Macro and Credit - The Carrington Event

"Faith may be defined briefly as an illogical belief in the occurrence of the improbable." -  H. L. Mencken, American writer

Watching with interest US stocks markets reaching new record levels, while investors are pondering what are the risks coming up in the horizon such as a potential trade war initiated by the Trump administration, China credit bubble bursting, an end of the euphoria in US High Yield, upcoming European elections in Holland, France and potential elections in Italy, we reminded ourselves for our chosen title analogy of the 1859 Carrington Event, a perfect solar superstorm and arguably the most underpriced risk in the world. At 11:18 in the morning on September 1st 1859, English astronomer Richard Carrington in his observatory saw two patches of intensely bright and white light breaking out as he wrote in his report "Description of a Singular Appearance seen in the Sun". The massive solar flare had the energy of 10 billion atomic bombs and hit our planet a couple of hours later wreaking havoc to the nascent global telegraph system. Today such natural "Electromagnetic Pulse" (EMP) disaster would inflict considerable damages to critical infrastructures around the globe. Extreme solar storms pose an existential threat to all forms of high-technology and create widespread power blackouts, disabling everything that plugs into a wall socket. According to NASA from their 23rd of July 2014 article entitled "Near Miss: The Solar Superstorm of July 2012", a similar storm to the Carrington Event of 1859 would exceed $2 trillion or 20 times greater than the costs of a Hurricane Katrina according to a study by the National Academy of Sciences. We find it interesting that the more technology and connected we are the more fragile we have become, the thesis of Nassim Taleb's "antifragile" theory. Furthermore as per our long fascination with "Rogue Waves" and risk, depicted in our February 2016 conversation "The disappearance of MS München", what apparently seemed to be an oddity in terms of probabilities, isn't in terms of frequencies as discovered by scientists studying the phenomenon to their dismay. In similar fashion, a solar superstorm appears to many people to be an extremely rare type of event with a low probability. It isn't. As per NASA's article to paraphrase Taleb, we are fooling ourselves with randomness: 

"In February 2014, physicist Pete Riley of Predictive Science Inc. published a paper in Space Weather entitled "On the probability of occurrence of extreme space weather events." In it, he analyzed the records of solar storms going back to 50+ years. By extrapolating the frequency of ordinary storms to the extreme, he calculated the odds that a Carrington-class storm would hit Earth in the next ten years. The answer is 12%. "Initially, I was quite surprised that the odds were so high, but the statistics appear to be correct", says Riley. "It's a sobering figure"." - source NASA

To paraphrase Donald Rumsfeld, while in financial markets today they are known unknowns, when it comes to solar superstorms it represent an unknown known, yet simply ignored by so many.  Such an event, if it hits Earth would cost several trillions of dollars, with a potential lasting recovery time given we are much more reliant on technology these days. Therefore we are way more vulnerable to these types of "rare" event than in the past, same goes with financial markets. Central banks meddling with assets prices have rendered the system much more "interconnected" therefore much more fragile and unstable. Globalization as well, has rendered economies much more entangled than in the past.

You might be wondering where we are going with our analogy. It seems to us that 2016, the many pundits that made the case for catastrophic events for BREXIT and Trump election got not only the outcome wrong, but also got the results wrong when it came to predict the impact on financial markets. In the case of 2016 we had "bad news" (on the back of "fake news") leading to "good news" for financial markets, we are wondering if in 2017 will not be "good news" (on the back of "real news") leading to "bad news" for financial markets.

In this week's conversation we will look at if indeed the "Trumpflation" story is not losing some steam and also what it entails in terms of allocation.

Synopsis:

• Macro and Credit - 2017 - From optimism bias to realism bias 
• Final charts - European sovereign yields - waiting for Mrs Watanabe and her friends

• Macro and Credit - 2017 - From optimism bias to realism bias 

2016 for "credit" performances was a story of "bad news" leading to "good news", with the first part of the year plagued by the widening in the energy sector thanks to oil woes and spilling over to equities. Clearly the second part of the year saw a dramatic reversal of fortunes with US High Yield and in particular the energy sector leading the way, while investors extended both their credit exposure and duration exposure. While 2017 continues to see a rally in both US equities reaching new height and credit continuing its strong pace thanks to very significant inflows. This is particular the case for fixed income which is clearly seeing no sign of the "Great Rotation" story playing out, from bonds to equities that is. In fact, what is of interest is that this "great rotation" is happening with significant inflows into High Yield, most likely out of Government bond funds. As we have commented before on numerous occasions, we believe we are moving into the last inning of the credit cycle and at this stage we do not think High Yield could easily repeat its 2016 feat.

When it comes to "reaching for yield", whereas 2016 saw an extension of both credit risk and duration risk, 2017 so far is seeing somewhat a more defensive play when it comes to duration, but in terms of credit risk, High Yield has been seeing some significant flows as reported by Bank of America Merrill Lynch in their Follow The Flow note from the 10th of February 2017 entitled "Reach Higher (yield), go Shorter (duration):

"No losers; everyone benefitting so far

Rising rates are not deterring investors from allocating more into fixed income funds. In fact last week’s inflow into the asset class was the strongest in 28 weeks. Inflows were strong mainly in the higher yielding part of the market, i.e. HY and EM debt funds, but also into high grade ones; predominantly on the short-dated part looking for a “shield” against rising rates. In other words investors are seeking high-yielding instruments and shifting into low-duration IG to protect against rising rates. Rising uncertainty is also favouring flows into commodity (particularly gold) funds.

Over the past week…

High grade funds continued on a positive trend for the third week in a row. The weekly inflow was also the highest in six weeks. High yield funds saw inflows for the tenth consecutive week, and the latest inflow was the largest since March ‘15. Looking into the domicile breakdown, the inflow last week came largely from US domiciled and globally-focused funds. Nevertheless the European-focused funds inflows improved from the previous trend.

