Thursday 29 November 2012

Why have Global Macro Hedge Funds underperformed?

"There is no better than adversity. Every defeat, every heartbreak, every loss, contains its own seed, its own lesson on how to improve your performance the next time." - Malcolm X 

Many pundits have recently looked at the lackluster performances of Hedge Funds from the European crisis perspective. We would like to have a different approach, namely the one of volatilities.

Courtesy of our good friends at Rcube Global Macro Research, the answer appears to be more simpler. It's the volatility stupid! Or lack thereof....

"Volatility across all asset classes has crashed. As the chart below highlights, when this happens, global macro strategies tend to suffer on both an absolute and relative basis."

"While investors have poured massive amounts in long equity volatility products over the last 9 months, as a hedge against long stocks exposure, this strategy failed spectacularly. We believe more pain lies ahead for long equity volatility trades."

We would like to highlight an interesting pattern on VIX future, illustrated by the following kernel regression analysis between these variables:

X: the sum of 100 days Z-Score of the S and P500 Index and the SPVXSTR Index (a rolling long VIX strategy, tracked by the VXX ETF).

Y: Annualized expected returns of the SPVXSTR Index

We see that when we are at the lowest of the range (meaning that volatility does not react to a market dip, which is currently the case), further weakness should be expected on vol forwards. 

Regarding other measures of sentiment/positioning, investors still seem to be extremely defensive while stock markets have substantially rallied over the last few months. This remains the most hated bull market in recent history. 

Classic measures of sentiment are still deeply negative and at levels that are usually reached after medium to long term bear markets.

The CBOE put call ratio reached historical highs on both the 10 and 90 days sma last week:

Stocks have very substantially lagged credit this year. We have advertised in recent publications why
we believe corporate credit outperformance is over.

The recent sharp improvement in US consumer sentiment doesn’t seem to have been priced by the stock to bond ratio.

We are also aware that earnings revisions have been on the weak side recently.

In addition to the great points made by our good friends from Rcube, with interest rates at zero it is as well very challenging for Global Macro Hedge Funds to play an economy against another in currencies markets due to the fall in volatilities.

To bring some solace to Global Macro Hedge Funds, their biggest liquidity and volatility providers, namely   top investment banks, are suffering as well, as reported by Neal Amstrong article in Bloomberg - Biggest Traders Hurt as Fed to ECB Crush Volatility - on the 23rd of November:
"The world’s largest currency traders say foreign-exchange revenue is sliding as central-bank policies stifle price swings and cut volumes by $300 billion a day. Deutsche Bank AG, the biggest dealer based on Euromoney Institutional Investor Plc data, says narrower margins cut revenue “significantly” last quarter. Barclays Plc, the third-largest, says foreign-exchange sales are dropping and fourth-placed UBS AG says it has been hurt by lower volatility. Daily turnover as measured by CLS Bank, operator of the largest currency-transaction settlement system, slid 6 percent to $4.72 trillion in the third quarter from the year-earlier period. The combination of interest rates at, or near, record lows in the U.S., Europe and Japan is diminishing the allure of the dollar, euro and yen, the three most-traded currencies. From Switzerland to Brazil, central banks are establishing controls on exchange rates, making it less lucrative to trade the franc to the real. “With interest rates being at zero it’s very difficult now to play the cyclical differences in economies,” David Bloom, global head of currency-market strategy at HSBC Holdings Plc in London, said in a telephone interview on Nov. 20. “We’re in a structural world where if you have an economic event, you are best placed to think about it in terms of equities or bonds rather than foreign exchange.”

"Past performance speaks a tremendous amount about one's ability and likelihood for success."
Mark Spitz

Stay tuned!

Monday 26 November 2012

Chart of the Day - S&P 500 earnings Yield versus US High Yield

"A picture shows me at a glance what it takes dozens of pages of a book to expound." 
- Ivan Turgenev (Fathers and Sons in 1862)

Great chart from Business Insider on the historic divergence between dividends stocks and High Yield - Morgan Stanley Makes Its 2013 Market Call, And Presents Three Big Ideas For American Investors

Morgan Stanley Makes Its 2013 Market Call, And Presents Three Big Ideas For American Investors

- source Bloomberg, the Yield Book, Morgan Stanley Research.

Stay tuned!

Sunday 25 November 2012

Credit - It's Alright Spreads are Coming Back

"The trouble with the world is that the stupid are cocksure and the intelligent are full of doubt." - Bertrand Russell, British philosopher 

This week we decided in our title selection to make a veiled a reference to one of pop British group Eurythmics top hit from their 1985 second album namely "It's Alright (Baby's Coming Back). Given credit spreads seem somewhat totally detached from economic reality, for now, we thought, using the lyrics of the song and the latest raft of economic data would be totally appropriate as per our usual rambling habits.

While we already touched on the irony of the performance of credit in 2012 with the clear disconnect with economic reality in our conversation "The year of the empty hand", we thought this week we should focus on the outlook for credit in 2013, given we are indeed full of doubt and not cocksure like some.

It's Alright Growth's coming back...In Europe? Not really.

- source Thomson Reuters DataStream / Fathom Consulting.

It's alright spreads are coming back...

Yes, they have and in a very significant way in 2012 but the disconnect with deteriorating fundamentals would warrant caution in 2013 and the need for clear selective bond picking based on assessing properly issuer by issuers will be even more essential next year.
- source Thomson Reuters DataStream

The market context for credit and the outlook for early 2013 was nicely summarized by Suki Mann, Credit Strategist for Societe Generale, on the 22nd of November:
"We’re tightening up in cash with maximum effect in the high yield and X-Over space, while investment grade credit is edging better every session. Outperformance continues from peripherals. There’s a grab for yield, in what looks like the last hurrah for the year. It won’t be any different in January as we reset the counter, faced with corporate credit spreads tighter and corporate yields lower versus where they are now. We’ll still see much cash needing a home and more than likely a clear tightening dynamic to kick off the year. For now, holders of higher yielding paper who are comfortable with the issuer should not be thinking about selling (booking profits and so on), but adding where they can. Yesterday’s Bord Gais deal was 42bp tighter versus reoffer and had the effect of pulling the ESB 2019 deal with it – as if it needed it. The latter was tighter at around B+315bp having been launched earlier this month at B+371bp, while September’s deal from the ESB (maturity 2017), launched at B+590bp, was bid at B+312bp. With the plethora of deals lined up for next week, it looks like we’re seeing out the year with an upbeat tone and choosing to ignore the inability of the troika to agree a deal on Greece, while US fiscal cliff concerns seem to have abated and even Spain’s woes have been put on the back-burner."

