Macro and Credit - The Zeigarnik effect

"Both poker and investing are games of incomplete information. You have a certain set of facts and you are looking for situations where you have an edge, whether the edge is psychological or statistical." -  David Einhorn

Looking with interest at the continuation of the rally in both equities and credit, including the high beta space while looking at the continuation in worsening macro data coming out of Europe, when it came to selecting our title analogy, thanks our fondness for behavioral psychology, we decided to go for the "Zeigarnik" effect given most investors are focusing these days on the uncompleted task of the Fed's balance sheet reduction. In psychology, the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks. In Gestalt psychology, the Zeigarnik effect has been used to demonstrate the general presence of Gestalt phenomena: not just appearing as perceptual effects, but also present in cognition. If a task is interrupted, the reduction of tension is impeded. Through continuous tension, the content is made more easily accessible, and can be easily remembered. The Zeigarnik effect suggests that students who suspend their study, during which they do unrelated activities (such as studying unrelated subjects or playing games), will remember material better than students who complete study sessions without a break (McKinney 1935; Zeigarnik, 1927). The results of the study of the "Zeigarnik effect" suggest that a desire to complete a task can cause it to be retained in a person’s memory until it has been completed, and that the finality of its completion enables the process of forgetting it to take place. In similar fashion the desire of the Fed to complete its balance sheet reduction could generate we think, a "Zeigarnik effect" in investors mind. After all it seems to us that the Fed's balance sheet contraction is more influential on assets prices than rates hike, hence the importance of the "Zeigarnik effect" but we ramble again...

In this week's conversation, we would like to look at the state of credit markets and US in particular given the significant rise in leverage in recent years versus Europe, as well as the state of the US consumer. 

Synopsis:

• Macro and Credit - R is for "recession" and D is for "deleveraging". 
• Final charts - Central banks to markets: let's be friends again...

• Macro and Credit - R is for "recession" and D is for "deleveraging". 

The central banking cavalry came late to the rescue with both the Fed and the PBOC coming to support risk assets in general and high beta in particular. Given the even weaker tone coming out of Europe we think it won't take long until we see more support coming from the ECB particularly given the grim growth outlook for the likes of Italy and its continuing ailing financial sector. Given that the European Banking Union remain "unfinished business", it is we think another case of "Zeigarnik effect" as the "doom loop" aka the nexus between the sovereign and the banks is yet to be meaningfully addressed. 

In our previous conversation we pointed out to the more pronounced slowdown affecting Europe including France as well. With French Services PMI at 47.5 in January, at the lowest level in the last 4 years versus 49 in December it doesn't bode well for French GDP going forward:

- graph source Bloomberg

This is what we had to say about France in our last conversation about France:

"The situation for French corporate treasures when it comes to cash flows from operations is deteriorating to a level close to 2012-2013 follow the Euro crisis. This we think, warrants close monitoring, given we think that the ongoing "attrition warfare" between the French government and the "yellow jackets" is taking its toll on the French economy as a whole, which as we reminded you last week is very much "services" orientated relative to other countries of the European Union (80% for France vs 76% of GDP on average)." - source Macronomics January 2019

Sure there is global weaker tone when it comes to macro data, but it is no doubt more pronounced in some places and in Europe in particular hence our concerns and the use of the dreaded "R" word, "R" for recession when it comes to Europe, with Germany coming close to it recently.

But, the latest dovish tone from the Fed is very supportive for high beta, bearish US dollar, bullish Emerging Markets equities, bullish gold and gold stocks as well.

With global "easing" on its way back, following investors fears of a policy mistakes and with a Fed more S&P 500 dependent thanks to the wealth effect, credit could see a return of "goldilocks" thanks to low rates volatility. 

The "R" word has been rising as of late thanks to the global deceleration in global trade on top of a flattening yield curve, but when it comes to credit markets in general and US credit markets in particular, it seems that the "D" word, "D" for deleveraging is staging a comeback as indicated by Bank of America Merrill Lynch in their Situation Room note from the 29th of January entitled "The (soft) floor on credit fundamentals":

"The (soft) floor on credit fundamentals

Our view is that large capital structures in the corporate bond market will go to great length to defend their IG ratings as it could become prohibitively expensive to operate in high yield. That (soft) floor on fundamentals remains one of the reasons we are overweight BBB-rated names. We make a couple of timely observations. First, although the situation remains evolving, we note that General Electric – the 6th largest BBB-rated issuer - is now again trading like the BBB-rated name it currently is, which is a remarkable turnaround after trading in line with BB-rated names during its weakest period last October/November (Figure 1).

Second, when Verizon – the second largest BBB - reported earnings this morning they managed to disappoint and the stock declined more than 3%. However with the company’s emphasis on deleveraging credit investors where not disappointed as spreads tightened about 2bps. AT&T – the largest BBB – was downgraded to BBB-flat in June last year. We would argue that for very large issuers BBB-flat is effectively the floor on ratings, as with further downgrades Fallen Angel risk would be too high for many investors. Since June 30, 2018 – when AT&T became BBB-flat rated in the indices – credit spreads in the Telecom sector, which is dominated by Verizon and AT&T, have tightened 12bps even as the overall IG market widened 10bps (Figure 2).

