Credit - 2014: the Carry Canary

"That's what the cat said to the canary when he swallowed him - 'You'll be all right.'" - Alvah Bessie, American novelist.

Looking at the continuous rally in the credit space, one has to wonder whether 2014 will indeed be the year of the credit carry trade which, as we posited last week, would be supported by a return of M&A, LBOs, as well as structured credit in similar fashion the year 2007.

Reading through the latest BIS Quarterly report published on the 8th of December, we do indeed share the same concern for the return of riskier credit instruments induced by the generosity of our "Generous Gamblers". As indicated by the BIS and reported by Bloomberg by Kate Linsell in her article "BIS Sounds Alarm Over Record Sales of Payment-in-Kind Junk Bonds", the return of these leverage structure is indicative of the similar pattern taken by the credit markets towards 2007 we think, hence our chosen title:

"Record sales of high-yield payment-in-kind bonds is triggering uneasiness among international regulators who are concerned investors may suffer losses when central banks tighten monetary policy.

Issuance of the notes, which give borrowers the option to repay interest with more debt, more than doubled this year to $16.5 billion from $6.5 billion in 2012, according to data compiled by Bloomberg. About 30 percent of issuers before the 2008 financial crisis have since defaulted, the Bank for International Settlements said in its quarterly review.

Companies are taking advantage of investor demand for riskier debt as central bank stimulus measures suppress interest rates and defaults approach historic lows. The average yield on junk-rated corporate bonds fell to a record 5.94 percent worldwide in May, Bank of America Merrill Lynch index data show, while global default rates dropped to 2.8 percent in October from 3.2 percent a year earlier, according to a Moody’s Investors Service report.

“Low interest rates on benchmark bonds have driven investors to search for yield by extending credit on progressively looser terms to firms in the riskier part of the spectrum,” according to the report from the Basel-based BIS. “This can facilitate refinancing and keep troubled borrowers afloat. Its sustainability will no doubt be tested by the eventual normalisation of the monetary policy stance.”

The BIS was formed in 1930 and acts as a central bank for the world’s monetary authorities.

Biggest PIK

Sales of payment-in-kind bonds last peaked in 2007 when companies issued $11.1 billion of the securities, Bloomberg data show. Offerings fell to $5.4 billion in 2008 and tumbled to $2.7 billion in 2010, the data show." - source Bloomberg.

We also agree with the BIS take that the ongoing "hunt" for yield and the instability it will create down the line:

"In addition to reflecting perceptions of credit risk, spreads may also drive default rates. A low interest rate environment naturally fosters cheap and ample credit. Coupled with the reluctance of crisis-scarred creditors to recognise losses, this can facilitate refinancing and keep troubled borrowers afloat. If such a process is indeed at work, its sustainability will no doubt be tested by the eventual normalisation of the monetary policy stance.

The ongoing search for yield has coincided with the breakdown in certain regions of a previously stable relationship between credit market and macroeconomic conditions. Over the 15 years ending in 2011, low or negative real growth had gone hand in hand with high default rates and credit spreads (Graph 4).

This pattern prevailed also more recently in the United States. By contrast, default rates in the euro area actually fell from 2012 onwards, even as the region entered a two-year downturn and the share of banks’ non-performing loans trended upwards (see below). 

Similarly, credit spreads in emerging markets dropped between late 2011 and mid-2013, just when local economic growth showed clear signs of weakness. This suggests that investors’ high risk appetite may have been boosting credit valuations in capital markets, keeping a lid on default rates." - source BIS Quarterly report published on the 8th of December.

Of course we would argue that the breakdown between in the relationship between credit market and macroeconomic conditions is due to "financial repression" and massive liquidity injections which have had the desired effect in repressing volatility.

This is clearly illustrated we think with the evolution of the Itraxx Crossover 5 year CDS index (European High Yield risk gauge based on 50 European entities) and Eurostoxx volatility (1 year 100% Moneyness Implied Volatility) - graph source Bloomberg:

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

On volatility being repressed and the level reached we agree with JP Morgan's recent Cross-Asset volatility snapshot:

"Vol continued its downward trend for the fifth year in a row. YTD, short vol strategies produced a profit even in the case of US rates. The biggest gain was produced by short equity vol strategies, e.g. selling variance swaps on the S&P500 index, and is not only up 11% YTD but it has also recaptured the level it held in early September 2008, just before the Lehman crisis erupted. The very low levels of vol and vol risk premia suggest that there is more upside than downside, and justify a long vol bias currently." - source JP Morgan.

The evolution of the US Vix index and its European counterpart the V2X tells as well a similar story of volatility being contained by the see of liquidity. Evolution of VIX versus its European counterpart V2X since 18th of April 2011 - graph source Bloomberg:

One space though where volatility has not been contained has been of course in the bond space, as depicted by the significant evolution of the MOVE index as well as for Emerging Markets currencies as indicated by the surge of the EM VYX index, following the Fed's tapering stance in the second quarter of 2013:

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

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

EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

The significant pain inflicted to Emerging Markets in the process has been described in our post "Osmotic pressure" back in August this year:

"Since 2009, the effect of ZIRP has led to a "lower concentration of interest rates levels" in developed markets (negative interest rates). In an attempt to achieve higher yields, hot money rushed into Emerging Markets causing "swelling of returns" as the yield famine led investors seeking higher return, benefiting to that effect the nice high carry trade involved thanks to low bond volatility." - source Macronomics

The effect of the "reverse osmosis" we did put forward can be seen in the outflows which the EM funds have suffered from this rapid flows as depicted in the below graph from Societe Generale Cross Asset 2014 Outlook:

"EM funds suffered net outflows of USD 39bn (equity) and 33bn (bond) since May 22"

- Cumulative net inflows into Equity and Bond funds (ETFs & Mutual funds) since 2007, monthly data

Source: EPFR, SG Cross Asset Research/Global Asset Allocation/ Mutual Fund & ETF Watch

So moving back to our title and as we already posited in last week's conversation, 2014 will indeed be the year of the "Carry Canary" in particular in the convertibles space given M&A and buyback activity are always a catalyst for issuance as posited by Bank of America Merrill Lynch in the Global Convertibles Outlook for 2014:

"In the year ahead, we anticipate firm M&A and buyback activity. Our High Yield Strategy team’s view regarding M&A activity is that in spite of earnings and economic growth, corporations will continue to find the need to expand through acquisitions rather than rely solely on organic growth. With ever growing balance sheets, we anticipate consolidation in many industries, as smaller, less levered companies are bought by larger firms looking to boost earnings without substantially increasing debt. On buybacks, our High Grade Strategy team expects releveraging event risk activity to pick up in the form of both M&A and buyback activity. Their contention is that rising rates, besides serving as a trigger (due to the urgency for locking in financing while costs are still low), changes the landscape of event risk. Yields will likely continue to be low relative to history, suggesting that the risk of re-levering corporate actions, such as share buybacks and debt financed M&A, should remain high next year, particularly as the expected pick-up in economic growth next year will likely lead to rising M&A volumes. Share buybacks were particularly effective to enhancing shareholder value in 2013, and companies that perceive themselves to be undervalued will continue to partake in such activity (Chart 6)."