The credit chadburn is clearly still on full ahead. IG returns YTD broke through the 12% barrier in November on a combination of lower bund yields and tighter credit spreads and demands for credit remains elevated, it is clearly due to "Yield Famine".

As Societe Generale put it in a recent note:
"The grind is relentless: There’s no mercy for those under-invested at the moment. Secondary market liquidity is very poor and the new issues are so oversubscribed that only the chosen few are getting anywhere near average or above average allocations. Corporate credit continues to grind tighter, pushing IG returns YTD to over 12% and HY to 20% (iBoxx index). The volatility from headlines/macro/elections is impacting equities and the iTraxx indices, but cash credit retains its lustre. This has been the story for much of 2012, and will be for 2013 as well. Spreads have fallen by 50% this year, and while we don’t think they will by as much next year, another 25-30% is feasible. For now, frustrated investors are generally looking to add, but the new issue market is the best route to get some paper on board. Issues are 4-7x oversubscribed and performing on the break in most cases. We look for the whole dynamic to stay intact into year-end." - source Societe Generale.

We are witnessing the "Japonification" of the European Credit Markets which we touched on in our July conversation "Yield Famine".

Below are some key points highlighted by BNP Paribas relating to investor views and summarizing the views of several (fixed income focused) hedge funds, asset managers and private banks they have visited recently, eerily reminiscent of the 2005/2006 market context before the credit bubble burst:
"- Most had a very good performance and intend to protect their performance (have reduced exposure recently).
 -“Search for yield” demand applies to everyone. The focus was on hybrid corporate bonds, Financials, high yield bonds, EM and ABS instruments. 
- Some were eyeing an exit from high grade credits. The yield of non-fins iBoxx index is now below 2% and this isn’t enough for some institutional investors. 
- There was appetite brewing for high yield, EM and illiquid credits to capture more yield
- Even the most skeptical are “no longer negative on Europe” 
- Consensus view was to “buy on dips”, which according to one HF could trigger a rally (with nobody to sell it) 
- One investor thought the ITRX Main could trade at 50-60bp next year (currently 130) given a decrease of volatility and shortage of assets. 
- There is strong appetite for EM bonds from private banks in particular. 
- No one was active in sovereign CDS anymore."

As far as fixed income allocation is concerned, it has been the big winner in 2012 as indicated by CreditSights recent note on the 21st of November on Euro Investment Funds entitled - No Stocks, Just Long Bonds:
"As part of that stretch for yield, investment funds' purchases of bonds have also been overwhelmingly in longer-dated instruments. Over the four quarters to 3Q12, net allocations to short-dated bonds have been zero; all €168 bn in net allocations to bonds were to two-year-plus instruments."  - source CreditSights

"I'll be your cliff (you can fall down from me)."- It's Alright (Baby's Coming Back)  lyrics - Eurythmics 1985

In last week's conversation we focused our attention to the risk of "Profit Cliffs" rather than the highly commented fiscal cliff. We would tend to agree with a recent chart from Bloomberg from the 20th of November, indicating that the budget gap hinges on the economy, not the fiscal cliff - source Bloomberg:
"Sustaining U.S. economic growth may narrow the federal government’s budget deficit more than raising taxes or reducing outlays, according to James W. Paulsen, Wells Capital Management Inc.’s chief investment strategist. The CHART OF THE DAY tracks deficits and surpluses as a percentage of nominal gross domestic product, unadjusted for inflation, since 1969. Paulsen included a similar chart in a report two days ago. Deficits totaled 6.9 percent of nominal GDP for the 12 months ended in September, according to data compiled by the Treasury. The gap narrowed from 10.4 percent in December 2009, six months after the latest recession ended, even as President Barack Obama and a Republican-led House of Representatives sparred over fiscal policy. “We’ve had gridlock throughout this recovery and yet the deficit’s been improving all on its own,” Paulsen said during a Bloomberg Radio interview on the 19th of November. At the current pace, the budget gap is poised to fall below 5 percent of nominal GDP in two years, according to the Minneapolis-based strategist. Any “grand bargain” by the White House and Congress on the so-called fiscal cliff of tax increases and spending cuts runs the risk of cutting off economic growth, which is mainly responsible for the shrinking deficit, he said. Nominal GDP has expanded at a 3.8 percent to 4.5 percent pace since the second quarter of 2010, based on year-over-year changes. Last quarter’s growth amounted to 4 percent." - source Bloomberg.

Last week we argued:
"We believe the biggest risk is indeed not coming from the "Fiscal Cliff" but in fact from the "Profits Cliff". The increase productivity efforts which led to employment reduction following the financial crisis means that companies overall have reached in the US what we would call "Peak Margins". In that context they remain extremely sensitive to revised guidance and earnings outlook as we moved towards 2013." - Macronomics - The Omnipotence Paradox.

Indeed, dimmer profit outlook has been seen weighting on stocks as of late as indicated by Bloomberg:
"Lower earnings estimates are dragging down stocks from this year’s highs and their full effect has yet to be felt, according to Hasan S. Tevfik, a global equity strategist at Citigroup Inc. The CHART OF THE DAY compares the performance of an earnings-revision index, or ERI, compiled weekly by Citigroup with MSCI Inc.’s All-Country World Index since the beginning of last year. Tevfik had a similar chart in a report yesterday. Since the first week of May, the revision index has been less than zero, which means there were more estimate cuts than increases among analysts. The MSCI gauge of stocks in developed and emerging markets rose to its peak for the year in September and then lost as much as 6.7 percent. “ERI remains an anchor for global equity markets,” Tevfik wrote. A similar disparity between estimate changes and share prices in 2011 was resolved when stocks declined in July and August of that year, the London-based strategist added. The chart highlights the earlier retreat. Earnings projections for next year are poised to decline further, he wrote, citing the gap between analysts’ estimates for companies and strategists’ projections for stock indexes. Citigroup strategists are collectively calling for profit growth of 7 percent, trailing a 12 percent increase implied by company-specific estimates, Tevfik wrote. The lower figure maybe too high, he added, as economic growth slows worldwide." - source Bloomberg, Chart of the Day - 20th of November

Mind the Gap...