While we appreciate the longer term challenges to the Telecom industry from technological change, for the next several years we are comforted by relatively stable cash flows and the financial flexibility to support BBB ratings afforded by high dividend yields in the 4.5%-6.6% range. Hence our overweight stance on the Telecom sector." - source Bank of America Merrill Lynch

If there is indeed a slowly but surely rise in the cost of capital, yet at more tepid pace thanks to the latest dovish tone from the Fed, then indeed, this could be more supportive for credit, if companies choose the deleveraging route in the US to defend their credit ratings. In this kind of scenario, it would be more "bond" friendly than "equity" friendly from a dividend perspective we think.

In addition to a potential "D" for deleveraging story playing out for the US, Europe as well could also see a more defensive balance sheet stance coming from CFOs given the weakening growth outlook more pronounced on European shores. On that very subject we read some interesting additional points made by Bank of America Merrill Lynch in their note mentioned above:

"Credit Strategy/Equity Strategy: Who are the refi “losers”?

From the era of hubris… to the reality check

Between 2012 and 2017, European corporates basked in ever-declining debt costs, thanks to unprecedented support from the ECB. The result was a steady boost to Earnings Per Share estimates. Buoyant credit markets thus led equity markets higher. But now the tables have turned, and the equity market should be prepared for a reversal of this symbiotic relationship. European credit spreads have doubled over the last year and companies are finding that they must now pay large concessions on bond deals to attract the requisite demand. Moreover, bond refinancing is a pressing need for a number of companies that failed to term-out their debt maturities during the good times. We think that credit markets now signal that EPS downgrades lie ahead.

A walk into the future - who are the refinancing "losers"?

Table 1 screens for European issuers that could see the greatest EPS downgrades from refinancing their 1-5yr debt. Based on today's credit landscape, we calculate EPS hits of up to 4%. Which names tend to be captured by our screen? Those with plenty of frontend debt still, and those where credit markets have already priced-in steep credit curves.

While Table 1 highlights a variety of names, reflecting these mix of themes, (peripheral) utilities, autos, industrials and telecoms feature prominently. And while there may be mitigants to EPS hits for utilities (regulatory regimes) and autos (financial debt), if debt costs continue to rise in Europe, these sectors would be impacted in other ways.

The canary in the credit mine for stocks

At the height of ECB QE, interest costs for European companies had dropped to 20yr lows. However, interest expenses returning to pre-QE levels will likely become a reality, and will be a further headwind to an already slowing profit cycle. EPS Revision Ratios have been trending down since 2017, when credit spreads turned, and our top-down profit cycle model is predicting 0% EPS growth this year. While operational leverage is undoubtedly the key profitability driver, a 100bps rise in interest costs could lead to a ~2% hit to European EPS. Our strategic view on equity styles and sectors is to focus on quality companies with higher profitability and lower leverage - names that we think will be less vulnerable to rising interest cost and widening credit spreads.

Defend the debt…not the dividend

Companies manage to shareholders, not bondholders. That is the unspoken rule. But we believe that this narrative may no longer hold in today's world of tougher debt rollovers. Equity investors should be prepared for companies to "defend" their debt more than their dividend going forward. Equity investors should therefore be mindful of companies with a high quantum of front-end bonds, and with high dividend payout ratios.

Who are the refi "winners" still?

The silver lining for equity investors is that while debt costs are rising everywhere, some companies have been relatively slow to refinance their bonds over the last few years, and are thus paying higher-than-market coupons on their existing debt. When refinancing time comes, we believe these companies (Table 2) will likely see a small EPS boost.

- source Bank of America Merrill Lynch.

Whereas 2018 was not a good vintage for European stocks, then indeed there might be more additional pain for some equities holders should CFOs in Europe as well embrace a more defensive balance sheet stance, though, leverage in Europe has been creeping up at a much slower pace with the exception of France, being the outlier when it comes to corporate credit leverage overall.

We pointed out in our previous conversations that corporate treasurers in France were becoming more cautious given the deterioration they were seeing in their operating cash flows and slowdown in activity. We could therefore see more dividend cuts coming from French local players, if indeed CFOs adopt a more credit friendly approach when it comes to their balance sheet. The French "leverage" is highlighted in the below Barclays chart from their European Equity and Credit Strategy report from the 30th of January entitled "How worried should we be about Credit?":

- source Barclays

In relation to the European situation we read with interest Bank of America Merrill Lynch's Credit/Equity Strategy note from the 29th of January entitled "Who are the refi losers":

"Canary in the credit mine for stocks

The end of all-time lows on interest charges, as QE ends Since the inception of ECB QE in 2015, corporate borrowing costs have been falling up until 2017, when we saw the Euro cost of debt drop to all-time lows (Chart 5).

With ECB QE coming to an end, we have seen widening corporate credit spreads amid a widespread economic downturn and trade tensions. In periods of declining macro conditions, although safe-haven government bond yields tend to fall amid expectations of looser monetary policy, corporate credit spreads tend to widen due to the perception of rising default risks.

Interest expenses returning to pre-QE levels becomes especially important when EPS Revision Ratios in Europe have been trending down since May ’17 (chart 6) and our topdown earnings model predicts 0% EPS growth in Europe over the next 12 months (chart 7).

Unsurprisingly, investors are increasingly demanding that companies preserve cash to pay down debt rather than spend it on dividends or capex (chart 8).

We prefer more defensive High Quality names with lower relative quantities of frontend debt (or flatter credit curves). These are names that are less likely to see a hit to EPS from future debt refinancing, we think. Also similar to the list, we are strategically overweight the Food & Beverages equity sector in Europe.

