Tuesday 30 October 2012

Spain surpasses 90's perfect storm

"It is better to meet danger than to wait for it. He that is on a lee shore, and foresees a hurricane, stands out to sea and encounters a storm to avoid a shipwreck." - Charles Caleb Colton, English writer 

While we already touched on the subject of "Rogue Waves" in our conversation "the Italian Peregrine soliton", being an analytical solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), and being as well "an attractive hypothesis" to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace, the latest surge in Spanish Nonperforming loans to a record 10.51% and the unfortunate Sandy Hurricane have drawn us towards the analogy of the 1991 "Perfect Storm".

Generally rogues waves require longer time to form, as their growth rate has a power law rather than an exponential one. They also need special conditions to be created such as powerful hurricanes or in the case of Spain, tremendous deflationary forces at play when it comes to the very significant surge in nonperforming loans.

Looking at the comparison between Sandy and the 1991 "Perfect Storm" Wave Height Analysis, Sandy has been telling us indeed a story of its own when it comes to wave conditions collected offshore Delaware on the 29th of October:
- source gCaptain, gCaptain is the top-visited maritime and offshore industry news blog in the world - NOAA buoy 44009. Sandy is shown in red while the “Perfect Storm” is in blue. (x-axis=Days since 10/23, y-axis=wave height in meters).

The Perfect Storm:
"On October 30, 1991, a buoy located 425 km (264 mi) south-southeast of Halifax reported a peak wave height of 30.5 m, or 100 ft., representing the highest wave height ever measured on the Scotian Shelf. Further south, a buoy located East of Cape Cod reported maximum sustained winds of 56 mph with gusts to 75 mph, and a significant wave height (meaning the average height of the highest waves) of 39 feet, or 12 meters, on October 30, 1991." - source gCaptain.

Sandy Wave Heights:
"Oct 29, 2012 21Z wind/wave analysis has indicated 47 ft sea heights (again meaning the average height of the highest waves) associated with Hurricane Sandy. The storm is now even being declared the Atlantic’s Ocean’s biggest-ever tropical storm."  - source gCaptain 

The Spanish storm surge, fast rising Nonperforming loans - source Bloomberg:
While the 1990-1994 saw a significant rise in nonperforming loans peaking at 8.99% in April 1994, the period going from 31st of October 2006 to the latest figure of 10.51% saw nonperforming loans rising significantly above the 1994 record in similar fashion hurricane Sandy has beaten the record of the 1991 "Perfect Storm".

While we recently touched on correlations and causation, in significant fashion to "rogue waves", for such "freak" phenomenon to occur, you need no doubt special conditions, such as the conjunction of fast rising unemployment (high winds), economic contraction (falling pressure towards 940 MB), and credit contraction as well as austeriy measures.

In that context, we decided to realise a similar comparison exercise between Hurricane Sandy and the "Perfect Storm" with the two periods that saw rising nonperforming loans in Spain in number of months:
While during the first crisis in the 1990, the wave of surging NPLs peaked after 50 months at 9.15%, in the on-going Spanish crisis, we are yet to see the peak in the surge of nonperforming loans with the latest record being broken at 10.51% after 70 months.

Whereas Hurricane Sandy has told us a story of its own versus 1991 "Perfect Storm", the on-going Spanish crisis is as well telling us a special one as well with its economy contracting for a fifth quarter, declining 0.3%  through September, compared to 0.4% the prior quarter with consumer prices rising 3.5% from a year earlier. Spain will most likely miss its 6.3% overall deficit goal for 2012 given after eight months the government shortfall was already at 4.77%, wider than the full year target. According to Bloomberg's survey of economists, the shortfall points to 6.5% for the deficit and the 2013 outlook points to a contraction of 1.4% of GDP compared to the government's prediction of 0.5%. Unemployment is expected to rise above 27% by 2014.

Spain is busy setting up a bad bank with the transfer of 45 billion euros worth of assets with a discount of 63.1% for foreclosed assets and 45.6% average discount on for loans, which is a condition for a European bailout of as much as 100 billion euros for its banking sector. The bad bank will also apply a 79.5% discount for foreclosed land, 63.2% on unfinished developments and 54.2% on foreclosed new homes.

With 200 billion euros of financing needed for 2013, Spain is indeed facing a perfect storm...

"Anyone who says they're not afraid at the time of a hurricane is either a fool or a liar, or a little bit of both." - Anderson Cooper

 Stay tuned!

Saturday 27 October 2012

Credit - When causation implies correlation

"All human actions have one or more of these seven causes: chance, nature, compulsions, habit, reason, passion, desire." - Aristotle 

Looking at the dismal economic figures coming out of Europe as of late (PMI, consumer confidence, unemployment in Spain, IFO, etc.), we could not resist using in our title a veil reference to the phrase used in science and statistics "Correlation does not imply causation". Admittedly, a correlation between two variables does not necessary imply that one causes the other, but when it comes to European woes, not only did the ECB's LTROs amounted to "Money for Nothing" given the lack of transmission to the real economy as we posited in February this year, but looking back at the overzealous deficit targets set up by the European Commission which we discussed in our conversation "A Deficit Target Too Far", we are not surprised to see that the economic causation does indeed implies correlation to current European economic woes unsurprisingly due to poor loan growth as displayed by the below Bloomberg graph displaying loan growth in in the Euro Zone with the Euro Zone Money Multiplier at multi-year low:
"Third quarter bank results will shed further light on the outlook and appetite for euro zone bank lending. The money multiplier remains at multi-year lows and recent regulatory steps to soften or defer the implementation of new liquidity and capital rules underscore the pressing need for banks' loan supply to improve, release cash to the economy and support growth" - source Bloomberg.

Yes, some will counter us, by saying that the opposite assumption which we used in our title, that correlation proves causation is a questionable cause of logical fallacy also called "cum hoc ergo propter hoc" ("with this, therefore because of this"). Well, truth is, the economic contraction in Europe is a consequence of the first event sometimes describe in latin as "post hoc ergo propter hoc" (after this, therefore because of this) namely rapid credit contraction due to accelerated bank deleveraging courtesy of the EBA (European Banking Association) objective for most European banks to reach a Core Tier 1 capital of 9% by June 2012.
So dear readers, no, we do not think it is a logical fallacy, "post hoc" supposedly being a "tempting error" because the temporal sequence in Europe appears to be integral to causality namely credit contraction:
A occurred, then B occurred
Therefore, A caused B

Of course as of late, our "Generous Gambler" aka Mario Draghi, ECB's president, has defended is latest OMT (Outright Monetary Transactions) bond buying plan on the 24th of October in front of the German parliament with a warning about deflation risks:
"In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries"
and added:
"In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it."

Arguably our dexterous "Generous Gambler" has indeed been highly successful in propelling Spanish bonds gains above Germany as indicated by Bloomberg:
"Investors who held onto Spanish bonds this year as the price of the securities whipsawed amid the euro-area debt crisis stand to earn more than those who sought refuge in German bunds. The CHART OF THE DAY shows Spanish debt has handed investors a 4.2 percent return since Jan. 3, rebounding from an 8.7 percent loss in the period through July, according to data compiled by Bloomberg and the European Federation of Financial Analysts Societies. German bunds, perceived as Europe’s safest sovereign debt, have earned 2.7 percent this year. The Iberian nation’s securities have surged since the European Central Bank said it will buy bonds." - source Bloomberg

Making us reminding ourselves part of the great poem from Charles Baudelaire which we have used in numerous conversations:
"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

The most recent table of monthly purchases of sovereign debt is a clear indicator of the faith many investors have put in our "Generous Gambler" - source Bloomberg:
"Euro zone banks purchased an aggregate 33.3 billion euros of sovereign debt in September, following sales of 24.9 billion euros in the preceding two months as yields fell and gains were taken. The ECB commitment to do "whatever it takes" drove the Spanish 10-year yield down to 5.5% from August highs above 7%, and recent bank purchases reflect this new-found confidence." - source Bloomberg

"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

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

Our generous gambler also argued the following: 
"OMTs will not lead to disguised financing of governments. All this is fully consistent with the Treaty’s prohibition on monetary financing. Moreover, they will focus on shorter maturities and leave room for market discipline."

But he also said the following:
"The ECB intervenes only in countries where the economy and public finances are on a sustainable path."

Our "Generous Gambler" is indeed kept on a tight leash for now, a German one that is, courtesy of the Banker's Algorithm.

Our "Banker's Algorithm" comes into play when you think about on-going Spanish deflationary vicious spiral given our computational reference which we touched again last week:

"The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state."
So of course, our Banker's algorithm has avoided the deadlock in Europe because of Spain. Clearly by denying or postponing the request, it has determined the Spanish request could put the European system in a clear unsafe state!