"I will be your storm at seas" - It's Alright (Baby's Coming Back)  lyrics - Eurythmics 1985

According to Bloomberg:
"The bank systems of Spain, Italy, Portugal, Ireland and Greece collectively borrowed a record 865 billion euros (gross) from the ECB in June 2012, 250% more than a year earlier. Since the commitment from Mario Draghi to "do whatever it takes," lower and more stable yields and a gradual opening of wholesale markets should afford banks the ability to reduce ECB reliance."

2013 could be a story of lower yields, lower volatility and lower ECB reliance. 2011 was dominated by capital shortfalls for banks leading to liability management exercises (bond tenders, debt to equity swap, skip of calls for Lower Tier 2 bonds, and other interesting exercises we discussed at length in numerous conversations) in conjunction with the dearth of liquidity (issues with dollar funding) leading to the ECB saving the day by providing cheap funding via the LTROs. 2013will also be a story for banks of additional deleveraging and restructuring of some of their activities. For instance structured finance was a big victim in 2012, and we discussed the impact it had on shipping in our conversation - "Shipping is a leading credit indicator" - A follow up - April 2012.

The current European bond picture with slightly lower Spanish 10 year government bond yields at 5.68% this week and Italian 10 year government bond yields at 4.77% with somewhat rising Core European Government bond yields  - source Bloomberg:

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
A story of falling High Yield risk premiums as indicated by the fall in the Itraxx 5 year Crossover index spread level back towards 500 bps in 2012 and falling volatility (now at 21%).

"I'll even be your danger sign." - It's Alright (Baby's Coming Back)  lyrics - Eurythmics 1985

"Given credit investors are anticipatory in nature, in 2008-2009, credit spreads started to rise well in advance (9 months) of the eventual risk of defaults" - Macronomics - The Omnipotence Paradox.

Although default rates have remained low in 2012 as indicated by the below graph from Societe Generale, when it comes to anticipating default risks, credit spreads should indeed be your danger sign in 2013:
- source Societe Generale Cross Asset Research - Happy Hunting - Credit Weekly - 9th of November.

While credit yields are indeed heading towards 2% as shown by Societe Generale Cross Asset Research:

Credit nevertheless remains a compelling asset class in this low government yield environment given the yields are many times higher than that of government debt:
- source Societe Generale Cross Asset Research - Happy Hunting - Credit Weekly - 9th of November.

So if indeed Europe is repeating Japanese mistakes and we are witnessing the "Japanification" of credit markets, as we wrote in April in our conversation - "Deleveraging - Bad for equities but good for credit assets", credit could continue to outperform equities in 2013 but if the US economy is Japan on "fast forward", it should grow much faster than Europe in 2013:
- source Nomura - 14th of November 2012.

On a final note, the US is set to return as Japan's top export buyer as indicated by Bloomberg:
"The U.S. is poised to displace China as Japan’s largest export market as American consumer confidence improves and a territorial dispute strains relations between Asia’s two largest economies. The CHART OF THE DAY shows the percentage of Japanese exports purchased by the two nations, and the Conference Board’s confidence index for the U.S. since the end of 2008. China has been the bigger market from February 2009, except for a single month. So far this year, China has taken 18.2 percent of shipments compared with 17.3 percent for the U.S. A dispute over islands in the East China Sea claimed by both Asian nations has damaged economic and political ties, with Japan’s exports to China declining for the five months through October from a year earlier, finance ministry data show. China’s share of Japanese shipments was as high as 21 percent in late 2010 and early 2011, while the U.S. proportion dipped to as low as 13 percent in April 2011." - source Bloomberg

"Worry is the interest paid by those who borrow trouble." - George Washington

Stay tuned!

Sunday 18 November 2012

Credit - The Omnipotence Paradox

"The omnipotence of evil has never resulted in anything but fruitless efforts. Our thoughts always escape from whoever tries to smother them." -   Victor Hugo 

"The word "Omnipotence" derives from the Latin term "Omni Potens", meaning "All-Powerful" instead of "Infinite Power" implied by its English counterpart." - source Wikipedia.

While we recently delved into the consequences of the unlimited pledge in Quantitative Easings by the Fed and the continuous game of global "easiness" provided by most Central banks around the world in our conversation  "QE - To infinity...and beyond", as well as "Zemblanity", (being "The inexorable discovery of what we don't want to know"), we thought this week our title should be the Omnipotence paradox. Beliefs that "omnipotence" of Central Banks exist in any form can arguably be disproved. 

In similar fashion, the financial crisis and the consequent burst of the housing bubble which had taken aback the beliefs of some forefront central bankers such as Alan Greenspan; have clearly shown that Central Banks are not omniscient either (omniscient being the capacity to know everything that there is to know).
"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief." - Alan Greenspan -  October 2008.

Looking at the additional raft of economic data indicating the strength of the deflationary forces at play (one should never underestimate the powers of Evil Emperor Zurg aka deflation). For instance, a simple look at the margin pressure faced by Supermarkets, which are facing falling prices and rising costs (Fixed Income - Floating Expenses...), is clearly indicative of the deflationary forces at play as displayed by the below graph from Bloomberg relating to Food Inflation Rates:
"Supermarket chains may soon suffer as lower retail prices limit their ability to deal with surging food costs, according to Bob Summers, an analyst at Susquehanna Research Group. 
As the CHART OF THE DAY shows, grocery inflation slowed from year-earlier levels through the first nine months of the year, according to data compiled by the Labor Department. The streak ended last month, when the rate rose to 1 percent from 0.8 percent. October’s increase was too small to offset a 2.4 percent advance in prices charged by food producers. The chart displays the gaps between the inflation rates since 2001, as Summers did in his report. Deflation may occur by year-end as U.S. economic weakness leads to more intense competition in the supermarket industry, the New York-based analyst wrote. “Food inflation could return and accelerate meaningfully in the first half of 2013,” he wrote, because of higher costs for commodities affected by this year’s drought in the Midwest. This would weigh on profit margins and earnings at supermarket owners, the report said." - source Bloomberg.

