Sunday 14 April 2013

Credit - The Night of The Yield Hunter

"Ah, little lad, you're staring at my fingers. Would you like me to tell you the little story of right-hand/left-hand? The story of good and evil? H-A-T-E! It was with this left hand that old brother Cain struck the blow that laid his brother low. L-O-V-E! You see these fingers, dear hearts? These fingers has veins that run straight to the soul of man. The right hand, friends, the hand of love. Now watch, and I'll show you the story of life. Those fingers, dear hearts, is always a-warring and a-tugging, one agin t'other. Now watch 'em! Old brother left hand, left hand he's a fighting, and it looks like love's a goner. But wait a minute! Hot dog, love's a winning! Yessirree! It's love that's won, and old left hand hate is down for the count!" - Reverend Harry Powell - The Night of the Hunter - 1955 American Thriller by Charles Laughton

While watching with interest gold hitting an intraday low of $1,493.35 per ounce, putting it 22.3% below September 2011's intraday peak of $1,921.41, with Cyprus selling its bullion in the process, we thought this week we had to use as a title analogy one of our favorite movies of all time being "The Night of the Hunter". 

In the movie Reverend Harry Powell, a serial killer and self-appointed preacher has tattooed across the knuckles of his right and left hands two words "LOVE" and "HATE" so that he can use them in a sermon about the eternal struggle between good and evil. As investors, we think you should have two words tattooed across your hands: "INFLATION" and "DEFLATION" so that you can use them in assessing the eternal struggle between inflation and deflation in this current environment.

The sell-off in gold, a clear "sucker punch" moment - chart source Bloomberg:

 But as indicated by David Goldman, the former global head of fixed income research for Bank of America,  in a previous article about Gold and Treasuries and bonds in general he wrote in August 2011:
"Why should gold and Treasury bonds go up together? Gold is an inflation signal and bonds are a deflation hedge. At first glance it seems very strange for both of them to rise together. Why should this be happening?
 The answer is simple: bonds are an option on the short-term interest rate, and gold is a perpetual put option on the dollar. Both rise with volatility.
 It’s like the old joke about the thermos bottle: “How does it know if it’s hot or cold?” If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. By put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

We also agree with David Goldman's previous comment on gold, namely that it is not an inflation hedge; it is a hedge against the end of the dollar’s status as a reserve currency, a deep out-of-the-money put against the US currency as a whole.

So after all, our call last week for higher gold prices in the second quarter might be premature and some people might see the right hand "LOVE" (inflation) as "a goner" in similar fashion to Reverend Harry Powell's sermon.
It appears to us that old left hand "HATE", namely deflation, to the great sorrow of our self-appointed "preachers" aka central bankers, is currently having the "upper hand". Therefore in this week conversation, we would like to review some of the key indicators we are seeing as evident signs of the deflationary forces at play in this eternal struggle between "LOVE" (inflation) and "HATE" (deflation). 

As we posited in "Zemblanity", being "The inexorable discovery of what we don't want to know", we have always found most interesting the "relationship" between US Velocity M2 index and US labor participation rate over the years. Back in July 1997, velocity peaked at 2.13 and so did the US labor participation rate at 67.3%. Now at 63.5% the US is back to 1981 and velocity is still falling (1.58), even lower than 1960's levels- source Bloomberg:
The great Irving Fisher told us in his book "The money illusion" and in his equation MV=PQ that what matters is the velocity of money which is the real sign that your real economy is alive and well. We do not see any sign of rebound in velocity.

We do agree with James G. Rickard's view of the situation, a partner at JAC Capital Advisors, which he made in a presentation at the recent Global Investment Risk Symposium which was summarized in an article entitled "The Fed is playing with a Nuclear Reactor" at the CFA Institute:
"To really understand what is going on, you have to start with the quantity theory of money, or MV = PQ. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.) The issue here is that the theory doesn’t hold up in the real world because velocity — the number of times money changes hands, or turns over — is not constant. ”Velocity is collapsing,” Rickards said. “You can think of monetary policy as a desperate race between increasing money supply and decreasing velocity, and the Fed is printing money to offset the decline in velocity. . . . So the Fed’s problem is best understood as one of trying to bend this velocity curve."
A similar disconcerting image is the growing disconnect between Oil prices, US Treasuries, which have seen their yield falling and the S&P500 - source Bloomberg:

We think there is currently an accumulation of worrying signs that the global economy is decelerating and that old left hand deflation has indeed a solid grip when one looks at China's shrinking electricity use, a bearish sign for a price index of industrial metals that, according to Bloomberg, has posted a first-quarter decline for the first time in 12 years - source Bloomberg:
"The CHART OF THE DAY shows that a gauge of six prices from the London Metal Exchange fell 5.6 percent in the three months ended March, the first drop for the period since 2001. China’s electricity demand in January and February gained 5.5 percent from a year earlier, compared with an increase of 6.7 percent in those months in 2012 and more than 12 percent in 2011.
China, the world’s biggest consumer of metals from aluminum to zinc, targets economic expansion of 7.5 percent in 2013. Factory production, which accounts for two-thirds of power use, increased 9.9 percent in the first two months of the year, the weakest start since 2009. Profit at industrial companies still rose for the fourth straight month, indicating higher corporate investment to fuel growth." - source Bloomberg

While our friend Cullen Roche from Pragmatic Capitalism tracks Rail Traffic as an economic activity indicator, we, at Macronomics, tend to track shipping and Air Cargo Traffic, because they are not only economic activity indicators but as well as credit/deflationary indicators as we pointed out in our conversation "Shipping is a leading credit indicator":
"For us the Baltic Dry Index is another indicator in the deterioration of credit as well as an indicator in deteriorating credit conditions leading to a surge in Non-performing loans on Banks' Balance Sheets."

For instance, Shanghai's containerized freight is 6% lower year on year as of the 22nd of March, 23% below its peak in May 2012 as indicated by Bloomberg:
"The Shanghai Export Containerized Freight Index (SCFI) fell 6% yoy in the week ending March 22, the fourth straight yoy decrease. The SCFI is 23% below its May 2012 peak, while the China Export Containerized Freight Index is 3.2% higher yoy and 17.1% below the May peak. Containerized traffic is driven by consumers, and changes in spending have a direct effect on global traffic volume." - source Bloomberg

In similar fashion the burst of the credit bubble had a dramatic impact on housing, shipping was as well not spared as cheap credit did indeed fuel a bubble of epic proportion - source Bloomberg:

"The Baltic Dry 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. During 1Q, the index typically increases from its seasonally weak period. In 2013, it has been no exception, as the index declined 30.2% sequentially in 1Q. The gain was driven by the tightening panamax market." - source Bloomberg

The Baltic Dry has yet to recover.

China's slowdown is the reason behind the difficulties encountered by shipbuilders such as STX Group as indicated by Kuynghee Park on the 4th of April in his Bloomberg article - China Turns Graveyard From Goldmine Hurting Ship Makers:
"For shipbuilders such as STX Group, China was once a goldmine. Now it’s a graveyard. China’s lower appetite for commodities undermined the group’s plan to sell its shipping line, wiping out a combined $435 million of investor wealth at the South Korea-based conglomerate’s three main companies this week. That also threatens the group’s ability to repay $1.2 billion of debt by the end of the year. STX’s crisis comes after last decade’s boom prompted the group to set up a shipbuilding and offshore complex in Dalian, northeastern China. With Asia’s biggest economy slowing down and the European crisis adding to a plunge in cargo rates, China Cosco Holdings Co., the nation’s biggest mover of bulk commodities and containers, last week reported a loss for 2012, a third straight annual loss."  - source Bloomberg

From the same Bloomberg article:
"Since the credit crisis, orders to build new ships have plunged. Contracts for new vessels halved to $84.7 billion last year, compared with $174.7 billion in 2008, according to Clarkson Plc, the world’s biggest shipbroker."  - source Bloomberg

For financial institutions such as Germany's second largest bank Commerzbank and impaired German bank HSH Nordbank, a large part of their recovery is linked to the fate of new ship deliveries given their shipping loan books have been seriously damaged by over-supply in the container ship markets as reported by Michelle Wiese Bockmann in Bloomberg on the 1st of March in her article - German Banks With Record Soured Ship Loans Forgo Seizing Vessels:
"Deutsche Bank AG and two other German lenders providing about 14 percent of credit to ship
owners are forgoing seizing vessels even after soured loans to the industry rose to a record. Europe’s biggest bank by assets, as well as HSH Nordbank AG, the largest in the market, and Norddeutsche Landesbank Girozentrale, which finances 1,500 ships, are restructuring loans and setting money aside instead of repossessing vessels, officials from the companies said. They have about $69 billion in loans to the industry out of $500 billion in total, according to data compiled by the banks and Petrofin Research SA, an
Athens-based consultant. Owners from Denmark to Indonesia defaulted in the past year, while U.S. tanker company Overseas Shipholding Group Inc. sought bankruptcy protection and ship earnings fell to a record last month. An unprecedented $80 billion out of $125 billion of German loans to the industry aren’t performing as they should, estimates Paul Slater, chairman of Naples, Florida-based ship-finance consultant First International Corp." - source Bloomberg.