For Spain, it is "request denied" courtesy of the Bankers' algorithm."

Question being now, can Europe survive in the current form (number of countries) without making material sacrifices? One has to wonder...

By managing to keep Germany’s liabilities unchanged German Chancellor Angela Merkel has been in fact the clear "winner" of the last European summit in June (number 19...) we argued in our conversation "Europe - The Game of the Century". On the 18th of October, Chancellor Merkel in her address to the German lower-house has indeed craftily defended again Germany's liabilities by declaring:
"Financial aid without conditions attached has in some cases frustrated the drive to streamline economies, and therefore joint liability is the wrong answer"

Given the IMF has cut its euro-region growth forecast for 2013 from 0.7% to 0.2% with the European economy potentially shrinking by 0.4% in 2012 instead of the "projected" 0.1% by the ECB, in this week's conversation we will look at correlations and causation on our European ship given the increasing risks of "Mutiny on the Euro Bounty" in 2013 which we have been highlighting since April this year:
"As well as Fletcher Christian and part of the crew, our European "sailors" (politicians) were attracted to the "idyllic" initial cheap funding environment provided by a single currency umbrella. The recent austerity "harsh treatments" measures imposed by the captain of the ship (European Commission) which we reviewed in our recent conversation ("The Charge of the Light Euro Brigade") seems to be clearly pushing some of the members of the crew towards mutiny. This explains somewhat, why the European ship is attempting to change tack, moving towards growth."

"Prosperity makes friends, adversity tries them." - Publilius Syrus

Unemployment figures in Germany which will be published next week and will be key. So will be economic data from Germany. In September 2011, in our conversation "Much ado about nothing" we argued:
"And given Merkel's big u-turn relating to the Japanese nuclear disaster in 2011, and that next general election in Germany are to be held in September 2013, and we know that Merkel is already committed to a third term, we would really follow closely the German economy in general and the German labour market in particular. "

There is indeed a growing rift between France and Germany in relation to the course that needs to be taken in relation to Europe due to a growing divergence in the political agenda for both France and Germany. We agree with the latest report from Nicolas Doisy - Politoscope number 10  from Cheuvreux which validates our recent analysis Merkel and our Banker's algorithm:
"Delaying the euro federal Big Bang again: the Franco-German “phoney war” (redux):
-While it should be starting, Europe's federal Big Bang is stalling again due to diverging political agendas in Germany and France with regard to the euro institutions. The disagreement is partly real (i.e. of substance) and partly fake (i.e. purely motivated by domestic politics) and likely to drag on for months… if not years.
 -Merkel has timed her agenda in 2013 with a view to the full monty (re-election and a euro to her liking) and thus intends to frame the debate to her advantage. To keep her options open, Merkel wants to have the final say on any decision regarding Spain and the euro: this is why she uses the federal agenda as a red herring.
-To secure her chances for re-election, Merkel needs to keep the Eurozone quiet during the coming year: this is why she has agreed to the ECB's OMT for Spain. For as long as she is leading the electoral polls, she is sure to keep both France and the SPD in check: this is why she is skilfully nurturing German anti-euro feelings.
-Hollande's options are limited, as he can only bank on the SPD or market pressure to break the deadlock: he thus also uses this debate to keep his own left in check. His only potential ace is to use next year's recession in the Eurozone to table his "growth" agenda again, so as to get a more lenient fiscal treatment by Germany. 
-All in all, this Franco-German divide over institutional options looks very likely to lead to a two-speed Eurozone as the periphery will continue entering its debt-deflation." - source Cheuvreux.

Moving on to France and the subject of when causation implies correlation, we noted from the same interesting note from Cheuvreux the following interesting correlation. Namely that Hollande's popularity is 100% correlated with the rise in unemployment since he has taken office: 5,000 more unemployed = 1% less popularity for Hollande, so that (theoretically), according to Cheuvreux's analysis, he should be ousted when unemployment reaches 3.2 million:
"Hollande's first option out of this diplomatic deadlock could be for the social democrats to win next year's election or the leadership of another Grand Coalition. However, after supporting France's stance very vocally on several occasions in the winter of 2011, the SPD has gone mute on the issue of Eurobonds in particular. This clearly is a sign that Merkel has so far won the battle of public opinion on the euro issue." - source Nicolas Doisy - Cheuvreux.

Following up on François Hollande's political strategy of hoping for the social democrats to win next year's election, we could not resist, (given our post title) but refer to "Mierscheid law"!
The Mierscheid law was a satirical forecast published in German magazine Vorwärts on 14 July 1983 which forecasted that the Social Democratic Party of Germany (SPD)'s share of popular based on the size of steel production in Western Germany: "The Vote share of the SPD equals the Index of the crude steel production in the western federal states - measured in millions of tonnes - in the year of the federal election".

"The last corroboration of the law was in the 2002 election, where the West German crude steel production was 38.6 million tonnes, and the vote share of the SPD 38.5%. For the early election in 2005 the vote share was 38.4%, with a mean crude steel value of 40.0 million tonnes. Over the last ten elections, the two values were within two units nine times, and within one unit seven times." - source Wikipedia
- source - the full Wiki.

With German confidence falling to the lowest level in more than two and half years and Europe's composite PMI falling to 45.8 from 46.1 in September, the IFO institute's business climate index unexpectedly dropped to 100.0 from 101.4 in September, indeed accelerated deleveraging and generalized austerity is increasing the causation of economic woes and the correlation with worsening economic outlook. We feel comfortable with our recent call of growing divergence between the growth differential between USA and Europe as indicated by the recent PMI.

We also believe that as economic woes weight on both Germany and France in 2013, so will increasing political rifts arise in the process. We do agree with Nicolas Doisy's take from Cheuvreux, namely that there is indeed a new "phoney war" evolving between both countries:
"This (peaceful) remake of the Franco-German phoney war obeys a purely political logic and forces the Eurozone to continue walking along the abyss for another year. Unfortunately, it can only add to the uncertainty surrounding the fate of the Eurozone by leaving deflationary Spain very much on the hook: there is no clear prospect of Eurobonds any time soon, be it to recapitalise Spanish banks or help Spain's government. Beyond, this phoney war could well turn into another "battle of Stalingrad" when the actual size of the Spanish problem is fully revealed, right after the German election (if not before). It is thus to be hoped that another Grand Coalition wins in Germany, as seems to be the preference of the German electorate. Such an outcome would have the advantage of creating the conditions of a de facto national unity government in Germany. In any event, this Franco-German great divide over institutional options looks very much apt at leading to a two-speed Eurozone of sorts in the not-so-distant future. Indeed, it appears clearly from this debate that the core issue is what to make of the periphery. This amounts to raising the question: (where and how) does the periphery belong in the Eurozone? While still implicit, this theme will surely rise to the front in near future." - source Cheuvreux - Nicolas Doisy

Indeed, what to make of the periphery in general and Spain in particular given the recent Spanish banks earnings which clearly indicate that Oliver Wyman's nightmare scenario could as well play out which therefore clearly justify the retention in the allocation process of our European Banker's algorithm?
Caixabank, the third biggest bank saw its profit fall 42% as it accelerated loss recognition tied up to real estate with 4.41 billion euros of provisions in the first nine months to fully cover the required 2.44 billion euros from the first RDL (Royal Decree Law) and 600 million of the 2.1 billion euros in charges needed from RDL2 passed in May. Bad loans jumped to 8.42% in September from 5.58% in June and 4.9% in December 2011.
It was a similar story for Spanish giant Santander, with third quarter profit felling 94% due to the necessary purge in real estate exposure needed with net income falling to 100 millions euros from 1.8 billion euro a year earlier. Bad loans as a proportion of total lending rose to 4.33% from 4.11% in June. The bad-loan ratio across the Spanish business climbed to 6.38% from 5.98% in June and 5.15% a year earlier.

