Thursday, 27 September 2012

Credit - The World of Yesterday

"Every wave, regardless of how high and forceful it crests, must eventually collapse within itself."  
Stefan Zweig (1881-1942)

Our chosen title this week is a direct reference to the great writer Stefan Zweig's final masterpiece "The World of Yesterday". With the growing unrest in Europe and in particular Spain, we thought a reference to the great Stefan Zweig was appropriate given he remained all his life a pacifist and advocated the unification of Europe. It was unfortunately the growth of intolerance, authoritarianism and nazism and his feeling of hopelessness for the future that led to his suicide on the 23rd of February 1942 in the Brasilian city of Petropolis, but that's another story. 

Back in June in our conversation "Agree to Disagree", we indicated that until US Treasury Yields rose significantly in response to stronger growth and a healthier global economy, a secular bull market is not in the cards if history is any guide, although lower yields are indeed giving arguably more incentive to shift from bonds to stocks:
"When looking at the growing divergence between US stocks and US Bond yields, and softening US economic data, one can wonder our long US investors can "agree" to "disagree".

In our previous conversation we argued that the latest round of QE policy followed by the Fed would be hindered by US Corporate Borrowing given the already very low levels of funding which might overwhelm any growth in bond demand. Once again it seems to us that the latest policy enacted by the Fed looks farfetched and is that of engineering yet again another attempt in "wealth effect" in order to trigger shareholder spending as indicated by Bloomberg:
"Spending by households invested in stocks may determine whether the Federal Reserve’s efforts to bolster the economy bring more jobs, according to Jack Ablin, chief investment officer at Harris Private Bank. As the CHART OF THE DAY shows, the Conference Board’s consumer-confidence index has failed to keep pace with gains in retail sales during the past three years. Ablin cited a similar chart in a note yesterday after the board said the sentiment gauge rose to a seven-month high in September. The Fed is building confidence by holding down interest rates, which has lifted share prices along with home values, he wrote. The Standard & Poor’s 500 Index rose to its highest level since 2007 after policy makers agreed to open-ended purchases of $40 billion of mortgage-backed debt each month. “Retail spending is the next step in the Fed’s convoluted job-creation policy,” Ablin wrote. Sales growth brings higher corporate profits, which in turn lead to additional hiring, according to the Chicago-based strategist’s note." - source Bloomberg.

Yes, September's reading from the Conference Board, for the sentiment index was indeed at 87.4, more than any other time since January 2008, exceeding by 17.1 points the estimate. But, consumer "fear" might derail this plan and magnify the US fiscal cliff woes as indicated by Bloomberg:
"A slump in consumer spending may exacerbate any U.S. recession stemming from the so-called fiscal cliff of automatic tax increases and government spending cuts, according to Mike Englund, chief economist of Action Economics LLC. The CHART OF THE DAY shows Englund’s baseline forecast of a slow recovery in U.S. growth if the automatic fiscal changes are avoided, and his projection for gross domestic product if lawmakers fail to avoid the cliff. “I would assume that GDP growth would drop to a zero-to-1 percent contraction rate in first quarter and second quarter,” Boulder, Colorado-based Englund said in an e-mail. “A ‘fear’ or ‘panic’ effect might add to this if households pulled back in fear of the economic consequences of the news flow, and if stock prices fell and yields rose as markets feared sovereign defaults.” The economy expanded at a 1.7 percent annual rate from April through June after a 2 percent gain in the first three months of the year, Commerce Department figures showed Aug. 29. Consumer purchases, which account for about 70 percent of the economy, also grew 1.7 percent, the weakest in a year. Spending has cooled as the labor market struggles to improve. Employers added 96,000 workers to payrolls in August, less than economists projected, after July’s 141,000 gain, Labor Department figures showed Sept. 7." - source Bloomberg.

As far as we have seen as of lately, considerable data improvement has been priced in current stock prices, leading us to feel rather "uneasy" in this sea of "easiness". "Fundamentals" wise, economic support is indeed lacking for additional US stock gains as reflected by Bloomberg so "Mind the Gap":
"As the CHART OF THE DAY shows, the Standard & Poor’s 500 Index’s ratio to projected earnings has risen in the past four months as the Institute for Supply Management’s new-orders index for manufacturing has slumped. Knapp showed the contrast with a similar chart in a Sept. 14 report. Since June, the ISM gauge has been below 50, indicating more companies reported a drop in new orders than an increase. The index was last below the threshold in April 2009, when the U.S. economy was in recession. Indicators like this need to rebound for stocks to move higher, Knapp wrote in the report, because the economic outlook is one of two forces weighing on share prices. The other is the prospects for public policy, specifically regarding the federal government’s debt and deficits." - source Bloomberg.