HSH Nordbank has shipping loans of 29 billion euros covering about 2,800 vessels, but looking at weak trading conditions, as indicated in a recent note by JP Morgan on HSH Nordbank published on the 4th of April, some ship owners are pushing for new ship deliveries originally scheduled in 2013 to be delivered later in 2014, with additional deferrals expected:

But looking at the deflationary depressed level of Dry-Bulk Shipping rates which are down 9% YoY, but up 78% from 2012 lows - source Bloomberg:

In that context of depressed rates, it is currently driving ship owners to scrap vessels at a strong pace as indicated by Bloomberg:

"This year is expected to be the third straight year of strong scrapping of dry-bulk vessels, according to Eagle Bulk, with scrap rates at about $450 per lightweight ton. Eagle Bulk management forecast in its 4Q call that scrapping rates could equal 4% of the world fleet, or 30 million deadweight tons in 2013. Scrapping should be strongest for sub-panamax vessels, given that about 16% of this type are 20 years old or older." - source Bloomberg

Bulk vessels and Container ships have seen a steady number of ships being broken up due to weak rates and  tied up to the weakness in global economic activity - source Bloomberg:
"Excess capacity and depressed charter rates have increased the number of container ships sent to be scrapped by 503% since June 2005. This is creating a more efficient fleet as older ships are replaced by newer models. Triple-E ships consume about 35% less fuel per container and are able to carry 16% more containers, according to Maersk." - source Bloomberg

This deflationary environment, and "Schumpeter" like creative destruction is enabling innovation, in the container shipping space benefiting, the fittest to survive such as Danish Maersk currently busy upgrading massively its container fleet.

Whereas German HSH Nordbank's survival is depending on renewed global economic activity and its fate  is tied up to shipping and so is the fate of its subordinated bondholders who, at some point could indeed face the same "restructuring" music as Dutch SNS bondholders as indicated in JP Morgan's note:
"We remain negative on the T1 instruments, as we believe that the next catalyst for these bonds would provide negative pricing pressure due to our expectation that there will need to be a retroactive charge for the increased risk shield at HSH which will impact the cash flow expectations of the T1 instruments. We acknowledge the bonds are pricing in a significant number of deferrals already, however, we do not see a positive catalyst in the near term. For both the LT2 and T1 instruments we will be keeping a keen eye on the deliveries of ships and any delays into future years as this could potentially prolong the turn in the shipping cycle out into 2015. If this were to happen we would become much more concerned for the outlook of HSH and its debt securities." - source JP Morgan

Another economic activity and deflationary indicator we have been tracking has been Air Cargo. It is according to Nomura a leading indicator of chemical volume growth and economic activity:

"Over the past 13 years’ monthly data, there has been an 84% correlation between air cargo volume growth and global industrial production (IP) growth, with an air cargo lead of one to two months. In turn,
this has translated into a clear relationship between air cargo and chemical industry volume growth" - source Nomura:

"Our air cargo indicator of industrial activity came in at -3.8% (y-o-y) in March, following -7.8% in February and -8.3% in January. As a readily available barometer of global chemicals activity, air cargo volume growth is a useful indicator for chemicals volume growth."  - source Nomura.

Of course another sign of that old left hand "HATE", namely deflation, has been the absolute level of core European government yields, which have no doubt been supported by "Abenomics" like we indicated last week - source Bloomberg:
Government bond market yields across the euro zone dropped near 2-year low as the aggressive Japanese monetary action ripples through. Italy sold 7.2 billion euros of debt and French and Belgian government bond yields declined as well to record lows. The European bond picture, with Spanish 10 year yields  well below 5% at 4.71%, whereas Italian 10 year yields well  below 5% now around 4.35% and German government yields stable around 1.25% levels, but the most impressive move was on French OAT10 year bonds closing around 1.80%.