- source Bank of America Merrill Lynch

As far as our title is concerned, we believe the "Japanification" of the European credit market will lead to further spread compression. To that extent we agree with Morgan Stanley's take in their recent 2014 outlook namely that in the European Investment Grade space, "carry dominates returns" in a base case scenario, but the deflationary risks weighting on Europe makes credit counter-intuitively a good candidate for "Japanification":

"No Longer the Favored Region

-We downgrade European credit to Equal-weight as a supportive technical backdrop is offset by challenging fundamentals and middling valuations.

-IG and HY spreads tightened 20-30% in the last year despite leverage rising. Fundamental improvements are already priced in, we believe.

-Supportive technicals remain intact. In contrast to the consensus, we think demand will be stronger if rates rise, and lower if they fall.

-Europe's valuation discount to the US has been closing rapidly. EUR IG cash now trades at the tightest levels to US IG since 2009 (maturity, ratings, and FX-hedging adjusted)." - source Morgan Stanley

To illustrate further the convergence between Europe and US for investment grade, it clear the gap has been closing since 2011 as per the below graph displaying the Itraxx Europe Main (Investment Grade) CDS index versus its US counterpart CDX IG - graph source Bloomberg:

Whereas trading volumes in the CDS space have gone up, the issue with bank deleveraging has indeed been on the cash side and one of our top concerns when it comes to dwindling liquidity in the credit space with the return of riskier products as the hunt for yields gathers steam, namely our "carry canary" in 2007 fashion.

When it comes to trading volumes CITI in a recent report published on the 5th of December entitled "2013 Trading Volumes in Europe Credit" clearly indicates the trend of the "Carry Canary":

"European IG investors trade more CDS indices (Main) and fewer bonds. The 13% increase in iTraxx Main (on-the-run) trading volumes in 2013 (vs. 2012) together with the 15% decrease in cash bond volumes (€ iBoxx IG universe) is a reflection of this year’s high uncertainty and low conviction among European investors.

– More hedging via index products: The usage of both indices and especially index options as hedging tools increased this year; at the same time as investors were less keen on trading around their bond positions.

– Fears of outflows and lower liquidity in bonds have pushed many investors to (i) maintain higher than usual cash balances and (ii) use CDS index longs to make up the lost carry." - source  CITI

The reduction in trading volumes in Investment Grade bonds is indicated in more details in CITI's report:

"Trading volumes during 2013 in the € iBoxx bond universe have declined both in terms of the total volumes traded (15.0%) and the average amount traded per bond (21%), relative to the equivalent period in 2012. The lower decline in the total volumes traded (vs. the average amount traded per bond) is due to a slight (3.7%) increase in the average outstanding volume of bonds in the index versus the equivalent period last year ."

"€ iBoxx

The € iBoxx index captures all large (> €500mm) fixed rate investment grade corporate bonds with a residual maturity of greater than one year. This is a representative sample of the fixed rate IG European bond market, with short-dated bonds tending to be less liquid (and with no comparable data for FRN trading volumes)." - CITI

Of course 2014 will see a continuation of lower liquidity on dealers' balance sheets, which is a cause for concern as investors dip their toes further higher in the risk spectrum. 

Not only credit will be impacted by dwindling liquidity but the rates markets will also be impacted with increasing regulatory pressure on banks as indicated by Bank of America Merrill Lynch in a report published on the 2nd of December entitled "Will the leverage ratio impact the rates markets? Yes":

"Leverage ratio: the new binding constraint

US fixed income markets face major structural headwinds as regulators shift the focus of bank capital regulations away from risk-based capital in favor of blunt, riskneutral measures such as the Supplementary Leverage Ratio (SLR). Market participants and regulators have expressed divergent views about the potential implications for the rates market since the US SLR proposal was released in July. 

Lower demand for Treasuries and lower liquidity

We expect the leverage ratio to have a significant negative impact on the rates market. This stems from the balance sheet intensive nature of fixed income trading and the effective elimination of the favorable risk-based capital treatment of repo and banks' holdings of Treasuries and agencies under the risk-based capital rules.

The main market impact will occur via two channels: 1) lower demand for Treasuries and agencies and 2) adverse effects on liquidity, transaction costs and trading volumes in these markets. We estimate that price elastic demand for Treasuries and agencies that could be negatively impacted by the SLR could be as high as $850bn.

-Lower demand for Treasuries and agencies, as well as a higher liquidity premium, should result in higher rates, all else equal.

-Treasuries should cheapen to OIS, short dated swap spreads should tighten and coupon strips should cheapen to whole bonds.

-The constraints on dealer balance sheet should increase volatility around events such as Treasury auctions, even as the risk of tail events should decline due to lower systemic risk.

-The higher cost of providing unfunded bank commitments such as corporate revolvers, standby letters of credit and liquidity backstops may result in a sharp decline in corporate CP issuance.

There could be some potential offsets, including carve-outs for certain assets such as cash in the SLR exposure definition, new entrants in the repo market, and a slower pace of Fed tapering. We are skeptical that these offsets will be sufficient to fully neutralize the market impact." - source Bank of America Merrill Lynch

"If you think liquidity is coming back in the credit space, then you are indeed suffering from Anterograde amnesia" - Macronomics - May 2013 - "What - We Worry?"

Therefore dealers inventories will continue their downward trajectory, increasing the "instability" in the system as indicated in Bank of America Merrill Lynch note:

"Dealers: inventories to decline as capital requirements rise

Dealers will face higher costs of holding inventory and providing liquidity to clients as capital requirements increase. In our view, this will likely lead to a reduction in demand for duration as dealers scale back inventories. We estimate that Credit Suisse’s rates balance sheet, for example, is 10 times bigger under the SLR than it is under RWA. Under a 3% leverage ratio, this implies a 67% reduction in ROE relative to the risk-based capital framework. Credit Suisse and UBS have already been under pressure from Swiss regulators to reduce leverage, and thus are further along in the process of reducing fixed income trading assets. We expect other SLR-constrained dealers to also reduce their rates balance sheets as ROEs decline, though some level of inventories is required for normal market making." - source Bank of America Merrill Lynch.

Obviously the deleveraging in the US banking system has indeed been much more dramatic than in Europe:

- source Bank of America Merrill Lynch

So if banks are indeed less incline in purchasing US treasuries in 2014, can the Fed simply reduce its QE program? Here is Bank of America Merrill Lynch take on the subject:

"Can the Fed offset the impact though monetary policy?

As we discussed before, the price elastic demand for Treasuries and agencies that could be negatively impacted by the SLR could amount to as much as 60% of the Fed’s asset purchase program per year in duration terms. Thus, it is conceivable that if the Fed increases its program size, it could offset the market impact of lower demand due to the SLR. However, monetary policy is driven by progress toward the Fed’s dual mandate objectives (full employment and inflation) and our economics team is looking for the Fed to begin tapering their asset purchases in March 2014. Nevertheless, if financial conditions were to tighten meaningfully the Fed could slow its exit from QE3." - source Bank of America Merrill Lynch

Hence our doubts on the "tapering" stance from the Fed. 