Not only does the projected earnings have been rising but an upcoming earnings recession may soon put some additional pressure on US stocks as we moved towards the third quarter earnings season, hence our title give projected earnings as reflected in current stock prices look to us increasingly indicating "The World of Yesterday" and not 'The World of Tomorrow", sticking with our deflationary stance.
"Lower second-quarter profit has paved the way for an “earnings recession” that will hurt stocks, according to Jonathan Golub, chief U.S. equity strategist at UBS AG. As the CHART OF THE DAY illustrates, earnings at the Standard & Poor’s 500 Index’s non-financial companies fell in the second quarter and may drop again in the third. The result would be the first back-to-back declines since 2009, according to data that Golub presented yesterday in a report. “It’s very hard for the market to move forward when earnings aren’t progressing,” the New York-based strategist wrote on the 5th of September in an e-mail." - source Bloomberg.

On top of that the large Capital Good Orders drop at the end of August which have declined in four of the past five months is as well an early warning signal about future shipment growth turning negative in the near future:
“When the level of orders falls below the level of shipments, this tends to be a warning signal that future shipment growth will turn negative,” Feroli, chief U.S. economist at JPMorgan Chase and Co. in New York, said in a research note on the 24th of August. While orders have had a spotty record in predicting sales, when the degree of divergence gets this large, the correlation is tighter, Feroli said. He cited research by economists at the Federal Reserve in Washington that showed once orders are 1 percent to 2 percent weaker than shipments, the latter will probably shrink, hurting GDP. Bookings were 5.2 percent lower than sales in July, today’s Commerce Department report showed. Minutes of the Fed’s last meeting issued this week said many policy makers thought further action would probably be needed “fairly soon” without evidence of “substantial and sustainable” improvement in the recovery." - source Bloomberg.

While orders for durable goods slumped 13%, the most since January 2009, consumer confidence in the US climbed for a fifth straight week to -39.6 from -40.8. The "somewhat" improving housing market is indeed supporting the markets but as far as Europe is concerned Europe Economic confidence is in the doldrums, and dropped from 86.1 in August to 85 in September. Record unemployment and a deepening slump with euro-area contracting 0.2% in the second quarter are putting a strain on consumer confidence.

Following up on our previous conversation dealing with "Zemblanity" and why these Central Banks operations will eventually fail, we would like at this juncture to remind ourselves of what we wrote back in May 2010 in our conversation "The inflation debate or why you can have inflation in a deflationary environment":
The initial MV = PT Fisher equation means that a rise in ‘M’ leads in reality to a fall in ‘V’ leaving no net benefit.
Fisher's equation:
MV = PT where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place
"We are currently in a deflationary environment which poses no short term threat of massive inflation, but creates a risk of high inflation, if there is no debt restructuring at some point, as well as some profound structural reforms in public finances in the very near future, which will push us towards a double dip recession. It is unavoidable."

As a reminder:
"In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events occurs:
Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:
1.Debt liquidation leads to distress selling and to
2.Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3.A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4.A still greater fall in the net worths of business, precipitating bankruptcies and
5.A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
6.A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
7.pessimism and loss of confidence, which in turn lead to
8.Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause
9.Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest
." - (Fisher 1933)

We wrote at the time:
"Therefore a perceived inflation can happen in a deflationary environment, it can co-exist."

In the post "Low rates environment and the risk of evergreening à la Japanese", we described the following:
"Companies "are hoarding and in fact not hiring. The paradox of thrift versus the paradox of debt. Companies hoarding cash and households paying down their debt, typical of a deflationary environment and the fear of uncertainty. Households are busy rebuilding their balance sheets and companies have been busy defending their balance sheet."
We concluded our December 2010 conversation making the following important point:
"It is therefore critical to avoid evergreening à la Japanese, the sooner the restructuring of debt, the better and the faster the economic recovery."

To illustrate the above important point, we think the convergence between Iceland's  5 year CDS and Ireland is a compelling display of the impact an accelerated restructuring can have on economic recovery. We have discussed at length this important point back in our conversation in March entitled "Equities, there's life (and value) after default"): "By preventing default, creative destruction cannot happen in true Schumpeter fashion"- source Bloomberg:
Iceland and Ireland are now only around 68 bps apart when looking at their CDS spreads ("Iceland - The Great Debt Escape" - August 2011). - "He who rejects restructuring is the architect of default." - Macronomics.