Government bond funds had their third week of outflows despite rising rates. Money market funds weekly flows were positive after three weeks of outflows. Overall, fixed income funds recorded an even stronger week of inflows than the previous one, the highest in 28 weeks and the seventh positive in a row. The asset class is rapidly approaching the $20bn mark of inflows YTD. European equity funds flows were positive for a third week but with marginal volumes.

Global EM debt fund flows continued on the positive trend for a second week; and the latest inflow was the highest in 28 weeks. Commodities funds flow remained positive for a fourth week in a row, with the inflow pace going up again.

On the duration front, inflows continued in short-term IG funds for the eighth week in a row. Note that last week’s inflow was the highest since July ‘14. Mid-term funds’ flows flipped back to negative territory after last week’s strong inflow. On the other hand, flows into long-term funds moved back to positive after two weeks of outflows." - source Bank of America Merrill Lynch

Given such powerful flows as of late, it is hard to see what could be the catalyst that will finally derail this long in the tooth credit cycle. We are wondering what could potentially be the Carrington Event for credit. In the meantime, the rally runs unabated thanks to solid macro data and reasonable earnings for the time being. As we indicated earlier one, we wonder if 2017 will not be the reverse of 2016, namely that we will have a solid first half and probably a more difficult second half of the year. It is very difficult to assess what lies ahead with so many political events lining up for the year. In this context, we have raised our cash levels, and continue to play the gold mining theme while we are waiting for more clues from the Japanese crowd before being enticed again towards US Treasury notes. On the subject of tail events, we read with interest Bank of America Merrill Lynch Relative Value Strategist note from the 9th of February entitled "Always looking on the bright side of life":

"The anti-climax of tail events

In our view, the biggest financial misjudgments in 2016 were not about underestimating the probability of certain political events. We believe the larger error, in hindsight, was overestimating the immediate severity of the market’s reaction should they come to pass. So while we had two unexpected outcomes in Brexit and the US election results, both of which were viewed negatively in their respective run-ups, the aftermath has been quite anti-climactic in our view. The market has chosen to focus on the bright side of things, building up policy proposals that it favors like lower taxes and fiscal stimulus, while casting aside those like border adjustment taxes and renegotiating trade deals that could be detrimental to asset prices. While this may eventually prove to be the right call, our caution rests on the premise that all the good has been priced in already, with little heed to the possibility of some bad on the way.

As it stands, there seems to be widespread optimism that tax reform, deregulation and fiscal expansion this year will spur strong growth and inflation in the US. While this may eventually prove to be true, our caution rests on the premise that all the good has been priced in already, with little heed to the possibility of some bad on the way. This speaks to some complacency in our view, with not enough weight being given to medium-term policy uncertainty. 

Uncertainty is high. Stay liquid. Be hedged.

In the absence of some concrete action on the policy front over the coming months, we think the rally is likely to lose momentum. In fact it could be argued that this has already begun. We think this is a good time to switch to more liquid longs. In high yield portfolios in particular, given the liquidity issues in the cash space, we favor increasing allocation to liquid instruments and favor CDX HY over indices referring cash bonds, as the basis is unlikely to compress much further." - source Bank of America Merrill Lynch

As per our last conversation, we would side again with Bank of America Merrill Lynch in regards to favoring the liquidity of CDX HY over cash bonds particularly in the light of the compression seen so far in US High Yield since the beginning of the year (European High Yield as well has had a solid run):

But, nonetheless, a barbell strategy of quality investment grade including short duration High Yield, could still represent an attractive investment proposal, particularly in the light of continuing widening in European Government bonds and the convexity risk for long dated investment grade securities.

"Stay liquid: long CDX HY over HY cash

In the absence of some concrete action on the policy front over the coming months, we think the rally is likely to lose momentum. In fact it could be argued that this has already begun – SPX is down 0.5% in the last two weeks, while IG is 2bp wider. We think this is a good time to switch to more liquid longs. In high yield portfolios in particular, given the liquidity issues in the cash space, we favor increasing allocation to liquid instruments and prefer CDX HY over indices referring cash bonds.

The CDS-cash basis is unlikely to go much higher

The CDS-cash basis has reverted towards its pre-2015 levels. The BAML HY index, H0A0, now trades just about 50bp wider than CDX HY (Chart 1). (Note it was 38bp wider until IHRT was removed from HY27 post default.)

As Chart 2 shows, the IBOXHY cash index has consistently outperformed its CDX counterpart for a year now. We think there is limited upside to this now i.e. the basis is unlikely to compress all the way back to 2012 levels thanks to some amount of liquidity premium embedded in high yield cash bonds after the events of the last two years.

Liquidity, liquidity, liquidity

CDX HY offers a better value, liquid long here than HY cash in our view. In the event of a macro shock, the synthetic index might initially underperform cash, but if the weakness persists, bonds will eventually catch-up. More importantly, we think the level of uncertainty regarding policy and the prospect of a flare-up following this period of extremely low volatility demands a higher allocation to liquid products.

Hedge against rate risk

This switch to CDX or a positive basis trade (long CDX, short cash spread) will also perform well as a hedge against a sharp rate rise, should one materialize.

US equities outperformed European equities while volatility continued to decline in both
markets (Table 4). Equity vol in the US currently stands at 11 vol points, near the lows
seen over the past 10 years:

 (Click to enlarge)

- source Bank of America Merrill Lynch

What is of interest to us in the case of US High Yield is the very slow deteriorating trend as shown per the Q4 Fed Senior Loan Officer Survey which has been recently released. On this subject we read with UBS latest Global Credit Strategy note from the 7th of February entitled "Has US High Yield priced too much good news?":

"Has US high-yield priced too much good news?

