. Owners are haemorrhaging cash. Owners of Capesize ships — the largest kind — currently bring in around $3,000 a day less than the $8,000 they cost to operate. The losses for the many owners who have to service debts secured against vessels are far higher.
Basil Karatzas, a New York-based corporate finance adviser, points out that in an industry that has already been making steady losses for 18 months, such substantial losses quickly mount up.
“If you have 10 ships and you’re losing $3,000 to $4,000 per day per ship, that’s, let’s say, $40,000 per day, times 30 in a month, times 12 in a year,” he says. “You are losing some very serious money.”
The question is how long dry bulk owners — and the private equity firms which have invested heavily in the companies — can survive the miserable market conditions.
Michael Bodouroglou, chief executive of Paragon Shipping, another New York-listed dry bulk shipowner, says that owners are looking to negotiate partial repayments, standstills and payment moratoriums with their banks.
“They’re trying to batten down the hatches, reduce costs as much as they can,” he says.
Yet the brief arrest — seizure over unpaid debts — in November in Singapore of the Sparta, a Capesize dry bulk carrier controlled by private equity firms, illustrates why shipowners are especially pessimistic about this slump. The vessel’s arrest, at the request of Deutsche Bank, has been widely interpreted as a sign that banks’ readiness to keep amending loan terms to allow owners to ride out the slump might be coming to an end." - source Financial Times

We chuckled because although some pundits have the memory span of a goldfish, we don't and we clearly remembered the warnings we gave back in December 2013 on the billions poured by Private Equity players in the shipping industry in our conversation "All that glitters ain't gold":

"There is a wave of private equity money flowing into shipping, which for us is yet another manifestation of "mis-allocation" and "Cantillon Effects".We have long argued that "Shipping is a leading credit indicator", as well as a "leading deflationary indicator". We have also discussed at length the link between consumer spending, housing, credit and shipping back in August 2012.
The latest manifestation of the consequences of "cheap credit" and record cash is leading outside players such as private equity investors to dip into the structured finance shipping business

Whereas traditional shipowners tend to hold vessels for at least 20 years, private equity groups hope to turn a quick profit by listing companies or selling their vessels once charter rates and ship valuations recover.

The issue of course for our private equity friends that they will soon discover is that if quick profits depend on valuations, they also depend on "recovery". We think they are bound for some disappointment as overcapacity is still plaguing the industry. " - Macronomics, December 2013

Given the "evident signs" of the recovery as displayed in the latest dismal print for the Baltic Dry Index to 467, a new record low (since its creation in 1985), one might wonder if indeed the PE players will make their "quick buck" on their "shipping" ventures. We don't think so:

- source Bloomberg.

Why we don't think so? Because "cheap credit" has led to "malinvestments" with PE pundits placing bets on a business they hardly know, and they have added overcapacity to overcapacity. Simply put, there is a "shipping" glut.

One can ascertained QEs and ZIRP have been deflationary by looking at the fall in the US of M2 "velocity":

-source CLSA

In similar fashion in the shipping industry, the "velocity" of ships aka their speed has been as well falling as reported by Bloomberg in their article entitled "Slowing Boat From China Provides Clue to Health of World Trade" from the 17th of December:

"Even with fuel at its cheapest price in almost a decade, the ships that carry goods around the world have been reducing speed in line with the slowdown in China, the biggest exporter.
Shipping companies have been “slow steaming” since the global financial crisis in 2008, as a way to save costs and keep as many ships active as possible. Vessels are now operating at an average of 9.69 knots, compared with 13.06 knots seven years ago, according to data compiled by Bloomberg. 