European stocks dropped 18% last year, peak-to-trough, but have recovered the majority of December’s losses this year. Recent Fed action has clearly brought short-term relief, but so far has failed to generate large inflows back into Euro corporate credit. The key question is whether we can see a repeat of 2016, when the Fed took a long pause – and helped credit markets. However, in Europe, we think the ECB are unlikely to be able to offer new big stimulus, given the political constraints of QE.

We would note that equities have 88% correlation with credit spreads. But credit markets can also serve as useful leading indicators for equity investors. Large declines in EUR HY credit spreads have reliably signaled major troughs in equities in the past. With global growth in question, central banks are the only game in town (chart 9).

The credit market-equity market nexus

Note as well, that our analysis shows that a rise in European high-yield spreads of 100bp leads to an approximate 2% hit to market EPS in Europe (from the current levels). Given that our top-down model for European earnings suggests 0% EPS growth in 2019, we think that this is quite a meaningful number." - source Bank of America Merrill Lynch

If indeed the Fed's dovish pattern has been more positive for US equity holders including the high beta space, we do agree with Bank of America Merrill Lynch that, in Europe, the story might play out differently, with equities benefiting less from the ECB than credit markets overall. With slowing growth we continue to dislike European banks equities. From a credit perspective, it is more on a case by case basis we think but we would rather own selected credit from European banks than their stocks as far as we are concerned regardless of the high beta/cheap valuation put forward by some pundits or "confidence men" out there. 

So does it mean a return for "goldilocks" for credit? Sure they are many external factors such as Brexit and other geopolitical factors that come into play but, given the Fed has been in the driving seat in the most recent "risk-on" mood, there is a potential for a continuation of the rebound but probably not as significant as the one we saw during the second part of 2016 thanks to the rally in oil prices. We have touched this subject before on numerous occasions but when it come to a sustained rally for US High Yield, oil prices do matter a lot given the exposure to the Energy sector. 

With a notable slowdown in global growth on the back of rising angst surrounding the outcome of the trade war between the United States and China, with central banks coming to the rescue there is indeed a potential for credit to continue to perform on the back of the stabilization of fund flows in the asset class. In relation to US corporate credit's potential for pushing the United States into recession, as we stated before, earnings will be essential in 2019. On this subject we read with interest UBS's take from their Global Macro Strategy note from the 28th of January entitled "Credit Perspectives - US Corporate Credit - What we worry about and what we don't":

"While US growth is coming lower, rest of the world growth is still falling even quicker. Much as we think that at the aggregate level there are mitigating factors that imply US corporate debt won't itself lead to a US recession, there seems to be little doubt higher leverage means the US economy is more vulnerable to a profits slowdown, even one that has its origin abroad. The lack of willingness and ability from China to give a major stimulus this time has compromised growth both in Asia and Europe. Given that Asia has been a big driver of the demand for both tech and energy, key sectors for the US LL and HY markets, a slowdown here could have a big impact on US spreads. Energy issuers are still amongst the most vulnerable, even if the breakeven price for shale has fallen to USD 40-50 per barrel on WTI (Figure 24).

At those levels HY energy spreads could rise to 800-1000bps, we estimate. For the IG space, the big risk is European financials, to which US financials display a very tight correlation (Figure 25), and which have widened but less than would have been expected in the face of a sharp growth slowdown in Europe.

However, the decline in credit market liquidity means a sign of relative calm should not be read as a signal of health. Things could change dramatically with a few downgrades, or an uptick in NPLs." - source UBS

Given the significant rally in European credit since the inception of QE in Europe and with the ECB purchasing directly corporate credit, should a new TLTRO materialize in the coming months to continue to support the European financial sector, we do not think the upside will be as significant as seen before. We do have to agree with UBS namely that the "Zeigarnik effect" of our "generous gamblers" will probably be less potent than previously in engineering a significant rebound in credit markets à la 2016.

Moving back to the subject of earnings and risk-on/Goldilocks, we think there is limited upside in 2019 and we did warn in 2018, that when it came to earnings estimates, analysts were being overly optimistic in their outlook. December has clearly set the tone for vicious EPS revisions and cuts in many instances. If indeed CFOs become much more defensive of their balance sheet, then we could see more dividend cuts in 2019, which would be more credit positive, no wonder we suggested to seek higher quality in US Investment Grade versus high beta credit, performance wise, it has been more supportive to play quality (ratings) over quantity (high beta/yield) as highlighted in the below charts from Bank of America Merrill Lynch from their Credit Market Strategist note from the 25th of January entitled "High grades to IG":

"High grades to IG

While equities and high yield ended this week roughly flat (Figure 1) the strong rally in investment grade continued with credit spreads tightening at a roughly 5bps weekly pace (Figure 2).

This makes sense as the key economic data release this week – Jobless Claims – at the best level since the 1960s (Figure 3) confirms recession risk remains remote. Moreover, the Fed remains clearly on hold for an extended period of time (Figure 4) on the negative GDP impacts of tighter financial conditions and uncertainties surrounding trade war and the government shutdown.

For IG, the material decline in rate hiking risks in reaction to just some tenths cuts to economic growth is a good tradeoff. Being relatively more sensitive to economic growth for high yield and equities the tradeoff is a bit different.

The most likely scenario for how this year plays out, in our view, is continued improvement in the macro – US government reopens, Brexit resolves, US–China relations de-escalate and the US economy continues to grow above trend. As financial conditions ease this environment eventually puts the Fed in a position to resume its rate hiking cycle – probably sometime in the middle part of the year – which is going to be a more formidable challenge for IG. For now, we expect tighter credit spreads – although obviously the first big step has already been taken – but over time IG outperformance fades and turns to underperformance. We remain overweight IG corporate bonds." - source Bank of America Merrill Lynch

So yes, clearly, there is room for slightly more tightening with the Fed's dovish tilt and lack of interest rates volatility with falling inflation expectations. In terms of upside, it is a question of not having "great expectations" and being very selective hence the return of global macro and active management at this stage of the cycle with continued rising dispersion. 

