Sunday 22 July 2012

Credit - Hooke's law.

"A complacent satisfaction with present knowledge is the chief bar to the pursuit of knowledge." - B. H. Liddell Hart

"In mechanics and physics, Hooke's law of elasticity is an approximation that states that the extension of a spring is in direct proportion with the Load applied to it. Many materials obey this law as long as the load does not exceed the material's elastic limit. Materials for which Hooke's law is a useful approximation are known as linear-elastic or "Hookean" materials. Hooke's law in simple terms says that strain is directly proportional to stress." - source Wikipedia.
As a follow up to our recent conversation "Yield Famine", we decided this time around to venture towards a law of physics analogy, namely Hooke's law given the level of stress that can be ascertained from the level of core European yields making new record lows (Germany, France, Austria, Netherlands), which we think is indeed, directly proportional to the aforementioned stress. But it not only in Europe, we are seeing an extension of the "negative yield club", the United Kingdom as well is poised for joining the club:
"The CHART OF THE DAY shows the yield on the two-year gilt falling. It reached a record low 0.115 percent today. Similarly-dated Swiss rates dropped to minus 0.44 percent on July 16, with Germany’s and Denmark’s yields sliding to as low as minus 0.074 percent and minus 0.331 percent, respectively, two days ago. Shorter-maturity rates have turned negative for nations perceived as havens from the almost three-year-old debt crisis, which has sent Italian and Spanish yields to euro-era highs and countries including Greece, Ireland and Portugal seeking bailouts. A negative yield means investors who hold the notes to maturity will receive less than they paid to buy them." - source Bloomberg.
While we recently touched on the attractiveness of going long credit and going long equity volatility ("European Credit versus volatility looks increasingly appealing"), we also discussed in our last conversation the complacency and dwindling liquidity pushing investors out of their comfort zone in similar fashion the "yield famine" of 2006 and 2007 engineered the rise and fall of the structured credit market and other esoteric yield "enhancements" products. In our credit conversation, we would like to discuss the "unintended consequences" of this low yield environment will have to corporate balance sheets, which to some extent, tend to explain, why defaults tend to spike in a low rate deflationary environment such as today. But first, as always our credit overview.
The Itraxx CDS indices picture, with indices widening on the back of a worsening Spanish situation while falling core government bond spreads are making new record lows - source Bloomberg:
The Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) widened towards the 665 bps level, wider by 20bps on the day. Both the Itraxx Financial Senior 5 year index (25 banks and insurers) as well as the Itraxx Financial Subordinated 5 year index rose significantly in the process, respectively by 13 bps and 16 bps.
The current European bond picture with Spanish yields back above the 7% level while German government yields closing back to lower record level around 1.16% (1.20% on the 18th) with other European core bonds (France, Netherlands) making again new lows in this "yield famine" environment - source Bloomberg:
"Hooke's law": Core yields strain/levels are directly proportional to peripheral stress/levels.
Italy's 5 year Sovereign CDS versus Spain 5 year Sovereign CDS with Spain coming again under renewed pressure on the back of Sovereign government yields - source Bloomberg:
Spanish Sovereign 5 year CDS now wider by 80 bps, making a new record high, above Italian Sovereign 5 year CDS in conjunction with Government Bond Yields. Back in March, in our conversation "Spanish Denial", we highlighted the differences between Italy and Spain. In our conversation "Modicum of relief"  in March we stated:
"We think Spain Sovereign CDS will drift wider, indicating increasing default risk perception given:
-Italy's shrinking budget deficit to -3.9% in 2011 from -4.6% in 2010,
-Spanish unemployment level expected to reach 24.3% in 2012,
-Spanish Prime Minister Mariano Rajoy has decided to side step the 4.4% deficit target for 2012, for 5.8%."
The core of our macro thought process is based upon the difference between "stocks" and "flows", as we indicated in our conversation "The Spread Also Rises", Cheuvreux Cross Asset Research from the 19th of March validated our macro approach we think:
"The sovereign debt constraint in Italy is that of a stock - a high accumulated indebtedness - rather than a flow due to operational deficits. Accordingly, the arithmetic of sovereign sustainability in Italy is much more sensitive to the ratio of the cost of debt to trend nominal GDP growth than in Spain."
"Spain's ten-year yield closed above 7% for only the fourth time in the euro era, as auction costs for two- and five-year issues spiked and bid-to-cover levels fell significantly, further pressuring the ECB for action. The associated impact on its banks and their funding costs drove the Bloomberg Industries Spanish Banks Index (BIERBESC) to fresh lows." - source Bloomberg.

