Macro and Credit - Fuel dumping

"One of the tests of leadership is the ability to recognize a problem before it becomes an emergency." -  Arnold H. Glasow, American author

Looking at the Dow Jones and the S&P 500 having their worst month since 1931, with cracks clearly showing up in credit markets with weaker oil and outflows from Leveraged Loans, with the Fed hiking by another 25 bps, leading to markets being dazed and confused, when it came to selecting our title analogy, given our fondness for aeronautics ("Dissymmetry of lift" in August 2018, "The Coffin corner" in April 2013, the other being "The Vortex Ring" in May 2014), when it came to our title analogy we decided to go for "Fuel dumping". "Fuel dumping" (or a fuel jettison) is a procedure used by an aircraft in certain emergency situation before a return to the airport shortly after takeoff, or before landing short of its intended destination (or inflation target...) to reduce the aircraft's weight (the Fed's balance sheet with its QT policy, now up to $50 billion per month). 

Aircraft have two major types of weight limits: the maximum takeoff weight and the maximum structural landing weight, with the maximum structural landing weight almost always being the lower of the two. This allows an aircraft on a normal, routine flight to take off at the higher weight, consume fuel en route, and arrive at a lower weight. If a flight takes off at the maximum takeoff weight and then faces a situation where it must return to the departure airport (due to certain mechanical problems, or a passenger medical problem for instance), there will not be time to consume the fuel meant for getting to the original destination, and the aircraft may exceed the maximum landing weight to land at the departure point. If an aircraft lands at more than its maximum allowable weight it might suffer structural damage, or even break apart on landing. At the very least, an overweight landing would require a thorough inspection for damage. 

As a matter of fact, long range twin jets such as the Boeing 767 and the Airbus A300, A310, and A330 may or may not have fuel dump systems, depending upon how the aircraft was ordered, since on some aircraft they are a customer option. As a rule of thumb for the Boeing 747, pilots quote dump rates ranging from a ton per minute, to two tons per minute, to a thumb formula of dump time = (dump weight / 2) + 5 in minutes. In similar fashion, when it comes to the Fed's QT, there is no real rule of thumb when it comes to the pace of the reduction of its balance sheet. We read with interest Stanley Druckenmiller and Kevin Warsh's take on the Fed's policy in the Wall Street Journal yet it seems that as we pointed out in our October conversation "Explosive cyclogenesis":

"As we concluded our previous post, beware of the velocity in tightening conditions. Both Morgan Stanley and as well Goldman Sachs, indicates that given the large sell-off seen in October, investors perceptions have been changing, and that maybe  we have a case of "reflexivity" one might argue. Goldman Sachs Financial Conditions Index shows the equivalent of a 50-basis-point tightening in the past month, two-thirds of which is due to the selloff in equity markets. Early February this year financial conditions tightened about 80bp over a two week period akin to "Explosive cyclogenesis" aka a "weather bomb".

But, the difference this time around we think, even if many pundits are pointing that forward price/earnings ratio of the S&P 500 has tumbled to 15.6 times expected earnings, from 18.8 times nine months ago, making it enticing for some to "buy" the proverbial dip. We think that the Fed's put strike price is much lower than many thinks.

Sure "real rates" have been driving the sell-off but we think many more signs are starting to show up in the big macro picture pointing towards the necessity to start playing "defense". "- Macronomics, October 2018

The big question we think when it comes to Fed having both QT and rate hikes at the same time aka "Fuel dumping" is can you allow interest rates to rise without contracting the monetary base? Clearly the Fed put is still way "out of the money".

In this week's conversation, we would like to reflexionate more on 2019 given the Fed has been clearly telling you, it hasn't got your back anymore and you are on your own...

Synopsis:

• Macro and Credit - 2019: "Mean" mean reversion?
• Final charts  - What the Fed see and what they don't...  

• Macro and Credit - 2019: "Mean" mean reversion?

In our previous conversation we pointed out the weakness seen in credit, given the rise in dispersion witnessed during the course of 2018, leading to cracks showing up in cyclicals and with now leveraged loans weaknesses under scrutiny. Like any behavioral psychologist we indicated in numerous conversations that we would rather focus on the "flows" than on the "stock" given in our credit book, liquidity is what "matters" and when it comes to fund flows, in some segments of the credit markets "outflows" have been significant.

In our credit book, "flows" matter and when it comes to fund flows in credit land there has been plenty of "fuel dumping" as reported by Bank of America Merrill Lynch in their Follow The Flow report from the 14th of December entitled "The CSPP party is definitely over":

"More outflows and no more CSPP

Only three weeks to go before the end of the year, and outflows continued in Europe. Last week we saw a significant risk reduction across European IG, HY and Equity funds. Investors reached for safer assets with strong inflows in Govies and Money Markets. Even Global EM debt funds recorded outflows amid the recent sell off. It seems that this year will end on a negative note as investors are cutting positions across risk assets amid uncertainty around the macro and trade wars front. Italian politics are not helping either, contributing in a flight away from credit and equity funds.

Over the past week…

High grade funds suffered their largest outflow of the year, making this week the 18th week of outflow over the past 19 weeks. High yield funds also recorded a sizable outflow as well, the 11th in a row. Looking into the domicile breakdown, Euro-focused funds led the negative trend, followed closely by Global-focused funds. US focused funds experienced a more moderate outflow.

Government bond funds recorded an inflow this week, the 2nd in a row. Meanwhile, Money Market funds saw a large inflow, putting an end to 4 consecutive weeks of outflows.

European equity funds recorded a sizable outflow, in sharp contrast with the moderate outflow recorded last week, and making it the 14th consecutive week of outflows. During the past 40 weeks, European equity funds experienced 39 weeks of outflows.

Global EM debt recorded an outflow this week, the 10th in a row. Commodity funds recorded a marginal inflow.

On the duration front, mid-term IG funds led the negative trend by far, short-term funds also suffered, while the deterioration was more moderate for the long-end of the curve." - source Bank of America Merrill Lynch

 When the trend in outflows is not your friend...

As per our November conversation "Zollverein", when we talked about the vulnerability of leveraged loans, clearly they have been under the spotlight and some credit investors have indeed resorted in "fuel dumping" so to speak. As per LeveragedLoan.com outflows have been significant and accelerating in the asset class:

"Leveraged loan funds log record $2.53B outflow

U.S. loan funds reported an outflow of $2.53 billion for the week ended Dec. 12, according to Lipper weekly reporters only. This is the largest weekly outflow on record for loan funds, topping the prior mark of negative $2.12 billion from August 2011.

This is also the fourth consecutive week of withdrawals, totaling a whopping $6.63 billion over that span. With that, the four-week trailing average is now deeper in the red than it’s ever been at $1.66 billion, from negative $1.01 billion last week.

Mutual funds were the catalyst in the latest period as investors pulled out a net $1.82 billion, the most since August 2011. Another $704.9 million of outflows from ETFs was the most ever.

Outflows have been logged in six of the last eight weeks and that has taken a big bite out the year-to-date total inflow, which has slumped to $3.7 billion after cresting $11 billion in October.

The change due to market conditions last week was a decrease of $1.231 billion, the largest drop for any week since December 2014. Total assets were roughly $99.3 billion at the end of the observation period and ETFs represent about 11% of that, at roughly $10.9 billion. — Jon Hemingway" - source LeveragedLoan.com

If this isn't "fuel dumping" then we wonder what it is:

"In just the past four trading days, investors have pulled $2.2 billion from all loan mutual funds and exchange-traded funds. That brings withdrawals from the asset class to almost $9 billion since mid-November" - source Bloomberg 

- graph source Bloomberg

It looks like more and more to us the "credit aircraft" may have exceeded the maximum landing weight to land at the departure point given the posture of the Fed with its hiking stance and with its QT on "autopilot".