Our final charts below clearly highlight the importance of central banks and in particular the Fed in driving asset prices, with its balance sheet policy reduction being the most important factor at play when it comes to the "Zeigarnik effect".

• Final charts - Central banks to markets: let's be friends again...

With the most recent dovish tilt coming out of the US Federal Reserve, no surprise "risk-on" lives on. It is all about after all a question of "growth sensitive assets" as indicated in our final charts from Bank of America Merrill Lynch The Inquirer note from the 30th of January entitled "Wanted: Monetary easing, not Verbal flexibility":

All indicators point to weak global growth, and suggest EASING monetary policy

1) Only 5 out of 38 economies are seeing rising OECD leading economic indicators (LEI). The net proportion of countries with rising LEI is in the bottom decile of its history since 1988. 2) The world's monetary base shrunk 1.7% YoY in November, only the sixth time since 1980. All prior five occurrences of a shrinking monetary base were associated with recessions in Asia/emerging markets, and ALL were eventually associated with global monetary easing. The Fed's plan to "watch paint dry" and shrink its balance sheet by USD50bn/month this year, is likely to shrink the global real monetary base by 5% YoY by end-2019. Global central banks are implying a massive rise in the money multiplier to counteract this, and/or a rise in monetary velocity to keep nominal GDP growth humming. We think these assumptions are heroic. 3) The global 1m earnings revisions at 0.5 (i.e. for every upward revision there are two downward revisions) is in its bottom decile. 4) Asset prices that have an opinion on global growth (Dr Copper, Dr Sotheby's, Dr. Halliburton etc.) are in their lowest decile. Again, prior instances of such analyst pessimism and weak asset prices were followed by monetary easing. Policymakers seem to be flexible, and the markets like this flexibility if data weakens. Next stop easing?" - source Bank of America Merrill Lynch

Given the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks, it seems that markets are more than happy to remember an incomplete balance sheet reduction from the Fed at this stage but, we ramble again...

"An educated person is one who has learned that information almost always turns out to be at best incomplete and very often false, misleading, fictitious, mendacious - just dead wrong." - Russell Baker, American journalist.

Stay tuned!

Guest Post - Equity volatility - Going Higher

"When dealing with people, remember you are not dealing with creatures of logic, but creatures of emotion." - Dale Carnegie, American writer

Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the numerous factors pointing towards a volatility regime shift.

Equity investors are about to face a volatility regime shift. The low volatility regime US equities have enjoyed since 2010 is over. This document will try to demonstrate why.

(Notes to Readers Source for all charts: Rcube, DataStream, Bloomberg, Fred)

Equity volatility can be explained (with a lead) using 3 different sets of inputs:

Corporate balance sheet leverage, credit availability, and earnings revisions.

Our VIX model’s fair value has recently spiked to above 26, more than 10 points above spot, and 7 points above forwards. This is meaningful. As we will explain below, we strongly believe that equity volatility, which we view as an asset class, is a now a buy.

Corporate balance sheet leverage

When corporate balance sheet leverage rises, default probability increases down the line. We use two sets of indicators to track it.

The first one is our own definition of the financing gap. The FED only looks at the difference between internal funds and capital spending. We prefer adding to that equation the net amount of equity issuance (positive when issuance > shares buyback and negative when it is the opposite). The logic is straightforward. Shares buybacks drain liquidity away from balance sheets while share issuance replenishes coffers. When, like in 2007 or today, debt issuance is used to buy back shares, the impact on leverage is very substantial. In our model, it is captured by our second input tracking balance sheet strain: private sector credit growth. In the financial account of the United States, we look at non‐financial corporate business total credit instrument liability year on year growth rate.

The two mentioned indicators give us information on the financing needs of the private sector (rising leverage = rising financing needs) and debt accumulation. 

Today, shares buybacks equal 25% of cash flows.

The financing gap as we measure it has risen back to around 4% of GDP.

Private sector credit growth is rising fast, bank loan growth is running at almost 15% yoy, while total credit market instrument is rising at close to 10% above the last 3 years’ trend. In 2000 and 2007, it had reached 14% and 13% respectively. Since it works with a lag, the rapid debt accumulation over the last 6 years should only now start to impact balance sheet health.

Credit availability

Credit availability is another important input since, as long as credit is cheap and available, companies can roll over debt, minimizing default risk in the short term.

Bank lending behavior used to be the main indicator that we used, simply because banks were until recently the main suppliers of liquidity to the private sector through loans (this is still the case in Europe but not anywhere else). To track this supply side of the credit channel, we use the senior loan officer survey.

Bank lending behavior remains ample. The % of banks tightening lending standards is negative (banks on average are still easing terms). Nevertheless, there is no better indicator than the financing gap to anticipate bank lending attitude. The recent sharp releveraging implies that loan officers will soon react to this balance sheet health deterioration.

As they should, since rising financing needs cripple corporate profits down the line….

Our bank lending behavior model sees lending standards in the US being tightened this year:

However, as the BIS recently highlighted, the ratio of loans to corporate bonds has collapsed over the last 20 years in the US. This is why, now that investors have become the main providers of capital to the private sector, it is essential to look at risk appetite/sentiment set of indicators to evaluate that part of the supply dynamic.

