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!

No comments:

Post a Comment

View My Stats