That means Nike sneakers and Barbie dolls made in China can now take two weeks to arrive in Los Angeles and a month to reach Le Havre, France -- a week longer than if the ships were moving at full speed. And there’s scope for ships to go even slower, according to A.P. Moeller-Maersk A/S.
“This is the new norm,” said Rahul Kapoor, a Singapore-based director at Drewry Maritime Services Pvt. “The overall speed of the industry has gone down and there’s no going back.”
In the boom years before the 2008 financial crisis, shipping lines expanded fleets and ran ships as fast as they could to keep up with the surging demand for goods manufactured half a world away. As demand dropped, the lines were left with too many vessels, and customers eager to reduce inventory, who would rather pay a lower rate to receive goods than guarantee quick delivery." - source Bloomberg

The new norm has been slower M2 velocity, slower growth, slower shipping. For the PE punters who have played the "recovery" game, they will have to face the "music". End of our parenthesis.

In this week's conversation, given the on-going "bloodbath" in the oil space, we will look at some of the implications. We will also look at the debilitating state of the credit markets once more.

Synopsis:

• US Energy sector (ETF XLE) versus oil price - Much more downside to come
• Credit - The credit cycle has turned and global financial conditions are tightening
• Final chart - Correlations getting higher in a macro-driven market

• US Energy sector (ETF XLE) versus oil price - Much more downside to come

While watching the continuous downward spiral of oil prices, what really struck us is the resilience from the US energy sector in the equity space versus the price of oil. We are convinced that there is more downside to come on the equity side - graph source Bloomberg from the 6th of January:

- graph source Bloomberg.

Whereas at the end of 2008, oil and XLE where trading roughly at the same levels, today it appears to us that ETF XLE as a proxy for the oil equity sector is still at least 30% above the lows of 2009 with an oil barrel at a much lower level. More pain to come, we think...

On a side note, should a rebound of oil happen at some point in 2016, one sure way of playing it would be through Fx via the Canadian Dollar (CAD) and/or the Norwegian Krona (NOK). 

Whereas, equities present more downside risk, credit has already significantly underperformed in recent month in fact as indicated by Barclays in their Oil and Gas monthly note from the 5th of January indicates the following:

"High Yield Energy Bonds Drop 23.6% in 2015 

The Barclays high yield energy index decreased 12.2% in December, the second largest monthly decline since 1991 (worst was October 2008 at -19.2%). This month’s drop leaves high yield energy down 23.6% for the year, underperforming the overall high yield market by 19.1% in 2015. In December, high yield energy credits moved lower because of a 12% decline in front month WTI and a collapse in natural gas prices to a low of $1.75/mmBtu on warm winter weather. By rating category, BB bonds returned -11.6%, B bonds returned -13.6%, and CCCs returned -12.9%. The independent index declined 18.3% in December, reflecting sharp decreases in the unsecured bonds of California Resources, Legacy Reserves, Vanguard Natural Resources, and Memorial Production Partners. Oilfield services dropped 8.4% on decreases in Seadrill, Atwood Oceanics, and CGG. New issue activity dried up completely in December, leaving year-to-date high yield energy issuance at $33bn, down from $55bn issued in 2014. 

Leverage Sensitivities and Breakevens at $40/bbl WTI 

We recently published an E&P update on leverage sensitivities and breakevens at $40/bbl WTI (report). In the report, we show sensitivities to debt/EBITDA in 2016 assuming $40/bbl WTI and $2.25/mmbtu Henry Hub, close to where strip prices are today. Two-thirds of the peer group has leverage north of 5.0x and five companies have leverage north of 10x (SandRidge, California Resources, MEG Energy, Denbury, and EXCO). However, hedging gains account for almost half of the peer group EBITDA in 2016, leaving unhedged debt/EBITDA at an average of 20x. Under this screen, 16 of the 27 companies we model have leverage north of 10x. Lowest leveraged companies under a $40/2.25 deck include Concho Resources (2.2x), Hilcorp Energy (3.2x), Baytex Energy (3.7x), and EP Energy (3.8x). Although not our base case, we note that Moody’s recently lowered its 2016 price forecast to $40/2.25, potentially foreshadowing additional ratings downgrades. 