We have on numerous occasions discussed shipping as being not only a leading credit indicator (with the collapse in European structured finance) but as well a leading economic growth indicator (on that subject please refer to "The link between consumer spending, housing, credit and shipping"), the recent collapse of container shipment from Shangai to Spain or Italy, which has cratered by 46% to 955 USD in five months according to ICAP Plc and as reported by Bloomberg is yet another sign of the evident deterioration of the economic outlook for Europe as we move towards 2013. As reported by Niklas Magnusson in his Bloomberg article from the 15th of November entitled - Container Rate Plunge Shows Mediterranean Cast Adrift:
"Europe’s sovereign-debt crisis has led to a collapse in the rates container lines charge on routes from China to the Mediterranean, creating a two-tier price structure as they boost fees for destinations further north. The cost of a container shipment from Shanghai to Spain or Italy has tumbled 46 percent to $955 in five months, according to ICAP Plc, with the spread between south- and north-European rates widening to $436 as of Nov. 2 from $42 a week earlier. “Fundamentals on the Asia-Med are dire and we’re hearing demand is very, very low,” said Richard Ward, an analyst at ICAP, which provides ship broking services. “That’s led to the decline in rates as carriers look to secure what cargo they can.” While the holiday season typically marks a boom in consumer goods deliveries, households in Greece, Italy, Portugal and Spain are cutting back on gifts amid rising unemployment and public-sending reductions. The plunge in south-European rates may weigh most on A.P. Moeller-Maersk A/S, CMA CGM SA and other lines with multiple Mediterranean container services. “The Mediterranean area has experienced a much sharper drop than north Europe,” A.P. Moeller-Maersk Chief Executive Officer Nils Smedegaard Andersen said in a phone interview on Nov. 9. “Consumers in northern Europe are cautious, while consumers in the south are in an outright crisis.” Shares of Copenhagen-based Maersk have gained 8 percent so far this year, valuing it at 175.3 billion kronor ($30 billion)."
"Containership lines have increased rates five times by a total of $2,200 along west-east routes from Hong Kong to Los Angeles. The latest was a $500 peak-season surcharge effective Aug. 7. This has helped prop up rates by 63% ytd. In the Bear Case, excess capacity and a weak global economy may drive rates down even with price increases, pressuring margins." - source Bloomberg

"The relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending" - Macronomics - August 2012

We have been sounding the alarm for a while when it comes to the importance of maintaining credit conditions in Europe to avoid a deflationary spiral and the fact that LTROs amounted to "Money For Nothing" but overly ambitious budget deficit  targets" in conjunction with accelerated bank deleveraging courtesy of the stupid EBA (European Banking Association) requirements of reaching a Core Tier 1 ratio of 9% before June 2012 have had the desired destructive effect. Well done...
"The deteriorating economic situation in Europe, together with BASEL III capital requirements, have led to a number of shipping banks with large portfolios to exit the sector. High profile restructurings and payment defaults have started to take their toll on the few remaining lenders. This comes at a time when we have significant capital expenditures to finance our dry bulk and tanker new building programs. The lack of liquidity is further exacerbated by falling assets values, which continued to decline during the quarter." - Dryships Financial Report -  George Economou, Chairman and Chief Executive Officer of the Company.

The term omnipotent has been used as well to connote different religions. We believe the term omnipotent can be used as well to rebuke some economic school of thoughts, namely the Keynesian school of thought and the Monetarist School of thought. We have argued in our conversation "Zemblanity", when looking at the evolution of M2 and the US labor participation rate that both were indicative of the failure of both theories:
"Both theories failed in essence because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of "stocks" versus "flows"."

"Credit growth is a stock variable and domestic demand is a flow variable" as indicated by Michael Biggs and Thomas Mayer in entitled - How central banks contributed to the financial crisis.

As far as our "Generous Gamblers" or Central Banks "deities" are concerned, such as Europe's top Central Banker Mario Draghi, too many have faith the "omnipotence" of  Central Banks. We would like to challenge these believers hence our title.
"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its worldplan." - source Wikipedia.

"The gazing populace receives greedily, without examination, whatever soothes superstition and promotes wonder". - David Hume

Back in our conversation "The Uneasiness in Easiness" we concurred with David Hume's approach when discussing the latest ECB OMT (Outright Monetary Transactions):
"People often lie, and they have good reasons to lie about miracles occurring either because they believe they are doing so for the benefit of their religion or because of the fame that results.
People by nature enjoy relating miracles they have heard without caring for their veracity and thus miracles are easily transmitted even where false."

In early Freudianism, early childhood analysis has shown that children can live in a feeling of omnipotence for a long period, given at birth the baby is everything as far as he knows - "all powerful" but every steps he takes towards establishing his own limits and boundaries are painful because he has to lose his original megalomania of infancy, namely that "god-like" feeling of omnipotence. While "good enough" mothering is essential in enabling children to cope with the immense shock of loss of omnipotence, lack of "good governance" and lack of leadership in both Europe and in the US mean that "the gazing populace" continues to live in complete denial and continues to trust their "deities" and have faith in the pretentious omnipotent powers of Central Banks. So until we reach the "Zemblanity" moment, as far as economic school of thought or "religions" are concerned, we agree with Dan Ariely' argument from his book "Predictably Irrational" (chapter 2 - The Fallacy of Supply and Demand), namely that demand, the determinant of market prices, can be easily manipulated but we ramble again...