We agree with the recent comments from Exane BNP Paribas from their QE3 FAQ from the 21st of September:
"The effective impact of QE3 may be less elevated than suggested by econometric models, for two reasons. First, interest rates and mortgage rates have already reached record lows, without triggering much additional business investment. In other words, investment has been much less sensitive to interest rates than in the past and it is uncertain whether a further decrease in yields can change this situation. Second, the mortgage market remains impaired, as close to 50% of households with a mortgage cannot refinance or get a loan at the record low market rates due to their lack of equity."
"In sum, while QE3 will certainly help the economy in sustaining asset prices and financial conditions, this support should remain modest in the short term due to the excessive leverage that remains in the household sector. If financial conditions stay at their current level, we would expect a positive impact of around 0.25 points over the next year. Of course, this is a static estimate. Financial conditions may continue to improve as the Fed continues to buy long-term assets, or they could deteriorate if another shock hits markets. In any event, monetary policy would not be able to offset a sizeable fiscal shock that might occur in the coming quarters. Our base scenario is that fiscal policy would wipe out 1.2% of 2013 GDP, much more than monetary policy can currently add to growth." - source Exane BNP Paribas.

We think Dr Bernanke is indeed going "all in", expecting the "bluff" will be enough to raise expectations and therefore boost the economy and changing expectations.

There would be an easier way to boost the prospect for a return of economic growth and it would mean improving service for struggling homeowners given US banks have been failing to adhere to at least two sets of servicing guidelines since 2010. The Home Affordable Modification Program, that required speedy response from banks has repeatedly been ignored. As indicated by Bloomberg in their article - "Banks That Flunked Servicing Tests Face Watchdog" by Hugh Son from the 25th of September:
"One in five U.S. residential units are underwater, or tied to loans that are bigger than the value of the home, according to CoreLogic Inc., a Santa Ana, California-based mortgage data firm. Of those 10.8 million properties, 15 percent have fallen behind on payments."

We believe accelerating the restructuring process and the deleveraging of US households would be far greatly effective in helping out the US economy in the on-going deleveraging process otherwise the US risk facing "evergreening" à la Japanese as indicated above and might never move back towards "The World of Yesterday".

From the same Bloomberg article:
"The five biggest servicers have given about $10.6 billion in relief through June, mostly in the form of short sales in which a delinquent borrower’s home is sold for less than the amount owed, Smith said last month in a report. That results in fewer credits because servicers get less than 50 cents on the dollar for short sales. They are expected to ramp up loan modifications in the coming months."

Moving on to credit, we believe credit is becoming incredibly expensive and crowded akin to a potential  "Bull Trap" as indicated by CreditSights in their latest Euro Issuance Performance review from the 26th of September:
"With two days left before the end of September, fixed rate-euro denominated issuance has already easily exceeded all previous September issuance volumes with 52 billion Euro of investment grade and high yield deals brought to market. 
Those deals have broadly performed well, especially those from the stressed-eurozone countries. 
But outperformance remains reliant on improvement in the sovereign situation. And so while stressed-country new issues offers attractive yields and compelling new issue premiums, they could prove a trap for investors when volatility returns and liquidity disappears."

We already discussed at length the risks of dwindling liquidity in credit markets. Back in our July conversation "Hooke's law" we argued:
"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)."

In our last conversation we also indicated the following worrying trend:
"This latest credit market "euphoria" has been marked by the significant return of Covenant lite issuance. Back in May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz..."."
Our concerns have been duly validated by the following information relating to the covenant quality of new deals from the following Bloomberg article - "Bond Sales Approach $1 Trillion in Third Quarter: Credit Markets" - 27th of September:
"Bond investors are also accepting looser terms from speculative-grade companies. A Moody’s measure of weakness in bondholder protections included in U.S. junk-rated debt increased to 3.94 in September, the worst since November. The gauge, known as a covenant-quality score, compares with 3.71 in August and a 2012 average of 3.72 through last week, according to Moody’s. “In environments where there is a lot of demand, investors will have less say in the covenant package,” said Matthew Musicaro, an associate analyst at Moody’s. “Either you invest in the deal or you don’t.” Moody’s reviewed covenants on 41 bonds sold through Sept. 21 and focused on covenants including those that restrict the use of cash, investments in risky assets and leverage. The deals are rated on a scale of one to five, with five representing the weakest covenants."

Mouse trap, or Bull Trap, it is indeed definitely loaded...

"We can't forever be spending our lives paying for political follies that never gave us anything but always took from us, and I am content with the narrowest metes and bounds provided I have peace and quiet for work." - Stefan Zweig

 Stay tuned!

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