The rise in bad loans are all a reflection of the rise from bad loans in the construction sector as reported by Bloomberg:
"September's Spanish stress test projected aggregate losses of 270 billion euros for the banks under its adverse scenario, with a 43% loss on real estate developers, identical to Santander's 3Q real estate non-performing loan ratio. Spain's construction and real estate bad debt topped 100 billion euros at 1H and may rise faster and further than stress estimates." - source Bloomberg

No wonder the Banker's algorithm is reluctant in allocating "resources". In that context, the bad bank SAREB which need to be in place by December, will have as much as 90 billion euros of asset based on their transfer price, initially comprising land, developer loans and residential units that went bad according to Bloomberg article "Spain Bad Bank Seen Too Big to Work With $117 Billion: Mortgages" by Sharon Smyth from the 25th of October.
"The Bank of Spain has yet to fix transfer valuations for the assets based on the stress tests of Spanish lenders carried out by management consultants Oliver Wyman and published on Sept. 28. The 90 billion euro number is based on transfer prices, so the original value of the assets is likely to be higher.
In comparison, Ireland’s National Asset Management Agency, set up in 2009, spent 32 billion euros on mortgages with a face value of 74 billion euros to cleanse its banking system.
Lenders that take state aid will have to transfer to the bad bank foreclosed property of more than 100,000 euros, real estate and builder loans of more than 250,000 euros and controlling stakes in property firms, according to the Economy Ministry official. A decree to regulate the entity should be passed on Nov. 16. It may be amplified in the future to include loans to consumers, small and medium enterprises and retail mortgages." - source Bloomberg.

In relation to Bankia, we argued in May 2012 in our conversation "The Tempest the following" with our good credit friend:
"A better solution would be to force a conversion of debt to equity (In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company). Doing so will not require 7 to 10 billion funds, but would of course dilute shareholders and destroy bond holders (haircut)."

The ECB is now pushing for inflicting losses on junior debtholders as reported by Emma Ross-Thomas, Esteban Duarte and Ben Sills from Bloomberg on October 25 - ECB is Said to Push Bankia Losses as Spain Purges Assets:
"The European Central Bank and European Commission want investors including preference shareholders to swap their securities for new shares to reduce the cost to the taxpayer, according to two people who asked not to be named because the discussions are private. Profit at Banco Santander SA, Spain’s biggest lender, slumped in the first nine months as it took a 14.5 billion-euro charge on real estate losses.
Confronting the toxic legacy of Spain’s 10-year building boom is imposing political costs on Prime Minister Mariano Rajoy as he faces a separatist challenge in Catalonia, protests on the streets of Madrid and a battle to avoid a full bailout." - source Bloomberg.

Back in our May conversation we indicated:
"Transparency in asset valuations would finally help in discovering the extent of the problems plaguing the Spanish Financial sector. The set-up of a "Bad Bank" in similar fashion to Ireland's NAMA, would indeed force price discovery and true valuations provided a third party assessor is drafted."

and we added:
"Without credit growth resuming, the ambitious target deficits will not be met in Spain. The conditions for growth needs credit growth to resume, as shown by the recent credit growth in the US (see our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid..."). Spain has to go through resolving the Spanish banking encumbered balance sheets."

When causation implies correlation...

Credit wise, for Spanish banks, the rise in the issuance for "Puttable bonds" is a cause for concern we think. Puttable bonds are fixed-income securities which investors are able to redeem before maturity. It is a very dangerous option given the funding shock it could create should investors decide in concert to exercise their option. As reported by Bloomberg by Esteban Duarte and John Glover on the 25th of October in their article "Santander Seeks Salvation in Puttable Bonds":
"Banco Santander SA, Spain’s biggest lender, is placing its trust in bondholders by issuing 4.4 billion euros ($5.7 billion) of fixed-income securities that investors are able to redeem before maturity.
Bonds with put options make up 36 percent of Santander’s debt funding this year, compared with 9 percent in 2011, according to data compiled by Bloomberg. While the bonds have lower interest rates, they leave the bank vulnerable to a potential 7 percent increase in the 33.4 billion euros it must repay next year. Investors have already demanded early repayment on 1 billion euros of the notes." - source Bloomberg

Puttable bonds are indeed a typical instrument used by financial institutions under stress. For us, a big red flag.

Another red flag we think for Santander, comes from its dwindling capacity in absorbing potential losses at the parent bank by its increasing policy of partial IPOs such as the one done in Mexico as indicated by CreditSights in their report Spanish Banks - The Value of Empires from the 22nd of October:
"In Santander's case especially, the capacity of equity in its foreign subsidiaries to absorb potential losses at the parent bank is being reduced by its policy of partial IPOs (the goal being to list all the most significant subsidiaries within five years – see Santander: Partial IPO in Mexico). The erosion of loss absorbing capacity that this implies at parent or group level is reflected in the Basel 3 reform that will ultimately prevent banks from including in consolidated CET1 capital any surplus equity contributed by minorities in excess of the subsidiaries' minimum regulatory requirements." - source CreditSights

On a final note, looking at the our "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), falling again towards 1.55% versus 5 year Germany Sovereign CDS which has cratered below 25 bps, by avoiding increasing so far Germany's liabilities, Chancellor Merkel has in effect alleviated concerns on Germany's exposure to European woes we think - source Bloomberg:
It's deflation (デフレ) in Europe.

"Correlation is not causation but it is sure a hint" - Edward Tufte - professor emeritus of political science, statistics and computer science at Yale University.

 Stay tuned!

Monday 22 October 2012

Credit - Chadburn, on full ahead?

"If the highest aim of a captain were to preserve his ship, he would keep it in port forever." 
- Thomas Aquinas, Italian Theologian. 

Looking at the epic capitulation in the credit space and the significant rally of credit indices recently, which could lead the performance of credit in 2012 to match the performance of 2009 in terms of total return (around 12.5% for Investment Grade credit), we thought we would refer once again to one of favorite theme of shipping in our title, namely a chadburn which is the communication device for the pilot on the bridge to order engineers in the engine room to power the vessel at a certain desired speed. As far as credit is concerned it has been on full ahead.

An indicator we have been monitoring has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes. While touching again on the subject of asset correlation (see our post "Risk-Off Correlations - When Opposites attract"), in "Risk Off" periods we have noticed that the 120 days correlation had been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level. Currently the correlation is still falling towards 78%, albeit at smaller pace than when the first LTRO was initiated at the end of 2011, validating further this "Risk-On" phase we have been following  - source Bloomberg:
The correlation between both the German Bund and US 10 year note is still falling (77%).

The below graph from the 2nd of June highlighted our reasoning behind our 30th of March "Risk-Off" call, displaying the various "Risk-On" and Risk-Off" phases which we have been witnessing with the on-going European sovereign debt crisis which increased significantly in May 2010 - source Bloomberg:

In similar fashion to the liquidity LTRO induced rally of late 2011, the "whatever it takes" stance from Central Banks (Fed, ECB, BOE, BOJ) means the markets are provided with some tremendous firepower. Fighting one central bank is one thing, but fighting all central banks is another as indicated by the below Bloomberg graph highlighting 3.7 trillion of asset growths.
"The combined assets of the ECB and the Fed rose 220% from the start of 2008, as they injected more than $3.7 trillion of liquidity into the global economy. The IMF claims that U.S. bank recapitalization and restructuring has outstripped similar operations in the euro zone, implying that fiscal consolidation and central bank asset shrinkage may occur faster in the U.S." - source Bloomberg.

We will not discuss the problem arising from QE in the long term as we have already approached this subject in our conversation "QE - To infinity...and beyond".

Arguably, some have called the latest programme OMT (Outright Monetary Transactions) by the ECB as a game changer. It is not. This much awaited bond-buying programme has had the desired effect on peripheral yields as indicated by the significant rally in peripheral bonds and the significant drop in bond yields source Bloomberg:
Spanish yields have receded from their summer heights of more than 7% to around 5.50%, whereas Italian bonds have fallen from 6% to 4.75%.

For us it seems that so far our "Generous Gambler" aka Mario Draghi has been very apt in applying some of General Sun-Tzu's greatest concepts:
“The supreme art of war is to subdue the enemy without fighting.” ― Sun Tzu, The Art of War

Peripheral yields have been subdued even without the OMT being triggered and Spain requesting help, given the looming regional elections, which in effect, we think are delaying Prime Minister Mariano Rajoy official request.

So, in this week conversation, following our credit overview, we would like to focus on our credit chadburn given you can always have a disconnect between the order given (full ahead) and the real situation or the urgency of the situation that is. Urgent orders requiring rapid acceleration means the handle on a chadburn had to be moved three times so that the engine room bell was rung three times. So we will look at different indicators which could clearly indicate if effectively a proper rebound is on the way and if the credit bell has arguably rung three times which would mean an acceleration in global economic growth.

But first our usual credit overview!

We recently argued that the severing of the link between Sovereign risk / Financial risk would not happen ("Pareto Efficiency"). The main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index has been trying to break that close relationship, expecting that the European Banking Union will finally break this relationship - source Bloomberg:
My God! Lord, my God! Please make the devil keep his word!" - Charles Baudelaire, French poet, "Le Joueur généreux," pub

We mused around the latest round of "easiness" and voiced our concern in our conversation "The Uneasiness in Easiness":
"But what in effect our "Generous Gambler" did previously with the two LTRO operations have been reinforcing in effect the link between weaker peripheral financial institutions with their sovereign country, causing some to pile up on their domestic sovereign bonds and in effect precipitating their demise for some."