Hedging Protection is Limited in 2017 

In our latest hedge study (report), we found that high yield E&P companies have protected 36% of 2016 oil and gas production and only 12% of 2017 production. While some high yield producers used the rally in oil to $60/bbl in May 2015 to fortify hedges, few producers have added to hedges in 4Q15 given the decline in strip prices. Almost half the peer group remains unhedged in 2017. As of 3Q15, we estimate that the peer group had a hedge book value of $12.6bn, with Antero Resources leading the peer group at $2.8bn. Top hedgers in 2016 and 2017 include Memorial Production Partners and Antero Resources, with an average 78% and 76% of 2016/17 production hedged, respectively. Credits with no hedges in place for 2016/17 include Goodrich Petroleum, MEG Energy, Midstates Petroleum, and Swift Energy. Energy Spreads Wider in DecemberIn December, energy spreads widened 292bp, to 1,296bp, compared with 58bp of widening for the overall market. December’s move left energy spreads trading 636bp wider than the high yield market, cheap compared with the 10-year average of 38bp through. The sharpest outperformance came in the oilfield services subsector, which widened as little as 5bp versus the high yield market." 

- source Barclays

Given the lack of hedges for some as reported by Barclays, should the "oil conundrum" continues, meaning lower for longer, no doubt to us that some players are going to face the default/restructuring music in 2016. 

This brings us to the second point of our conversation relating to credit and the current state of affairs.

• Credit - The credit cycle has turned and global financial conditions are tightening

While looking at the evolution of Global Fx reserves and their evolution since 2003 and in comparison with the recent periods, one being 2008 and the start of the rise in the cost of capital since mid 2014, if we use the evolution of these Global Fx reserves as a proxy for "global liquidity", one can ascertain that an expansion of these reserves indicates expansion, whereas a fall, indicates a global contraction - graph source Macronomics / Bloomberg:

One can notice from the above chart that during the financial crisis of 2008, between the 31st of July and the 31st of March 2009, Global Fx reserves tightened by 4.86% ($339 bn in 8 months, roughly $42bn per month). Since the 31st of July 2014 until the 31st of December 2015, Global Fx reserves have fallen by 6.39% ($768 bn in 17 months = roughly $45 bn per month). The on-going "liquidity" crisis, which is indeed a very big US dollar "margin call", is not only much bigger than in 2008, but, is lasting much more longer!

So even if some "pundits" tell you that at these levels High Yield is a "bargain", dear reader you should think again, although no doubt there are some interesting credit story out there (much more likely in Europe where leverage is lower), credit in the High Yield space continues to deteriorate in the US, hence our recommendation of moving higher in the rating spectrum for the last few months and favor Europe from a relative value perspective (better credit metrics).

When it comes to US High Yield we have to agree with Bank of America Merrill Lynch's take from their latest High Yield strategy chartbook from the 6th of January, "Winter is coming":

"2014 redux 

Last year was a lot like 2014, only amplified. Bigger oil slump, worsening fundamentals and gappier price movements in HY, more geopolitical turmoil, and higher EM volatility. These factors were already eroding investor sentiment within HY when the US economy also buckled, showing signs of a slowdown at the heels of an already faltering global economy. The news of liquidation of several HY funds due to mounting losses from distressed credits turned out to be the last straw, driving US HY to a return of -4.6%, its first negative annual return in a non-recessionary period. The only bright spot: mutual fund redemptions were comparatively much lesser last year (-$10bn) vs 2014 (-$21bn), which arguably gave US HY a level of support. Across asset classes, US HY was the second worst performer. Only EM equities underperformed more, while less risky securities such as Treasuries, Munis, and Mortgages were the best performers. Leveraged Loans outperformed HY returning -0.69bps despite the heavy outflows (-$25bn). 