Spain on Friday said its recession would extend into next year in conjunction with the region of Valencia asking for a rescue from the central government. Spain's GDP will fall 0.5% in 2013 rather than rising by 0.2% in 2013 as the government had predicted on the 27th of April. Regions face about 15 billion euros of debt redemptions in the second half, with Catalonia and Valencia making the bulk. Spain is truly in a deflationary trap with unemployment reaching 24.6% in 2012 instead of 24.3%. The forecast for 2013 is unemployment to be 24.3% instead of 24.2%.  Clearly a case of "A Deficit Target Too Far".

So the pressure is mounting on the ECB to intervene yet again in the markets as Spanish yields rise.
"In May 2010 the ECB securities market program began, peaking at 219.5 billion euros in March 2012 and recently holding at 211 billion for several months. Two three-year liquidity injections and a June euro area summit release have failed to stabilize yields, which in turn continue to buffet bank stocks and liquidity supply, suggesting new actions are required." - source Bloomberg.

No wonder our "Flight to quality" picture is displaying "Risk-Off" with Germany's 10 year Government bond yields falling again towards record low levels at 1.16% and the 5 year CDS spread for Germany well below 100 bps in the process back to March 2012 levels - graph below, source Bloomberg:

We do agree with our good credit friend namely that considering the lack of liquidity in the credit space and the very high correlation between asset classes, the coming weeks could see a significant spike in volatility in the European space, so "Mind the Gap" because "The Gap is back"- Both the Eurostoxx and German 10 year Government yields seems to be moving out of synch, with falling German Bund yields and a higher Eurostoxx 50 index. - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

It is still the "D" world (Deflation - Deleveraging) - 2 year with two years core government going negative making, in true Hooke's law fashion, our "credit" springs are looking increasingly compressed.

As our good credit friend discussed on Friday, in terms of the news flow, nothing has materially changed:
"1-The EU finance ministers adopted the EU master Plan to bail out the Spanish banking system.  The decision paves the way for the EFSF to raise 30 billion euros. Spain’s bailout will start through the EFSF, which has 240 billion euros in remaining capacity. The permanent 500 billion-euro European Stability Mechanism (ESM) is on hold until a German court ruling due in September. But at the same time, the Province of Valencia is calling the Spanish central government for a bailout. Valencia next bond to be repaid is CHF denominated, matures on august 24th and was issued in march 2009 when the Euro/CHF was trading at 1.5350 (it trades now at 1.2000, which means that the municipality is facing an increase of 20% on the payment due, unless it was currency hedged, which we doubt).
Growth is slowing more in Spain, so we think we are heading for a full bail out of the Province of Valencia (Euro 6 billion, including a superb Euro 1 billion brand new stadium built with the help of the Province "credit card"), which will add pressure on the Spanish debt... Do not expect Germany or the ECB to rescue the world, because as we posited before we do not think they will. ("The Game of The Century").
2-EU is still discussing Cyprus bailout conditions. It seems we are talking of Euro 15 billion package, a lot considering the relative size of Cyprus.
3-Greek State Asset Sales Fund CEO (Mr Costa Mitropoulos) submitted his resignation to the government and is gone. Once again, it looks as if the Greek government promises to comply with the bailout conditions will not be met. I tend to think that our German, Finish and Austrian friends will pull the plug very soon.
4-The US economy is slowing down more as the country is following the path of the rest of the world. Remember, we live in an integrated Global Economy, and nobody is immune. Some US counties and municipalities are already defaulting, others will follow.
Quote: If you want to default, be one of the first to do it as there will not be enough money for everybody."