This sovereign-bank "Feedback Loop" cannot be broken to restore growth in the Eurozone as indicated by the below table from Bloomberg indicating the exposure of the ECB's exposure to peripheral Europe:
"With the ECB's estimated exposure to peripheral Europe exceeding 1 trillion euros or 30% of its total assets (purchased sovereign bonds, plus lending to banks) the fate of Europe's central banks, banks and sovereigns has become more closely aligned. Breaking this "feedback loop," which is distorting the effectiveness of monetary policy, is essential for economies to expand." - source Bloomberg

As displayed by the latest Spanish misery index making new highs, the deflationary spiral is still playing out - source Bloomberg:

As far as Spanish banks third quarter provisioning are concerned, the recent surge in non-performing loans (NPLs) is seriously raising question on the adequacy of the level of provisioning.

Back in February in our conversation "Money for Nothing", in relation to Spain we argued the following:
"What analysts should be concerned about is that BBVA’s bad loans as a proportion of total lending has remained little changed at 4.07 percent in the fourth quarter of 2011. They also should be concerned as well that its Chief Operating Officer Angel Cano said in April 2010 that asset quality was probably going to be “stable from now on.”Really?". Evolution of NPLs in Spain, source Bloomberg:
"Spanish banks' non-performing loans (NPLs) grew more than 30 billion euros in the five months to August 2012, raising the question of how their 3Q provisioning will evolve in light of an impending bailout. Median coverage ratios fell to 56% in 2011 from 240% in 2006, and the trade-off between profit and falling coverage will be key to results." - source Bloomberg

Sorry Mister Angelo Cano, but, we cannot really see the stability in asset quality...and we tried. Spanish Non Performing Loans rate - source Bloomberg:
"Mortgages get paid in good times and in bad". - Santander CEO Alfredo Saenz April 2012

We "agree" to "disagree" on that point. Assessing the impact of Spanish real estate prices on bank loans is not that difficult given that a large portion are real-estate related as indicated by Bloomberg data:
"Assessing the Impact of Spanish Real Estate Prices on Bank Loans: Bad loans at Spanish banks increased to a record 10.5 percent of total lending, according to the Bank of Spain. A large portion are real-estate related, and Bloomberg data show house prices may be lower than those captured by official figures and projected in consultant Oliver Wyman's stress tests. 
 The Spanish house price index collated by Tinsa, Spain's largest home appraiser, is sometimes thought to better reflect reality than official figures. 
 The chart shows an annualized price drop of 10.1 percent on the official index and 14.2 percent on the Tinsa index. Both show price declines accelerating relative to 2011
To put these numbers in context, the recently released Oliver Wyman stress test exercise uses a base case move of minus 5.6 percent in the house price index for 2012, followed by minus 2.8 percent in 2013 and minus 1.5 percent in 2014. The adverse case scenario uses minus 19.9 percent in 2012, minus 4.5 percent in 2013, and minus 2.0 percent in 2014. 
 With a visible acceleration of the drop in house prices as banks attempt to sell properties and fiscal consolidation takes hold, the adverse case might start to look optimistic." - source Bloomberg

"Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid." - Santander CEO Alfredo Saenz April 2012

As far as Spanish woes are concerned, we think the latest European summit has not dealt with the growing Spanish issues, courtesy of the "Banker's algorithm" concept:
"The Banker's algorithm is run by the operating system whenever a process requests resources. The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state."

So of course, our Banker's algorithm has avoided the deadlock in Europe because of Spain. Clearly by denying or postponing the request, it has determined the Spanish request could put the European system in a clear unsafe state! Indeed the worst-case scenario is playing out for Spain as indicated as well by Bloomberg article by Charles Penty from the 18th of October entitled - Spain Banks Face Pain as Worst-Case Scenario Turns Real:
"Spain’s request for 100 billion euros of European Union financial aid to shore up its banks is increasing concern about the nation’s growing liabilities. Standard & Poor’s downgraded the country’s debt rating by two levels to BBB-, one step above junk, from BBB+ on Oct. 10, saying it wasn’t clear who will bear the cost of recapitalizing banks."

Under Oliver Wyman’s worst-case projection, an economic contraction of 4.1 percent in 2012, 2.1 percent in 2013 and 0.3 percent in 2014 would contribute to 270 billion euros of credit losses and a 59.3 billion-euro capital shortfall for banks...
But maybe we are saying something stupid...

“If you wait by the river long enough, the bodies of your enemies will float by.” ― Sun Tzu

Request denied courtesy of the Bankers' algorithm:
"It is necessary that before we buy bonds, countries will apply to ESM" - European Central Bank Executive Board member Joerg Asmussen - 22nd of October 2012.
He also added:
"Let me say clearly, there is no automatism between an ESM application and our purchases".

Moving on to the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge), the divergence is back - source Bloomberg:
The HY risk gauge indicated by the Itraxx Crossover is still is moving towards expensive territory, but the recent widening has pushed back towards the 500 bps level. The gap between the Itraxx Crossover and Eurostoxx volatility has re-opened with volatility remaining relatively muted with the fall in systemic risk courtesy of central banks intervention.

In fact the "Risk-On" environment has clearly been supportive for our "flight to quality" picture given the significant fall we have seen in the German 5 year sovereign CDS versus the German 10 year government bond yield - source Bloomberg:

“Appear weak when you are strong, and strong when you are weak.” ― Sun Tzu, The Art of War

Back in July, in our conversation "The Game of The Century", we argued that Angela Merkel had been the big winner so far in this European game of chess, given that:
"By managing to keep Germany’s liabilities unchanged Angela Merkel appears to us as the winner of the latest European summit (number 19...). Question being for us now, can Europe survive in the current form (number of countries) without making material sacrifices in true Bobby Fischer fashion? One has to wonder."

Moving on to the subject of looking at different indicators which could clearly indicate if effectively a proper rebound is on the way and if the credit bell has arguably rung three times which would mean an acceleration in global economic growth led by the US economy, we noticed recently a significant rebound in the Baltic Dry Index - source Bloomberg:

Why the rebound? As we have argued in our conversation "The link between consumer spending, housing, credit and shipping":
"The relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending".

We also indicated:
"The on-going "green shoots" in US housing, the impact on the Containership industry led by consumer spending and consumer confidence is very significant"

Given consumer confidence in the US climbed to 83.1 in October according to the preliminary University of Michigan report (a 5 year high), improved sentiment and personal finances, could lead to a sustained level of optimism which could help jumpstart spending which accounts for 70% of the US economy. If the improving housing market leads to a rise in consumer spending, the GDP could surprise to the upside we think.

As far as containerized traffic is concerned as represented by the Baltic Dry Index, a change in consumer spending would have a direct impact on global traffic volume and economic growth. Looking at the Asia-Originated Containerized freight, on the 21st of September, it was up by 25%, although below May levels according to Bloomberg:
While Asia to Europe lanes worsen with volumes continuing to decline, trans-Pacific and Intra-Asia volumes are improving.

Whereas the US consumer confidence seems to be rising, falling European Confidence is hurting Air Travel Demand as indicated by Bloomberg:
"Demand for air travel in Europe will fall as business and consumer confidence is shaken by the sovereign debt crisis. The summer improvement in confidence has given way to weakness as debt problems in Spain, Italy, Ireland and Greece return to the forefront. The Bear Case is that uncertainty will lead consumers and businesses to pull back discretionary spending on air travel." - source Bloomberg.

One of the most important indicator we think in relation to our Credit Chadburn and the growth divergence between the US and Europe is the evolution of the Loans-to-Deposit ratio progress as displayed by Morgan Stanley in their recent report entitled - Tracking Deleveraging - from the 19th of October:

Another important point for the US chadburn, we think, comes from Citi's US Credit Strategy note from the 10th of October indicating the following:
"Bond vs. dividend yields: Back in ’07 the average HG non-financial bond was yielding 6.2%, while stocks for the same issuers offered a dividend yield of 1.9% (difference of 4.3%). The difference is now a negative 0.2% (2.7% vs. 2.9%), even before adjusting for factors such as high dollar prices. At some point the marginal dollar should flow from credit into equities, and it’s hard to see why we are not fairly close now."