As we posited in our conversation "Misstra Know-it-all":

"By suppressing interest rates through ZIRP, the Fed has allowed risks to be "mis-priced" leading to global aggressive "mis-allocation" of capital in the search for returns."

On a final note the dollar and the US treasury are now moving hand in hand as displayed by Bloomberg:

"The dollar and Treasury yields are moving together more than at any time on record as Federal Reserve officials say they may cut debt purchases in coming months, drawing funds to the U.S.

The CHART OF THE DAY shows the 120-day correlation between 10-year yields and the U.S. Dollar Index climbed to 0.65, after reaching 0.68 earlier this week. That’s the highest level in data compiled by Bloomberg that goes back to 1971. A figure of 1 would mean they move in tandem. The bottom panel shows overseas holdings of Treasuries rising as the extra yield U.S. notes offer over their Group of Seven counterparts increased.

“I’m buying dollars and Treasuries,” said Will Tseng, a bond trader in Taipei at Mirae Asset Global Investments Co., which oversees $50 billion. “The Fed is going to slow the pace of pumping money into the economy. That removes the downside risk for the dollar. It’s also going to keep the benchmark rate low, making yields attractive.” Fed officials said they may reduce their $85 billion in monthly bond purchases as the economy improves, minutes of their last meeting issued Nov. 20 show. Chairman Ben S. Bernanke said last month the central bank will probably hold its benchmark interest rate near zero long after the asset purchases end.

China added to its holdings of Treasuries in September as benchmark U.S. 10-year yields climbed to 3.01 percent, the highest level since 2011. The largest foreign lender to America increased its stake by 2 percent, the most since February, to $1.29 trillion, Treasury Department data show. Holdings by Japanese money managers, the second-biggest, rose to a record $1.18 trillion.

Ten-year notes yielded 2.87 percent as of yesterday. The yield rose to 47 basis points more than bonds in an index of G-7 peers in November, the most since 2010, data compiled by Bloomberg show." - source Bloomberg.

"Great Rotation"? We are not there yet, same goes with "tapering", we think...

"I Tawt I Taw A Puddy Tat" - Tweety

Stay tuned!

Credit - Livin' On The Edge

"There's somethin' wrong with the world today
I don't know what it is
Something's wrong with our eyes

We're seeing things in a different way
And God knows it ain't His
It sure ain't no surprise

We're livin' on the edge" - Aerosmith 1993, Livin On The Edge

While we contended this week about the complacency in US stocks, when looking at the "great rotation" between institutional investors and private clients for the last five consecutive weeks as reported by Bank of America Merrill Lynch, we thought this week we would use a musical reference for a change, namely 1993 hit song by Aerosmith, which reflected at the time the sorry state of the world.

In this week's conversation, while everyone is enjoying a summer break and some much needed normalization in credit spreads, which has seen cash credit tightened overall by 5 bps this week in the European market on the Iboxx Euro Corporate index, we would like to focus our attention on the growing disconnect between asset prices and the sorry state of the real economy.

Indeed we would have to agree with our chosen title when looking how the US stock market has been defying gravity compared to the sorry state of the US labor market. There has been a growing disconnect between Wall Street and Main Street. On that note we agree with Bank of America Merrill Lynch's report from the 1st of August entitled "When Worlds Collide":

"From their 2009 lows the US economy has grown by $1.3 trillion while the US stock market has grown by $12.0 trillion (in July the S&P 500 set a new intraday high). Policy, positioning and profits (in that order) best explain the seeming disconnect between Wall Street and Main Street. Wall Street and capitalists have enjoyed a boom, as the price of equities and bonds (and more recently real estate) have soared, while Main Street and the labor market have struggled" 

- source Bank of America Merrill Lynch

Yes recently we did indicate, "we're livin on the edge", when  not only looking at the rise of the S&P index (blue) versus NYSE Margin debt (red) but also at the S&P EBITDA growth (yellow) and as well as the S&P buyback  index (green) since 2009 - graph source Bloomberg:

No doubt to us that the current bull market which has started in March 2009 has been artificially "boosted" by "de-equitization", namely the reduction of the number of shares courtesy of buybacks. A drop in stock outstanding accounted for 25% of 2012 earnings-per-share growth in the S&P 500. Buybacks are a global phenomenon.

Capital, courtesy of ZIRP, is not only mis-allocated but also destroyed with the "de-equitization" process in order to boost even more the "infamous" wealth effect induced rally by Mr Ben Bernanke. As far as profits are concerned, companies as sitting on record amount of cash and have generated record corporate profits as indicated by Bank of America Merrill Lynch's graph below:

"Profits: corporate austerity since the Great Financial Crisis has induced record corporate profits ($1.6 trillion – Chart 3) and record levels of corporate cash ($1.2 trillion), an asset-positive, growth-negative combo." - source Bank of America Merrill Lynch

While the latest ISM / PMI releases point to some much hoped economic recovery, the latest disappointing read of the Nonfarm payroll coming at 162 K shows how much the recovery has been tepid so far whereas equities have continued their surge undisturbed.

US PMI versus Europe PMI from 2008 onwards. Graph - source Bloomberg:

But if short term wise economic data shows some sign of stabilization, the volatility in the fixed income space is very much present as displayed by Merrill Lynch's MOVE index jumping from early May from 48 bps and surging back towards the 100 bps level - graph source Bloomberg:

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

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

What we have been tracking with interest is the ratio between the ML MOVE index and the VIX which remains elevated from an historical point of view if we look back since October 2000 - graph source Bloomberg:

This latest surge in fixed income volatility has put some renewed pressure on Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD and High Yield, as displayed by the lost liquid ETF HYG - source Bloomberg:

If the fixed income space, the goldilocks period of “low rates volatility / stable carry trade environment” of these last couple of years seems to have been seriously tested, yet there remain a big disconnect between equities and fixed income. As we posited in our conversation on the 13th of June "The end of the goldilocks period of low rates volatility / stable carry trade environment?":

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

For now volatility indicators in both Europe (V2X) and the US (VIX) have been fairly muted. Graph source Bloomberg:

So the big question is indeed are we indeed "Livin' On The Edge"? Here is what Bank of America Merrill Lynch posited in their 1st of August note on this subject:

"United we fall, divided we rise

Secular bears of financial assets will argue, with some justification that the worlds of Wall Street & Main Street cannot diverge indefinitely. This may well be so. But in the past 5 years this view has repeatedly missed the point that a divided world of High Liquidity & Low Growth has been the foundation of a ferocious bull market in financial assets.

And of course not all asset prices have reflated as nonchalantly and aggressively as US corporate stocks and credit. Commodity markets and the performance of global cyclicals versus defensives continue to point to a very, very subdued global growth environment. A breakdown in the Continuous Commodity Index (CCI –Chart 4) below 500 in coming weeks would discourage global growth upgrades (and stymie the recent rebound in Emerging Markets). 

It is very rare to see such outperformance of defensive stocks (up 26% over the past two years) versus cyclical stocks (down 4%) in a non-recessionary world (Chart 5).

- source Bank of America Merrill Lynch

As we argued back in April this year in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option", the downward protection from Consumer Staples can be illustrated from the following Bloomberg graph highlighting the performance of Consumer Staples versus Consumer Discretionary and Financials since October 2007 until October 2012:

Another "great anomaly" has been that low volatility stocks have provided the best long-term returns.