One of the most critical questions that portfolio managers face when investing relates to what is priced into the market. We have tackled this question before. One year ago, we highlighted to investors that it was not attractive to short US high-yield, as spreads near 850bps implied a US recession was imminent, while underlying fundamental data suggested otherwise. Fast forward one year, and we are in a very different world. US high-yield spreads sit at 400bps, only 43bps above cycle tights in July 2014. US highyield has returned a superb 21.2% over the last 12 months, one of the strongest rallies ever outside of a post-recession recovery. The key question for investors: Is there still room for US high-yield to rally?

It’s certainly possible. In our recent client meetings, we have heard the strong current of institutional pressure dragging active managers into the market to stem client outflows and reduce what has been an exceptionally difficult period of active manager underperformance vs. the broader index (Figure 1). We think this theme is dwindling as cash balances are falling, but it cannot be discounted from extending further . In addition, if developed market central banks remain dovish (i.e. only 2 Fed hikes in 2017, ECB keeps Taper talk to a minimum, BOJ keeps 0% 10yr JGB yield target), we believe that would be a positive near-term for setting the marginal price of credit.

However, it is becoming impossible to ignore downside fundamental and political risks that are more elevated than when high-yield last traded at such levels. Bank and nonbank lending standards are not easing, credit card and auto loan delinquencies are rising, bank C&I loan growth has stalled, and more protectionist sentiment is being underprized in our view as a macro risk. We believe investors should protect gains at current levels, with both high-quality (BB) and low-quality (CCC) high-yield credit at expensive prices. We suggest investors own junk credit through CDX to protect against illiquidity risk in cash bonds. Investors can also bet on a widening Cash-CDX HY basis as a downside hedge with very attractive risk-reward characteristics. Lastly, we reiterate our 2017 preference for US investment-grade credit and leveraged bank loans over US high-yield.

We believe the main conclusion that investors should take away is the following: While US high-yield has rallied to near cycle peaks, fundamental data highly correlated to US high-yield has not followed suit. Today’s release of the Q4 Fed Senior Loan Officer Survey highlighted a net 0% of banks tightening standards on small firm C&I loans, marginally worse than the -1.5% of banks easing conditions in Q3 (Figure 2). While 0% is not terrible, we need to remember that in the sweet spot of the cycle, a net -5% to -10% of banks typically ease conditions. It should be rather disappointing to bullish investors that one of the strongest high-yield rallies in history has been unable to induce banks to ease standards on CI loans.

Even more important than the headline number, we found only a net 7.4% of banks tightened spreads on C&I loans (average across large and small firms). This reduction of spreads is very modest in light of the massive spread tightening seen in the high-yield bond market. In context, this reading is worse than that experienced in Q2’98 and Q2’07. Put simply, banks are not passing on the decrease in market funding costs to their customers, at least not to the same extent as in the high-yield bond market. Given that these two lending indicators empirically lead both high-yield spreads and default rates, we keep our year-end forecasts for HY credit spreads, default rates, and total returns unchanged (YE 2017 HY spread: 570bps, 2017 HY Default Rates: 3.6%, 2017 HY total returns: 0.1%). For more details on our overall credit forecasts, please see our 2017 outlook pieces. In addition, the rather mixed performance of the lending survey was not limited to C&I loans; a net 23.8% of respondents tightened standards on CRE loans, a net 8.3% tightened on credit cards (worst post-crisis) and 7.3% tightened on auto and other consumer loans (worst post crisis) (Figure 3).

The Q4 Senior Loan Officer Survey also asked two sets of special questions regarding the future outlook for 2017 lending standards and delinquencies. The results here again are mixed, but mixed is not good enough with prices so high. On the former, it is true that a net -16.4% of banks expected lending conditions to ease for C&I loans to small firms, assuming economic activity progresses in line with consensus forecasts. This is the most bullish reading in the SLOS survey for credit investors and if it came to fruition could indicate the credit cycle is restarting. However, at the same time, a net 10.5% of banks expected to widen spreads on small firm C&I loans over the next year. This expected level of spread widening is empirically inconsistent with the forecasted easing in lending conditions, given the strong correlation between the two (Figure 2). To put in context, 10.5% of banks widening spreads is consistent with late 1999 and 2007 levels.

Significant numbers of banks indicated continued tightening for CRE (23.6%) and consumer loans (0% credit cards, 5.1% auto loans next year) as well in 2017. The outlook for delinquencies was also rather mixed. C&I loans only saw a small improvement, with a significant fraction of banks expecting rising NPLs in credit cards and auto loans (Figure 4).

This weakness in the consumer area remains a key source of concern. Our recent Evidence Lab primary survey on the US consumer suggested that rising post-election optimism was balanced out by households stating they were more likely to default on a loan over the next 12 months. Bottom line, there is clear potential for winners and losers post-election, rather than all winners.

The divergence of spreads relative to fundamentals goes beyond bank lending. Non-bank liquidity continues to tighten, largely flying under the radar of most investors. This has continued to tighten since we wrote our initial warning piece on the credit cycle in 2015 (Figure 5).

Non-bank trade credit (i.e. the financing of working capital) in particular continues to struggle, as improvement in the CMI trade-credit index has been modest and highly focused on better-quality names. (The favorable component of this series is currently at 60.8, the highest since July 2015). More stressed firms are under pressure however, with the unfavourable component of the CMI index at 49.5 in January, in contraction territory. The divergence of high-yield spreads versus weaker trade credit is now gaping. Figure 6 highlights that high-yield spreads are tightening rapidly at a time when the usage of collection agencies to collect on unpaid debt continues to grow.

When high yield spreads were at similar levels in 2014, the prospect of collection agencies was not even a remote concern. The CMI Index highlighted that retail names in the service sector were facing the most pressure, consistent our preference for underweighting this sector in US HY.