In relation to US credit in general and US HY in particular, Goldman Sachs in their recent note from the 17th of October entitled - Assessing the interplay of macro surprises and spread products made some very interesting points:
"Macro surprises matter for spread products but in different ways.
We investigate the impact of macro surprises on the corporate bond and Agency MBS markets. 
We find that for both investment grade corporate bonds and Agency MBS, it is total returns (or equivalently yields) that respond to macro surprises. 
For high yield bonds, it is the spreads that respond to macro surprises. 
This difference reflects a trade-off between the ‘rates effect’, where positive surprises cause a back-up in rates, and the ‘spread effect’, where positive surprises lower the default premium. 
For investment grade bonds and Agency MBS, the ‘rates effect’ largely dominates the ‘spread effect’, while for high yield bonds the two effects cancel out. 
The impact is broader and larger since the global financial crisis Focusing on the post-global financial crisis (GFC) sample period, we document that the impact of macro surprises on both the corporate bond and Agency MBS markets has become larger and broader. 
Recent spread rally driven by declining premia, not better data.
Looking at the recent spread rally, we find that both high yield bonds and Agency MBS have outperformed the macro data, confirming our view that the rally has been driven mostly by risk premia compression as opposed to a better macro picture. 
The relationship with macro surprises is reasonably robust for both corporate bond spreads and MBS yields: CCC and B spreads are negatively related to the surprises, while the inverse pattern prevails for CMM yields. 
The intuition conveyed is simple: positive surprises lift growth expectations and thus cause the default risk premium to compress and Treasury yields to back up. The result is tighter corporate bond spreads and wider MBS yields.

Three key findings: Not all macro indicators are created equal (unsurprisingly). 
-For both the credit and mortgage markets, labour market indicators (non-farm payrolls, initial claims, the ADP employment report and the unemployment rate) tend to have the strongest impact. Survey data (such as the ISM – both manufacturing and nonmanufacturing – and Philly Fed) and hard data (such as retail sales and durable goods) also appear to have a significant impact on daily moves in credit spreads and total returns, as well as on CMM yields. 
-In spread terms, only high yield is sensitive to macro surprises. Moreover, the response of high yield spreads to macro surprises is monotonic in ratings: the lower the rating, the stronger the response. By contrast, investment grade credit spreads are virtually unresponsive to macro surprises for both financials and non-financials. 
-Lastly, CMM yields respond to macro surprises in a way that is almost identical to 10-year Treasury yields. This is consistent with the notion that agency MBS and 10-year Treasury securities are close substitutes of each other."

On a final  note, falling bond yields and the Fed's purchases of MBS (mortgage-backed securities) will erode further US banks profitability in the next few quarters according to David A. George, a Robert W. Baird and Co. analyst as indicated by Bloomberg Chart of the Day:
"As the CHART OF THE DAY illustrates, banks’ net interest margins have generally contracted for more than two years. The chart, based on data compiled by the Federal Deposit Insurance Corp., shows the gaps in percentage points between the average interest earned on loans and investments and the average rate paid to depositors. JPMorgan Chase and Co.’s third-quarter results showed the average yield on its securities holdings fell 18 basis points from the second quarter, George wrote on the 15th of October in a report. At Wells Fargo and Co., the drop was steeper: 27 basis points. Each basis point equals 0.01 percentage point. “Unfortunately, this headwind should accelerate” in the fourth quarter, the St. Louis-based analyst wrote. Refinancing rates for home loans have dropped as the Fed begins purchasing $40 billion of mortgage-backed bonds a month. The decline has resulted in faster payoffs on the mortgages underlying the securities, he wrote. Profits may also suffer as banks shift toward loans from securities and compete more intensely to draw borrowers, George wrote. He added that lenders may retain more of their mortgages, which would reduce fee income from selling the loans. Net interest margins peaked in 2010’s first quarter and narrowed in eight of the next nine quarters. Margins at banks with more than $10 billion in assets have dwindled more than the average for all federally insured institutions, as the chart shows." - source Bloomberg

Provided the fiscal cliff is avoided, we think the growth divergence between the USA and Europe will continue to grow and the chadburn on USS USA might indeed move on "Full Ahead" whereas for USS Europe (NCC-1792), we think it is on "Dead Slow Ahead", it is indeed in the credit prices...

"A sailing ship is no democracy; you don't caucus a crew as to where you'll go anymore than you inquire when they'd like to shorten sail." -   Sterling Hayden, American actor.

Stay tuned!

Saturday 13 October 2012

Credit - Growth divergence between the USA and Europe. It's in the credit prices stupid!

"I don't believe we're seeing the beginning of a divergence. We have seen a partial divergence on this case." - Mario Monti 

Following up on our previous conversation relating to the growth divergence between the USA and Europe in May this year (Growth divergence between the USA and Europe? It's the credit conditions stupid...), we want to point out in this credit conversation that the aforementioned divergence has been growing as well in the credit space.

The divergence between US and European PMI indexes - source Bloomberg:

Back in our May conversation we indicated the following reasons behind the growth differential between both economies was due to credit conditions:
"In recent conversations as well we have been highlighting the growth differential between the US and Europe ("Shipping is a leading deflationary indicator"):
"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."

The divergence of growth between the US economy and the European economy has been indeed reflected in credit prices such as the US leveraged loan cash price index versus its European peer. You can clearly notice the uncanning similarity with the above graph from Bloomberg indicating the evolution of the PMI index - source Bloomberg:

While both the PMIs and Leveraged loan prices cratered in 2008, you can see the impressive rebound in 2009, leading in the rapid surge in cash prices for leveraged loans and the increasing divergence in cash prices as indicated by the growing spread between US leveraged loan prices and European leveraged loan prices now at 7 points apart.

Similarly, the evolution of Credit indices such as the Itraxx Main Europe representing 125 entities of investment grade companies and the CDX IG index for US Investment Grade are both reflecting a similar divergence as reported by Morgan Stanley in their European Credit Strategy report from the 8th of October:

This divergence can as well be seen in the perception of credit risk for Investment Grade. This is divergence between the CDX IG 5 year CDS index and the European Itraxx Main Europe CDS 5 year index (125 Investment Grade entities), is at 32 bps but fell from the highest point reached of 64 bps in September 2011 thanks to the LTRO operations at the end of 2011 and the recent ECB pledge - source Bloomberg:

Given the latest forecasts for economic growth in both the USA and Europe (2% for the US and -0.4% for Europe according to the IMF), one can expect US investment grade credit to outperform European investment grade credit as implied by Morgan Stanley's 3 month forward model from their recent report:
- source Morgan Stanley Research, Markit, Bloomberg Company Reports.

Europe vs US Loan prices - source Morgan Stanley, S&P LCD, European Credit Strategy, 8th of October 2010:

Morgan Stanley's economic forecast between Europe and the USA,  not only points towards a growing divergence between both but an environment which still present value for credit given the low yield and low growth current environment:

So why the continued growing divergence? It is all about deleveraging and access to funding.

For the last two years, European companies have been using the bond markets for funding to replace bank financing and particularly in Europe. In their latest Euro Consumer Takeaways from the 10th of October, independent credit research company CreditSights indicated the following:
"For at least two years, European corporates have been using the bond markets to replace bank financing as a major source of funding. Given the size and stability of European food and beverage companies, that exit from bank financing was less pressing than for smaller, more leveraged companies. But a similar trend now looks to be coming to pass in food and bev. AB InBev, Heineken and to a lesser extent, Nestlé have all pre-financed acquisitions in the bond markets when putting bank facilities in place would have been the norm. In addition, we would note that the publicly-issued and privately-placed US dollar bonds have been the instruments of choice. Seven of our coverage have issued dollar debt this year. This looks like a diversity play for both the companies and the investor base. The companies want access to another funding source. In some cases, they have borne the costs of swapping into their domestic currency. The investors seek the attraction of non-US exposure in a relatively risk-free industry in order to provide portfolio diversification without the euro currency risk. Interestingly enough, the tranche-ing of the four multi-billion dollar deals from SABMiller at the start of year to Heineken in early October has been relatively similar. This suggests that investor preferences on maturities haven't really changed through the course of this year, implying that the ebbs and flows of the global business environment haven't really changed where investors see value. Anecdotally, there seemed to have been good dollar appetite so perhaps, once SABMiller set the template early this year, it might have been a case of 'if it ain't broke, don't fix it'. Maybe that is the real lesson of investing in European Retail and Food and Beverage this year."

While more recently we have been relatively concerned about the dwindling liquidity ("Yield Famine"), and the role of positive basis in credit  as an additional indicator of our "uneasiness" ("The Uneasiness in Easiness"), low growth, low yield and low volatility regime in the current environment make allocation to  non-financial credit (both High Yield and Investment Grade) essential.
As a reminder on the definition of basis in credit:
The basis represents the difference in spread between credit default swaps (CDS) and bonds for the same debt issuer and with similar, if not exactly equal maturities. In the credit derivatives market, basis can be positive or negative. A negative basis means that the CDS spread is smaller than the bond spread.