On the investors’ sentiment front, the picture is we think quite worrying. The best measure of investors’ risk appetite is high yield corporate credit spreads. They have been widening since last summer in part due to the oil crash, but not only.

If we look at FX volatility, which is another good proxy for risk appetite, it is the same story. FX volatility is, in our opinion, a major input. When it rises, hedging overseas profits becomes more expensive, and overall visibility for global CEOs gets much more blurred.

We have used EURCHF as a risk appetite proxy for a very long time. Back in Q3 2010, we warned that Europe was in a meltdown as evidenced by the massive capital inflows into Switzerland. The EURCHF was crashing and its implied volatility soaring. Six months later, equities were plummeting and risk appetite completely gone.

This is exactly what is happening today. Just like back then, most investors we speak to tell us that European QE, which is responsible for the EURCHF turmoil, is a good thing for risk appetite. We agree, but we would add that the CHF strength, just like a host of historical indicators of risk aversion, tell us that at the global level, there has been no appetite for risk since last summer.

The MSCI World is flat since July, corporate credit spreads are widening everywhere, commodities and FX volatility have soared since then, and financial conditions have tightened globally as a result.

Retail investors’ sentiment is also important since they hold a lot of corporate debt through mutual funds or ETFs. Their sentiment remains bullish but it is probably the most volatile of all, and one that should be looked at more from a contrarian point of view, especially at extremes like is the case today.

Earnings revisions

Cash flows are the last variable bloc of our model. To repay debt, a company needs stable to rising cash flows. Earnings thus need to be watched closely. We look at earnings revisions (the one month change on 12mth forecasts) as the best leading indicator for expected cash flow momentum. Negative earnings revisions imply weakening cash flows and inversely.

It is astonishing to realize that today, earnings revisions are the most negative since 2008, and almost equal to the peak level of the 2002 bear market, while US equities have just printed a new historical high. Earnings forecasts are being revised lower at an alarming pace, mostly because of the dollar’s strength but also because capital goods spending are being cut aggressively. In the meantime US equities are being lifted on the back of European and Japanese QE. This tells us that we could be in the very final stages of the equity bull market that started 6 years ago. Complete disconnect between fundamentals (earnings) and prices are a classic signs of a top formation.

The current environment reminds us of 2011 but totally reversed. Back then, US earnings revision were strong, balance sheet were still healthy, and credit availability was large. As a consequence, the VIX fair value was substantially lower than spot level. Fears about the Eurozone sovereign crisis pushed US equity volatility to levels completely unjustified by US fundamentals. In time, the VIX converged towards its fair value. Today, US fundamentals have deteriorated but equities are at historical highs and volatility in the mid 10s. We think that unless earnings estimates are not revised upwards very quickly, a burst of downside volatility will materialize. Between 2009 and 2012, selling equity implied volatility was part of our investment strategy. For the first time in more than 6 years we are now looking to buy it.

While timing a market top can be costly and energy consuming, we are convinced that equity volatility will soon rise very sharply. Equity prices could rotate in a range for a while longer before moving down, but volatility will rise in the process.

Furthermore, the US dollar strength is tightening financial conditions globally. Because cheap dollar funding has infiltrated the corporate world from Moscow to Beijing and Sao Paolo, defaults will inevitably rise together with equity volatility. Implied volatility bottomed exactly when the US dollar started rallying in July 2014. This is because in a world where the stock of dollar credit to non‐banks outside the United States has reached $9.2Trn, to which we should also add sovereign debt in USD, a sharp appreciation of the US currency equals a sharp tightening of financial conditions for non US borrowers. And we know that tighter financial conditions imply increased risks of defaults and hence higher volatility.

All the factors mentioned above (balance sheet leverage, private sector credit growth, credit availability) are even more stretched for Emerging Market equities.

The EM Earnings Revision Ratio is weak.

Private sector credit growth has been buoyant since 2009, dollar denominated debt has spiked, rising at close to 15% every year since 2009. EM corporates balance sheet leverage has significantly risen as a consequence.

The credit channel, as evidenced by the IIF EM lending survey, is tightening domestically. The EM currencies crash vs. the dollar are tightening financial conditions even more. NPLs are on the rise. Rating downgrades are accelerating sharply. In Q4 2014 there were 111 more downgrades than upgrades, up from 26 in Q3. In 2015, there has already been 56 net downgrades.

As downgrades outnumber upgrades, the weakest borrowers are shut from capital access, which exacerbates further the default cycle, which leads to more net downgrades and so on: a classic negative feedback loop.

The situation in China is probably worse than anywhere else. If we had proper data on corporate financing needs, balance sheet leverage and credit availability, the fair value on HSCEI implied vol would be we believe quite elevated. It is also interesting to highlight that all previous housing  downturns triggered a spike on volatility. Housing prices are now down 5.5% yoy, and with 69 out of 70 cities registering negative yoy prices, the momentum on the downside is alive.

Emerging market implied volatilities are interestingly cheap today.

If we look at EEM, the 12mth implied volatility it is at the 8 percentile so is the 12mth implied ratio with SPX (7 percentile)


EEM, KOSPI and HSCEI implied volatilities are cheap on both an absolute and relative basis.

"Logic is the technique by which we add conviction to truth.' - Jean de la Bruyere

 Stay tuned!