Another hole in the rally is how high-yield spreads have decoupled from underlying bank C&I loan growth (Figure 7).

Despite the well-publicized increase in consumer confidence and business optimism post the US election, bank C&I loan growth has stalled. We think this is not normal for an economy that is expected to hit mid 2% to 3% growth rates in 2017. In fact, the current growth rate of bank C&I loans is more consistent with levels seen just before recessions. Historically, high-yield spreads lead loan growth, as banks take time to restructure old loans and new firms wait to see evidence of consumer spending before borrowing anew. But this is typically an argument made after a recession. It is difficult to reconcile why bank loan growth has slowed already, since it is now generally established that the prior increase in credit spreads and funding costs did not impact US real GDP broadly to a meaningful extent. Could non-bank financing be crowding out bank financing to skew these numbers lower? This may matter somewhat, but many small US businesses with no access to capital markets must rely on bank financing if they wish to expand their businesses. Bottom line, we need to see loan growth picking up again.

Lastly, we believe there is significantly more political risk than many investors are appropriately pricing. We see the prospect of future protectionist policies from the new administration has the potential to be a key headwind, and our conversations with clients suggest this is not being taken seriously enough. A September 2016 paper by now Commerce Secretary Wilbur Ross and National Head of Trade Council Peter Navarro indicates a desire to reduce the US trade deficit meaningfully. The authors wrote in this report that “Those who suggest that Trump trade policies will ignite a trade war ignore the fact that we are already engaged in a trade war.” On the concept of tariffs, Mr Ross and Navarro wrote that “tariffs will be used not as an end game… Trump will impose appropriate defensive tariffs to level the playing field.” The authors believe that deregulation, lower taxes, lower energy costs, and a strong US bargaining position would offset any price increases and retaliation from increased protectionism, leading to a boom in US growth. However, we view any aggressive move to reduce the US trade deficit near-term via perceived protectionist measures would likely create considerable volatility in financial markets." - source UBS

You probably understand by now why our bullet point is entitled "From optimism bias to realism bias". It is important at this stage of the credit cycle to keep a heavy dose of realism. As we mentioned as well in numerous conversations we are tracking closely US Commercial Real Estate (CRE) particularly in the light of significant tightening financial conditions as depicted in the most recent Senior Loan Officer Survey. In recent musings we pointed out that tightening financial conditions were already showing up in the US in Commercial Real Estate (CRE). This is a segment we will be particularly monitoring in conjunction with its synthetic CMBS proxy the CDS CMBX index and in particular series 6 which comprises the highest retail exposure with 37%. As a reminder in our February 2016 conversation "The disappearance of MS München", we discussed the significant headwinds for the retail sector and in particular series 6 for the CMBX index due to its larger retail exposure. We recently read with interest from an article from Matt Scully in Bloomberg from the 9th of February entitled "Deutsche Bank Says Next Big Short Is on CMBS as Malls Suffer":

"Analysts at Deutsche Bank AG, one of the biggest underwriters of bonds tied to U.S. commercial mortgages, say now it’s time to bet against the securities.

The bonds are vulnerable because they are supported in part by leases from retailers, a lagging part of the economy, wrote Ed Reardon and Simon Mui in a note this week. A combination of bankruptcies and closures could lead to faster-than-expected mortgage defaults for stores and malls, as long-term pressure from internet competitors wears many companies down, the analysts wrote.

Deutsche Bank recommends that investors bet against two series of indexes of commercial mortgage bonds: one from 2012, and another from 2013, a trade that amounts to shorting the underlying securities. Those indexes have larger exposure to malls than their more recent counterparts.

The lender famously recommended betting against real estate before. Before the financial crisis, traders led by Greg Lippmann shorted residential mortgage bonds, which helped the lender weather the global banking meltdown. His efforts were portrayed in the book and movie “The Big Short.”

Falling Index

In this week’s note, Deutsche Bank advised buying credit default protection on the parts of CMBX indexes that are a single step above junk, known as the BBB- tranches. Morgan Stanley recommended betting against portions of those indexes last week. The BBB- rated portion of the 2012 Markit CMBX price index, known as the series 6, has been falling since the end of January.

That index traded at 90 cents on the dollar on Wednesday, compared with 95.2 cents on the dollar on Jan. 27, according to data compiled by Bloomberg. The price has dropped as wagers on the index have climbed in recent weeks, reaching $2.3 billion at the end of last week, according to Depository Trust & Clearing Corp. data.

Deutsche Bank was the biggest underwriter of commercial mortgage bonds in 2012 and 2013, selling about a fifth of the deals, according to trade publication Commercial Mortgage Alert. Buying default protection on the CMBX indexes from those years amounts to betting against many of the bonds the bank sold during that period.

Commercial mortgage bonds that the bank underwrote have performed worse than those of many rivals, said Don McConnell, a senior portfolio manager at Bank of Montreal’s BMO Global Asset Management in Chicago, who helps manage $15 billion of taxable bonds. Of property securities that are delinquent, 40 percent were underwritten by Deutsche Bank, the highest of any lender, even though it is the second-biggest underwriter, he said. JPMorgan Chase & Co., the biggest underwriter, accounts for 10 percent of delinquencies.

Failing Malls

More losses may be coming. The Hudson Valley Mall went into foreclosure last year after Macy’s Inc. and J.C. Penney Co. left the mall. The mall liquidated last month at a $42 million loss to investors -- by far the largest realized loss since the CMBS market restarted in 2010, according to Morningstar Credit Ratings. Sears Holdings Corp.’s credit rating was recently cut further into junk territory after sales in stores open at least a year fell 12 to 13 percent during the holidays.