So yes indeed in, we do live, in an ambiguous world where low volatility provides the best returns, and with a great disconnect between equities and the real economy, with fixed income and equities. We think we are "Livin' On The Edge" and as indicated by Bank of America Merrill Lynch, but, we are not too far from "The Moment of Truth":

"Perhaps the best example of this bi-polar world is the fact that the US equity market now represents almost 50% of the world’s market cap. Despite limited support from the US dollar, US equities relative to EAFE are close to relative levels not seen since the 1960s (Chart 6), as investor positioning reflects belief in ongoing US market and macro leadership.

So moment of truth for the economy will arrive in the second half of this year. If ever the US were finally to achieve “escape velocity” it must be now. Significant monetary stimulus, the end of fiscal austerity, a booming housing market, a cheap dollar, and record corporate cash balances mean the US economy should meaningfully accelerate in coming quarters. Our own Ethan Harris looks for 2.0% GDP growth in Q3, 2.5% in Q4 and 2.7% in 2014.

Our investment strategy remains predicated on that outcome. In coming quarters we expect PMI’s to accelerate, job growth and bank lending to improve, higher interest rates to coincide with higher bank stock prices, and US dollar appreciation. We favor assets (such as financial stocks) and markets (such as Europe) that have lagged in the “High Liquidity-Low Growth” world of recent years." - source Bank of America Merrill Lynch

Unfortunately we do not share Bank of America Merrill Lynch's optimism on the acceleration of USD GDP growth in the coming quarters. For us, it is still muddle-through with significant risk on the downside.

US labor growth remains very weak as indicated in the below Thomson Reuters Datastream / Fathom Consulting graph:

QE and the law of diminishing returns - US QE in practice - Payrolls and Manufacturing ISM, graph source Thomson Reuters Datastream / Fathom Consulting:

In addition to this the regular economic activity and deflationary indicator we have been tracking has been Air Cargo. It is according to Nomura a leading indicator of chemical volume growth and economic activity:

"Our air cargo indicator of industrial activity came in at -3.8% (y-o-y) in June, following -4.8% in May and -7.4% in April. As a readily-available barometer of global chemicals activity, air cargo volume growth is a useful indicator for chemicals volume growth.

Over the past 13 years’ monthly data, there has been an 83% correlation between air cargo volume growth and global industrial production (IP) growth, with an air cargo lead of one to two months (Fig. 2). In turn, this has translated into a clear relationship between air cargo and chemical industry volume growth (Fig. 1).

- source Nomura

On a final note, if you think that stocks are "Livin' On The Edge" and that a QE tapering is around the corner, then maybe you ought to think about US Treasuries again, for a very simple reason, government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". In fact the case for treasuries is also indicated in Bloomberg's recent Chart of the Day:

Investors should buy Treasuries if they anticipate the Federal Reserve will reduce its purchases, based on the last two times that the biggest buyer of bonds stepped back from the market.

The CHART OF THE DAY shows the benchmark 10-year yield dropped and gains in the Standard & Poor’s 500 Index slowed after the Fed ended each of the prior two rounds of quantitative easing in the past four years. The yield declined 1.26 percentage points between the end of the first round of Fed purchases in March 2010 and the beginning of the second round in November that year. The U.S. stock gauge rose 2.4 percent, compared with a 36 percent advance during QE1.

The yield slid 1.3 percentage points between the end of the second round in June 2011 and the beginning of Operation Twist in September the same year. The S&P 500 fell 12 percent after gaining 10 percent during QE2.

“The Fed will taper QE not because the economy is booming but because the program has been creating excess liquidity, boosting risk assets too much,” said Akira Takei, the head of the international fixed-income department at Mizuho Asset Management Co., which oversees $37 billion and whose U.S. affiliate is one of 21 primary dealers that underwrite U.S. debt. “Ending QE is likely to trigger a correction in risk assets, driving bond yields down.”

Fed Chairman Ben S. Bernanke said on June 19 that the U.S. central bank may slow the third round of bond-buying, valued at $85 billion a month, later this year and end it entirely in the middle of 2014 if the economy achieves sustainable growth. Half of the 54 economists surveyed by Bloomberg News said the Federal Open Market Committee will decide to start taking such steps at its September meeting.

Futures traders see an almost 60 percent chance the Fed will keep the benchmark rate at a record-low range of zero to 0.25 percent through to at least the end of 2014. The 10-year Treasury yield is likely to fall to 1 percent by the end of March and may touch 0.8 percent next year, Mizuho’s Takei forecast. It was at 2.71 percent yesterday, up from 1.72 percent when QE3 was announced on Sept. 13 last year." - source Bloomberg.

Looks to us that the S&P 500 is no doubt "Livin' On The Edge".

Oh well...

"To him that waits all things reveal themselves, provided that he has the courage not to deny, in the darkness, what he has seen in the light." - Coventry Patmore, English poet.

Stay tuned!

Credit - Pain & Gain

"The aim of the wise is not to secure pleasure, but to avoid pain." - Aristotle 

Looking at the continued rally in the credit space, with the Iboxx Euro Corporate benchmark tightening to the tune of 5 to 6 bps every week in the last three week in the cash market, in conjunction with the massive compression of spreads in the Itraxx Credit indices space, we thought this week, we would use a reference to 1999, New Times three-part series of articles called "Pain & Gain" by writer Pete Collins which inspired 2013 American film directed by Michael Bay.  The story revolved around a gang of local bodybuilders with a penchant for steroids (liquidity from central bankers?), strippers, and quick cash. They later became known as Miami's Sun Gym gang and quickly developed a taste for blood and money.

Gain: 

We closed the week on almost 15 bps on Itraxx Main Europe to 92, the lowest since May 2010, which is the risk gauge for Investment Grade credit, and 50 bps in Itraxx Crossover to a low of 378 bps. 

Pain: 

As one credit index trader put it in his closing comments (which are reminiscent of the early days of 2007):

"With street put short yesterday by the massive short cutting, dealers are finding it hard to recycle positions and were having more and more pain as client kept selling index today as well. With shallow volumes, every enquiry drove the market lower. The incredibly strong payrolls drove us through 90 and this was the point when people were starting to have discussions of whether these tights are the new fair trading range or whether they should put those shorts."

 

There you go, the penchant for steroids induced rallies in the credit space is starting to inflict some serious pain to market makers as they are having to bid for credit indices and getting hit in a severe tightening market, not only inflicting P&L pain, given they are having trouble recycling their positions with less players in the market place than in 2007 (gone are the prop traders, fewer credit hedge funds and fewer market making banks) but, they are also facing negative carry on the trades they have had to absorb and did not recycle. Oh well...

So this week, we will focus our attention to the credit space, the releveraging taking place in the US and Mario Draghi's ambition of reviving the Euro Zone Corporate lending . But first, a quick market overview.