For Bank of America Merrill Lynch in their Weekly Securitization Overview note from the 14th of December entitled "Mission accomplished; damage assessment", the price action in Leveraged Loans should be watched closely and we agree as we posited back in our November conversation "Zollverein":

"We consider the recent free fall price action for leveraged loans (Chart 5) underlying collateral of CLOs and specifically noted in the FOMC’s September minutes as posing “possible risks to financial stability.” The end result of the Fed’s hawkishness is that less, not more, rate hikes are now expected than in September (see below), so the interest in floating rate instruments such as leveraged loans, and CLOs, has declined. That explains part of the weakness. Another important part of the latest sharp re-pricing of loans is simply that they had lagged the spread widening/risk re-pricing seen in other sectors. This week saw some major catch-up." - source Bank of America Merrill Lynch

 Clearly some pundits are concerned about the "liquidity" factor of Leveraged Loans and decided that "Fuel dumping" was the right strategy given the growing cracks seen in credit with the significant underperformance of US High Yield thanks to weaker oil prices and its exposure to the Energy sector (we have touched on this subject in recent posts). No surprise to see Lisa Abramowicz on her twitter feed commenting on US High Yield spread blowing out today:

"U.S. high-yield bond spreads rose yesterday the most on a percentage basis since August 2011."

- source Bloomberg - Lisa Abramowicz - twitter

Obviously with its QT akin to "Fuel dumping", the Fed has been successful in tightening further financial conditions.

But in relation to Leveraged Loans and the deterioration in both price and flows, comes the question about its impact on the US economy as a whole. On that point we read with interest Wells Fargo's take from their Economics Group note from the 18th of December entitled "Leveraged Loans - A Deathknell for the US Economy?":

"Executive Summary

The leveraged loan market, where the bank debt of non-investment grade companies is traded, has experienced rapid growth over the past few years. But weakness in the market in recent weeks may bring back unpleasant memories of the sub-prime loan debacle a decade ago. Does this recent weakness in the leveraged loan market have negative implications for the macro U.S. economy?

In our view, the leveraged loan market, taken in isolation, is not likely to bring the economy to its knees anytime soon. But its recent weakness may reflect a broader economic reality about which we have been writing. Namely, the overall financial health of the non-financial corporate sector has deteriorated modestly over the past few years. If the Fed continues to push up interest rates and if corporate debt continues to rise, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth

Stress Appears in the Leveraged Loan Market

The leveraged loan market in the United States has mushroomed to more than $1 trillion today from only $5 billion about 20 years ago (Figure 1).

 Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

Growth has been especially marked in the past two years with the amount of leveraged loans outstanding up more than 30% since late 2016. But the market has weakened recently. The amount of leveraged loans outstanding declined by nearly $20 billion between late November and mid-December, while prices of loans fell about 2 points over that period (Figure 2).

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities 

Before discussing macroeconomic implications, we first offer a quick primer on the leveraged loan market. A leveraged loan is a loan that is made to a company with relatively high leverage (i.e., companies with high debt-to-cash flow ratios). Usually, these companies are rated as less than- investment grade. Years ago, banks would hold these loans on their balance sheets, but in the  past few decades an active market has developed in which these loans are bought and sold. Often, an investment bank will buy leveraged loans from commercial banks to bundle them into structured financial instruments that are known as collateralized loan obligations (CLOs). CLOs trade like bonds, and they improve the liquidity in the leveraged loan market.

Leveraged loans are floating-rate financial instruments, so investors piled into the market over the past two years when the Fed was in rate-hiking mode. However, some investors have started to sell their holdings of leveraged loans recently as doubts have risen about how much higher short-term interest rates actually will rise. Moreover, the evident deceleration occurring in the economy could negatively affect the ability of some highly levered companies to adequately service their debt obligations, which has also contributed to some nervousness in the leveraged loan market. Could the recent weakness in the leveraged loan market have implications for the U.S. economy?

Does the Leveraged Loan Market Have Broader Macro Implications?

When banks sell their leveraged loans, they then have room on their balance sheets to make new loans. If weakness in the leveraged loan market negatively affects the ability of commercial banks to offload their leveraged loans, then growth in bank lending could slow. Everything else equal, slower growth in bank lending could lead to slower economic growth, which could then lead to further weakness in the leveraged loan market, etc. In short, a vicious circle could be set in motion. Is there any evidence to support the notion that weakness in the leveraged loan market has led to slower growth in bank lending?

Figure 3 plots the leveraged loan price index which was shown in Figure 2 along with the year-over-year growth rate in commercial and industrial (C&I) loans.

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

The price of leveraged loans collapsed in 2008, and C&I loan growth subsequently nosedived as well. But the U.S. economy at that time was beset by the deepest financial crisis and recession it had experienced in more than 70 years. The weakness in the leveraged loan market in 2008 may have contributed to the swoon in C&I lending that transpired in 2008-2009, but there probably were more important factors that were causing the sharp drop in C&I lending at that time. 

Indeed, over the past two decades there have been two episodes of weakness in the leveraged loan market that have not been associated with marked deceleration in C&I lending. Between early 1997 and late 2000, prices of leveraged loans fell about 10 points. But growth in C&I lending held up reasonably well during that period, before turning negative as the economy fell into recession in early 2001.

Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

More recently, leveraged loan prices fell 8 points between May 2015 and February 2016. Growth in C&I lending edged down a bit, but we would not characterize that episode as one of “significant” deceleration in C&I lending. In short, there does not appear to be overwhelming evidence to support the notion that weakness in the leveraged loan market leads to significantly slower growth in C&I lending.

C&I lending accounts for less than 20% of total bank credit. Perhaps other components of bank credit, such as the securities holdings of banks, residential and non-residential real estate lending or other types of consumer lending, may show more sensitivity to the leveraged loan market than C&I lending. However, Figure 4 shows that growth in overall bank credit generally has had a low degree of correlation with prices of leveraged loans as well.

 Source: LCD (an offering of S&P Global Market Intelligence) and Wells Fargo Securities

Although we acknowledge that the weakness in the leveraged loan market has the potential to eventually weigh on bank credit, there appears to be very little fallout thus far. Indeed, the amount of C&I loans outstanding as well as total bank credit have both risen in recent weeks.

In our view, the weakness in the leveraged loan market at present reflects a broader economic reality about which we have been writing in recent months. That is, the overall financial health of the non-financial corporate sector has deteriorated over the past few years. The phenomenal growth in the leveraged loan market since 2016 reflects both demand-side and supply-side factors. In terms of demand, investors have been attracted to the relatively high returns that leveraged loans and CLOs offer. On the supply side, the marked increased in leveraged loan issuance over the past few years speaks to the steady rise in non-financial corporate debt, especially among non-investment grade businesses, that has occurred.

Taken in isolation, the leveraged loan market is not likely to bring the economy to its knees anytime soon. But recent weakness in the leveraged loan market may be symptomatic of rising concerns that investors may be having about the outlook for the financial health of the business sector. Spreads on speculative-grade corporate bonds have widened in recent weeks, and investment grade spreads have also pushed out. As we have written previously, we do not view the overall financial health of the American business sector as “poor” at present. But investors apparently are starting to react to its modest deterioration. If the Fed continues to push up interest rates and if corporate debt continues to rise, which would put upward pressure on spreads, then financial conditions would tighten further, which could eventually lead to a sharper slowdown, if not an outright downturn, in economic growth." - source Wells Fargo

After the Great Financial Crisis (GFC), many banks retreated from the Leveraged Loans business thanks to heightened regulatory oversight. In this context, Nonbank direct lenders, business development companies as well as collateralized loan obligation funds and private equity affiliated debt funds all stepped in and funded acquisitions and private-equity buyouts as the M&A market rebounded in recent years. US banks one would argue are in a much healthier "leverage" situation than their European peers, though when it comes to the Leveraged Loan market both in the United States and Europe have seen the rise of "disintermediation" aka shadow banking stepping in. Where we slightly disagree with Wells Fargo's take is indeed the rise in "disintermediation" as banks have been facing rising competition from even "new" competitors entering the private lending space.

Yet, when it comes to C&I loans, change in the last three months have been significant we think:

- graph source Bank of America Merrill Lynch

As we mused in our conversation "Ballyhoo" in October, using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions. We argued that the velocity seen in greater tightening of financial conditions could be seen as a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions hence the outflows and the acceleration in "Fuel dumping" or outflows from "credit" to the benefit of the US long end of the yield curve as well as US money market funds, in essence some good old "crowding out".