“Big mall loans have outsize losses for investors,” said Morningstar analyst Edward Dittmer. “We expect the stores like Sears, Macy’s and Penney to close more stores later this year and next year, and as they close, there will be knock-on effects that lead to other mall tenants leaving. This can start the cycle of blight.”- source Bloomberg

While CMBX Series 6 saw it prices recover somewhat following the volatile first semester of 2016, the recent price action in conjunction with the weaker Senior Loan Officer Survey does suggest that there is indeed more pain coming for the sector and it is already playing out in this particular CMBX series. This as well documented in Bank of America Merrill Lynch's latest Securitized Products Strategy Weekly note from the 10th of February;

"Recap & relative value

With benchmark conduit spreads unchanged, no private label deals pricing and only one conduit transaction in the marketing process, the majority of this week’s conversations remained focused on the retail sector. Over the past two weeks short-risk interest in lower-rated CMBX6 tranches surged (Chart 45), fueled by a consensus among some hedge funds that retail and regional mall problems will accelerate in the coming months.

As a result, lower-rated CMBX6 tranches, which are collateralized by about 37% retail exposure, have borne the brunt of the pain (Chart 46), falling by as much as 3.5 points since the beginning of the month.

Although retail sector problems will likely continue to unfold over the coming months and years, it is important to understand what sparked the recent selloff. Over the past two weeks there has been some negative retail-related news (Wet Seal, LLC, filed for bankruptcy on Feb 2, Hudson’s Bay Co. approached Macy’s about a takeover, etc.) and the recent broader-market risk-rally stagnated as evidenced by range bound equity markets and falling 10-year Treasury yields and breakevens (Chart 47).

Ultimately, however, we think the recent move lower in the CMBX wasn’t based on new, fundamental information. Despite the selloff among lower-rated CMBX6 tranches over the past few weeks the underlying cash reference obligations have held in extremely well: there has been little client selling and cash bond spreads have barely moved. As a result, the BBB-minus and double-B cash/synthetic spread differential gapped sharply negatively (synthetics underperformed the similarly rated cash bonds) and (Chart 48) and are now testing, or through, their tightest historical ranges.

This isn’t to say that problems don’t exist. The regional mall space is likely to consolidate over the coming years, which may put pressure on some of the loans collateralized by these assets. Aside from those investors that are using lower-rated CMBX6 tranches to hedge their long-risk books (as some distressed investors do), in order for the “short CMBX6.BBB- or CMBX6.BB” trade to work successfully for an investor that is selling risk outright, the retail sector would need to experience a significant, large shock that has systemic implications to serve as a catalyst. The most commonly mentioned catalyst by many investors would be a near-term bankruptcy of a large retailer. Among retailers, Sears tends to be one that many investors focus on, given the company’s broad-based regional exposure in regional malls and the difficulties that it has experienced over the past few years.

Over the past few weeks, however, no new negative announcements have been made by the company that could have sparked renewed downward pressure on the CMBX. In fact, the company today issued a press release in which it announced it initiated a restructuring program targeted to deliver at least $1 billion in annualized cost savings in 2017. This is not to say that all is fine: although 4th quarter earnings were better than expected, total comparable store sales for the fourth quarter declined 10.3%, comprised of a decrease of 8.0% at Kmart and a decrease of 12.3% at Sears Domestic.

Ultimately, there are several independent “variables” that need to play out simultaneously for an outright short-risk CMBX6 trade to work as well as many hedge fund investors hope it will. In all likelihood, we think this is unlikely to happen. Instead, we think lower-rated CMBX6 tranches will trade in a wide range over the upcoming months and be exposed to potentially significant price fluctuations – both higher and lower – as investors react to headlines. At this point, following the magnitude of the recent move, which began at the end of January (Chart 49), we think the lower-rated CMBX6 tranches are over-sold and could rally as investors get short squeezed.

Given the lack of material, significant fundamental news, this week’s move seems largely technically driven. Over the past few weeks we’ve analyzed the regional malls collateralizing the CMBX6 and last week looked at loss severities for mall loans that were liquidated last year (Regional mall rhetoric has become too negative). One additional data point that we didn’t discuss, but which we think is important, relates to the timing between when loans first show signs of stress and when they were ultimately liquidated. Although this may not matter for investors shorting CMBX6 as a trade, it is important to investors shorting the index outright, since losses would need to be crystalized in order to receive a payout. On average, for the loans liquidated in 2016 that were collateralized by regional malls, it took approximately 48 months between when loans first began to show signs of stress and when they were ultimately liquidated" - source Bank of America Merrill Lynch

So, while no doubt, when it comes to the retail sector there is blood in the water and sharks are starting to circle, it appears to us that in this particular case "someone" is effectively "talking his book". While some pundits might eagerly follow the "Optimism bias" course of action with that "short" trade idea, we would rather side with Bank of America Merrill Lynch and play the "Realism bias" given the potential for the enthusiastic punters to get "short-squeezed" in very short order on that move.

For our final chart and when it comes to being more a "realist" the recent significant widening in French yields have been explained by many pundits by the sudden rise in the political risk in French from seeing Marine Le Pen getting elected at the next presidential election in France. For us, as we have been explaining in numerous conversations, when it comes to European government yields, you seriously need to track the flows from Japan.