The absolute level of core European government yields has continued to fall even after the 25 bps rate cut this week - source Bloomberg:

2 year Italian yields dropped to 1.068% the lowest since Bloomberg started tracking the data in 1993 and Italian 10 year yields fell 7 bps to 3.84% the lowest since October 2010. Spanish yields also receded with the 10 year falling to 3.97% below 4%, the least since October 2010 and 2 year below 1.60%, the lowest since April 2010.

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

Credit wise the rally in 2012 has been epic courtesy of "whatever it takes 1" (Mario Draghi) and "whatever it takes 2" (Abenomics). Itraxx Main Europe 5 year CDS index (Investment Grade credit risk gauge based on 125 entities) and Itraxx Crossover 5 year index (European High Yield risk gauge based on 50 European entities) - source Bloomberg:

The absolute spread between both credit indices is closing to the level of March 2011 (255 bps apart) before the liquidity crisis of summer 2011 which was tempered by a good dose of "steroids" (LTRO 1 and 2).

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

We are back to early 2008 levels for both the Itraxx Crossover index and Eurostoxx volatility.

While the Eurostoxx seems struggling to break the 2800 level, the German 10 year Government yields have touching record low levels this week towards the 1.16% yield level  and the Itraxx Financial Senior 5 year CDS index (indicative of credit risk for financials in Europe) have been dramatically falling towards 140 in the last couple of weeks while volatility remains muted at 18 for the V2X index - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

We already indicated that divergence between the US PMI and European PMI divergence which we explained in our conversation "Growth divergence between the USA and Europe", was here to stay in 2013. This divergence can be seen as well in the difference in credit spreads risk gauges such as the Itraxx Main Europe CDS index and its US CDX counterpart - source Bloomberg:

What has been interesting has been the strong correlation between the US, High Yield and equities (S&P 500) since the beginning of the year. We have also noticed the strong rebound in Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD - source Bloomberg:

Talking about Pain and Gain, whereas March was brutal for investment grade, the rebound in April has indeed been very significant. As one can see the correlation between High Yield and equities seems to be stronger than ever as both the S&P 500 and the ETF HYG seems to be perfectly moving in synch.

But, if we focus our attention this week on credit, we would have to say that the unintended consequences of "steroids" induced policies from Central Banks is pushing investors more and more up the risk spectrum as everyone is seeking higher returns as indicated by Fitch recent European High Yield Chart book:

"As yields continue to compress in high yield, the risk-reward proposition for the investor becomes increasingly difficult to justify, shifting the dynamics in favour of issuers. European non-financial BBs now trade equal to equivalent US BBs, despite materially weaker growth, greater policy volatility and uncertain liquidity. European Bs continue to offer premia, though these too are tightening. Global monetary stimulus from quantitative easing in the US, the UK, and Japan together with an expected ECB rate leaves little choice for investors other than to move out along the maturity curve and go down the credit spectrum to seek diversification as they satisfy return objectives.
Deteriorating credit quality poses a risk to the market, but this is largely expected to translate into a migration of ratings to lower levels rather than any substantial increase in the default rate. The legacy loan market is at greater risk of rising defaults due to the concentration of riskier borrowers from 2006 and 2007 who were able to access tighter spreads and higher levels of leverage than the high-yield market could accommodate at the time.
However, further spread compression may entice riskier lower B‟ or CCC rated issuers from the leveraged loan market to issue high-yield bonds. Such developments tend to signal the end of cycle in European high yield and a period of yield and spread widening together with subdued new issuance. To date in 2013, the market is accepting lower quality instruments from higher quality borrowers, such as Sunrise Communications Holdings SA (BB−/Stable) recent PIK note (B− instrument rating). When the market tests low-quality instruments from low-quality borrowers the cycle will be set to return." - source Fitch

The European and US High Yield Market, new issuance and yields - source Fitch:

Using again our "Pain & Gain" title analogy, we would like to further delve into our analysis of the "Japonification" of credit in Europe and the difference with the US where we are seeing re-leveraging at play in the credit space.

For instance, many pundits are wondering how come peripheral EMU bond yields and peripheral bonds have been performing so strongly when indices such as the FTSE Italian bank index is still flat at 10,000.

For us, it is very simple, deleveraging is generally bad for equities and in particular financial stocks, but good for credit assets. We discussed this very subject back in April 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"When companies turn conservative and start reducing debt, credit holders benefit and equity holders lose out."

Why would we have had a rally in Italian banks? It doesn't make sense. For us a bank is a leverage play on the economy, it is the second derivative of a sovereign. No credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and no earnings for banks. Banks in peripheral countries had no choice but to shrink their loan books, reducing therefore their profitability and ROE.

European Banks ROE by countries from 2005 to 2011 - source Bloomberg - Macronomics:

Nota Bene: 2011 data for Germany not available. McKinsey & Co. said in its bank sector annual report. European bank average returns on equity were 15% to 17% in 2005-07, vs. 7% to 9% currently. With the revenue outlook poor, further cost cuts remain a key profitability lever. Median ROE in 2011 in the European Union was 2.2%.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 1.2% inflation rate is telling you hence the ECB rate cut this week. But, once again ECB is behind the curve courtesy of the stupid European Banking Association decision of imposing a 9% Core Tier 1 threshold to European banks to be reached by June 2012, which precipitated a credit crunch in peripheral countries, leading to a surge in unemployment, bankruptcies and rapid rise in nonperforming loans.

A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse in 2011). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen in the European banking space and other accounting tricks...). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios in peripheral countries.

Therefore in Europe, you have been much better off buying senior financial corporate bonds as part of the reflation "whatever it takes" trade in this deflationary environment than peripheral financial stocks. As seen in Japan in the past, credit outperforms equities in a deflationary environment.

Peripheral banks equities = Pain

Peripheral banks senior financial bonds = Gain

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Macro Research which we introduced in our conversation "The Night of the Yield Hunter":

Whereas credit wise, European peripheral financials are deleveraging, hence the performance of their bonds ("Gain" - Love) rather than their equities ("Pain"- Hate), what we are starting to see in the US is leverage rising as indicated by Fitch, in their recent US High Yield Default insight from March 2013:

"Credit Gains Hit Speed Bump:
In the March 2013 edition of the “Fitch Ratings/Fixed Income Forum Senior Investor Survey,” a majority of investors saw U.S. corporate leverage moving higher over the coming year and expected some credit deterioration across both high grade and high yield. Fitch’s recurring analysis of the aggregate financial performance of a large sample group of speculative grade companies shows that leverage began to turn up in 2012 — a product of higher debt balances and sluggish EBITDA growth (see Debt / EBITDA chart below).

In the second half of the year, in fact, the number of companies in Fitch’s sample reporting year-over-year increases in EBITDA (approximately 55%) had fallen to the lowest level in three years and was on par with the share reporting year over year increases in total debt (also 55%) (see Companies Reporting Increases in Debt and EBITDA chart below). 