This velocity we think is important given the combination of rates hike and balance sheet reduction given many pundits are already talking about "policy mistake" being made by the Fed. The whole question is about the transmission of the velocity of tightening financial conditions towards the real economy. We have already seen significant weakness in various US cyclicals (Housing, autos, etc.). On the subject of this transmission mechanism we read with interest Bank of America Merrill Lynch's take in their US Economic Watch note from the 19th of December entitled "Fed up":

"Getting ahead of the shocks

One of the many factors the Committee has considers in their policy reaction function is the impact of financial conditions on the real economy. As was clear from the press conference, “The additional tightening of financial conditions we have seen over the past couple of months along with signs of somewhat weaker growth abroad have also led us to mark down growth and inflation growth a bit.”

To understand the transmission of financial conditions onto the economy, we run various financial shocks through FRB/US, the Federal Reserve Board’s large-scale general equilibrium macroeconomic model. These shocks are 100bp increase in the conventional mortgage rate, 100bp increase to the interest rate on new car loans, 50bp increase in credit spreads (proxied by an 50bp increase in BBB term premium) and a 10% decline in household equity wealth. Note that the shocks to the mortgage rate, car loan rate, and BBB term premium have been approximately calibrated to the moves seen since the start of the year while the equity shock has been roughly calibrated to the decline since peak of the equity market over the summer (Chart 1 and Chart 2).

The shocks are run individually through FRB/US and sustained through the simulation period.

The results of the stylized exercise are presented in Table 1. There are several points worth noting:

• Financial conditions work through the economy with a lag. With the exception of the mortgage rate shock, the peak drag to growth from tighter financial conditions hits the economy 2 to 3 quarters after the initial shock.
• The impact of the individual shocks is fairly muted. For example, a 10% decline in household equity would roughly translate to less than 0.1pp drag to growth in the 2H of year 1 after the shock hits. But add up the multiple shocks, there’s a meaningful slowdown in growth that leads to higher unemployment rate and lower core inflation.
• Higher borrowing costs for businesses have the greatest and most persistent impact on the economy. A 50bp widening in the credit spread acts as a roughly 0.1pp drag in year 1 and 0.1-0.2pp in year. This is consistent with Fed research which shows that the primary transmission of tighter financial conditions works through weaker business fixed investment.2
• The cumulative tightening we’ve see over the past year is roughly equivalent to 33bp of Fed tightening. Another way to interpret these results is tighter financial conditions would prescribe the Fed to ease up on the pace of rate hikes by roughly one fewer hike, consistent with the latest median dots.

What about weaker global growth? The direct impact should be fairly muted given that the external macro linkages are only a small share of the US economy. However, weaker global conditions will filter through tighter financial markets, primarily through higher borrowing rates for businesses and to a lesser extent a decline in household equity wealth that will act as a headwind for the economy." - source Bank of America Merrill Lynch

While global trade has been decelerating thanks to the trade war narrative, the spike in "real rates" in early October triggered the repricing of US equities. Our timing using another "aeronautics" on the first of October in our post "The Amstrong limit" was probably lucky:

"Watching with interest the Japanese Nikkei index touching its highest level in 27 years at 24,245.76 points, with US stock indices having rallied strongly against the rest of the world during this year, and closing towards new highs, when it came to selecting our title analogy we decided to go for another aeronautic analogy "The Armstrong limit". The Armstrong limit also called the Armstrong's line is a measure of altitude above which atmospheric pressure is sufficiently low that water boils at the normal temperature of the human body. Humans cannot survive above the Armstrong limit in an unpressurized environment." - source Macronomics, October 2018.

We wondered at the time if we had reached the "boiling point". In retrospect we did.

The big question many pundits are asking is should the bold pilots at the Fed continue with QT on autopilot. Back in February 2013 in our conversation "Bold Banking" we used another aeronautics reference:

"While 1994, was the year of a big sell-off in many risky assets courtesy of a surprise rate hike, 1994 was as well the year of the demise of "Czar 52" on the 24th of June 1994 which saw the tragic crash of a Boeing B-52H "Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force Base during practice maneuvers for an upcoming airshow. The demise of the BUFF (the nickname among pilots for the B-52 meaning Big Ugly Fat Fellow) was due to Colonel Bud Holland's decision to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick".

So what is the link, you might rightly ask, between "bold banking" and "bold piloting"?

A subsequent Air Force investigation found that Colonel Bud Holland had a history of unsafe piloting behavior and that Air Force leaders had repeatedly failed to correct Holland's behavior when it was brought to their attention (not  French president Hollande in that instance but we digress...).

When it comes to "reckless banking" and "reckless piloting", we found it amusing that current leaders have repeatedly failed to correct central bankers' policies, like the ones pursued by former Fed president Alan Greenspan and current Fed president Ben Bernanke, or, the ones pursued by Japan. These policies are instigating, bubbles after bubbles at an inspiring rate." - Macronomics, February 2013

For now the pilots once again at the Fed seem pretty confident in the strength of the US economy, on our side we do not think their optimism is warranted as per our final charts.

• Final charts  - What the Fed see and what they don't...  

With Philadelphia Fed manufacturing index undershooting in similar fashion to the New York Fed released this week as well, one might indeed be wondering if "Fuel dumping" is warranted given the heavy load of the US airplane in terms of corporate debt binge. Our final charts comes from Wells Fargo Economics Group note from the 19th of December entitled "Where the Fed May Be wrong" and in their note they are pondering whether or not the Fed is making a "policy mistake":

"Caught Between A Rate Hike and A Hard Place

Recessions are typically triggered by policy mistakes and the Federal Reserve may very well be on the road to making one. The policy statement that accompanied the Fed’s latest rate hike attempted to allay fears the Fed would tighten too much by acknowledging the economic outlook has diminished and that the balance of risks was now roughly even. FOMC participants also slightly lowered their expectations for the federal funds rate and now call for just two rate hikes in 2019 and one more after that, while the drawdown of the Fed’s balance sheet is expected to remain on auto-pilot at $50 billion a month in 2019.

The financial markets provided some powerful real-time feedback to the Fed. Stocks had rallied just before the Fed’s decision was released, gave back their gains after digesting the policy statement and then sold off heavily during Chairman Powell’s testimony. The yield curve also flattened further and remains inverted between the two- and five-year notes. The markets shot down the Fed’s dovish tightening because they feel economic growth may not be as strong as the Fed believes and is certainly not strong enough to hold to the notion that monetary policy, in its entirety, remains short of neutral.

Economic growth may not be as ‘strong’ as the Fed believes. The strength in the U.S. economy has been narrowly focused, with the energy and technology booms accounting for a disproportionate share of economic growth. Both sectors now appear to be slowing, with the former struggling under the weight of sluggish global economic growth and lower oil prices, while the latter is facing an onslaught of government oversight concerning privacy concerns and anti-trust matters. Growth in the more cyclical parts of the economy is also slowing, with demand for home sales and capital goods flagging for the past few months.

The Fed’s confidence about the strength of the economy may be grounded in the satisfaction that the unemployment rate remains so low at just 3.7%. The unemployment rate is a lagging indicator, however, and monetary policy works with a long and variable lag. Moreover, the IT revolution and growth in online job search platforms have likely changed the way job seekers interact with the labor force. This may help explain why the surge in job openings has not led to a resurgence in wage increases.

The Fed may also be underestimating the impact the drawdown of the Fed’s balance sheet and continuation of enhanced forward guidance are having on global liquidity. Both policies were projected to have strong positive effects when they were implemented. Why wouldn’t they have an equally strong impact now that they are headed in the other direction? Moreover, the high degree of certainty the Fed has displayed that these policies will continue, effectively on auto-pilot at a time that growth is decelerating, has sent a foggy message to the financial markets, which has likely increased uncertainty— hence the rush out of stocks and into bonds and the dollar." - source Wells Fargo

It might be the case that the pilots at the Fed are slightly over-relying on "auto piloting" QT aka "Fuel dumping" while interpreting incorrectly the readings from their pilot cabin's instruments, but we ramble again...

We wish you all a Merry Christmas and a Happy New Year. Don't hesitate to reach out to us in 2019, a year in which we hope to celebrate the 10 year anniversary of this very blog. Thank you for your praise and support.

as the old pilot saying goes:

"There are old pilots and there are bold pilots; there are no old, bold pilots!" 