• Final charts - European sovereign yields - waiting for Mrs Watanabe and her friends

In 2016, in numerous conversations we have indicated the importance of tracking Japanese flows from the Government Pension Investment Fund (GPIF), their Lifers friends and Mrs Watanabe playing it through the famous Uridashi retail funds. We believe that in 2017, following Japanese flows is paramount when it comes to assessing yield movements in European government bonds. While the political rational might be enticing for some, for us it is simply a question of flows, or lack thereof, from the voracious 2016 Japanese investors which have been on a diet as of late. Our final chart comes from Bank of America Merrill Lynch Japan Rates and FX Watch note from the 8th of February and displays the cumulative purchase of European sovereign bonds by Japanese since 2012 (JPY trn):

"FDI and portfolio outflow offset current account surplus

Today Japan's Ministry of Finance (MoF) released international balance of payment statistics for December and a preliminary portfolio investment report for January (based on reports from designated institutions). The seasonally adjusted current account surplus was ¥1,669bn, somewhat lower than in November (¥1,780bn), but still a high level. The current account surplus for CY2016 was ¥20.6trn, and direct investment deficit of ¥14.6trn cancelled out most of this. The ¥30.5trn deficit in portfolio investment is sizable, but a significant part of this portfolio investment should have been hedged. This pattern of investing surplus funds overseas and using the profits to fund the home country reflects Japan’s status as an aging developed country. Also, due to the rising number of foreign visitors to Japan, a surplus of ¥1,339.1bn was recorded in the travel account, the largest such surplus since 1996.

The Trump shock’s aftereffects and Europe’s political risk

The rise of US yields following the US presidential election appeared to settle down around the beginning of 2017, but Japanese investors continued to sell a net ¥1.62trn of foreign bonds in January. Banks were the main sellers. They were net sellers of ¥1.97trn in one month. Life insurers, who had been net sellers along with banks in the previous month, switched to a net purchase of ¥159.8bn in January. Details of flow for January have not been released yet, but we do know from December figures that the net sale of US Treasuries was ¥2.39trn that month, the largest since May 2013." - source Bank of America Merrill Lynch

So if indeed in the Land of the Rising Sun, the sun is in fact setting on their appetite for European sovereign bonds, then no doubt you might get your equivalent of a Carrington Event and solar storm in European bond land we think. It might simply be that "Bondzilla" the NIRP monster might have a serious case of "bond" indigestion after his epic fest of 2016, but we ramble again...

"The world is divided into two classes, those who believe the incredible, and those who do the improbable." -  Oscar Wilde

Stay tuned !

Shipping is a leading deflationary indicator

"All things are subject to decay and when fate summons, monarchs must obey."
John Dryden

In our recent post "Money for Nothing", we argued the following:
"Many pundits have been arguing about the importance of the Baltic Dry Index as a leading indicator. For us, it is just another indicator in the deterioration of credit and for tracking NPLs for the Danish banking sector given, as indicated by Bloomberg:
"Nordea highlighted the weak economic environment in Denmark and decreasing collateral values in the shipping industry as key drivers of the 134% increase in loan losses since 3Q. These trends will likely hurt peers Danske Bank (27% share of total Danish lending) and DNB Bank (11% share in syndicated shipping loans)."

In this conversation, we would like to go further. Shipping is in fact an important credit and growth indicator, but, more importantly a clear deflationary indicator.

As a reminder:

Danish Bankruptcies rising:

As indicated by Deutsche Bank in their shipping survey from the 13th of February:
"Modern tanker values have now firmly trended below the lows of 2008/2009 as the rate slump pressure owners' financing".

Looking at the historical 5 year Old Dry Bulk Ship Prices since 2006, one can clearly see the weak trend of the economic recovery and the deflationary forces at play - source Deutsche Bank:

Given big player Maersk is expecting its container line, the world's largest,  to lose money again in 2012, as rates drop, as indicated by Bloomberg on the 27th of February by Christian Wienberg (Maersk Says Container Line to Lose Money Again as Rates Drop), it spells trouble ahead for the exposed Danish banking sector:
"Maersk’s container division had a net loss of 2.88 billion kroner ($521 million) last year compared with a profit of 14.9 kroner a year earlier, the Copenhagen-based company said today in a statement. That exceeded an estimated loss of 2.28 billion kroner in a survey by SME Direkt. The container result for 2012 will be “negative” as overcapacity will continue to hurt the market, Maersk said today.
Global rates have dropped because the container shipping industry has added too many ships in anticipation of an economic recovery, causing overcapacity. Container demand growth will slow to as little as 4 percent this year compared with 7 percent in 2011 and expansion on Maersk’s most important trade lane, Asia to Europe, will be lower than the global average, the company said today. Maersk also predicted that earnings from its oil division will decline."


LTRO 1 and LTRO 2 will not enable Europe to escape a slower growth, credit crunch and a recession. Maersk is in fact shifting its business away from Europe as indicated by Christian Wienberg in Bloomberg in his article - Maersk Bets Against European Recovery as Recession Kills Trade:
“We think there will be negative growth in Europe this year and that is affecting our view of Asia-Europe trade,” Trond O. Westlie, chief financial officer of A.P. Moeller-Maersk A/S, the owner of Maersk Line, said yesterday in an interview in Copenhagen. “The solution that Europe is trying to take is different from the solution that the U.S. is taking. We believe that general growth will be higher in the U.S.”

We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe (US economy will grow 2.2% this year versus a 0.4% contraction in the euro area, according to the median economist estimates compiled by Bloomberg):
"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012.

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities of the ECB will have to depreciate."
The law of unintended consequences - 25th of January 2012.

Also in the same Bloomberg article:
"Maersk, which is also struggling to adjust to over-capacity, has responded to Europe’s turmoil by deploying fewer ships for the route. The company said Feb. 17 it will cut capacity on Asia-to-Europe trade by 9 percent in an effort to avoid further losses. In contrast, Maersk has no immediate plans to cut vessels to the U.S. or high-growth markets, Westlie said.
“The question as to when we’ll see demand picking up depends on when euro zone leaders will come together and resolve their issues -- and there are quite a few issues,” he said.
Euro area leaders have yet to agree on how to bolster their rescue fund as U.S. policy makers including Treasury Secretary Timothy F. Geithner have urged Europe to make crisis-fighting efforts “credible.”