Credit - Every Silver Lining has its Cloud

"To penetrate and dissipate these clouds of darkness, the general mind must be strengthened by education." - Thomas Jefferson

Following up on our guest post from Rcube Global Macro Research, where our friends looked at the weakening global earnings momentum (except in Japan), we thought this week, we would take the contrarian approach given equities market seem oblivious to the gathering storm ahead, silver lining being the metaphor for optimism in the common English-language.

The origin of the phrase "Every Cloud has a Silver Lining is traced to John Milton's "Comus" (1634) with the lines:

"Was I deceiv'd, or did a sable cloud

Turn forth her silver lining on the night?"

Indeed, as John Milton's 1634 Comus, it has all to do with deception we think. 

We touched on the subject of cognitive bias in our "Dunning-Kruger effect" conversation. Like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content, therefore, we would tend to agree with our friends Rcube latest call on global weakening earnings momemtum.

As humans we posited in our previous conversations that we tend to suffer from optimism bias as indicated by the work of Tali Sharot:

"Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events." - Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

Not only do we suffer, from optimism bias, but we suffer as well from "deception" and we also all play "deceit" to some extent. We are all "great pretenders", some way or another. In similar fashion to the 1955 hit by the Platters "The Great Pretender", while the song described a man who deals with his heartbreak by denying it, we seem to be dealing with the "broken economy" (more so in Europe) by "denying" its reality, but we ramble again. For those of you who enjoy human's ability in practicing deception, like ourselves, we recommend the site "deceptology.com" dealing with its various forms.

In this week conversation, we would like to look at the negative trend in Spanish nonperforming loans, indicating Spain is tilting towards the adverse scenario which was used by Oliver Wyman in their Spanish banking stress tests. We will also look at the divergence in Central banks approach and the consequences as well on credit from a "loan" perspective. But first a quick credit and markets overview.

The story last week has clearly been some normalization following the explosion of the "Daisy Cutter", namely bond volatility as displayed by the evolution of the Merrill Lynch MOVE  index, which has been falling  - 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.

Therefore the receding volatility in the fixed income space has led to a significant rebound in High Yield as displayed by the price action in one of the most liquid and active ETFs in the High Yield space, namely HYG. Whereas its investment grade equivalent namely the LQD ETF has not rebounded significantly - graph source Bloomberg:

More interestingly the normalization in the credit space was accompanied by a significant tightening in Itraxx indices credit spreads, thanks to a more dovish tone from Ben Bernanke at the Fed. Therefore, not only credit investors have been enjoying some welcome respite for a fourth consecutive week, which has been the longest streak of gains since before the bond route drove yields to a nine months high in June according to Bloomberg, but, benefited from the re-opening of the new issue markets, with credit investors showing again their strong appetite. For instance Gazprom issued a benchmark bond with an initial price guidance of a 4% coupon 5 year (BBB rating) which attracted 5.5 billion worth of orders in the book from 450 different investors, leading to a lower revised guidance to a more reasonable 3.75% coupon at the launch.

Of course the dovish tones from both the Fed and the ECB have so far limited the surge of European Government Bonds yields as indicated in the below graph with German 10 year yields staying below the 1.60% level and French yields now around 2.16% - source Bloomberg:

As far as summer 2013, the on-going respite is indeed a different experience so far from the summer of 2011 and 2012, which saw a liquidity crisis for the first, followed the following year by a spike in peripheral bond spreads during the summer 2012 which was called-off by the "whatever it takes" stance which kept the "feral bond hogs" at bay for the rest of the year leading to 2012 being a spectacular year for credit returns, following closely the record "reflationary" year of 2009.

But, as we posited last week, and in accordance with this week's chosen title, every silver lining has its cloud, and as far as Europe is concerned, clouds are indeed gathering. Record basking temperatures might indeed lead us to some thundering storm ahead in Europe, looking at the unemployment issues particularly hindering the economic prospects for peripheral countries. One just has to glance at the Spanish "Misery" index to fathom the uphill struggle face by our European politicians - graph source Bloomberg:

The misery index is calculated by adding the 12-month percentage change in the consumer price index to the jobless rate. Arthur Okun, an adviser to Presidents John F. Kennedy and Lyndon Johnson, created the indicator in the 1960s.

As far as Spanish banks are concerned, the recent surge in non-performing loans (NPLs) is seriously raising questions again on the adequacy of their level of provisioning. Particularly if ones look at the continuous fall in Spain real estate prices - graph source Bloomberg:

From a starting point of a 100 in September 2007, Spanish prices are now down to 72.64, a fall of more than 28%.

Given that we are now in the middle period considered by the previous Oliver Wyman (OW) stress tests for Spanish banks one can indeed look at the trend for actual nonperforming loans (NPL) and the implication for Spanish banks loss absorption capacity. This exercise is exactly what Nomura has done in their recent note from the 19th of July entitled - "Spanish Banks - On the road for the adverse scenario?":

"Now that we are in the middle of the period considered by the Oliver Wyman (OW) stress tests, we compare actual non-performing loans (NPL) trends with the implied expected probability of default (PD). We estimate an adjusted NPL ratio in May 2013 of 19.5%, representing 55% of total expected 2014 PD in the adverse scenario of 35.2%. On a three-year horizon, the NPL trend is closer to the baseline scenario. However, without a relatively vigorous recovery in 2015, asset quality deterioration could continue beyond the timeframe of the stress test, which would make the current trend closer to the adverse scenario.