Winter is coming 

It’s a binary world we live in: 2015 returns were heavily dragged down by commodities, outside of which the index was roughly flat (tab 1.01). Half the HY universe by market value today trades at 310bps, while the other half is at 1050bps. The distressed list has a disproportionate representation of commodities (33%). However, this dispersion doesn’t bode well for US HY, as our fears of valuations eventually catching up to fundamentals have not abated. Default and distress ratios are increasing, even outside commodities:

and while rating migrations ex-commodities have not reached 2011 levels, they are heading in the wrong direction. CCC issuance has plummeted (chart below) and the US-domiciled USD HY market has seen a net annual contraction for the first time since 2008:

We expect all of this to continue well into 2016, putting more pressure on non-commodity paper. In terms of opportunities, we think Fallen Angels will provide a unique one to HY investors in 2016 as demand for higher quality paper increases, especially in light of reduced primary market activity. We also like Leveraged Loans for many of the aforementioned reasons, and believe they will outperform bonds once again this year." - source Bank of America Merrill Lynch

2016, no doubt will be an interesting year for US High Yield particularly given the contagion risk, should market turmoils continue to run unabated as it seems to be the case so far. As displayed in Bank of America Merrill Lynch's data, not only leverage is higher than in 2008, but earnings have been falling faster in terms of EBITDA YoY changes:

Even Ex Energy earnings are falling...

We know nothing, Jon Snow 

Is it possible that the world remains in its current bifurcated state? Yes, if oil prices don’t bounce back and ex-commodity fundamentals don’t degenerate further. We can sympathize with the commodity bears given the levels of global oversupply, but corporate earnings power has been eroding for one too many quarters (charts above), and top cycle behavior has surfaced one too many times this past year for us to think that the corporate credit cycle has not turned. This is the foundation of our opinion that spreads have more room to widen from here, and a broader default cycle is looming, especially if outflows pick up. The more nuanced questions for 2016 and beyond however, include: what will be the direction of the global economy and how will that impact the business cycle back home? Will events in the HY market be enough to create another impediment for the US economy? Enough to turn the business cycle? The answers to these, we don’t know yet." - source Bank of America Merrill Lynch

So, don't push your luck dear reader, we might be breaking the fourth wall, but "overplaying" the "beta" game when the US credit cycle has turned is, we think asking for more trouble than "carry".

What we have long argued during the course of 2015 is that the more correlations were getting "positive" the higher the number of "sucker punches" aka large standard deviation moves. It is no surprise to us, that the year ended, for some bond holders of Novo Banco, with a bang as described earlier in our conversation. When it comes to 2016, given cross asset correlations have risen, we do expect even more "sucker punches" being delivered hence our mention of "risk reversal" opportunities in our last conversation of the year 2015. When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing.

• Final chart - Correlations getting higher in a macro-driven market

We already discussed the rise in +/-4 standard deviations moves or more in various asset classes back in August 2015 in our conversation "Charts of the Day - Positive correlations and large Standard Deviation moves":

"Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations. There is a growing systemic risk posed by rising "positive correlations. Since the GFC (Great Financial Crisis), correlations have been getting more positive which, is a cause for concern" - Macronomics, August 2015

The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis. This is confirmed by our chosen chart from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 6th of January entitled "When credit met technical analysis":

"Correlations getting higher in a macro-driven market 

The credit CDS index market is a macro risk gauge. Post the global financial crisis and the subsequent central bank interventions, we find that pairwise correlations among different credits are now at a different (higher) regime (chart 4). 

Macro shocks (oil, Greece, China, EM risks, Fed, ECB) dominate credit markets. We see little prospect of the current market set-up changing in view of ECB QE.

Pairwise correlations across different asset classes have also been trending higher. Chart 5 shows the cross-asset pairwise correlations for equity, credit, implied vol and FX markets both in Europe and the US. Note that recently cross-asset correlations were at the highest level in a decade."

- source Bank of America Merrill Lynch.

Sorry to be breaking again the fourth wall dear readers, but, in our book, rising cross asset correlations is not a good sign for a smooth ride, but, at least indicates, there is convexity and risk reversal opportunities out there...and volatility is therefore a buy...

"A heart well prepared for adversity in bad times hopes, and in good times fears for a change in fortune." - Horace

Stay tuned!