Nomura's Fixed Income Research team made some very important points we think in their latest report entitled - Who sets the cost of capital? Policy makers or markets? - on the 11th of October :
“Our argument is that the financial risk of firms has been falling more than business risk as cash balances have been increased, balance sheets have been deleveraged and the maturity of debt structures increased. In addition, this has come at the expense of medium-term growth expectations as retained earnings have not been used to boost capital spending but rather to de-risk corporate balance sheets. And this marking down of medium-term growth expectations produces ever lower expected forward risk-free rates underscoring the improved financial risk of the corporate sector. So we make the case that the business risk component of corporate risk has fallen by less than the financial risk and as such credit represents a better source of alpha than equity. This sort of thinking leads naturally to Robert Merton's work on valuing corporate debt. He views debt and equity as contingent claims on a firm‟s assets, with option pricing being the vehicle of choice for finding the value of those claims. In Merton's world owning a corporate bond is equivalent to holding a risk-free bond plus selling a put option on the firm's assets to equity investors. Seen from this perspective the yield spread is merely the premium for selling the option. It is not a huge jump to see falling implied equity volatility as a green light to look for at worst stable credit spreads and therefore carry trades to be the focus. “ 
"Simply put, lower levels of leverage mean more of the intrinsic un-diversifiable risk within the firm is being passed on to equity holders than debt holders." - Nomura

Indeed, corporate deleveraging might imply a new golden age for credit because, as we indicated in April 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets", credit is far less volatile than equities (see above graph from Nomura). 

Nomura in their recent report put forward this very central point:
“Given that the bulk of returns in equities is linked to earnings whereas the credit spread should be driven by distance to default and recovery rates, flat earnings are not necessarily bad for credit as long as risk premia remain under control. And policy appears to be aimed squarely at keeping a lid on risk premia. Clearly this argument would not hold if earnings fall back significantly, or in other words a recession became the central case. “ 

and also added:
"Total return in credit should be seen as less risky if the Fed is taking yields on the risk-free rate down at longer maturities."  - source Nomura

Why is so?
We agree with Nomura namely that it depends who sets the cost of capital, markets or policymakers:
"So, if the drivers of returns remain precariously balanced, leaning together like drunks on a tram so to speak, then the undoubted outperformers we maintain are fixed income products, in particular HY and IG. What could go wrong with this? Well obviously two things – policy is ineffective and another recession occurs, or policy is effective and the economy booms. 

Central banks are now well outside their “normal” remit of setting short-term interest rates and are instead attempting directly to set the cost of capital for a series of normally market-determined assets. In the US the Fed has embarked on twist, and now MBS purchases, and in the euro area the ECB has embarked on contingent shifts in front-end government bond yields toward a policy-mandated level. While the motivation for each may be rather different (market failure considerations versus stimulus), the impact on other asset classes is of a great deal of interest via portfolio rebalancing as competing required returns must react. 

If we think about this in terms of the securities market line (SML) from the capital asset pricing model (CAPM) then the debate may be easier to get a handle on. 

Normally we treat central bank policy action as shifting the intercept of the securities market line up or down with the setting of interest rate policy - the risk-free rate. The slope of the securities market line (SML) is seen as being set by fundamentals (how risky the market portfolio is seen to be and the general aggregate level of risk aversion). This does not mean that individual assets can't migrate up and down the SML as their perceived betas shift around - the most obvious recent one being the entire emerging markets fixed income world. 

By setting the risk-free rate at (essentially) zero central banks engaging in QE, twist or OMT are instead shifting the required return on individual assets out along the SML. Now, the key question is whether by doing this they can lower the slope of the entire SML line via reduced expected risk and/or higher risk appetite. 

The determining factor as to whether the whole line flattens or only the targeted asset beta shifts, we would argue, is the effectiveness of monetary policy (perhaps the slope of the IS curve might give us a clue). If policy is seen as being ineffective, then it is likely that a beta shift will occur only for the targeted asset and only if the new policy does not make the fundamentals worse. If policy is effective then the entire market portfolio does better even if the forward risk-free rate is expected to rise. 

In the present era we have made the case before but feel it is worth restating, that market confidence/sentiment has taken the place of the traditional credit channel of monetary policy. Central bankers want to generate improving expectations as a result of policy, which in turn begets better growth expectations and a flatter SML line and so on and so forth. 

Anything that detracts from that bullish sentiment undermines the credibility of the policy. Detractions can be mistakes elsewhere - i.e. Europe or EM growth - or perverse effects of the policy itself. In terms of the former, note how EM equity betas rose as the Fed engaged in Twist. This is partly because EM growth concerns began to rise then. 

And in terms of policy having perverse effects, we have argued that the attempt to set a lower cost of capital for all assets merely causes a distortion (unless there is genuine market failure) in the cost of capital across different quality firms and assets, which is unwarranted given their intrinsic risks. 

This may go some way to explaining the curious lack of M&A, buy backs and private equity deals over recent times. Could it be that strong firms are loath to pay what are perceived to be high prices for weaker firms? Could it be that by shifting the entire SML down policy has lifted all boats including the weakest and thus has delayed or actually removed the need for poor, value-destroying businesses and managements to change business strategy or be ¡°taken out¡± of the market? 

If this is the case then it is an extremely important consideration since it implies that we should continue to expect only modest growth in aggregate demand since cash balances will continue to be held rather than "worked" and firms that by definition are using capital unproductively will continue to exist

The unpleasant side effect of intervening to set the cost of capital is that it probably means more modest medium-term growth expectations than otherwise might be the case, which leads to lower expected returns being attached to equities and initially at least a higher required return for holding them (i.e. a fall in price now). And this can happen without high volatility owing to liquidity swamping risk premia." - source Nomura

Arguably in our recent conversation "The World of Yesterday", we posited that a Mouse trap, or Bull Trap, had indeed definitely been loaded in the credit space, looking at the worrying trend of the return of Cov-lite loans financing (Back in May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz..."). Not only are we seeing the return of dubious financing that peaked before the financial crisis such as Cov-lite financing, but we are also seeing the return of payment-in-kind notes as reported by Sarika Gangar and David Holley in Bloomberg in their article  - Bubble-Era Financing Returns as Profits Falter on the 11th of October:
"A type of financing that peaked before credit markets seized up four years ago is staging a comeback just as concern mounts that corporate profits are falling and the global economy is losing steam. Offerings of $2.1 billion in the past 30 days of so-called payment-in-kind notes, which allow borrowers to pay interest with extra debt, account for more than a third of this year’s $6 billion of deals, according to data compiled by Bloomberg. Pharmaceutical Product Development Inc., a Wilmington, North Carolina-based contract research firm, sold $525 million of the notes yesterday. Sales of high-yield, high-risk bonds are soaring to a record pace as interest rates hover at unprecedented lows send investors toward riskier assets. JPMorgan Chase and Co. says credit metrics are deteriorating, with leverage at investment- grade borrowers potentially approaching financial crisis levels by year-end, as the International Monetary Fund lowers its global growth forecast to the slowest pace since 2009. “You only hear about PIK bonds when the high-yield markets are really frothy,” William Larkin, a fixed-income money manager who helps oversee $500 million at Cabot Money Management Inc. in Salem, Massachusetts, said in a telephone interview. The trend “is OK if we’re at that part of the cycle where things start to accelerate. But we don’t know that.” " - source Bloomberg.

So yes, the above confirms  that the Credit Mouse trap has indeed been set and loaded as confirmed by the conclusions of the  quoted Bloomberg article:
"While PIK bonds may perform for a while, “when they stop performing well they become virtually unsellable at times, and they can drop in price rather substantially,” James Kochan, chief fixed-income strategist at Wells Fargo Funds Management LLC in Menomonee Falls, Wisconsin, said in a telephone interview." - source Bloomberg

On a final note as far as Consumer-Loan growth is concerned, according to Bloomberg Chart of the Day, it helps schools, not stores:
"The CHART OF THE DAY compares the amount of consumer credit outstanding with the total excluding student loans, as compiled by the Federal Reserve. Borrowing for school expenses accounted for all of this year’s 2.9 percent growth in credit. Any gains for retail chains will be limited to “some incremental spending” made possible by the education loans, John Heinbockel, an analyst from Guggenheim Securities LLC based in New York, wrote two days ago in a report. The current rate of borrowing may be unsustainable, the report said. This year’s average monthly balance of consumer loans rose 4.6 percent through August from a year earlier. The increase exceeded growth in household income by 1.4 percentage points, about twice the average gap since 1969." - source Bloomberg.