Not only Maersk will reduce its capacity on Asia-to-Europe trade, they indicated on the 17th of February, they would as well increase freight rates on the route. As indicated by Bloomberg Chart of the Day on the 8th of March, this price effort might be futile - source Bloomberg:

"The CHART OF THE DAY shows fee increases announced by A.P.Moeller Maersk A/S since 2010, and the actual change in spot rates on the planned implementation day and two weeks later, based on figures compiled by Alphaliner, a Paris-based data provider. Maersk, the world’s biggest container line, intends to raise rates by $400 per 20-foot box starting April 1. Other lines have announced similar plans (CMA CGM SA, Orient Overseas International Ltd.).
The additions, if implemented, may be quickly rolled back or trimmed, if history is any guide. Vessels on the Asia-Europe route are operating at less than 90 percent full and that will probably decline further next month because of new ships entering service, said Tan Hua Joo, an analyst in Singapore for Alphaliner. Overcapacity, price wars and rising fuel costs caused the industry to lose about $5.1 billion worldwide last year, according to Drewry Shipping Consultants Ltd."

Baltic Dry Index on Course for Lowest Monthly Average Since 1986 - source Bloomberg:
"The Baltic Dry Index (BDIY), a measure of commodity shipping costs, is on course for its lowest monthly average in more than 25 years as an oversupply of vessels keeps hire costs below break-even levels."

It is still a game of survival of the fittest.

Consolidation, defaults and restructuring are going to happen no matter what we commented recently:
"Standard and Poor's Ratings has lowered its long-term corporate credit rating on the world's third largest containership operator, France's CMA CGM S.A., to 'B-' from 'B+'. The ratings agency also lowered its issue ratings on CMA CGM's debt to 'CCC' from 'B-' and placed all issuer and issue ratings on CreditWatch with negative implications. The recovery rating on the debt remains '6,' indicating S and P's expectation of negligible (0%-10%) recovery in the event of a payment default."

CMA CGM in debt moves - Financial Times - 7th of March 2012:
"France’s CMA CGM plans asset sales to raise cash and has asked its banks to reschedule debt payments for this year and next, demonstrating how slumping container ship earnings have undermined the finances of the world’s third-biggest line.
Rodolphe Saadé, the Marseilles-based company’s executive director, told the Financial Times the company had outlined the request for a debt restructuring to its bankers at a meeting on Tuesday where it had given details of its 2011 performance."

Of course it was expected, that's what the bond and CDS markets had been telling us for a while:
Zero Freight Rates Fueling CMA CGM Default Risk to 90%: Corporate Finance - source Bloomberg, 5th of September 2011:
"Bonds and derivatives tied to CMA CGM SA, the third-largest container line, are signaling that the company has a nine in 10 chance of defaulting as the slowing global recovery pushes freight rates to about zero."

"He who rejects change is the architect of decay. The only human institution which rejects progress is the cemetery."
Harold Wilson

"He who rejects restructuring is the architect of default." - Macronomics.

Stay tuned!

Ireland in the need of a lucky Shamrock...

Anglo Irish Bank is definitely a black hole for the Irish Government.

I wrote about zombie banks and zombie hotels in Ireland recently.

It looks the zombie bank is decaying more rapidly than expected, pushing the Irish budget in very dangerous waters.

http://www.telegraph.co.uk/finance/financetopics/financialcrisis/8033960/Ireland-faces-34bn-bill-for-Anglo-Irish-Bank-forced-to-redraft-budget.html

"Ireland faces €34bn bill for Anglo Irish Bank, forced to redraft budget."

"The country has so far ploughed €29.3bn into Anglo Irish Bank, and the country's Central Bank said on Thursday the lender could need an additional $5bn under a worst-case scenario."

In the previous post about Zombie banking in Ireland I indicated the below:

"Total support for Anglo Irish amounts to 22.9 billions Euros so far and will cost 25 billions to the Irish taxpayers according to its CEO Mr Aynsley but S&P put the figure at 35 billions Euros."

Looks like the CEO was a bit too optimistic on his forecast...

But there is also Allied Irish bank and Irish Nationwide in the need of additional support...

"Allied Irish Banks will need to raise an additional €3bn by the end of the year. Support for Irish Nationwide will rise to €5.4bn from €2.7 bn. The €40bn bailout of the banks has cost Irish taxpayers the equivalent of 20pc of GDP."

This is an horror blockbuster movie in the making...When fiction goes beyond reality.

The worst case scenario according to the Guardian is summarised below. I'll go for the worst case given the previous excellent forecast from Anglo Irish's CEO thank you very much.

Murphy's law: 'Everything that can possibly go wrong will go wrong'."

Murphy Junior's law: "My father is too optimistic."

http://www.guardian.co.uk/business/2010/sep/30/irish-bank-bailout-costs-breakdown

Bailout breakdown:

"Anglo Irish Bank €29.3bn (including €22.9bn already committed by government) – could rise to €34.3bn in worst-case scenario
Allied Irish Banks up to €6.5bn (including €3.5bn already invested by government)

Bank of Ireland €3.5bn (it says it does not need any more capital from government)

Irish Nationwide Building Society €5.4bn (including €2.7bn already committed by government)

Educational Building Society €350m (further requirement for €440m and possibly more expected to come from its new buyer)

Total €45bn, rising to €50bn in worst-case scenario."

By the way NAMA is also taking over 3.35 Billions GBP worth of Ulster loans...

I started drafting this post on the 30th of September, and given I was travelling, a lot of news have been unravelling during my trip:

Allied Irish was nationalised and on the 6th of October, Fitch downgraded Ireland from AA- to A+...

http://online.wsj.com/article/SB10001424052748703735804575535651744296256.html

"The ratings could be downgraded further if the economy stagnates and broad-based political support for and implementation of budgetary consolidation weakens," Fitch said.