Stay tuned !

Macro and Credit - Pregabalin

"Optimism is the opium of the people." - Milan Kundera

Watching with interest the largest outflow ever in US High Yield ($3.9bn last week) in conjunction with the unprecedented 9 days of weakness in US equities and the concomitant rise in the VIX index, given the indecisive outcome for the US elections thanks partly to the FBI's recent change of heart, when it came to selecting this week's title analogy, we decided to steer towards a pharmaceutical one. Pregabalin is a medication used to treat epilepsy but more commonly to treat generalized anxiety disorders. Given markets predicaments and violent gyrations, one might wonder if indeed one should take some pregabalin to ease these rising anxieties. While we have been musings around a pre-revolutionary mindset setting in on the global stage, no doubt to us that the rise in flare-ups in Hong-Kong, Florence in Italy, Greece and palpable rising tensions in France as a few examples, make us believe that the US elections anguishes are not the beginning of the end but more likely akin to the end of the beginning to paraphrase Winston Churchill. Although investors have received some respite as of late with the FBI changing again its tune, we do believe that no matter how some pundits would like to spin it, the lateness in the credit cycle appears to be as evident as the recent record numbers in M&A transactions typical of a late credit cycle rally.

In this week's conversation rather than focusing on the US elections outcome, we would like to look at the situation in Europe when it comes to disintermediation and deleveraging for the European banking system as well as shipping still being a deflationary indicator.

Synopsis:

• Macro and Credit - Disintermediation accelerating in Europe
• Macro and Credit: If you think about deflationary forces at play and global trade, think about shipping
• Final chart: Asia will become the largest driving force in world trade in the coming decades

• Macro and Credit - Disintermediation accelerating in Europe

While we have in many musings discussed the "japanification" process linked to the significant deleveraging process needed in the European banking system versus the US, we were reminded by KPMG as per Bloomberg's article on the 30th of October that European bank were still sitting on €1.2 trillion of nonperforming loans on their balance sheets:

"Eight years after Lehman Brothers’ collapse sparked the financial crisis, Europe’s banks still have 1.2 trillion euros ($1.3 trillion) of non-performing loans and will probably be stuck with them for decades to come, according to KPMG LLP.
Anemic economic growth across the region is making it harder for lenders to off-load toxic assets, hurting profitability while banks also come under pressure from tougher capital rules and fines for misconduct, London-based KPMG said in a report published Monday. Firms could take “decades rather than years” to reduce their exposures, hampering profitability.
European lenders are battling to cut soured loans as they face evaporating income from lending amid negative interest rates from the European Central Bank. Net interest margins, the difference between income from lending versus cost of funding, average about 1.2 percent in the region compared with about 3 percent in the U.S., according to KPMG.
“Reversing the profitability of European banks is not a lost cause but it will certainly be a lot of hard work,” Marcus Evans, a partner at KPMG’s ECB office, said in a statement. “It’s clear that across Europe banks are still grappling with the new world of low, or negative, interest rates and mounting capital and regulatory costs.”
The total value of toxic loans in Europe has surged since 2008 from about 1.5 percent of lending to more than 5 percent since 2013, according to the report. This has a negative impact on profitability from unpaid interest, raising provisions against impaired assets and realizing losses when disposing bad debts, according to KPMG." - source Bloomberg

When it comes to dealing with this burden, we have been pretty vocal in the past of what needed to be done back in July when 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

We also re-iterated our call on ailing Southern European banks back in August in our conversation "The Law of the Maximum":

"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...." - source Macronomics, August 2016

What is of course of interest when it comes to deleveraging, disintermediation and "japanification" is that corporate bond funding in Europe has been on the rise thanks to record issuance levels in the bond market. The financial repression from the ECB in conjunction with its latest corporate bonds asset purchases has moved hand in hand with the primary market for bonds. On the subject of disintermediation, we read with interest Société Générale quarterly note entitled "In the mood for loans" published on the 7th of November:

- source Société Générale

Whereas the above picture shows the overall picture, it is far more interesting to look at it on country to country basis given the significant differences between core countries and peripheral countries, where the impact of nonperforming loans has not been trivial when it comes to providing new loans regardless of the compression in interest rates for new loans as put forward as a success by the ECB:

- source Société Générale

What we find most interesting from Société Générale's report from a "credit impulse" perspective is the situation in Europe compared to the US, which we pointed out in the past has led to different growth outcome in recent years:

- source Société Générale

Obviously the pressure NIRP is putting on Europeans Banks Net Interest Margins (NIM) is accelerating the disintermediation process while in no way leading to some massive improvement for peripheral countries in credit impulse leading to better growth prospects, Italy being a good example of the failings of the ECB, not to mention the unresolved large pending issues of growing nonperforming loans which has yet to be addressed meaningfully. The impact of the European Banking Association core tier one capital rule which lead to a credit crunch in Southern Europe as some banks decided to drastically reduce their loan book to attain the core tier one ratio threshold can be seen in the below chart from Société Générale's extensive loan report:

"YTD figures show a big contrast between the two corporate lending markets. Bonds are obviously more resilient then loan funding, which could fall more than 30% short compared to 2015.
Part of this shift is attributable to the strong impact of the ECB’s CSPP buying programme. The impact of this programme (between €8-9bn of purchases per month) has strongly narrowed bond spreads and has very likely diverted supply towards bonds." - source Société Générale

As we pointed out in numerous conversations is that, liquidity doesn't resolve solvency but, more importantly, the longer time you take to deal with nonperforming loans, the weaker the credit impulse and your economic recovery and ultimately economic growth. But for now, the ECB and disintermediation, in similar fashion to what happened in Japan in the past, makes investment grade credit still an appealing proposal, particularly in the US thanks to the continuous appetite from the Japanese crowd in general and lifers in particular as pointed out by Nomura in their FX Insights note from the 28th of October entitled "JPY: Lifers still prefer foreign bonds":

"Japanese lifers’ investment plans show strong demand for foreign bonds, even after the introduction of yield curve control by the BOJ. Slight steepening in the JGB yield curve since early July is viewed as not enough for them to consider aggressive JGB investment. Their views on hedging suggest unhedged foreign bond investment is likely when JPY appreciates. The current USD/JPY spot is already slightly higher than their end-March forecast, but dip-buying demand from lifers is likely, especially if US political uncertainty disappears." - source Nomura

So while US High Yield as of late have seen significant outflows particularly in the feeble retail ETF space, we continue to favor quality (Investment Grade) over quantity (low rated US High Yield such as CCCs). Though some expect the convexity game to bite with additional rate hikes from the Fed starting in December which could impact dearly the long dated / low coupon investment grade crowd. At least for now, in terms of flows, the Japanese investor crowd still has your back.

Moving on to the never ending argument between inflation or deflation, while we chose the middle grown in our previous conversation discussing "biflation" over "stagflation", we continue to assess the deflationary forces at play thanks to the shipping industry as per our next bullet point.

• Macro and Credit: If you think about deflationary forces at play and global trade, think about shipping

As we pointed out in the past, when it comes to deflationary pressures, disintermediation and "japanification" process, we have long been looking at shipping loans as a good indication of deterioration in global trade and credit. We have regularly pointed out German banking woes when it comes to their outsized exposure to the sector which has been impacted in recent years by slumping freight rates illustrative of weaker global trade. This has been leaving shipping companies struggling to pay their creditors which meant that some German banks decided that they would even themselves run some ships to avoid recognizing their losses. For instance, back in 2013, German Commerzbank given their nonperforming shipping loans had resorted to running themselves the ships rather than recognizing the losses.

What some pundits fail to grasp when assessing world trade is that containerized traffic is dominated by the shipment of consumer products hence our stance regarding the weak recovery we are seeing. Any change in consumer spending trends depends on a more pronounced housing market revival and will directly impact container traffic. Weaker demand means weaker traffic, that simple.

When it comes to German banks exposure, there is much more deleveraging to come in relation to their shipping loan portfolios and woes as per Société Générale's report:

"Already evidenced in the 3Q15 data, German, Greek and UK banks shrunk their balance sheets in the sector in 2015 by -20% to -34%.
On the other hand, French, Benelux and Scandinavian banks all increased their balance sheets by 8% to 9%, while NL banks did so by+22%."