“As long as the music is playing, you've got to get up and dance." Citigroup's ex-chief executive, Charles O. Prince -  July 2007.

 Stay tuned!

Wednesday 10 October 2012

QE - To infinity ... and beyond!

"The last proceeding of reason is to recognize that there is an infinity of things which are beyond it. There is nothing so conformable to reason as this disavowal of reason." - Blaise Pascal, French philosopher

Apologies dear readers for not having posted recently our credit ramblings, but, once in a while, bloggers such as ourselves are in the need for some R and R (Rest and Recuperation). This is exactly what we did. We rested our mind while enjoying some wine tasting in the United States. Of course, one would immediately turn their initial thoughts on California. Luckily the immensity of the United States means diversity, and we found ourselves enjoying Long Island and its many wineries as well as a particular Paumanok 2005 Cabernet Franc but then again, we fall prey to our usual rambling habits. 

Following up on our recent conversation entitled "Zemblanity", and "The inexorable discovery of what we don't want to know", we could not resist to refer to Buzz Lightyear's catchphrase from the Toy Story franchise in our title as another reference to the unlimited pledge in Quantitative Easings by the Fed and the continuous game of global "easiness" provided by most Central banks across the globe (Fed, BOE, BOJ, ECB). In this post we will revisit the consequences of unlimited QE.

Buzz Lightyear of Star Command (central bankers), space ranger protecting the universe from Evil Emperor Zurg (deflation):
While Buzz Lightyear was indeed the most popular toy in the first outing of Toy story, it looks to us that currently QE is the most popular toy being used by our central bankers over the world. But, in similar fashion to our Buzz Lightyear from the movie Toy Story, it looks to us that central bankers are indeed as deluded as Buzz Lightyear was. Buzz Lightyear in the first movie believed he was a space ranger before realizing he was just a toy. It appears to us that, courtesy of "Zemblanity", at some point, central bankers will have indeed to realize that QE is just a toy and a dangerous one to play with for too long in fighting Evil Emperor Zurg (deflation). This is clearly illustrated by Japan's plight in fighting off "Zurg" for the last 25 years as indicated by Bloomberg:
"The Bank of Japan’s failure to halt yen gains through domestic bond buying over the past decade is pushing policy makers to consider a new tack, purchasing foreign debt to produce the currency weakness exporters crave. The CHART OF THE DAY shows the yen’s effective exchange rate climbing to about 5 percent above its 10-year average, ignoring BOJ asset purchases that helped swell the money supply to 124.33 trillion yen ($1.6 trillion), the most ever in data going back to 1970. Policy makers’ efforts are faltering as bank lending dropped 3 percent from a six-year high reached in March 2009, preventing the cash injected into the financial system from filtering into the wider economy. Buying foreign bonds is a promising tool, Economy Minister Seiji Maehara said this week, echoing the two newest BOJ board members who’ve said new types of easing should be considered. BOJ Governor Masaaki Shirakawa said such purchases would be a type of currency intervention, which only the government can do. The BOJ starts a two-day policy meeting today. “Current policy tools are reaching their limits in ending deflation and yen appreciation, increasing political pressure on the BOJ,” said Koji Takeuchi, senior economist at Mizuho Research Institute. “Purchases of foreign bonds are being considered, which would require changes to the central bank charter.” The yen traded at 78.48 per dollar as of 8 a.m. in Tokyo from 78.49 yesterday. The currency reached a post World War II record of 75.35 per dollar on Oct. 31, 2011. The yen’s 14 percent climb over the past three years is reducing earnings at exporters." - source Bloomberg.

The approach of "infinity...and beyond" has been clearly demonstrated by our "Buzz" Central Bankers' willingness in committing to maintaining interest rates at zero for a long period. In Japan's case, the BOJ has promised to keep rates at or near zero until inflation reaches a certain level, and thus close to an "inflation target". "To infinity and beyond!"...One may posit, as Japan has been playing with its QE toy for the last 25 years.

In a recent note published by Nomura Securities entitled "Lessons from Japan" - Securities Investment in a Low-Yield, Low-growth Environment from the 2nd of October 2012, they indicate the following:
"Japanization trades in rates markets BOJ measures were in response to falling growth and inflation expectations The roots of Japanization lie in the substantial declines in growth and inflation expectations (graph below). This process took place over more than 10 years, starting with the financial bubble burst in the early 1990s – the BOJ’s policy duration and QE measures appear to have had a direct effect on JGB price action, but the BOJ only responded to the low growth and inflation environment." - source Nomura.
"Government bond markets mean revert under policy duration regime Policy rates are the starting point in shaping the yield curve. As these rates are likely to be kept close to zero for a prolonged period, government bond yields will likely be anchored as if to mean revert, with their volatility falling (see below graph). As such buying maturities with high carry and roll on dips (i.e., on yield upswings) and holdinh onto them may appear the best option as  long as the low-rate commitment remains in place." - source Nomura.

Unintended consequences of playing too long with a QE toy:
"Inflows of short-term capital create bond bubble 
In addition to long-horizon trades for carry and roll, government bond markets attract large amount of flows seeking short-term gains, which have resulted in yield curve shapes that are significantly flatter than the ones justified by the expected growth and inflation rates. When central banks buy government bonds as part of QE measures and thus tighten supply and demand in the market, government bonds are likely to outperform other assets due to capital gains, attracting further inflows of short-term capital. Moreover, this kind of rally is likely to be bolstered by optimistic views on market fundamentals that justify the low-rates regime (for example, the central bank will keep policy rates low further into the future, and the economy will become increasingly deflationary)." - source Nomura.

We agree with the above.

Nomura also made an important point in their note from the 2nd of October 2012 relating to the Taylor rule. A Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle):
"Undue reliance on policy duration may be risky
Considering that monetary policy measures are devised in response to changes in the macro backdrop, we should not ignore the impact that a low growth and inflation regime has had in shaping the government bond market and monetary policy, i.e., the concept of the Taylor rule. For that matter, we note that the Fed’s current forward guidance indicates that it will keep fed funds rates at ultra-low levels through “mid-2015,” but this is quite a bit later than the timing that would be deemed appropriate according to the Taylor rule*. Although the BOJ has set achieving 1.0% CPI inflation as its policy objective and thus has not specified the time until which it will keep the current policy in place, the market’s expected policy duration has been extended close to historical levels, after which sharp JGB sell-offs have followed – we doubt that such high expectations can be sustained as the economy begins to pick up." - source Nomura.

*Based on the current output gap and the Fed’s economic projections, the Taylor Rule would suggest that the Fed’s ZIRP should continue only until early 2014.

Some may put too much hopes that our "Buzz Lightyear" central bankers have designed an escape capsule from their "infinity...and beyond" policies.

We also agree with Nomura's chief economist Richard Koo in his most recent publication "Reconsidering quantitative easing" published on the 2nd of October, namely that one should not put too much hopes on the escape capsule:
"Perceived limits on fiscal policy increase pressure on monetary policy
In spite of these experiences, the baseless view that fiscal policy has reached its limits has come to dominate the debate in many countries, including Japan. That, in turn, has placed a great deal of pressure on central banks and led them to inject a sea of liquidity into the market when there is no reason why more liquidity should have any effect. 
This liquidity will create no problems as long as there is no private demand for loans, since the funds essentially sit in the financial system. 
The problems come when private demand for loans returns to normal levels and those funds resume circulating. 
Central banks must tighten aggressively when loan demand picks up 
As soon as private loan demand recovers the central bank will have to mop up the excess liquidity, which is currently running at two to three times the normal level. Otherwise prices could double or triple. 
But to do so the central bank must sell the bonds it bought, putting upward pressure on interest rates just when the private sector is ready to borrow money again. 
The Fed, for example, will have to sell $1.4trn in bonds when conditions in the private sector return to normal, at a time when the economy is recovering and businesses and households are becoming sensitive to interest rates. 
And if the market decides that the central bank is not mopping up excess liquidity fast enough, that alone could lift private inflation expectations and send bond yields sharply higher. In short, the central bank finds itself in a difficult position whether it sells the securities or not. Either way a major ordeal awaits both the central bank and the bond market. 
Once this point is reached, the central bank will probably attempt to reduce the “real value” of liquidity in the market by sharply raising the statutory reserve ratio for commercial banks, a tactic frequently employed by the People’s Bank of China. 
But all these measures will have significant negative implications for the economic recovery. While QE will do little damage at a time when private loan demand is weak or nonexistent, like today, it requires the central bank to engage in aggressive tightening just when the private sector is beginning to recover." - source Nomura - Richard Koo.