So while everyone and their dog is focused on the consequences and the risk of the "Fiscal Cliff" could have on the US economy, we would like to focus this week on more important subjects, one being the "Profits Cliff" which has been clearly indicated by Albert Edwards from Societe Generale and reported by Cullen Roche from Pragmatic Capitalism in his post "Stepping Off the Profit Cliffs", the other subject being the broken credit transmission mechanism in the Eurozone. But first a quick credit overview!

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. 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 now rising towards 80%, indicative of the recent weaknesses witnessed in the equity space, which is validating somewhat a switch towards "Risk-Off" - source Bloomberg:

No wonder that our "flight to quality" picture has been supportive of both the German 5 year sovereign CDS versus the German 10 year government bond yield as of late, given the latest "deities" intervention have been revealing of their dwindling "omnipotence" powers - source Bloomberg:
German Bund moving towards record low levels while German 5 year Sovereign CDS remains so far on the lowest level reached in 2012. So far German liabilities are unchanged as we argued in the "The Game of The Century": "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."

The current European Bond Picture - source Bloomberg:
Peripheral yields have been subdued even without the OMT being triggered and Spain requesting help indicative of the "omnipotence" of the ECB.

Both the Eurostoxx and Itraxx Financial Senior 5 year CDS index representative of financial risk (25 European financial institutions risk gauge) have been converging indicative of a deteriorating picture - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

Back in our previous conversation "The Uneasiness in Easines" we argued:
"The lag in European stocks given the very recent negative tone in Europe has made them much more volatile. Should the "Risk-On" scenario persist in the coming weeks it should lead to an outperformance of European stocks versus US stocks."

This is exactly what has happened and in fact the negative stance on Europe has meant US stocks have been more vulnerable than their European peers. We have been tracking over the months the growing divergence in the performance of the Standard and Poor's 500 index and the Eutostoxx in conjunction with Italian 10 year government yields - source Bloomberg:

This convergence can as well be seen in the perception of credit risk for Investment Grade. The divergence between the CDX IG 5 year CDS index and the European Itraxx Main Europe CDS 5 year index (125 Investment Grade entities), is fading falling from 32 bps in October 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) to now 25 bps - source Bloomberg:

Could we be wrong on our US outlook? We are starting to wonder. As we indicated recently in our conversation "The year of the empty hand", the divergence of growth between the US economy and the European economy is reflected in credit prices such as the US leveraged loan cash price index versus its European peer - source Bloomberg:
The US growth in 2013 might indeed be weaker than expected we think.

It will depend on the credit conditions for small market firms given credit conditions for commercial and industrial loans were tightened both for small and large companies during the crisis as indicated in a recent report by Dr Torsten Slok from Deutsche Bank - Do Small businesses worry about the fiscal cliff - published in November:
- Firms with less than 20 employees make up 90% of all companies in the US
- Small and medium-sized firms employ half of all workers in the US
- Small and medium-sized firms generate half of all revenue in corporate America
- Small firms create around 3mn jobs every year 
- Job growth during this recovery has mainly come from small and medium-sized companies
- Global total employment in S and P 500 companies is only 17% of total employment in the US
- S and P 500 companies have been hiring significantly over the past 2 years but mainly outside the US.
Bottom line: 
Small businesses are a critical part of the US economy and have been a very important source of the US recovery over the past three years. The reason is likely that the US is a closed economy where small businesses worry less about macro risks, including the fiscal cliff."
- source Deutsche Bank - Credit Conditions for commercial and industrial loans.

Given credit investors are anticipatory in nature, in 2008-2009, credit spreads started to rise well in advance (9 months) of the eventual risk of defaults as indicated by the below graph from UBS in their European Credit Strategy 2013 Outlook  entitled - All yields are not created equal:

The uncanning similarity between the US leveraged loan cash price index versus its European peer and the US PMI and European PMI index - source Bloomberg:

"The empirical relationships between lagged economic indicators (e.g. global PMIs) and defaults suggests zero growth should move default rates up towards the 5-8% context over the next 12 months" - source UBS:

With the Eurozone technically back in recession with GDP contracting in Q3 by 0.1% q-o-q following a 0.2% q-o-q contraction in Q2, not only the contraction in the Eurozone is going to last but it will as well accelerate in the last quarter of the year. In that context, default rates will undoubtedly rise in 2013 given the surge in recent profit warnings. Q4 will therefore be worse than Q3.

Moving on to the subject of the risk of the "Profits Cliff", we believe the biggest risk is indeed not coming from the "Fiscal Cliff" but in fact from the "Profits Cliff". The increase productivity efforts which led to employment reduction following the financial crisis means that companies overall have reached in the US what we would call "Peak Margins". In that context they remain extremely sensitive to revised guidance and earnings outlook as we moved towards 2013. As we discussed in June in "River of No Returns", 56.5% of discretionary stock have a Beta greater than 1.1 and consensus for 2013 were the highest in discretionary stocks. We quoted Morgan Stanley's research note at the time of this conversation: "Earnings, like trees, don't grow to the sky".

We would like to repeat last week's conclusion namely that:
"high expectations + strong consensus = danger".

As indicated by Citi's recent credit research note "Strong growth requires more than just liquidity":
Fixed Income, Floating Expenses...We are more concerned about the "Profits Cliff" or "Peak margins" effect given that companies can't figure how to make use of their cash hence the flurry of buy-backs which we greatly dislike. Indeed, the "unintended consequences" of the zero rate boundaries being tackled by our "omnipotent" central banks "deities" is that capital is no longer being deployed but destroyed (buy-backs being a good indicator of the lack of investment perspectives):
- Source CITI

Not only this but Private Equities power house so apt at raising money are struggling in finding ways of deploying their cash stash.