No doubt Kuroda's "whatever it take" moment has delivered a powerful right hand "LOVE" moment, inflating its Nikkei index in the process and surging past emerging markets equities surging now well above the MSCI EM index - source Bloomberg:
In relation to our title being "The Night of The Yield Hunter", it appears to us that Japan, is having a very strong effect on global yields, in similar fashion to a gigantic black hole or a powerful vacuum cleaner.  So on that premise although last week we indicated that France's economy was in trouble, selling OATs is "NO GO" at the moment for that specific "Japanese" reason. We would therefore be incline to go for duration and look for visible, stable sources of income.

This Night of The Yield Hunter is as well marking the return of the famous retail Uridashi funds also known as Double-Deckers which we discussed in February in our conversation "The surge in the Brazilian real versus the US dollar marks the return of the "Double-Decker" funds."
The Brazilian Real is one of the top "Double-Deckers" preferred currency play for its interesting carry:
"As we indicated in October 2011, in our conversation "Misery loves company", the reason behind the large depreciation of the Brazilian Real that specific year was because of the great unwind of the Japanese "Double-Decker" funds. These funds bundle high-return assets with high-yielding currencies. "Double Deckers" were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest, have recently piled in again."

And as indicated by Boris Korby and Julia Leite on the 11th of April in their Bloomberg article - "Kuroda’s $75 Billion Lets Gerdau Win Lowest Yield", Brazilian corporate credit is benefiting from this Yield Hunt from yet another self-appointed preacher namely Kuroda:

"Fixed-income money managers are scouring emerging markets for higher returns after Bank of Japan Governor Haruhiko Kuroda said last week that he would double bond purchases to $75 billion a month to help revive growth in the world’s third-largest economy. As the yen fell to a four-year low and the nation’s government bond yields sank to a record, Japanese and investors following them may have bought about $13.5 billion of non-Japanese bonds since the announcement, 10 times more than the previous period, Societe Generale SA said." - source Bloomberg

In that global hunt for yield which has been further stigmatised by Kuroda's monetary policies, even the lowest rated Brazilian issuers are taking advantage of the on-going hunt as indicated in the same article:
"Brazil’s lowest-rated investment-grade issuers are taking advantage of the absence of Brazil’s largest and most creditworthy borrowers from the market to raise funding and reduce borrowing costs, according to Henrique Catarino, the head of international sales at Banco Votorantim SA in Sao Paulo.
Lenders Itau Unibanco Holding SA and Banco Bradesco SA as well as state-run oil company Petroleo Brasileiro SA and iron-ore producer Vale SA, which sold a combined $13 billion abroad in the first quarter of 2012, have refrained from issuing bonds this year, flush with cash and willing to delay issuance until borrowing costs retreat further, according to Catarino. All four companies are rated at least Baa2 by Moody’s and BBB by S&P, on par with Brazil’s government." - source Bloomberg

We made the following point in "Structural Instability":
"The great Hyman Minsky thesis was "stability leads to instability", we would argue that dwindling liquidity and excessive spread tightening in core quality credit spreads courtesy of zero interest rates policy in both the US and Europe is extremely concerning and are already indicative of a great build up in structural instability."
We also added our previous "Hooke's law" ending remarks:

"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates."

When reading the following article from Lisa Abramowicz entitled "Hardest-to-Sell Junk Lures Buyers Hooked on Fed", no doubt the self-appointed preachers of this world, namely central bankers have set this credit mousetrap:
"Investors are favoring the riskiest, hardest-to-trade junk bonds by the most in 17 months as confidence mounts that central banks from Japan to the U.S. will prop up debt markets through year-end.
The extra yield investors demand to buy the least-traded bonds with the lowest speculative-grade ratings instead of more liquid securities narrowed to 1.2 percentage points on April 9, the smallest gap since November 2011, according to Barclays Plc data. Yields on the smallest and oldest CCC rated notes contracted by 1.9 percentage points this year, three times the drop on yields for more active notes with comparable grades. Bond buyers seeking to escape the financial repression brought on by near zero interest rates are venturing deeper into the market in search of returns. They are bidding up the debt of companies that would otherwise be the most vulnerable to bankruptcy had the Federal Reserve not injected more than $2.3 trillion into the financial system since 2008." - source Bloomberg