Rating trends further confirm this pattern, offering a more complete picture of the direction of credit quality. Fitch recorded more U.S. corporate downgrades than upgrades in 2012. In the first quarter of this year rating activity was roughly even for speculative grade borrowers, and so it appears that the negative rating drift has stabilized, but trends remain lackluster, especially compared with 2010 and 2011 activity when credit quality was more firmly on the upswing. Also notable, the volume of bonds rated ‘CCC’ or lower is now $237.5 billion, up from $226.5 billion at the end of 2012 and $196.8 billion at the end of 2011. Even absent aggressive precrisis transactions, there is still plenty of organic sensitivity to the subpar domestic and global economic environment. An offset to this is funding. Thanks to the Fed’s commitment to low interest rates and the demand it has created for yield product, companies have been able to successfully push out bond and loan maturities. This provides a meaningful support for keeping default rates low in the near term."

In terms of flattening yield curve, indicative of the credit cycle, we think as credit investors you should start monitoring the flattening of CDS curves. As a market maker commented recently:
"1 year and 2 year CDS curves are flattening, only a matter of time before 3 year versus 5 year curves does the same and flatten."

We have of course seen this movie before in the credit space in the heyday of the credit bubble build up in 2006 and 2007.

So as credit investors, yes we are indeed still dancing as the music is playing, but, given the liquidity levels closer to 2002 than 2007, we'd rather be dancing close to the exit door. As Aristotle put it, our aim, being wise we think, is not to secure pleasure, but to avoid pain, which will no doubt materialise at some point.

On a finale note, Mario Draghi ambitions to revive the real economy and corporate lending that is. The LTROs after all amounted to "Money for Nothing":

"Although LTRO provides cheap funding to European banks, rising unemployment levels and deteriorating credit conditions should consequently lead to a significant rise in Non Performing Loans (NPLs) on banks balance sheet."

Meaning plenty of liquidity impact (steroids) for banks (our European Sun Gym gang which have a taste for blood and money) but confirming our 2011 fears of credit contraction for corporates and households (Italy and Spain) - source Bloomberg:

"Corporate loans across the euro zone fell more than 350 billion euros ($460 billion) to March's total of 4.5 trillion euros from January 2009 highs. ECB President Mario Draghi's lowering of the marginal lending rate and hint at reviving European Asset-backed Securities mark early steps toward enlisting banks to lend-again. An ABS market would enable banks to package new lending into an ABS structure and post with the ECB to access further funding." - source Bloomberg.

As far as we are concerned, the deflationary forces at play and the unemployment levels in Europe cannot be addressed by ZIRP for the following "creative destruction reasons" as indicated by CreditSights in their recent Sovereign Analysis from the 1st of May entitled -If the ECB doesn't mind Spain deficit, nor do we":

"Spanish non-financial corporates alone saved the equivalent of 3.3% of GDP last year. That difference between corporates' revenues and expenses was used to pay down debt. Spanish, non-financial corporates have net debts equivalent to 129% of GDP. But it comes at the expense of Spanish households'. In the process of using revenues to pay down debt, corporates are ensuring that they aren't spending it and in the vast majority of cases won't not generate incomes for households. Those cut backs in investment spending are contributing to the decline in wages and rise in unemployment.

Unemployment has now reached 27.2% as of the first quarter. And wages have fallen by 1% over the past year. The decline in incomes mean that household savings have fallen from 6% of GDP in 2009 to 1% of GDP in 2012 as they have been forced to fall back on savings to be able to maintain spending. While households added €22 bn in financial assets in 2011 they reduced their holding of financial assets by €15 bn in 2012. That swing from saving €22 bn to dis-saving €15 bn contributed €37 bn to household spending and meant that year on year it rose by 0.2% in nominal terms rather than falling by more than 5.5%." - source CreditSights

 

Since 2008, you have seen creative destruction at play, meaning companies have preserved their margins by doing more with less people. Some job will just not return. What is the benefit of QE and ZIRP on structural unemployment? Zero so far:

ZIRP isn't only a European problem in this credit "japonifiaction" process at play. It is also the case in the US.

In fact productivity in the US has been rising as companies have been indeed preserving their margins by managing very tightly their labor costs and adapting to the low growth environment they face as reported by Shobhana Chandra in her Bloomberg article from the 2nd of May - Productivity in U.S. Rises as Companies Try to Cut Labor Costs:

"The productivity of U.S. workers rose in the first quarter as companies focused on containing labor expenses.
The measure of employee output per hour increased at a 0.7 percent annual rate, after dropping 1.7 percent in the prior three months, a Labor Department report showed today in Washington. The median forecast in a Bloomberg survey of economists called for a 1 percent advance. Expenses per worker increased at a 0.5 percent rate after jumping 4.4 percent.
Employers tried to control expenses by making do with their existing staff as demand grew in the January to March period. The emphasis on wringing efficiency gains may mean hiring will take time to accelerate, particularly as across-the board federal budget cutbacks and higher payroll taxes restrain the world’s largest economy." - source Bloomberg.

By keeping interest low to promote investment, like the Fed is also currently doing, full employment would therefore be "attainable" in the pure Keynesian tradition. For Keynes, the velocity of money should move together with the level of economic activity (and the interest rate). Well guess what. It isn't.

Why?

Credit growth is a stock variable and domestic demand is a flow variable.

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

The only country in Europe we can think of which tackles efficiently structural unemployment by retraining the labor force is Sweden.

Why would the US labor participation rate in the US increase?

If the cost of capital is not priced but set by central banks, how can capital be efficiently deployed to innovation and not "mis-allocated"?

 

MV = PQ. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.).

Monetary policy at the moment is a desperate race. They are increasing money supply but velocity keeps falling. So the Fed’s problem is best understood as one of trying to bend this velocity curve.

Alan Greenspan made mistakes after mistakes, bubbles after bubbles, central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate.

Pain in employment levels - Gain in financial markets.

"Prefer a loss to a dishonest gain; the one brings pain at the moment, the other for all time." - Chilon


Stay tuned!

Credit - Winner-take-all

"One should always play fairly when one has the winning cards." -  Oscar Wilde

"Winner-take-all is a computational principle applied in computational models of neural networks by which neurons in a layer compete with each other for activation. In the classical form, only the neuron with the highest activation stays active while all other neurons shut down, however other variations that allow more than one neuron to be active do exist, for example the soft winner take-all, by which a power function is applied to the neurons." - source Wikipedia

Looking at the recent raft of European data in general and PMIs in particular, we thought we would venture again towards computational analogies in our chosen title, in similar fashion to our previous post "Banker's algorithm" in 2012.

In similar fashion to the winner-take-all computational principle, when ones look at the growing divergence between France and Germany when it comes to PMI, in the pure classical form, it seems only the country with the highest activation stays active while all other see their growth prospects shut down - source Bloomberg:

In our first credit post of the year, namely the "Fabian Strategy", we sounded the alarm in relation to France being clearly in the crosshair in 2013:

The story for 2013 in Europe we think, will be France:
In relation to France, in our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

Back in November in our credit conversation "Froth on the Daydream" we argued:

"Should industrial production print fell to -3.3%, we believe France will no doubt be in recession, putting in jeopardy its overly ambitious target of 3% of budget deficit in 2013 (A Deficit Target Too Far")."

In this week's conversation, we would like to reiterate our views on France in particular and Europe in general and why France will be in the spotlight in 2013.

While the French government has decided to revise its growth outlook for the year, the overly ambitious fiscal deficit in France of 3% will not be met and even the revised growth outlook of 0.2% to 0.3% will not be reached.