• "Within the container segment, mid-sized panamax vessels are being particularly hit by the situation. The Hanjin bankruptcy has been exacerbated by the re-opening of the widened Panama Canal, which means the Panama vessels are now undersized and outdated.
• In the offshore business, drilling business remains very weak. Many drilling rigs and jackups are struggling to find profitable redeployment at the end of existing contracts, and the idle fleet is therefore increasing, which will put pressure on cash flow in due course.
• New financing activity is low, and there has been a flight to quality among lenders, who are increasingly selective on new business while they closely manage existing portfolios. Liquidity remains strong for the top credits, and funding can be very aggressive despite the weak underlying markets. This is particularly true in Asia, where local banks (Malaysian, Taiwanese, Indian, etc) can price very aggressively to support their local clients, while Chinese lessors are being aggressive on a global scale to build market share.
• In addition to this difficult environment, the uncertainties regarding the Basel IV regulatory capital study are further constraining banks’ appetite for new lending. The new framework, as initially drafted, is based on more standardisation and higher capital requirements for shipping lending activities, the result of which would potentially further reduce bank liquidity for this business as well as increase the cost of borrowing for shipping clients. This might in time narrow the pricing gap between traditional bank lending and alternative sources of funding in the capital markets, particularly non investment grade. Banks will need to be more agile in managing portfolios, and without anticipating the final implementation of the Basel IV rules, banks will have to be more innovative in their distribution, extending their OTD model.
• During the summer, the industry acknowledged the bankruptcy filing of South Korea’s third largest shipping company, Hanjin Shipping. This is by far the largest bankruptcy in the sector and will have important consequences. The two other large Korean shipping companies, STX and HMM, have also been through significant restructuring in the past. HMM has announced that it is among a list of five potential bidders for some Hanjin ships.
• A number of significant strategic operations took place this year and could bring some discipline to the container sector in the future. Examples are Marseilles-based CGM-CGA’s acquisition of Singapore’s NOL; Hamburg-based Hapag-Lloyd’s merger with Qatar/Saudi Arabian-backed UASC; and, hot off the press, the likely merger of the container operations of the three largest Japanese shipping companies – NYK, MOL and K-Line.
• Overall, the outlook remains challenging, which is no doubt a source of stress to ship-owners and banks alike. This will require more innovation as banks evolve towards Basel IV, possibly accelerating their OTD business models to manage capital more smartly. Investor appetite for IG shipping debt is proven, with the likes of pension funds active in this market.
• The difficulty will stand with non-IG lending (i.e. the majority of the shipping sector) where alternative investors such as hedge funds and infrastructure funds have very different approaches to pricing. Whereas banks value the underlying collateral over which they have security and this currently drives the advantageous capital treatment and lower margin, typically hedge funds don’t value this component and price on an unsecured high yield basis." - source Société Générale

On top of the weakness in global trades, which has been plaguing the shipping industry and their banking creditors, the only solace they have seen as of late has been coming from weaker bunker fuel prices. As a reminder bunker fuel constitutes the bulk of voyage expenses for shipping companies. Higher bunker fuel prices would adversely affect already ailing earnings for the industry as a whole. Bunker fuel prices, the largest cost of running a ship, correlate with crude oil prices.  For the week ended October 28, 2016, the average bunker fuel price was $321–$325 per ton. Bunker fuel prices are 13% higher than they were in the same period in 2015, when they were $321–$324 per ton. A continuation in the rise of bunker fuel would of course put additional strain on already difficult earnings for the industry as a whole. On top of that new types of bunker fuel need to be developed to meet demand for low sulfur marine fuel following the decision of the International Maritime Organization to impose a global 0.5% sulfur cap on marine fuel in 2020, according to bunker industry organization IBIA. This will as well put additional pressure on the cost structure for existing shipping companies, meaning more pain to come thanks to increase regulation and more provisions to make for the likes of Commerzbank. This means probably more "pregabalin" intake for shipping companies and creditors alike we think but we ramble again...

When it comes to deflationary forces at play in global trade, we do not see a reversal in sight for the current weakening trend we have seen in recent years. This is as well clearly put forward by Deutsche Bank in their Logistics note from the 8th of November entitled "Weak environment - no trend reversal in sight":

"Over the next three to five years, global trade is likely to grow only at or around the same pace as global GDP.

This structurally weaker momentum should be reflected in slow growth in the global and regional flow of goods, as has already been the case in recent years. In its role as an open, export-oriented economy, Germany – and the German logistics sector in particular – should continue to feel the sting of this development. At a nominal average of 2% a year, turnover growth in the sector is likely to be below the long-term average in the years ahead.

Global openness – the share of trade in global GDP – increased from just over 10% in the mid-1990s to more than 30% in 2008.

In the wake of the 2008/09 global recession, global trade suffered a setback. Openness fell to around 27% in 2009. Due to the lingering weakness in global trade since 2012, global openness has yet to return to above 29% in 2015. We expect global trade to remain anemic in the years to come.

Low global trade growth goes hand in hand with weak momentum in the global flow of transportation.

The growth rate in international seaborne trade fell each year between 2012 and 2015. Growth came in at just 2% in 2015 – its slowest pace since 2009, a year plagued by recession. The situation is similar in global airfreight, where transport volume grew by an average of just 1.5% a year between 2010 and 2015. Between 1993 and 2010, airfreight transport volume expanded by more than 5% a year.

The slow expansion of trade in recent years is ultimately also reflected in domestic freight transport.

In 2015, the total volume of goods transported in Germany was only around 3% higher than it was in 2011, corresponding to an average annual growth rate of 0.7%. Between 1995 and 2011, transport volume increased by an average of 2.6% a year. The total volume of goods transported in Germany looks likely to grow by only slightly over 1% a year between 2017 and 2019.

In this climate, it is not surprising that the German logistics sector has also been mired in less than stellar growth for years now.

Nominal turnover in the sector increased by only slightly over 1% a year between 2012 and 2015. As a result, average growth was significantly lower than it was between 2003 and 2008 (4.6% a year). From 2016 to 2020, turnover growth in the German logistics sector will probably come in at just over 2% a year on average. Some segments, such as contract logistics and the provision of value-added services, fundamentally offer opportunities for higher growth." - source Deutsche Bank

So if you think that the rise of populism and discontent à la 30s is potentially coming back, then indeed, global trade could be further threatened down the line by additional pressure on "Global Openness as described above by Deutsche Bank. If global trade does remain anemic in the years to come, then indeed the deflationary floor we mentioned embedded in US TIPS we talked about recently as a low correlated asset allocation tool is still of good value we think.

If politicians start in earnest dealing with "globalization" thanks to rising discontent triggered by a rise in inequality, then again the inflationary burst we have seen will not lead we think to "stagflation" but no doubt to the "biflation" scenario we mentioned in our last conversation:

"What we are seeing we think is more akin to the development of "biflation" rather than "stagflation" in the sense that we could see the development of the simultaneous existence of inflation and deflation in an economy. This would lead to a resurgence in inflation in commodity prices with deflation in debt-based assets. Biflation can occur when a fragile economic recovery causes central banks to "overmedicate" via their monetary policies. This may results in higher prices for certain assets such as energy and precious metals with declining prices for leveraged assets such as real estates and automobiles (see our July conversation on declining prices for classic cars "Who is Afraid of the Noise of Art?"). With biflation,  the economy is tempered by increasing unemployment and decreasing purchasing power. As a result, a greater amount of money is directed toward buying essential items and directed away from buying non-essential items. Debt-based assets (mega-houses, high-end automobiles and other typically debt based assets) become less essential and increasingly fall into lower demand." - source Macronomics, 30th of October

The weaker trend in global trend has been running on since 2012 as illustrated by Deutsche Bank in their note:

"The lingering weakness in global trade since 2012 caused global openness to fall to 29% in 2015. Our analyses to date suggest that global trade is likely to continue posting anemic development in the years ahead, as the elasticity of international trade with regard to global GDP growth has probably decreased, partially due to structural factors. As a result, the link between cyclical and structural factors continues to exist.