In relation to point number 3 above, EU Banks Greek Sovereign Exposure is down by 15.5 billion USD:
"Latest BIS data confirm that after further writedowns and asset sales, the total exposure of European banks to Greek sovereign bonds and public sector debt fell more than 70% quarter-on-quarter to end-March, and now stands at $6.4 billion. Should Greece exit the euro, resolution of private sector debt and guarantees remain the largest outstanding issue. (Corrects currency.)" - source Bloomberg.

We do agree with the following quote from James Hertling Bloomberg article - European Bailout Bid Gets Vote of No-Confidence as Markets Drop from the 20th of July:
We’re looking at a situation when people are realizing we’re at a point of debt restructuring and repudiation,” Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London, said in an interview today. “It’s cold-hearted reality. The great blag and bluff of the euro zone has always managed to kick the can down the road, but it is no longer a viable strategy. We’re getting to a crunch point.”

On the 18th of July, Deutsche Bank published in their Bank Research one slide resuming the political stalemate, the opposing positions between stakeholders suggesting the crisis will be a long drawn out affair:

As far as game theory is concerned, we have argued in our conversation "The European iterated prisoners' dilemma": "The only possible Nash equilibrium is to always defect - It looks to us increasingly probable that the outcome could be different to what is expected from Germany. The outcome for the European project is going to be rather binary. It is either "Federalism" or break-up."
We stick to our view.

The options market is validating our views as far as game theory is concerned as reported by Bloomberg. "Game-theory analysis shows the options market is underestimating the risk the euro will slide as European policy makers fail to take actions necessary to end their financial crisis, according to Bank of America Corp. The options market is underpricing the risk of the voluntary exit of one or more countries and a weaker euro,” David Woo, head of global rates and currencies research at Bank of America Merrill Lynch in New York, said in a telephone interview. “Investors are holding out hope, and are complacent in believing, that policy makers will come in and save the day. That is simply wrong because what is good politics in Europe may not be good policies.”
"The top panel of the CHART OF THE DAY shows implied volatility on one-year options for the euro versus the U.S. dollar has plunged since last year, when yields on Spanish and Italian debt had surged, sparking speculation the debt crisis was spreading. The middle panel is a gauge of option demand for hedges against extreme moves in the common currency over the next year. The final graph shows demand for puts, which grant the right to sell the euro, relative to calls is the weakest since April. A call allows for purchases of the euro. Game-theory and cost-benefit analysis show Germany is unlikely to agree to issue euro-region bonds, viewed by strategists as important to stemming the crisis, and Italy and Ireland have the most incentive to voluntarily exit the currency bloc, Bank of America said. The so-called Nash equilibrium in a game in which Greece has the choice of adopting austerity or not, and Germany can choose between issuing Eurobonds or not, is no austerity and no euro bonds, the bank’s analysis shows. Game theory is a study of strategic decision-making. A Nash equilibrium, named after John Nash, a Nobel laureate in economic sciences, is a scenario in which no player in a strategic game has an incentive to unilaterally change an action. Bank of America forecasts the euro, at $1.2199 yesterday in New York, will trade at $1.2 at the end of September." - source Bloomberg.