Get ready for some more downgrades...



http://www.ft.com/cms/s/0/d7bcff58-cf1c-11df-9be2-00144feab49a.html?ftcamp=Popu_story3/NL/UKOctober2010/Vanilla_irehng/0/

"Unlike Greece this spring, it has cash. It has already secured all its borrowing needs until mid-2011. “We’re absolutely funded until next July and we’re not obliged to go to the markets,” says Mr Lenihan. Ireland’s average cost of borrowing this year, moreover, is the same as last year at 4.7 per cent – not the 6.9 per cent reflected by the spike in spreads last week, at which, obviously, no borrowing was taking place."

Well, Mr Lenihan, given the obvious downgrades Ireland just been hit with, get ready for a surprise in mid 2011 when you come back to the market for more funding...

Anglo Irish is a monster that should had never been let to grow unchecked. Where were the regulators and why the government did not step in earlier?

The Financial Times article quoted above goes through the rise and fall of Anglo Irish:

"Anglo Irish Bank, the bank responsible for 90 per cent of Ireland’s €40bn taxpayer-funded bail-out, was originally involved in financing the import of fridges and washing machines for Irish housewives after the trade reforms of the 1960s, writes John Murray Brown."

"By 2007 the bank was half the size of Bank of Ireland and, on a market capitalisation basis, it was briefly Ireland’s largest bank in July that year, valued at a scarcely credible €13.3bn."

"But, like the property market, Anglo was heading for a fall. Essentially a monoline business, it was concentrated in land and development property lending. It is thought 10 developers accounted for half its loan book."

What a sick joke...10 developers = 50% of the loan book. Have they heard about risk concentration?

"It was only later in January 2009 that the government was forced to nationalise Anglo, after another run on deposits following revelations that Sean FitzPatrick, its powerful chairman and former chief executive, had not disclosed to auditors that at the end of 2008 he had €87m of personal borrowings from the bank."

Conflict of interest for Sean FitzPatrick?

I would like to advise Mr Abramovich to get a new team of portfolio managers for his investment vehicle Milhouse.

"Roman Abramovich’s investment vehicle is threatening to sue Ireland over its treatment of junior debtholders in this week’s bail-out of several Irish banks."

http://www.ft.com/cms/s/0/be0897ce-cda6-11df-9c82-00144feab49a.html

Very amusing indeed...

"The bond held by Millhouse was yesterday trading at about 62 per cent of face value, implying that holders do not think they are likely to be paid back in full. But it is above similar bonds from Anglo, which are trading at between 20 and 30 per cent.

Subordinated bonds pay higher yields than senior debt to reflect the fact that they are more likely to take losses if the issuer gets into difficulties."

There are some greedy people, they are some stupid people, and they are also some stupid greedy people.
There is no free-lunch when you buy risky sub debt...If his team had done a proper risk assesment of their investment (which they are supposedly paid for...), they would have seen that the government guarantee's expiry was running out on the Thursday 30th of September.

There should not be bailout for stupid investors....

My very first post on this blog in 2009 was about Dubai and the stupidity of some "portfolio managers":

"Perception of the credit worthiness on Dubai World was all about implicit guarantees from the Dubai Government. Investors invested believing in implicit support. Probably the same investors who believed in the sacro-saint AAA rating issued on dodgy CDOs and CLOs as a gauge of credit quality of the underlying pool of assets in the structure. Probably the same investors who believed that a callable LT2 bond will be called on the call date by the issuer, because it has been market practice in the past. How suprised they were when Deutsche Bank, nearly a year ago in December 2008, decided not to redeem some sub debt on the date of the call! Investors trade sub debt based on the date of the call to calculate the price of the bond."

For Dubai World Debt, if the credit analyst or portfolio managers had done "properly" their job in assessing the risk, they would have read in the bond offering documents that there never was no implicit guarantee from Dubai government and not even a legal guarantee. They just assumed it.

Same applies for the "talented" portfolio managers running Milhouse, they got attracted by the yield of the risky sub debt and believed in an implicit guarantee which had an expiry date which everyone knew about, except them maybe...

My message to them: get real. My message to Mr Abramovich, I know some very talented portfolio managers out there, out of job and very cheap. It might be time for Milhouse to upgrade...

Ireland 5 years CDS is trading wider todat at 451.78 bps, Cumulative Probability of Default is at 32.50 % (Source Credit Market Analysis Ltd).



Anglo Irish Debt Swaps May Pay Out on Burden Sharing:

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aJ6LEncQh.2w

"There are 674 credit-default swap contracts insuring a net $390 million of Anglo Irish’s senior and subordinated debt, according to Depository Trust & Clearing Corp. data. It now costs 5.2 million euros in advance and 500,000 euros annually to insure 10 million euros of the bank’s junior bonds for five years, implying a more than 82 percent probability of default, according to data provider CMA."

Bye bye Anglo Irish...The game is over.

"The Anglo Irish rescue package will cost every man, woman and child in Ireland as much as 7,500 euros."

The Irish Taxpayers must be thrilled.

And Abramovich should start writing down some of his investment in risky Irish Bank sub debt:

"Lenihan said that, while senior bondholders will be paid in full under the bailout, legislation is being prepared to “address the issue” of junior bondholders taking a loss on their investments."

"After the U.K. government nationalized Bradford & Bingley Plc in 2008, it changed the rules to allow the troubled lender to defer interest on its subordinated debt without that legally constituting a default. Its failure to pay still triggered credit-swaps protecting all the Bingley, England-based bank’s bonds in July."

There will be a restructuring on the debt and a CDS event.

I don't think the current Irish Government will get re-elected...