In particular, the following aspects point to continued weak global trade going forward: slower economic growth in China and the realignment of the Chinese economy towards more domestic consumption, the probable plateau in the development of global value chains, the faltering status of multilateral trade liberalisation and the increase in the number of additional trade restrictions since 2008. Furthermore, there are no unique events on the horizon with the potential to boost trade globally or, at the very least, regionally. In the previous decade, such events included China’s admission to the WTO in late 2001 and the EU’s eastward expansion in 2004. This less positive outlook for global trade also means muted prospects for globally active logistics companies." - source Deutsche Bank

But, if you believe like ourselves in very long term trends, then indeed what we are seeing is the rebalancing towards Asia as mentioned by Angus Maddison in his outstanding book "Contours of the World Economy, 1-2030 AD, Essays in Macro-Economic History". The interesting part is relating to the share of World GDP for China, the peak was around 1820 at 32.9% according to Angus Maddison. It dropped to 17.9% in 1870 which is explained by the industrial revolution experienced by Western Europe at the same time. In 1950 and 1973, China's share of World GDP was 4.6 %. In 2003, China's share of World GDP came back close to 1870's level at around 15.1 % of World GDP.

This is where it is becoming interesting, according to Angus Maddison's projection for 2030(page 340 in his book), you can expect the following:

• Western Europe share of GDP will drop to 13% in 2030 from 19.2% in 2003.
• Asia (including Japan) shares of World GDP will power ahead from 40.5 % in 2003 to 53.3% in 2030.
• In 1820 Asia's share was 59.4 % with a low point of 18.6 % in 1950.

Before you reach for your pregabalin, we encourage you to read the stunning work of Angus Maddison given our final chart.

• Final chart: Asia will become the largest driving force in world trade in the coming decades

Asia will become the largest driving force in world trade in the coming decades and this is clearly illustrated as well in Deutsche Bank's note by our final chart taken from their note:

"Significant shift in the flow of trade away from Europe and towards AsiaBehind the aggregated global flow of trade lies a significant shift in the importance of regional trade within a continent or between continents. At 27%, the trade in goods within Europe continues to account for the lion’s share of global trade. But, from the early 1990s to today (2010-2015 average), it has grown slower than global trade overall, bringing Europe’s share down by five percentage points. Asia, by contrast, has grown significantly in importance. The share accounted for by trade within Asia increased by eight percentage points to 23% over the same period (chart 7).

China’s breathtaking rise to becoming the world’s largest trading power (WTO admission in 2001) was the main driving force behind Asia’s growing importance. China is a partner in each of the five largest bilateral trade relationships that have seen the strongest growth in their share of global trade since the early 1990s. Bilateral trade between China and the US has seen the strongest growth in importance and now places fourth with a share of almost 3% of global trade. In relative terms, trade between the US and Japan and between the US and Canada has lost the most significance. However, bilateral trade between the US and Canada remains in first place.
This shift towards Asia is likely to continue on account of the significantly higher growth rates in Asia than in Europe and progress on trade agreements, such as the Trans-Pacific Partnership (TPP), the Regional Comprehensive Economic Partnership (RCEP) and the Free Trade Area of the Asia-Pacific (FTAAP). Although the Transatlantic Trade and Investment Partnership (TTIP) negotiations between the US and Europe are still under way, critical voices have recently been gaining strength among the public and policymakers. Should the trend that has been around since the early 2000s continue, trade within Asia could outstrip trade within Europe by 2019.
A look at the flow of trade between the continents also illustrates Asia’s growing importance. The share of global trade accounted for by the flow of goods between Asia and Europe has grown by more than one percentage point since the early 1990s, reaching 13% in 2015. Although the significance of trade between America and Asia started to decline in the early 1990s, it has again risen to 12% since the mid-2000s. The importance of trade between America and Europe has fallen by almost three percentage points to 7%." - source Deutsche Bank

Sometimes the long term trend is indeed your friend...While the credit clock might be slowing thanks to central banks meddling, deflationary forces while temporarily at bay might come back thanks to the risk of renewed populism, rising discontent over inequalities and a return of protectionism, but that's another story. For the time being all eyes are on the US elections.

"Under the pressure of the cares and sorrows of our mortal condition, men have at all times, and in all countries, called in some physical aid to their moral consolations - wine, beer, opium, brandy, or tobacco.' - Edmund Burke

Stay tuned !

Credit - Sympathy for the Devil

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

Looking with interest Spain issuing a 50 year bond with a 4% coupon, in conjunction with the latest raft of the decisions taken by our "Generous Gambler" aka Mario Draghi being a very crafty poker player no doubt in the steps of his July 2012 OMT bluff triggering a continuation in the weakness of the Euro versus the US dollar, we decided this week to venture towards a musical analogy in picking up our chosen title. Sympathy for the Devil is a song by The Rolling Stones which first appeared in 1968. 

In a 1995 interview with Rolling Stone, Jagger said: "I think that was taken from an old idea of Baudelaire's, I think, but I could be wrong. Sometimes when I look at my Baudelaire books, I can't see it in there. But it was an idea I got from French writing. And I just took a couple of lines and expanded on it. I wrote it as sort of like a Bob Dylan song." 

Mick Jagger wasn't wrong. As one knows, the "Devil is in the details" and if Mick Jagger had taken a closer look to his Baudelaire books he would have noticed that his inspiration indeed came from this great text from Charles Baudelaire called the "Generous Gambler" we have used in the past as a title for a post. This poem appears to be the 29th poem of Charles Baudelaire masterpiece Spleen de Paris from 1869 (an interesting anagram with 1968 we think):

"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!" - Charles Baudelaire - The Generous Gambler

We previously pointed out in our conversation "Complacency" back in November 2011 that this seminal work from Baudelaire also inspired the scenarists of the great 1995 movie Usual Suspects:
"The greatest trick the devil ever pulled was to convince the world he didn't exist" - Roger "Verbal" Kint- The Usual Suspects

Of course as our earlier quote goes, we could not resist using Baudelaire's work as an inspiration as well but we ramble again.

In this week's conversation we will look at why European banks deleveraging has much further to go (hence the much commented latest round of ECB decisions taken to support the banks in Europe in the process) as well as the credit clock and the on-going fast releveraging in the US corporate sector which we touch briefly in our previously published Chart of the Day and our fear in a US dollar rising too fast for some Emerging Markets (EM).

Whereas investors have indeed been mesmerized by Mario Draghi with his "Whatever it takes" and "Believe me it will be enough" moments, it is no surprise to us to see an acceleration in the continuation in yield compression, going negative for some, in the European government space. 

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

"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!" 

But as years have gone by in the European tragedy, we have become somewhat immunised from our great magician's spells. Many investors have indeed shown the greatest sympathy in respect to piling up on European Government Debt in the process, while banks have been shedding assets leading to outright credit contractions leading in the past two years European banks to cut their lending to businesses by about 8.5 per cent as reported by Matthew C Klein in FT Alphaville in his article "How to spend it: ECB bond-buying edition"  adding the following comment: "a remarkable development considering what has happened to credit spreads since Mario Draghi pledged to do “whatever it takes” to save the currency union"

For us, it isn't remarkable, as we have always stipulated in this blog that LTRO 1 and 2 in conjunction with the fateful EBA decision pushing banks to reach a Core Tier 1 ratio of 9% precipitated the recession and the credit crunch in peripheral countries more significantly. For us it amounted to "Money for Nothing" we argued at the time given the lack of transmission to the real economy. It looks to us the 8.5% credit contraction validates our take and the crowding out of the private sector we discussed in prior conversation "Tokyo Drift" being the latest:

Indeed, declining peripheral yields have not transferred to peripheral private sector funding due to "crowding out" which we discussed a year ago in our conversation "Fears for Tears":

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector.

"Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments

It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

We also commented at the time:

"Yes, we all know that Mario Draghi's OMT "nuclear deterrent" has yet to be tested. But what we are concerned about is, as we indicated in our conversation "Cloud Nine", is the lack of credit growth in peripheral countries which are most likely to be exacerbated by the upcoming AQR 

As a reminder: AQR = Asset Quality Review, planned for 1st Quarter 2014 as a prelude to the ECB becoming the Single Supervisor for large euro area banks in 2H 2014. The AQR's intent is to review banks challenged loan portfolios and the need for capital increase.