For instance, 3i Group Plc the private equity house announced in June it was restructuring its private equity business and that it would cut a third of its workforce. 3i Group Plc is planning to more than double its debt-management unit moving away from investing in buyout deals as reported by Bloomberg by Patricia Kuo - 3i Boosting Debt Business:
"New private-equity investments have shrunk in a “subdued”market for mergers and acquisitions, 3i said today in an earnings statement. The firm spent 138 million pounds ($219million) on new investments compared with 448 million pounds in the same period a year earlier, it said. It reduced headcount by 104 employees and closed offices in Barcelona, Copenhagen, Hong Kong, Milan and Shanghai, according to the statement. 3i will avoid mezzanine financing, distressed debt and real estate, as well as asset-backed deals for the time being. “I am not convinced there is room for growth for real mezzanine financing, ” Ghose said. “It will become more difficult to get buyout firms to see the merit of using mezzanine debt now that required returns almost match that of equity.”" - source Bloomberg
- Source CITI

So not only the Zero Rate policies induced by our "omnipotent" Central Banks are destroying capitalism in the sense that capital because of lack of return cannot be deployed efficiently, but it is as well to some extent neutering volatility as indicated by the volatility in Japan which has returned to pre-quake levels - graph source Bloomberg:
"The CHART OF THE DAY shows the Nikkei Stock Average Volatility Index, a gauge of how much it costs to buy options protecting against swings in the country’s main stock-price measure, fell to a 21-month low yesterday. The lower panel tracks how the price of one-month contracts protecting against declines in the Nikkei 225 also dropped to the lowest level since February 2011 on Nov. 9.The chart’s upper panel shows how on Nov. 7 the Nikkei volatility gauge dropped below its U.S. counterpart, the Chicago Board Options Exchange Volatility Index, for the first time since May. A 24 percent rally in the so-called VIX since an Aug. 17 low signals that demand for protection against U.S. stock losses is intensifying. Japan’s benchmark equity gauge rose 2.4 percent this year through Nov. 13 compared with a 9.3 percent gain by the U.S.’s Standard and Poor’s 500 Index. - source Bloomberg

The other subject of conversation is the broken credit transmission mechanism in the Eurozone. Eurozone companies are, according to CreditSights recent note (Eurozone Corp Debt - Broken Banks or Weak GDP?) net of borrowing, repaying bank debt for only the second time on record and yet net bond issuance is at close to record levels. Why is so?

Banks in Europe are "broken" and unable to lend, or unwilling given the weak outlook for companies revenues which is as well undermining the demand for credit:
"The Eurozone's latest national economic accounts show that over the past year non-financial corporates have been repaying loans, but borrowing near record amounts of bonds. Over the past year, companies in the euro area have repaid a net €45 bn of loan debt and increased their use of bond financing by €90 bn, respectively equivalent to -0.5% of GDP and 1% of annual GDP. Euro area companies have only made greater use of bond financing than they are currently making in 2010 when loans were shrinking dramatically following the banking crisis, and in 2001 when the euro-denominated credit markets were still developing and the dotcom and euro high yield boom were in their final days.
The most obvious explanation for this shift in funding from loans to bonds is that banks are broken and unable to lend and therefore these companies are large enough to turn instead to the bond markets are using that option. The rest are being forced to deleverage or default. If that is the case, then the obvious answer must be to fix Europe's banks in order to ease the pressure on corporates and allow those too small to access to the bond markets to rely once again on the banks. But there are reasons to doubt that fixing European banks alone will be enough. While it is a necessary condition of returning European Corporates to borrowing and investing it is not by itself, a sufficient condition. And although the financing conditions of Europe's smaller and medium-sized companies may seem irrelevant to investors in bonds, it should be remembered that these SMEs are the suppliers  to those large companies, the distributors of their products and the employers of their customers. If European SMEs are cutting spending, that will redound to the detriment of large European companies revenues."

On a final note revenue shortfalls as indicated by Bloomberg's chart of the day does indeed bring Profit-Margin caution:
"Growing disappointment with U.S. companies’ revenue may be a harbinger of lower profit margins, according to Myles Zyblock, chief institutional strategist at RBC Capital Markets. As the CHART OF THE DAY shows, the gap has widened this quarter between the percentage of companies in the Standard and Poor’s 500 Index that are exceeding analysts’ sales projections and those coming out ahead on earnings. The figures are based on comparisons with average estimates in Bloomberg surveys. Fewer than 30 percent of S and P 500 companies are delivering so-called positive surprises on revenue, according to the data. The proportion has fallen from 52 percent a year earlier. S and P 500 earnings surprises have been more consistent, falling to 64.5 percent from 69 percent during the period. “The heat is on for companies to preserve margins,” Zyblock wrote yesterday in a report. Their success will depend on pricing power, or the ability to raise prices without losing business, the Montreal-based strategist wrote. Broadcasters and cable companies, business-service providers, homebuilders and tobacco producers are most likely to sustain profitability, the report said. Zyblock based his conclusion on an analysis of industry price indexes and net margins, or net income as a percentage of sales. Automakers, chemical companies, paper producers and software makers are most at risk, he wrote. These industries suffer from a combination of reduced pricing power and falling net margins." - source Bloomberg

We think we have reached "Peak margins" as far as US earnings are concerned. so "Mind the Gap"...

So, we do not really care about the "Fiscal Cliff", we'd rather much care about the "Profits Cliff", but then again, we might be lacking faith, trust, or both, in our "Omnipotent" Central Banks and governments altogether.

"Omnipotence is not knowing how everything is done; it's just doing it."- Alan Watts, English Philosopher.

Stay tuned!

Wednesday 14 November 2012

The decline of Japanese companies illustrated by the CDS market

"What is at a peak is certain to decline. He who shows his hand will surely be defeated. He who can prevail in battle by taking advantage of his enemy's doubts is invincible." - Cao Cao

The CDS market is a clear illustration of the surge of Chinese and Korean corporates versus the slow decline of Japanese corporates - source Bloomberg:
The Itraxx Ex-Japan CDS index above (Blue line) is primarily weighted in Chinese and Korean corporates whereas the Itraxx Japan CDS (Red line) is very much weighted by the following sectors: Technology, Utilities, Shipping and Steel which are currently under tremendous pressure.

"Nature's laws must be obeyed, and the period of decline begins, and goes on with accelerated rapidity."  - Warren De la Rue, British Scientist.

Stay tuned!