Why so? Well, having a look at one definitely scary graph displaying, French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tells the story on its own, we think - source Bloomberg:

A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 42.7 for Services PMI is the lowest since February 2009. Overall French composite PMI is at 42.3, the lowest level since April 2009. 

If the Services PMI contracts at such a rapid pace, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

Germany versus France, a story of growth divergence and unemployment divergence - source Bloomberg:

In that context, we would have to agree with Nomura's take on French Q1 GDP forecast of -0.3% q-o-q and as well with their annual GDP forecast of -0.5% in 2013, meaning France will have to find additional resources to fill the gap in its public finances.

"At the sector level, the euro area manufacturing PMI dipped slightly to 47.8 from 47.9 in January (Consensus: 48.5; Nomura: 48.4), mainly owing to the fall in the output sub-index (from 48.7 to 47.5). However, the forward-looking indicators seem to be more positive than the headline index, with the new orders component rising to 47.7 from 46.8 previously, thus taking the new order-to-inventories ratio to 1.02, the highest level since June 2011. In particular, thanks to the strong demand in Asia and the US, new export orders, mainly led by Germany, returned to expansion (at 51.7 from 49.5) for the first time since May 2011. In the services sector, the headline index (at 47.3 from 48.6) and almost all the sub-indices declined. Against a weak backdrop for domestic demand, new business and business expectations remained at low levels, suggesting a bleak near-term outlook. Country details again revealed significant divergences across the region, with the situation in France increasingly worrying." - Source Nomura - Euro area composite PMI to increase pressure on ECB - 21st of February 2013.

 The divergence between the US PMI and European PMI, is here to stay in 2013 - source Bloomberg:

But, before we look into more details about France in particular, first a quick credit overview.

The European bond picture, with Spanish 10 year yields staying around 5.15%, whereas Italian 10 year yields below 5% hovering around 4.45% and German government yields stable around 1.60% levels - source Bloomberg:

While this picture has been relatively stable for the last couple of weeks, the uncertainties surrounding the Italian elections could through a spammer and derail this overall picture of yields stability for peripheral countries.

Sovereign CDS wise, Credit Default Swaps in Portugal, Spain, Italy and Ireland have tightened over the last 3 Months, with Portugal showing the biggest improvement, tightening 32% to 381.1 bps. Italy improved the least, but still tightened 12.5bps (5%) to 247.5 since 23rd November according to CDS data provider CMA part of S&P Capital IQ:

Looking at the week ahead, arguably the Italian elections taking place on Sunday and Monday will be key in determining the willingness of the Italian population to push forward reforms: Italian elections (Sunday and Monday) as indicated by Nomura's take in their latest "The Economy Next Week" from the 22nd of February:
"The Italian national elections will be held on Sunday 24 and Monday 25 February, with polls closing at 2pm London time on Monday and the first exit polls likely available a few minutes after that. Our baseline view is for a centre-left majority in both houses of parliament, with Pier Luigi Bersani as prime minister. In the likely case Bersani fails to win the Upper House, we then believe he will negotiate and build a coalition with Mario Monti for the remainder of next week. We view this as more likely than new elections and we expect such a coalition to face difficulties in implementing reforms. The fragmented political landscape and the possibility that the shape of the government will be decided as a consequence of post-election alliances rather than from a decisive vote are recipes for instability and slow reform momentum, our main concerns after the elections." - source Nomura

One thing for sure, the Italian election is going to be a close call and could add potential uncertainty to the European project. As displayed by Bloomberg's Chart of the Day, the Berlusconi effect, while present, might
not be enough to counter Italian premiership candidate Pier Luigi Bersani - source Bloomberg:

"The CHART OF THE DAY shows that Bersani’s average lead in opinion polls of 6 percentage points for elections to the lower house of Parliament is similar to Romano Prodi’s advantage of 5.8 percentage points over Berlusconi in 2006. While Prodi went on to win by just 0.1 percentage point, the victory margin for Bersani will drop to only about 2.4 percentage points assuming the same survey bias this year, as more parties contest the election now than seven years ago. The bias may reflect a so-called Berlusconi effect, whereby voters tell polling companies they won’t support the three-time premier, perhaps out of embarrassment, only to cast ballots for him on election day, D’Alimonte said. The case resembles the “Bradley effect,” named after Tom Bradley, the black former Los Angeles mayor who unexpectedly lost the 1982 California election for governor after most surveys indicated he would win. “There’s certainly a number of people who are reluctant to say they’re going to vote for Berlusconi, but they actually will,” D’Alimonte said by phone. Still, “it’s unlikely they will be enough” to give Berlusconi the edge over Bersani in the election for the Chamber of Deputies, he said." - source Bloomberg

Interestingly we have been tracking over the months the growing divergence in the performance of the Standard and Poor's 500 index and the Eutostoxx in conjunction with Italian 10 year government yields - source Bloomberg:

The lag in European stocks given the very recent negative tone in European economic data has made them much more volatile. Should the "Risk-Off" scenario come back in the coming weeks it should lead to additional weakness for the Eurostoxx and rising Italian yields in the process.

In similar fashion, the recent weakness in European stock has led to a growing divergence between the evolution of VIX versus its European counterpart V2X - source Bloomberg:

While V2X has reached 20.40 from a low of 14.85, VIX has surged from its low of 12.31 towards 15.22.
As we pointed out last year in our conversation "The two main drivers of equity volatility" with the help of our friends from Rcube Global Macro Research:
"The two main drivers of equity volatility are for us, credit availability (Merton model) and revisions of earnings forecasts estimates.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

As we posited in "Yield-Famine": "Credit is increasingly becoming a crowded trade, forcing yield hungry investors to get out of their comfort zone and reaching out for High Yield as well as Emerging Markets in the process. While everyone is happily jumping on the credit bandwagon in this "yield famine" environment, we would advise caution given liquidity, as we discussed on numerous occasions (and liquidity mattered a lot in 2011...), is an important factor to consider in relation to investor confidence and market stability."

On the subject of credit becoming a crowded trade, it seems some high-yield investors are also starting to take notice of credit entering bubble territory. As reported by Cecile Gutscher and Doug Alexander in Bloomberg on the 22nd of February - Top Junk Bond Manager Marshall Sees Rally Ending:
"CI Investments Inc.’s Geof Marshall, the second-biggest Canadian manager of high-yield debt, said the four-year rally in below-investment-grade bonds is coming to an end as companies begin to take on too much risk. “The high-yield rally is long in the tooth,” Marshall, who manages $6.8 billion as head of high-yield investments, said in a Feb. 20 interview at his Toronto office. Investors can expect “coupon-like returns” this year, he said. The Bank of America Merrill Lynch High-Yield Index gained 18.8 percent in 2012, beating the returns of investment-grade corporate debt for the third time in four years. After using junk bonds to propel his Signature Diversified Yield mutual fund to the top 10 among Canadian balanced funds last year, Marshall is cutting holdings of the securities to 35 percent, from 40 percent in the middle of 2012. Following four years of balance-sheet repair and cost-cutting, many issuers are shifting their preference back to boosting return on equity, while the re-emergence of debt-laden takeovers such as Dell Inc. and HJ Heinz Co. will undermine confidence, he said. “Companies can borrow cheaply, shareholders are clamoring for returns, so to the extent that high-yield companies can borrow for growth or to increase dividends, I think you’ll see more of that,” Marshall said. “The quality of high-yield issuance probably begins to deteriorate in general.”' - source Bloomberg.