"Until the AQR is completed and capital shortfalls identified and remedied, you cannot expect a significant pick up in lending." 

The issue of course is that the deleveraging in the European banking space has a very long way to go as indicated by this Loan-to-deposit ratios chart coming from McKinsey's Working Paper on +Risk number 56 entitled "Risk in emerging markets" published in June 2014:

-source McKinsey

The scale in the deleveraging can be ascertained from the chart above with a reduction of 58% in the US and 31% in the United Kingdom. 

In regards to the capital structure, in comparison to Europe, the United States have increased much rapidly their capital levels than their European counterparts as displayed in the below chart from the same McKinsey report:

-source McKinsey

US banks have increased their capital basis by 57% since 2007 until 2012 while Western European banks by only 37% on the same period.

While investors boast sympathy for our "Generous Gambler", some German economists do not seem to show much sympathy given that at the end of July the German Constitutional court received yet another challenge, this time around the European Banking Union. It has not been reported as much by financial pundits but, a group of professors in Germany has filed a complaint claiming the European Banking Union has no legal basis in the EU treaties as reported by EurActiv on the 29th of July:

 "European banking union constitutes a violation of fundamental rights, said professor of finance and economic policy at the Technische Universität Berlin Markus C. Kerber, in a statement for the German newspaper "Welt am Sonntag".

The rules for the new single supervisory mechanism "represent the first step towards unprecedented German taxpayer liability for banks outside national banking supervision", Kerber said. According to the economic law expert, European banking supervision can only be introduced if changes are made to the EU treaties.

Kerber is not alone. He stands alongside numerous critics from the Europolis Group who are convinced that the German government and Bundestag have disregarded the responsibility for integration while dealing with Brussels' plans for a banking union.

The group has decided to lodge a complaint before Germany's constitutional court against the underlying legal regulation as well as the law ratifying the transfer of bank supervision to the European Central Bank (ECB).

Announcing the group's decision on Sunday (27 July) in Berlin, Kerber also accused German Finance Minister Wolfgang Schäuble of deceiving the public regarding the risks of banking union.

The complainants announced their intention to extend the constitutional complaint as soon as the regulation on the Single Resolution Mechanism (SRM) and its corresponding bank resolution fund take effect.

Starting in November, the new single supervisory mechanism will fall within the remit of the European Central Bank (ECB). It is a central component of banking union.

“We consider the banking union constitutional,” the German Finance Ministry explained, adding its legal basis was thoroughly assessed with the constitutional department.

The ministry said Germany did not feel the EU Treaty's internal market article [Article 127(6) TFEU], on its own, was sufficient for the union, as the Commission proposed. As a result, an additional agreement was made among the member states.

Kerber has been a strict opponent of EU bailout policy from the start. "The worst is yet to come", he warned in May 2012, predicting an imminent collapse of the eurozone. At the time, he called for the introduction of second currency in parallel to the euro called the "Guldenmark".

In March 2014, the German constitutional court finally gave the green light to the euro area bailout package, rejecting numerous complaints against the European Stability Mechanism (ESM). Kerber was among the official complainants at the time." - source EurActiv Germany

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

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

Moving back to credit and the lack of private credit to the real economy which has been plaguing the much vaunted "recovery", disintermediation in Europe has accelerated in Europe where asset managers and private investors are picking up the direct lending baton from banks which in many instances have been in retreat due to lack of capital therefore balance sheet constrained. 

In last week Chart of the Day focusing on the difference between US High Yield and US we indicated the following:

"In Europe, the situation is different, where the explosion in growth in the High Yield market comes from substitution from corporate loans to bond issuance due to the disintermediation on the back of bank deleveraging (which by the way is way behind the US). Existing loans in Europe are getting refinanced therefore via new High Yield issuance in the bond market, which implies that there is no significant releveraging as seen in the US so far."

An illustration of the direct lending trend business in Europe can be ascertained by the increase in loans origination to mid-cap corporates and the hiring taking place in that space, with Paris based asset manager Tikehau hiring for its direct lending business veteran banker Nathalie Bleuven former deputy head of the mid-cap LBO and corporate acquisition from Societe Generale, While large corporates in Europe do not have issues with loan syndication or directly taping the market through the bond market, there has been a rise in the European markets of new entrants in terms of issuance to the bond market. European corporates depended to around 85% to the loan market in 2011, with bond issuance only representing 15%.  Europe has a very large banking sector relative to GDP. The aggregate balance sheet of euro area banks is around 270% of GDP, whereas in the US, where capital markets are deeper, it is only around 70% of GDP. A deleveraging banking sector implies lower credit supply, which is problematic and explains therefore the lack of recovery in the European economy. Of course the ECB is aware of the size of the problem as indicated by the speech given by  Yves Mersch, Member of the Executive Board of the ECB, in a keynote speech entitled "Finance in an environment of downsizing banks" given at the Shanghai Forum in May 2014:

"In terms of location, the cost of and access to finance in the euro area remains strongly based on national conditions. For example, the average cost of borrowing for non-financial firms in Portugal is more than 5% per year, whereas the equivalent for French firms is around 2% per year.

One would imagine in this situation that a Portuguese firm would seek out a French bank, but the euro area banking market does not facilitate such arbitrage. Direct cross-border loans to firms account for just 7.5% of total loans to firms. And local affiliates of foreign banks represent on average only around 20% of national markets, and much less in larger countries. Thus, firms depend heavily on the health of their domestic banks.

Moreover, while corporate bond issuance has partially substituted for bank lending, it is strongly concentrated in non-distressed countries where there has been no decrease in the net flow of bank loans. The net issuance of debt securities, quoted shares and bank loans in non-distressed countries was plus €66 billion in 2013, whereas it was minus €93 billion in distressed countries.

Of course, in principle firms from distressed countries can issue securities in non-distressed countries. In practice, however, it is legally complicated due to issues of different governing law, especially when securities are traded along a chain of financial intermediaries.

This analysis points to two missing pieces in the euro area financial market: lack of retail banking integration and lack of capital market integration.

The low level of retail banking integration reflects several factors, but diverging approaches to supervision and resolution are certainly among them. For one, the persistence of national borders in a European financial market has in the past created compliance costs and reduced the synergies of banking integration. A European Commission survey in 2005 found that opaque supervisory approval procedures were a major deterrent to cross-border banking M&As. [4]

Moreover, national considerations may have reinforced the fragmentation of retail markets during the crisis. For example, some commentators have argued that supervisors erected de facto “internal capital controls” within the euro area, which restricted the flow of funds between banks and within cross-border banks.

A similar pattern can be observed in how national authorities in the euro area have dealt with failing banks. In general, non-viable banks were merged with other national banks, rather than being wound down or broken up and sold off. Thus, what could have been an opportunity to increase foreign competition in domestic markets, and indeed to work through the crisis more quickly, in some cases ended up increasing national concentration. To give a comparison with the US, the FDIC has resolved around 500 banks since 2008, mainly by selling parts of banks to other banks, whereas the equivalent figure for the euro area is around 50.

All this suggests that the move towards a genuine Banking Union in the euro area could help create the conditions for deeper retail banking integration. A Single Supervisory Mechanism (SSM) should lead to harmonisation of rules and standards, and also remove distortions created by national borders. And a Single Resolution Mechanism (SRM) should ensure that banks are resolved from a European perspective and according to least-cost principles, which should in principle open the door for cross-border resolution strategies.

In this way, even though the banking sector on aggregate is downsizing, credit allocation across the euro area may become more efficient. Banking Union is key part in ensuring that location becomes a diminishing factor in access to bank finance.

While Europe is and will remain a bank-based economy, adding the second missing piece of the euro area financial market – deeper capital market integration – is key to ensure that firms in all jurisdictions can use capital markets as a “spare tyre” when banks are not lending – and not only those in larger countries with more developed bond markets. Within a single currency area, there is no reason in principle why firms should not be able to tap a European pool of savings. What prevents this in practice, however, is regulatory heterogeneity across the euro area." - source ECB

A recent example of a firm tapping a large European pool of savings has been the recent set up of Banque PSA Finance (the banking arm of French automobile constructor) in Belgium attracted by the very large pool of short term deposits of around €250 billion euros.