Moving on to the "unintended consequences" of this low yield environment will have to corporate balance sheets, to some extent, it tends to explain, why defaults tend to spike in a low rate deflationary environment such as today. The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (56%) than in Germany (45%). In fact, in our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

In our conversation "The European crisis: The Greatest Show on Earth", we indicated:
"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."
One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest report is sending us again a clear warning signal indicative of a growing deterioration:
The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in receiving payments from your clients tend to fall, remain stable or rise?
Delays in Terms of Payment as indicated in their May survey published in June have been reported rising by corporate treasurers. Overall +36% of corporate treasurers reported an increase compared to June (+27.8). The record in 2008 was 40%...
According to their latest survey realised early July 2012, the opinion of French treasurers for large corporates cratered in the last two months from -0.7% in May to -19% in July, the most significant drop in two months since this survey exist (first one was December 2005).

According to an article from John Glover from Bloomberg from the 20th of July - Europe’s $180 Billion of Maturities Lifts Swaps: Credit Markets:
"Speculative-grade corporate debt in Europe is the most expensive to insure against losses in 1 1/2 years relative to sovereign bonds as companies need to refinance as much as $180 billion of debt by 2014. An index of credit-default swaps on junk-rated European companies exceeds one for government bonds by 2.44 times, up from 1.65 in March, according to data compiled by Bloomberg. Finnish mobile-phone manufacturer Nokia Oyj led the increase among European non-financial companies, with a 136 percent jump in the last three months, followed by Rome-based toll-highway
operator Atlantia SpA, whose swaps climbed 72 percent.
Borrowers in Europe, the Middle East and Africa face $84 billion of junk-rated debt maturing next year and $96 billion in 2014, compared with 2011’s record bond sales of $70 billion, Moody’s Investors Service said. Their ability to service debt is being hurt by the worsening economic outlook, with the International Monetary Fund forecasting July 16 that output will shrink 0.3 percent in the euro area this year."
"Yield Famine" and Hooke's law, from the same Bloomberg article: 
"The divergence between high-yield corporate and government default risk is being exacerbated by investors snapping up bonds of the safest sovereigns, in some cases agreeing to pay to lend to the nations. Germany’s two-year note yield fell to minus 0.074 percent on July 18 while Austrian, Swiss and Finnish rates also turned negative this week for the first time." - source Bloomberg.

The deterioration in speculative-grade European company credit is being worsened by the outlook for economic growth, hence the risk of seeing a spike of defaults, in this low yield, deflationary environment. Lack of growth means lack of unemployment prospects and reduced tax revenues with increasing pressure in cash flows as indicated by the pressure in the terms of payments from the AFTE monthly survey. It is still a game of survival of the fittest. It’s also causing some companies to pay more to raise money or to be taken over when they cannot pay their debt as indicated in the Bloomberg article quoted above:
"Findus Group Ltd., the frozen-food company owned by private-equity firm Lion Capital LLP, will be taken over by its junior lenders in a debt restructuring after it breached debt covenants that creditors had waived in March, four people with knowledge of the situation said July 7. Under the plan led by Lion Capital, Highbridge Capital Management LLC and JPMorgan, junior creditors will write off more than 200 million pounds ($310 million) of mezzanine loans in return for ownership and provide 70 million pounds in a short-term credit facility, said the people, who declined to be identified because the discussions are private. They will inject 220 million pounds into the company, including 125 million pounds to reduce senior debt, the people said." - source Bloomberg.

Consolidation, defaults and restructuring are going to happen no matter what, for struggling corporates, struggling Spanish regions and provinces, as well as struggling countries. We touched on the subject for the European car industry with Peugeot in our last conversation. In similar fashion to our conversations involving shipping (Shipping is a leading deflationary indicator) and air traffic (Air Traffic is a leading deflationary indicator), the auto industry is as well facing a game of survival of the fittest in this current deflationary environment we argued.

The Bloomberg article concluded with the following quote from Andrew Sheet, European Credit Strategist at Morgan Stanley in London:
"If companies “don’t have cash on the balance sheet” they’re "not in a good place". If a company
generates free cash then it’s in control of its own future."

So, in relation to our title, in true Hooke's law fashion, given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894).

"If you build a better mousetrap, you will catch better mice."
George Gobel - American comedian.

Stay tuned!

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