In terms of sector allocation and as far as the story of the "Great Rotation" goes, namely allocating from credit to equities, it seems some players are already taking a few chips from the High Yield table and rotate some of their High Yield allocation into equities as reported in the same Bloomberg article:
“What we’re doing is very gradually letting the high-yield weight fall” in funds including the High Income fund, where junk is mixed with other assets, Marshall said. “As we get inflows, the marginal dollars are being invested in equities as opposed to credit.” Apart from equities, Marshall is boosting bets on U.S. dollar leveraged loans, which pay similar coupons of about 6 percent to U.S. junk bonds and get paid first in bankruptcies. “The value gap between loans and high-yield bonds is greatly diminished,” he said." - source Bloomberg.

Geof Marshall concluded is  Bloomberg interview with the following important points:
"“We’re at the cusp of transitioning from a market that’s driven by systemic, macro challenges, risk-on, risk-off, to a market that’s going to be more idiosyncratic,” Marshall said. “I don’t think the high-yield trade is over per se, I just think that returns are going to be lower going forward.” - source Bloomberg.

Moving back to our French subject, and in continuation to last week conversation around goodwill impairments on corporate earnings, French giant France Telecom, in similar fashion to its French relative Credit Agricole wasn't spared either by goodwill writedowns and took a 1.84 billion euros impairment charge on its units in Poland, Romania and Egypt which dragged down its 2012 profits. As we indicated last week in our conversation "Bold Banking", the Telecommunications sector has seen some large goodwill impairments in recent years, such as Deutsche Telekom 7.4 billion euros goodwill writedown in November 2012 on its T-Mobile USA unit and Vodafone as well with a 5.9 billion pound writedown on assets in Italy and Spain.
Whereas France has been one of the worst performer of core European countries, its flagship France Telecom has been arguably the worst performer in French CAC40's index falling 32.4% during the past 12 months.

But, what have the factors plaguing French GDP?

In a recent note entitled French GDP - Drivers of Corp Revenues and Investment, CreditSights indicated the following:
"The shrinkage is primarily a result of weak corporate investment spending, which is in turn the result of weak household expenditure and, since the fourth quarter, falling export demand." - source CreditSights.

What are the swing factors according to CreditSights:


"It is household consumption and investment spending that tend to be the swing factors. Government's purchases of goods and services from the private sector have tended to be reasonably stable.

But investment spending (to the extent that it is corporate investment spending) is not only a driver of corporate revenues, it is also responsive to revenues. If companies are experiencing weaker sales they will run down inventories and then look to cut back on capex.



That relationship between investment spending (including building of inventories) and company revenues is illustrated by the scatter plot on the right hand chart above. It shows annual changes in investment spending versus annual changes in revenues. Even ignoring the outliers in investment and revenues during the 2008 recession, the R square (the extent to which changes in revenues are associated with changes investment spending) is still 33%. That suggests that French companies' investment plans are, unsurprisingly, heavily reliant on their revenues. And therefore French companies are unlikely to start investing unless it is in response to a pick up in demand somewhere else. In short, corporates require an external stimulus either from greater household spending or greater export demand." - source CreditSights.

Truth is when it comes to greater export demand which could offset the current headwinds plaguing the French economy, France is indeed the outlier, has displayed in the following graph from Deutsche Bank's note "Why Italy and France lack competitiveness from the 20th of February 2013:

As far as our title and computational analogies goes "Winner-take-all". While Germany has been the clear winner in the period going from Q1 2008 to Q3 2012, both Spain (+12.2%) and Ireland have seen their performance improve as far as peripheral countries are concerned.

As a follow up on our introduction relating to the significance and importance of the recent poor display in France's Services PMI, France export underperformance is not due to unfortunate sectorial diversification as indicated by Deutsche Bank note:

"French machinery exports in cumulative terms increased 68% in the 12 years to 2011. But they would have risen by twice as much if they had kept pace with the trading partners’ demand levels in the machinery sector. Indeed, France’s performance gap in the machinery sector is 0.5.

An advantage of developed economies is a more advanced service sector. Unfortunately, France’s poor performance was not limited to exports of goods, as shown in Figure 9. Even in services, the country did not manage to keep up with the expansion of trading partner demand." - source Deutsche Bank.

Regarding the growing divergence between Germany and France, both countries have taken different paths leading to different outcomes as indicated by Deutsche Bank's note:
"France and Germany have followed different strategies to take advantage of globalisation. German companies have outsourced only part of their production process to low-cost countries, mainly located in Central and Eastern Europe. Germany’s geographical position facilitated this process. Using the intermediate low-cost inputs allowed German firms to reduce overall production costs and increase the productivity of their own production plants as well as their profitability. Conversely, French companies often outsourced the entire manufacturing process to lowcost countries. So although the product is sold by a French company, it does not enter French exports." - source Deutsche Bank

A stark reminder of the "Regret Theory":
"The Regret theory (also called opportunity loss) being defined as the difference between the actual payoff and the payoff that would have been obtained if a different course of action had been chosen by our European politicians. The Regret theory is also a model of choice under uncertainty defined as the difference between the outcome yielded by a given choice (credit crunch, economic recession) and the best outcome (muddle through) that could have been achieved in that state of nature (deflationary forces at play).

As far as Europe is concerned, one can wonder what would have been the "economic outcome" if a different course of action would have been undertaken. On that matter we wonder why our "European elites" did not use the minimax regret approach being a decision rule used in decision theory, game theory, statistics and philosophy for minimizing the possible loss for a worst case (maximum loss) scenario." - source Macronomics 

Not only France has lost ground in industrial exports but more critically in high-tech sectors as displayed by Deutsche Bank:

"France’s export market share in high-tech products decreased sharply from 7.1% in 1999 to 4.4% in 2006, rebounding modestly to 4.8% in 2008. Over the 1999-2008 period, Germany’s export market share in high-tech products increased slightly from 7% to about 8%.


The EC sees France’s decreasing market share of high-tech exports as a consequence of insufficient innovation. While – contrary to Italy – R&D in France is not too far from that of Germany (Figure 19) and public investment is high, private investment in R&D lost ground compared to Germany. According to the EC, over the past decade R&D spending by companies in France remained broadly constant at 1.4% of GDP per year, while in Germany it rose to 1.9% of GDP." - source Deutsche Bank.


Finally, loan growth in France to households and corporates points to additional weakness in economic growth, as indicated in the below graph from Nomura's economic research:

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits.

After all the "Japonification" of Europe is a story of a broken monetary policy transmission channel, leading to liquidity constraints to the private sector with and therefore no impact whatsoever to the real economy, so no potential for economic growth to resume in France in particular and Europe in general.

"Between stimulus and response there is a space. In that space is our power to choose our response. In our response lies our growth and our freedom." - Viktor E. Frankl, Austrian psychologist.

Stay tuned!