There is indeed in Europe a growing shadow-banking on the back of bank deleveraging as illustrated by asset managers like Tikehau and Banque PSA Finance growing implantations. This is also illustrated in Mr Mersch speech given in May 2014:

"The size of this “shadow banking” system – which in my view is a misleading term – has increased considerably in the euro area since the crisis, rising by almost 20% since 2008. It has also taken on a greater role in financing the real economy. At end-2013, outstanding amounts of loans from euro area non-bank financial intermediaries to euro area non-financial firms amounted to €1.2 trillion. But the key challenge from a policy perspective is to ensure that these funds make their way to the most credit-starved SMEs." - source ECB

Most credit-starved SMEs are relying more and more on non-traditional players such as asset managers in providing much needed financing.

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

Whereas Europe sits more closely towards the lower right quadrant, it is increasingly clear that the US is showing increasing leverage in the corporate space, indicating a move towards the higher quadrant on the left of the Global Credit Channel Clock we think. What we have been seeing is indeed a flattening yield curve in the US with re-leveraging courtesy of buy-backs financed by debt issuance which is the point we made in last week Chart of the Day.

The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters and as shown in CITI Research Credit Strategy report entitled "Wider or Tighter recently published, the evolution of the median leverage ratio in the US warrants close monitoring we think:

"We calculated leverage for two baskets of names — the overall IG universe updated quarterly since ’06, and for a basket comprised of credits that held an IG rating at any time since ‘06 (to capture falling angels). Either way, it doesn’t look good."

Who is Levering Up?

Pretty much everybody. We calculate leverage for the IG universe today and three years ago (leverage ratio on the Y axis, names on the X axis and ordered from most to least levered). In gross and net terms there has basically been a parallel shift upward.

In theory and all else equal, a company that buys its own shares will boost its EPS, but unfortunately its default risk is likely to rise as well. This may not be good for share price. But in practice this is not necessarily true, since factors such as QE can drive default risk as much as company-specific actions." - source CITI Research

What of course is still supportive in the US fixed income space is the total net supply which hasn't quenched the fierce appetite for yield as displayed by CITI in their note:

"Net supply in the overall bond market has been well below the longer-term average in recent years ($1.4 tn vs. $1.8 tn), a trend we expect to remain in place in the near-term." - source CITI Research

More interestingly CITI Research highlighted an important point when it comes to traditional investors reaching for yield outside their comfort zone:

"In credit we have seen two way capital flows in the wake of QE; for example, corporate treasuries have increased HG exposure at the expense of Treasuries, but HG has lost capital to HY as traditional HG investors added HY risk. In essence, non-traditional capital entered, traditional capital left. Perhaps market segments that haven’t experienced two-way flows may be most vulnerable."

- source CITI Research

In continuation to us voicing our concerns of a potential currency crisis thanks to dollar scarcity in our conversation "The European Catharsis" we remind ourselves the following:

"We expect a "regime change" in FX volatility as well. In fact we voiced our concern with the impact the end of tapering would have in terms of dollar liquidity in June 2013 in our conversation "Singin' in the Rain":

"If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?

It is a possibility we fathom." - Macronomics, June 2013 

At risk in the LATAM region in the near term is Venezuela which saw its foreign currency reserves fall to an 11-year low of about $20 billion last month. Venezuela and its state-owned oil PDVSA has to make a $5.3 billion in bond payments in October. The country may find itself running out of cash to service debt as soon as next year as foreign reserves continue their downward trajectory to an 11-year low and oil prices continue to fall. When Chavez took over Venezuela oil giant PDVSA employed 51,000 people and produced 63 barrels per employee per day. 15 years later, PDVSA employs 140,000 people and the production per employee has fallen to 20 barrels per day per employee, meaning the country is envisaging importing oil from Algeria according to Reuters.

According to Bloomberg, the country earns about $70 billion a year from oil exports, with total debt service equal to about 25 percent of that amount.

Another candidate prime for "default risk monitoring" is in the High Yield corporate space in Brazil. Back in February 2013 in our conversation "The surge in the Brazilian real versus the US dollar marks the return of the "Double-Decker" funds" we indicated the following:

Brazilian companies have sold the most junk bond on record since May 2011 last Month according to Boris Korby from Bloomberg in his article - Junk Bond Frenzy Poised to Spill Into February: Brazil Credit from the 1st of February:

"Brazilian companies led by Banco do Brasil SA sold the most junk debt since May 2011 last month as unprecedented global demand for high-risk securities enabled the neediest borrowers to chop their financing costs. State-owned Banco do Brasil sold $2 billion of junior subordinated perpetual bonds rated BB by Standard &Poor’s in the nation’s second-largest high-yield sale on record, pacing $4.25 billion of speculative-grade offerings in January. Junk- bond issuance accounted for 81 percent of Brazil’s corporate debt sales, versus 34 percent globally and 18 percent in the country last year, data compiled by Bloomberg show." -source Bloomberg

The reason Brazil High Yield is at risk and US High Yield by contagion is as follows, as indicated by Fitch in their August 2013 note entitled "U.S. High Yield Sensitive to Emerging Market Defaults":

"EM dollar denominated issues total $116.5 billion, or close to 10% of U.S. high yield market volume. The EM total is up from just $65 billion at the end of 2010 with $43.3 billion issued since January 2012. 

The $116.5 billion includes some large issuers that are in distress, including Brazilian oil company OGX (Issuer Default Rating CCC, Negative Outlook, $3.6 billion in bonds).

The largest country concentration in this group is Brazil ($30 billion), followed by Mexico ($16.3 billion) and China ($14.4 billion). The industry makeup of these issues befits their EM source with infrastructure-related and financial bonds representing most outstanding volume. The top sectors include energy ($27.7 billion), banking and finance ($18.0 billion), telecommunication ($11.2 billion), real estate ($11.1 billion) and building and materials ($8.5 billion). The cyclical nature of the industry mix adds to their vulnerability if growth stalls.

The par weighted average recovery rate on the EM issues has been 36.9% of par to date. With the exception of one bond, the affected issues were all unsecured. Of the $116.5 billion in EM bonds currently outstanding, an estimated $95.2 billion is unsecured." - source FITCH

Given Brazilian growth is clearly stalling with Brazil's GDP shranking 0.6% in the second quarter from the previous three months, and first-quarter data was revised to a 0.2% contraction, according to the Brazilian Institute of Geography and Statistics with a growth forecast of 0.48% this year and 1.10% next year, we would indeed watch closely the LATAM space in the coming months.

On a final note given our concerns in relation to a rising US dollar for local EM "players" who have attracted the yield "tourists", we leave you with some Morgan Stanley graphs and comments from their recent FX pulse note entitled "Don't fight the ECB" showing that Low US bond yields have indeed been driven by capital inflows:

"As the Fed has reduced its monthly security purchases, falling US bond yields in an environment of rising local economic activity are the result of US capital inflows. Once US capital demand increases at a faster pace than the increase of global savings into the US, US bond yields should increase. This is when the USD rally should broaden out.

There are direct and indirect effects to observe. Rising USD funding costs will increase the cost of existing USD debt and via the higher USD push the valuation of USD debt higher in local currency terms. Where currencies are still pegged against the USD, the translation into local currency debt funding costs is one to one. But, even where currency pegs have weakened over recent years; USD rates are providing reference indications for local rates. Within pegged or quasi-pegged environments the cost-increasing effect on local debt from rising USD funding costs is most significant. Most Asian and other EM economies fall into this category.

This is simply a function of the external funding requirements of EM economies, which remain heavily skewed to USD denominated funding. 

Exhibit 11 shows current borrowing via tradable bonds issued by EM governments broken down by currency denomination; and shows that with exception of the CEE region, USD-denominated debt dominates. Borrowing by individuals and corporates broken down by FX denomination is also important in assessing FX sensitivity to rate market volatility – however, such data is not available for all currencies under our coverage. That said, we think government borrowing provides a good enough proxy.

- source Morgan Stanley

While we indeed have "Sympathy for the Devil" given the extent of European woes, when it comes to EM dollar sensitivity and a rising US dollar risk, we do indeed find the "Usual Suspects".

"You can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time." - Abraham Lincoln

Stay tuned!