Monday 12 November 2012

Fiscal Cliff vs China stabilisation - Volatility market angle

"Living at risk is jumping off the cliff and building your wings on the way down." - Ray Bradbury 

Moving outside the credit spectrum, we would like to entertain you with some interesting points made by our good cross-asset friend with whom we regularly discuss our macro and market interests:

"These last few days saw an increasing focus on fiscal/political risks of the US markets. 

At the same time several macro data releases seem to hint at a stabilisation of economic activity in China.

Wrong or right trend, equity options markets seem to validate this view, as shown by the record low spread between emerging markets implied vol (summarised by EEM US ETF options) and S&P 500 options. 3 months atm (at the money) implied vol :

However these kind of disconnections in volatility markets generally do not last long...

Stay tuned!

Sunday 11 November 2012

Credit - Froth on the Daydream

"Do you think when two representatives holding diametrically opposing views get together and shake hands, the contradictions between our systems will simply melt away? What kind of a daydream is that?" - Nikita Khrushchev

Definition of froth:
noun - A mass of bubbles in or on a liquid; foam 
verb - to produce or cause to produce froth
source - Collins English dictionary.

Our reference in this week title is of two-fold. A froth being a mass of bubbles in a liquid form, looking at the quantity of liquidities injected in the system courtesy of central banks (see our post "QE - To infinity...and beyond"), and given the incredible rally in the credit space with more and more players looking at "stealing third base" (to use a baseball analogy), one can argue that many investors are really getting outside their "comfort" zone and investing once again in the riskiest part of the capital structure (Leveraged loans, High Yield, PIKs bonds, etc.), hence our froth reference. Yes, arguably once more, central banks are indeed "frothing".

But, our title is as well a reference to 1947 novel by French author Boris Vian, one of our favorite books of all time. It tells the story of a man who marries a woman, who develops an illness that can only be treated by surrounding her with flowers. We think the current global economic situation tells a similar story, namely that economies developed an illness (credit bubbles) that can only be treated by surrounding them with liquidities.
Credit Booms and Financial - Crisis - IMF
"The majority of the largest financial crises over the past three decades followed significant private credit expansion. While credit booms need not be followed by a period of bust (the IMF calculates that one third of booms sampled were followed by a banking crisis) it notes that many more were followed by sub-trend growth for the subsequent six years." - source Bloomberg

In Boris Vian's great poetic novel, the hero Colin marries Chloé, but Chloé falls ill upon her honeymoon with a water lily in the lung, a painful and rare condition that can only be treated by surrounding her with flowers. One can as well argue that a BSR (Balance Sheet Recession) is a rare condition that can only be treated by surrounding it with liquidities but if credit is not flowing to the real economy which is definitely the case in the Eurozone; a similar fate looms for the European economy as for Chloé in the novel. In the novel at some point, the flower expenses become prohibitive and Colin soon exhausts his funds. 
"The CHART OF THE DAY shows that the ECB’s assets have climbed to 33 percent of the gross domestic product of the nations that use the euro, exceeding levels for the U.S. and Japan. It also shows Draghi’s proposal could drive the central bank’s holdings to exceed 43 percent if policy makers bought all 1.01 trillion euros ($1.27 trillion) of Italian and Spanish bonds due by end-2015 and failed to sterilize purchases. Draghi will propose unlimited buying of government debt, while refraining from a public cap on yields, according to two central bank officials briefed on the plan before the ECB meets today. Sterilization involves draining money from other parts of the financial system to offset the new funds being added." - source Bloomberg.

We are very fond of Boris Vian's novel, and we can find many more analogies in this week credit rambling's title with his masterpiece. 
For instance, as Chloé becomes even sicker, the house they live in starts to shrink and becomes darker and gloomier on a daily basis although the little grey mouse that lives in the house does all its best to clean the windows in order to let the light in. When one looks at the future for Greece, it looks increasingly likely that Greece will become the euro's poorest nation in two years as indicated by Bloomberg:
"The CHART OF THE DAY shows Greek output per person adjusted for relative price levels is set to fall to 71.3 percent of the European Union average in 2014 from 79.8 percent last year, according to the commission’s Ameco database. Slovakia, the second-poorest euro nation, will surpass Greece as early as this year, while Estonia, the zone’s most impoverished state, will top Greece at the end of 2014. Greece is struggling to meet debt-reduction targets imposed by international lenders more than two years after receiving its first bailout. The need for more austerity measures is pushing the economy deeper into recession and more than one-fifth of output will have been erased by 2014, when growth is set to resume after six years of recession." - source Bloomberg

In Boris Vian's book, Colin struggles to provide flowers (credit) for Chloé to no avail and his grief at her ultimate death is so strong his pet mouse commits suicide to escape the gloom. Looking at how the ECB (Colin) is struggling at providing real flowers (credit) to the Spanish real economy (we have long argued that the LTROs provided by Mario Draghi amounted to "Money for Nothing"), we can only wonder about the accuracy of our reference when looking at the deflationary bust unfolding in Spain before our very own eyes - graph source Bloomberg:
"The CHART OF THE DAY shows that the 30 percent expansion of the ECB’s balance sheet since Draghi’s first meeting as President in November 2011 has reduced the Euribor-OIS spread, a measure of European banks’ reluctance to make unsecured loans to one another, to a five-year low. In that time, Spain’s 10-year borrowing cost has risen, even after Draghi channelled 1 trillion euros ($1.3 trillion) to banks via two rounds of Longer-Term Refinancing Operations in December and February. Draghi has also cut interest rates to 0.75 percent in three 25 basis-point reductions, and reinforced his July 26 pledge to do “whatever it takes” to defend the euro by announcing an unlimited bond-purchase program. Spain is yet to request aid, a precondition of central bank bond purchases. The ECB left interest rates unchanged on thursday's meeting." - source Bloomberg

"Maintaining lending and credit flows is paramount to avoid a credit crunch which would essentially impair GDP growth in the process." - Macronomics, Modicum of relief - March 2012

Euro Area Bank Lending Survey - source Thomson Reuters Datastream / Fathom Consulting:

When ones looks at the amount of consumer gearing in Europe versus the USA, no wonder that the amount of "frothing" or flowers from the ECB has been staggering. As indicated by Bloomberg in the below graph, the Credit Penetration has been falling from the 2009 highs, courtesy of the BSR and the deleveraging needed but the gearing of private households as fallen in the US whereas it has risen in Portugal for instance!
"Globally, domestic credit to GDP has fallen seven percentage points from 2009's all-time high, as banks deleverage and consumers pay down debt. While Portugal and the U.S. have the same 193% ratio, the Portuguese credit boom drove consumer gearing to 193% from 135% in 2005-09, unlike the U.S., where the ratio has dropped over the same period." - source Bloomberg

Looking at the recent surge of the Bloomberg US Consumer confidence Index from -34.7 to -34.4 in the period ending November 4, the best reading since April, we remain more positive on the US economy than the European economy. As we indicated last week in our conversation "The year of the empty hand", the divergence of growth between the US economy and the European economy is still reflected in credit prices such as the US leveraged loan cash price index versus its European peer - source Bloomberg:

In our previous conversation "The link between consumer spending, housing, credit and shipping", we indicated that Shipping is an important credit and growth indicator:
"The relationship between container shipping and consumer spending, traffic is indeed driven by consumer spending".

The below Bloomberg graph displays such a link between economic growth and shipping as well as housing:
"The Baltic Dry Index is a barometer of the health of the shipping industry and broader global economic activity. The daily index aggregates the costs of moving freight via 23 seaborne shipping routes. It covers the movement of dry-bulk commodities, such as iron ore, coal, grain, bauxite and alumina. It also gauges dry-bulk supply-and-demand dynamics." - source Bloomberg

Consumer Confidence is as well a barometer of economic conditions. When one looks at the Consumer Confidence evolution in the Eurozone, one can see the growing headwind for growth to resume which would alleviate the concerns in regards to solvency issues for some European countries:
Source Thomson Reuters Datastream / Fathom Consulting.

In similar fashion, we already touched at the link between European Consumer Confidence and Consumption in our June conversation "Yogurts, European Consumer Confidence and Consumption" where we argued: 
"Yogurts matter as an indicator? One has to wonder...As austerity bites consumer spending and with Italy and Spain in recession, companies have been forced to lower cost to protect earnings so far. End of May the ECB also indicated that loans to households and companies in the euro zone grew at the slowest pace in two years as the on-going crisis curbed demand for credit."

Yogurt giant Danone share price versus European Consumer Confidence since 2006 - source Bloomberg:
"Mind the Gap..."

Economic Sentiment is a well a leading indicator we think, when it comes to predicting GDP growth as in the below Bloomberg Graph plotting the evolution of both in Europe since 1998:
Another, "Mind the Gap".

No wonder GDP growth in Europe is indeed turning South for all:
Source Thomson Reuters Datastream / Fathom Consulting.

In relation to France, in our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

As far as our new barometer of Euro Risk is concerned, all is not well. The 3% deficit target in 2013 is highly unlikely to be reached when one looks at a very simple economic indicator, namely France's industrial production and GDP growth since 2001 - graph, source Bloomberg:
French recession will happen. Industrial production slumped to -2.5% the lowest level since 2009 and the biggest drop since January 2009. More than the 1% decline forecast by economists in a Bloomberg news survey. Not only industrial production is cratering but sentiment among manufacturers executives was unchanged at 92 in October.

Should industrial production print fell to -3.3%, we believe France will no doubt be in recession, putting in jeopardy its overly ambitious target of 3% of budget deficit in 2013 (A Deficit Target Too Far").

What was that Standard and Poor's April note indicating with which we completely disagreed with in our April conversation relating to France - "France's Grand Illusion"? As a reminder:
"Apr 04 - Although the current recession in Europe will probably extend into the third quarter, we believe the economy may pick up modestly late this year and in 2013, said Standard and Poor's today in announcing the publication of its report "No Fast Lane Out Of Europe's Recession."

We did not share the same beliefs as Standard and Poors and we still do not share them.

France Fiscal Position - source Thomson Reuters Datastream / Fathom Consulting:

As far as France sovereign CDS is concerned, it trades at the same level as Belgium with Belgium being in a better fiscal position - source Bloomberg:
Back in our conversation "Spanish Denial", we indicated:
"When it comes to Net Financial Wealth of Households as a percentage of GDP, 2000 and 2007, as indicated by Eurostat, Italy is indeed a much richer country than expected, even compared to France and Spain. We could even go further in our analysis and compare Belgium to Italy, given their similar high debt to GDP levels (98.5% for Belgium, 119.6% for Italy), but very low household debt (around 53% for Belgium), very high savings rate (around 17% in 2011 in Belgium) as well as very high level of savings and a mostly domestically held government debt. Both countries enjoy massive private sector wealth, therefore foreign debt is negligible"

The current CDS level reflects our position that Belgium is a better risk than France having not only a much better Fiscal position but a much lower household debt and a very high saving rate:
"A wealthy private sector is significant when it comes to debt dynamics given that by broadening the tax base and introducing bigger transfers from the private sector to the public sector means the demand for government bonds in the primary market can provide a stable base as indicated by last year's report published by Danske Bank - Euro area: Why Italy is not Greece:
"The deficit in the peripherals, apart from Italy, increased sharply in 2008 and 2009. In Italy, however, it never exceeded 6% of GDP, and in 2010 the deficit of 4.6% was half that of Spain and Portugal and much better than Greece and Ireland."

On a final note in relation to France, BNP Paribas latest quarterly earnings has revealed the extent of credit contractions in France as indicated by Bloomberg:
"The appetite for loans in France is diminishing on stagnant growth. BNP said decelerating demand in its domestic retail network had edged loans down in 3Q, with consensus calling for GDP growth of just 0.1% in 2012. Net interest income at French lenders could be under pressure from waning demand and persistent low rates. French business lending contracted 0.5% yoy in September (ECB)." - source Bloomberg

"high expectations + strong consensus = danger."

"Both expectations and memories are more than mere images founded on previous experience."  - Samuel Alexander, Australian philosopher.

Stay tuned!
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