Provided our "Buzz Lightyear" central bankers decide to use the escape capsule from their stricken spaceship, Richard Koo's commented:
"The magnitude of the increase would depend on how much liquidity had to be absorbed, but a major increase is possible given that both the economy and private loan demand will be recovering. 

The liquidity supplied to the market should be manageable if the rebound in private loan demand is weak, as it has been in Japan since 2006. But there could be negative implications for the economic recovery—including a sharp rise in long-term rates—if the central bank is forced to mop up these funds by selling long-term bonds." - source Nomura.

But then again a future rebound in private loan demand is questionable.

A sharp rise in long-term bonds would have indeed devastating effect on a country such as the United Kingdom and it reminded us what we wrote back in our June 2011 conversation "The UK conundrum - Stagflation redux and other housing/banking issues": "Bank of England will have to stay accommodative for longer than expected, given two thirds of UK mortgages depend on short term rates. This means that the UK households will continue to be battered by a declining real income, meaning an absolute decline in the standard of living. At the same time UK banks are piling on Gilts like US banks are piling on US Treasuries, not lending, shrinking their balance sheet but earning a nice spread in the process by borrowing close to zero and locking the spread on Government bonds."

So billionaires seeking safe haven for their wealth by investing in a luxury London home should be well advised to reconsider given gold has indeed presented higher returns from fixtures and fittings in the last decade than the property itself according to Knight Frank, as reported by Bloomberg:
"A typical so-called super-prime property in London’s Kensington neighborhood would have cost 24,000 ounces of gold a decade ago, compared with about 9,800 ounces now, Knight Frank said today in a report. “To visualize this, 9,800 ounces would be a cube about the size of a small footstool, admittedly a heavy one,” the London-based real estate broker said. The CHART OF THE DAY shows how the value of super-prime homes doubled in the past 10 years and climbed 14 percent since their previous peak in March 2008. In comparison, gold prices have surged more than fivefold in the last decade. Knight Frank defines super-prime as homes valued at 10 million pounds ($16 million) or more in central London neighborhoods such as Knightsbridge, Kensington, Mayfair and Belgravia." 
- source Bloomberg

Yes, every asset class has a cycle, and until the escape capsule is triggered, we are unlikely to see an end to the trend in surging gold prices, although the scarcity of prime real estate for sale have enabled prices to held their value better. You have a similar scarcity case in Paris, for prime real estate.

Some additional important points made by Richard Koo in his recent are the following:
"More liquidity = greater economic instability once QE ends
Those making a case for inflation targeting or GDP targeting never say how much liquidity will be needed. All they say is that the supply of liquidity should be increased until the targets are reached. 
But the actual outcome would be very different depending on whether achieving the targets required a 20% increase in liquidity or a 200% increase. 
If only a 20% increase were needed, it might be possible to drain excess liquidity in the course of normal market operations once the targets were reached. But absorbing a 200% increase in liquidity would require massive bond-selling operations that could have a major negative impact on interest rates and the economy. 
That the BOE was unable to turn the UK economy around with a 300% increase in the supply of liquidity suggests at the very least that 300% would not be enough. 
Moreover, economic activity supported by such a reckless increase in liquidity is likely to be unstable and to become even more so once the central bank began mopping up excess liquidity. 

QE may have net negative economic impact when viewed across life of program 
It has been argued that during a balance sheet recession, when the private sector is rushing to minimize debt, liquidity supplied by the central bank does not stimulate the economy. Once the private sector completes its balance sheet adjustments and is ready to borrow again, draining liquidity will serve to lift interest rates and depress the economy. 
This means if we examine the impact of QE across the life of the program, the negative impact of mopping-up operations may actually outweigh the positive impact of the initial easing. 
During a balance sheet recession, after all, the absence of private loan demand dulls the economy’s sensitivity to interest rates, which means its response is likely to be muted regardless of whether the central bank engages in QE. 
When the economy starts to recover, however, private loan demand would have also picked up by then, increasing the economy’s interest rate sensitivity. A rise in rates then would have a major negative impact. 
Viewed overall, it may be better under some circumstances not to supply excess liquidity at all during a balance sheet recession. This is because without it, there is no need to drain liquidity once the economy pulls out of the recession. 
The debate up to now has ignored the fact that rates will rise when liquidity is drained from the system, with potentially adverse consequences for the economy. Proponents of further accommodation continue to urge the central banks to leave QE in place until deflation has been vanquished. But they might come to a very different conclusion if they also considered the impact of the exit from QE. 

Time to reconsider quantitative easing 
So far, no QE program has been successful, even if we consider only the initial impact and ignore the exit process. The Japanese, US, and UK economies all remain in the doldrums. It is hard not to question the overall effectiveness of QE when we consider the fact that aggressive tightening (i.e., a draining of excess liquidity) awaits once the private sector finally starts looking forward again. 
Recently QE has been welcomed in some quarters for its ability to boost share prices or devalue the local currency. But there are pitfalls here as well. 
Share prices, for example, must ultimately be justified by earnings. But while equity prices have been rising in the US, the economy remains sluggish and the outlook for corporate profits is not particularly bright." - source Nomura.

Yes, share prices must ultimately be justified by earnings, but also by "inflation expectations" so "mind the gap" between consumer discretionary stocks and consumer staples stocks:
"As the CHART OF THE DAY illustrates, the S&P 500’s consumer-related industry groups increasingly mirrored each other after the index peaked at a record five years ago today. They were the period’s best performers among the 10 broadest industry gauges in the S&P 500. Makers of food, beverages, household products and other consumer staples set the pace by rising 29 percent. Companies most dependent on consumers’ discretionary income -- retailers, media companies, homebuilders, automakers -- ranked second with a 25 percent gain. The chart also shows financial stocks, whose 55 percent decline was the steepest among the 10 groups. Consumer-discretionary stocks may falter as a falling dollar spurs inflation, Leger wrote in an Oct. 5 report. The Dollar Index, a gauge of the U.S. currency’s value against the currencies of six major trading partners, has dropped as much as 6.1 percent from this year’s high on July 24." - source Bloomberg

Following what we commented in our previous conversation "Zemblanity" on what our Buzz Lightyear central bankers might find out in targeting the unemployment level (given the relationship between M2-velocity and the US labor participation rate over the years) is that the jobless rate can be a misleading gauge of labor market health as indicated by Bloomberg:
"One reason the Federal Reserve may be unable to reach consensus on an unemployment target: the jobless rate can be a misleading gauge of labor market health. While unemployment has fallen to 8.1 percent from 10 percent in 2009, the CHART OF THE DAY shows the percentage of people working, known as the employment-population ratio, has remained near its lows of the recession, suggesting limited progress toward a recovery in jobs. “In a better economy we would see an improvement in this data,” said Adolfo Laurenti, deputy chief economist at Mesirow Financial Inc. in Chicago. While the ratio has fallen as the baby boomer generation retires and because more students are returning to school “the tougher nut to crack is those people who are truly discouraged workers, who could be in the job market but are leaving.” The employment-population ratio climbed to a record high 64.7 percent in April of 2000 before falling as low as 58.2 percent in December 2009, the lowest level since 1983. A lack of labor-market improvement, even with the drop in the unemployment rate, prompted the Fed to begin a third round of asset purchases, or QE3, in which it’s buying $40 billion a month of mortgage-backed securities. While Fed policy makers have proposed continuing the Fed’s accommodative policies until the unemployment rate hits a certain level, as long as inflation remains contained, they haven’t been able to reach consensus on a jobless target. “We want to see the unemployment rate come down, but that’s not the only indicator, obviously, of labor market conditions,” Fed Chairman Ben S. Bernanke said in a Sept. 13 press conference. “The unemployment rate came down last month because participation fell; that’s not necessarily a sign of improvement.”" - source Bloomberg.

Once again, there is what you see and what you don't see in true Bastiat fashion.

To infinity...and beyond...we think.

Meanwhile Employment opportunities remain elusive for some Americans meaning that the poverty rate could remain high particularly with the looming risk of the fiscal cliff:
"The CHART OF THE DAY shows that the percentage of Americans living below the poverty line was little changed last year at 15 percent, or 46.2 million people. The poverty line is defined by the U.S. Census Bureau as those living on less than $11,702 per year, or $23,021 for a family of four. Food-stamp use climbed to a record 46.7 million people in June, according to the Department of Agriculture." - source Bloomberg

Unless the housing rebound in the US is genuine, and the private wealth effect translates to the real economy, we cannot see the long term benefits but mostly greater risks in maintaining for too long the QE toy in place.

 "I cannot help it - in spite of myself, infinity torments me." - Alfred de Musset

 Stay tuned!
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