Moving back to our "The Night of the Hunter" analogy, we  think that Japan is a well a great illustration for assessing this LOVE / HATE relationship between inflation and deflation in this current environment. One just have to look at gold priced in yen and the weakening of the yen versus the dollar to get the point - source Bloomberg:
"The CHART OF THE DAY shows gold priced in yen jumped 2.9 percent in March as the currency slid 1.8 percent against the dollar. The metal rose another 4.3 percent this month through yesterday, and may reach 165,842 yen ($1,675) an ounce this year, the highest since February 1980, according to Bart Melek, TD’s head of commodity strategy. Bank of Japan Governor Haruhiko Kuroda said on April 4 that the central bank would boost its monthly bond purchases to 7.5trillion yen ($76 billion) in a bid to fight deflation and revive the economy. The bank suspended a cap on some bond holdings and dropped a limit on debt maturities as they set a two-year horizon for their goal of 2 percent inflation." - source Bloomberg.

We would like to make the following points in relation to the deflationary forces at play in Europe:
-Without private credit growth, how exactly do you get inflation in Europe? It would be the only big reason to sell core European governments bonds and French OATs, or another reason would be 'The Big One" (to use another analogy, this time an earthquake analogy), meaning the unwind of the European project.
-Unless European banks start lending to the private sector again – and this seems unlikely – how is this scenario not deflationary?
Consumer credit, which represents 12% of lending to households, decreased on average by 2.8% over 2011.
-Lower banking profits are a symptom of deflation as well, you are getting smaller ROE in the European banking space, well below double digits
The place to buy banks is where there is economic growth. Banks are the second derivative of an economy. For us, it is a leverage play. (Brazilian banks have double digits ROE in the region of 15% - 17% but that's another subject...).

 -Falling home prices in Europe are a symptom of deflation
 -Governments restructuring debt is a symptom of deflation.
 -A contraction in Europe of banks balance sheets is deflationary.

We believe Europe face the risk of a disinflationary aka deflation bust.
A great definition of a disinflationary bust was made by the Gavekal team:
"Disinflationary Bust: If credit conditions tighten too much then capitalism is strangled: companies pull back on investment, their customers put away their wallets, and economic growth slows. These conditions encourage the marginal equity investor (some of whom have bought with leverage) to exit the market. Investors then typically head for the safety of long-term bonds, as there is little sign of inflation and short rates are likely to fall in response to slowing growth and/or deflation fears." 

In similar fashion UBS in their March 2012 note entitled "The Ides of March" made an interesting point which could validate the on-going weakness in both commodities and Emerging Markets:
"The end of Federal Reserve and European Central Bank (ECB) stimuli will cause an acceleration of capital flows out of emerging markets, hitting commodity demand."  - source UBS

They published last year on that subject an interesting investment clock:
- source UBS.

UBS indicated at the time they were following the HY ETF HYG as a stress indicator:
"We follow the HYG US high yield bond ETF to signal the state of US credit conditions."

In the US, High Yield credit has remained in line with equities since the beginning of the year. The de-correlation between credit and equities is nearly exclusively coming from Investment Grade credit and we indicated the relationship between High Yield and Consumer Staples in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option" how defensive the rally in the S&P500 has been so far - source Bloomberg:

The risk of a deflationary bust, validates our negative stance towards commodities and emerging markets as indicated last week for the second quarter. Here comes that "HATE", that old left hand.

On a final note, the 30 year-year interest-rate swap spread is approaching zero again linked to the fact that Dodd-Frank is forcing swaps to become cleared which will be supportive for US Treasuries as indicated by Bloomberg:
"The CHART OF THE DAY shows the 30-year interest-rate swap spread approaching zero. The swap rate has held below the similar-maturity Treasury yield, causing the spread to be negative, for almost every day since November 2008. The spread fell below zero for the first time following the September 2008 collapse of Lehman Brothers Holdings Inc., which prompted dealers to shore up balance sheets.“Part of Dodd Frank is forcing derivatives to become exchange cleared and creating the need to post margin on swap trades,” said Michael Cloherty, head of U.S. interest-rate strategy at Royal Bank of Canada’s RBC Capital Markets unit in New York. “That has made it cheaper for investors to use Treasuries and Treasury futures, rather than swaps, to obtain the duration they need." - source Bloomberg.

As far as Europe is concerned one could argue in similar vein to Reverend Harry Powell that:
"Salvation is a last-minute business, boy."

Stay tuned!

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