Non-recurring income to absorb continued deterioration of asset quality Capital gains from the debt portfolio and other asset disposals should allow the Spanish banks to absorb the continued asset quality deterioration and partially absorb the new provisions needed for restructured loans. We expect net interest income (NII) to reach the bottom this quarter in most cases, although we still see limited upside given the low interest rate environment and ongoing deleveraging.

Support from LatAm – not so much this quarter

Volatile FX and rising bond yields could add some additional headwinds to the earnings contribution from LatAm for BBVA and SAN this quarter (although more so for Brazil vs Mexico). We believe the revenue environment in Brazil remains weak, and given a deteriorating economic outlook, concerns about the outlook for asset quality could return. Although the economic outlook remains positive in Mexico, in our view, this quarter faces some pressure from rising NPLs (particularly from homebuilders).

Relative preferences

We remain negative on the Spanish banking sector. The expected continued asset quality deterioration, the potential impacts of removing mortgages floors, the additional provisions needed for restructured loans or the slowdown in some LatAm economies, are examples of the headwinds facing Spanish bank profitability. In relative terms, we prefer BBVA (Neutral) owing to our bullish medium-term outlook for Mexico and, among the domestic banks, CABK (Neutral) owing to its relative higher returns, and the recent measures announced regarding their international financial stakes, which will allow them to improve the capital position." - source Nomura

As far as nonperforming loans are concerned and in relation to Spain, clearly, the trend is not the Spanish banking friend as indicated by Nomura in their note:

"The OW stress test was made for a three-year period, starting at the end of 2011, so we are now in the middle of the period being considered. In Fig. 4, we compare the 2011 NPL ratio with the 2014 OW expected PD and the actual level of NPLs, adjusted and reported, at a sector level.

The reported ratio includes total sector NPL balances over total credit and loans, reaching 11.2% in May 2013. The adjusted NPL ratio also considers the sectors foreclosed assets, the assets transferred to the SAREB and other EUR 30bn of problematic assets, mainly restructured and substandard loans classified as performing, leaving the May adjusted NPL ratio at 19.5%.
The adjustment of EUR 30bn of problematic assets considers that around 50% of total sector restructured loans are NPLs instead of the 37% reported at the end of 2012. In our recent report, Better today than tomorrow, we showed how total sector restructured loans at the end of 2012 were EUR 208bn, representing 14% of private sector loans, of which EUR 43bn were classified as substandard, other EUR 88bn as performing loans and the remaining EUR 77bn were not performing. The Spanish banks are reviewing these portfolios in order to apply the new and more conservative classification criteria, which will increase the non-performing and substandard restructured loans balances. If we consider as problematic assets all restructured loans, the adjusted NPL ratio will increase from 19.5% to 25.5% for May 2013. Fig. 4 shows that the Spanish financial sector adjusted NPL of 19.5% in May represents 55% of expected 2014 PDs under the OW adverse scenario." - source Nomura

Nomura has also gone further in their report hand have looked at the trend in the on-going deterioration in asset quality:

"The OW stress test assumed a three-year period. However, we believe the economic outlook in 2015 is not clear and a further deterioration in asset quality is possible. In Fig. 6, we show the expected NPL ratios trends if the period was extended to four years instead of the three-year period considered in the OW exercise. In this case, the current adjusted NPL ratio of 19.5% is closer to the adverse scenario than the base one, which theoretically for a four-year period are 21.4% and 17.3%, respectively.

From a macroeconomic perspective, in Fig. 6, we compare the latest available forecasts for the Spanish economy with those considered in the OW stress tests. The IMF published its July World Economic Outlook update on 9 July, downgrading its 2014 GDP and unemployment forecasts for Spain. Its new forecasts now assume that the Spanish economy will not grow until 2015, and it expects a 2014 unemployment rate of 26.5%, which is 50bp above its previous estimate (although this is below the 28% forecast recently published by the OECD).

Although the IMF macroeconomic estimates are still below ours, the downgrades highlight the potential risks for the Spanish economy. We also consider as negative the ongoing political scandals about alleged corruption, which, considering what happened recently in Portugal, could also add more volatility and uncertainty to the country and the banking sector.
We remain negative on the Spanish banking sector. The expected continued asset quality deterioration, the potential impacts of removing mortgages floors, the additional provisions needed for restructured loans or the slowdown of LatAm economies in the case of the two large banks, are some examples of the challenging outlook for the Spanish banking sector and the potential additional negative impacts." - source Nomura

Of course we would have to agree with Nomura, in this case the trend is indeed not your friend and regardless of the "silver lining" of some credit returns, there are indeed some clouds gathering on the horizon. While the ECB has recently tweaked its collateral framework as additional policy support, as part of the intent towards re-launching the ABS market to improve SME funding conditions, we think it is too little, too late and that the credit transmission mechanism has been broken in Europe, leading to a surge in bankruptcies as well as unemployment.

As an illustration of this broken credit transmission mechanism, one can only look at the below graph from Nomura relating to loan growth in Italy to get a clear picture of the damages inflicted to the real economy:

Loan growth? What loan growth?

No wonder the story separating the US economy from the European economy is a credit story. For instance we have been looking on numerous occasions on the price action of the  US Leveraged Loans market versus the European Leveraged Loans market. Comparing market fundamentals between both regions from a credit perspective is paramount in order to gauge the potential growth outcome for the two regions we think. Morgan Stanley in their recent Global Leveraged Insights from the 19th of July and entitled "Game of Loans: US vs Europe" look at these differences:

"Comparing Market Fundamentals: European loans have lower average ratings, higher trailing default rates, and a more challenging loan maturity wall, relative to the US. However, given a much more ‘issuer-friendly’ environment in the US, cov-lite volumes are higher, LBO leverage is greater, and levering transactions are more prevalent.

Technical Strength, but for Different Reasons: The US has been a story of strong demand, thanks to substantial fund inflows and strong CLO issuance. In Europe, positive technicals have been much more a story of low net supply." - source Morgan Stanley

As we posited in May this year in our "Chart of the Day - Too many European banks and why the deleveraging has only just started", the impact of credit growth in Europe is seriously impaired by the on-going deleveraging leading to a vicious deflationary spiral in the European space. It is therefore not a surprise to learn from Morgan Stanley's report the importance in Europe for banks in the loan market:

"Differences in the Investor Base: Banks continue to account for a much larger share of the Europe loan buyer base. As we show in Exhibit 2, banks’ share of the primary market for loans has shrunk over the last decade in both the US and Europe. But banks still account for 50% of the European loan market compared to just 13% in the US." - source Morgan Stanley.

Of course there are as well some quality differences:

"Differences in Credit Quality: The average credit quality of the two markets also differs. Whereas the US loan market is split almost evenly between BBs and Bs, the European loan market is clearly skewed towards Bs (66%), with only 17% BBs. It is notable that this difference in credit quality is almost the exact opposite of what is seen in the US and EU High Yield bond markets, where Europe has a much higher average rating. Investors should keep this quality differential in mind when comparing headline spreads and yields." - source Morgan Stanley

The growth differentiation between the US and Europe is no doubt to us a question of supply in credit:

"Weak Supply Story in Europe, Stronger in the US: In 1H 2013, the US loan market absorbed $267bn in gross institutional issuance, nearly matching levels last seen in the 1st half of 2007. The mix of this issuance, however, is much different today. In 2007, LBOs accounted for 36% of issuance, compared to 10% in 1H13. The majority of gross issuance today is still for refinancing. Subtracting repayments, net issuance for the US loan market was a more manageable $92bn in 1H13, compared to $181bn in 1H07. While stronger 2H growth in the US could lead to more corporate activity, and in turn net issuance, our base case is that supply remains manageable in the US near term.

In Europe, supply has been more muted. From the second half of 2009 through the 1st quarter 2013, LTM leveraged loan net supply was negative, and has only turned positive (just under €1bn) in 2Q13. An important reason for low supply in Europe has been bond-to-loan refinancings. 1H13 EUR high yield bond issuance was €48bn, just slightly below the total for 2012 – the highest year on record. By our estimates, 27% of this issuance has been to refinance bank debt and unlike previous years, concentrated (60%) in single-Bs that tend to dominate the loan market. Naturally, this trend has led to lower issuance of loans and as a result, soft demand has been outpaced by even softer supply. There are, however, tentative signs of revival in the loan market, and we do expect net supply to remain positive in Europe." - source Morgan Stanley

But even for the US, every silver lining has its cloud given the fast pace of credit releveraging and surge in covenant quality trends as highlighted by Morgan Stanley in their note:
"New Issuance Trends – More Worrying in the US
However, not everything looks better in the US from a fundamental perspective. Covenant quality trends in the US have been particularly worrying. Year to date 51% of US loans have been cov-lite — a far higher share than the previous peak in 2007. Although the share of cov-lite issuance is high in Europe by historical standards, it is miles behind that of the US.

Across both markets, new issuance has primarily been used to refinance outstanding debt. US issuance has had a somewhat more shareholder friendly tone, with 15% of proceeds used to fund dividends or share buybacks compared to just 6 percent in Europe. New LBOs also make up a larger share in Europe, although this is predominantly a result of lower overall issuance levels." - source Morgan Stanley

For sure, the buy-back frenzy, has no doubt been more "equity" friendly and definitely more worrying from a credit investor's perspective, making the US market therefore more attractive as of late.

On a final note, "housing bubbles" thanks to cheap credit and hot inflows has no doubt been exported to Emerging Markets when one looks at the cost of housing in Columbia, so much for a post-bubble world... - gaph source Bloomberg:

"Anyone presuming financial markets are in “a post-bubble world” might have a different view after looking at the cost of housing in Colombia, according to Yale University Professor Robert J. Shiller.
The CHART OF THE DAY shows how a home-price index compiled by the South American country’s central bank compares with the Standard & Poor’s/Case-Shiller price gauge for 10 U.S. cities from seven years earlier. Colombia’s index focuses on Bogota, Cali and Medellin, the three largest cities. Both indicators
have been adjusting for inflation. 
“I was not expecting a bubble story when I visited Colombia last month,” Shiller wrote yesterday in a commentary posted on the Project Syndicate website. “People there told me about an ongoing real-estate bubble.” 
Home prices in Colombia have increased 69 percent in real terms since 2004, according to the posting. The gain recalled a 131 percent surge in the 10-city index from its 1997 low to its 2006 peak, he wrote.
Falling inflation and interest rates largely explain the Colombian market’s strength, Shiller wrote. Consumer prices rose in February at the slowest pace since 1955. The central bank cut the overnight lending rate seven times in the past year, and the current 3.25 percent rate is Latin America’s lowest.
Shiller also cited a diminished threat from a Marxist rebel group, the Revolutionary Armed Forces of Colombia, that has been active for half a century. The government has held peace talks with the guerrillas, known as FARC, since October. “That is a good enough story to drive a housing bubble,” the New Haven, Connecticut-based economist wrote." - source Bloomberg

"Every silver lining has a cloud." - Mary Kay Ash

Stay tuned!