Saturday 4 May 2013

Credit - Pain & Gain

"The aim of the wise is not to secure pleasure, but to avoid pain." - Aristotle 

Looking at the continued rally in the credit space, with the Iboxx Euro Corporate benchmark tightening to the tune of 5 to 6 bps every week in the last three week in the cash market, in conjunction with the massive compression of spreads in the Itraxx Credit indices space, we thought this week, we would use a reference to 1999, New Times three-part series of articles called "Pain & Gain" by writer Pete Collins which inspired 2013 American film directed by Michael Bay.  The story revolved around a gang of local bodybuilders with a penchant for steroids (liquidity from central bankers?), strippers, and quick cash. They later became known as Miami's Sun Gym gang and quickly developed a taste for blood and money.

We closed the week on almost 15 bps on Itraxx Main Europe to 92, the lowest since May 2010, which is the risk gauge for Investment Grade credit, and 50 bps in Itraxx Crossover to a low of 378 bps. 

As one credit index trader put it in his closing comments (which are reminiscent of the early days of 2007):
"With street put short yesterday by the massive short cutting, dealers are finding it hard to recycle positions and were having more and more pain as client kept selling index today as well. With shallow volumes, every enquiry drove the market lower. The incredibly strong payrolls drove us through 90 and this was the point when people were starting to have discussions of whether these tights are the new fair trading range or whether they should put those shorts."
There you go, the penchant for steroids induced rallies in the credit space is starting to inflict some serious pain to market makers as they are having to bid for credit indices and getting hit in a severe tightening market, not only inflicting P&L pain, given they are having trouble recycling their positions with less players in the market place than in 2007 (gone are the prop traders, fewer credit hedge funds and fewer market making banks) but, they are also facing negative carry on the trades they have had to absorb and did not recycle. Oh well...

So this week, we will focus our attention to the credit space, the releveraging taking place in the US and Mario Draghi's ambition of reviving the Euro Zone Corporate lending . But first, a quick market overview.

The absolute level of core European government yields has continued to fall even after the 25 bps rate cut this week - source Bloomberg:
2 year Italian yields dropped to 1.068% the lowest since Bloomberg started tracking the data in 1993 and Italian 10 year yields fell 7 bps to 3.84% the lowest since October 2010. Spanish yields also receded with the 10 year falling to 3.97% below 4%, the least since October 2010 and 2 year below 1.60%, the lowest since April 2010.

Credit wise Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes going negative again and indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:

Credit wise the rally in 2012 has been epic courtesy of "whatever it takes 1" (Mario Draghi) and "whatever it takes 2" (Abenomics). Itraxx Main Europe 5 year CDS index (Investment Grade credit risk gauge based on 125 entities) and Itraxx Crossover 5 year index (European High Yield risk gauge based on 50 European entities) - source Bloomberg:
The absolute spread between both credit indices is closing to the level of March 2011 (255 bps apart) before the liquidity crisis of summer 2011 which was tempered by a good dose of "steroids" (LTRO 1 and 2).

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
We are back to early 2008 levels for both the Itraxx Crossover index and Eurostoxx volatility.

While the Eurostoxx seems struggling to break the 2800 level, the German 10 year Government yields have touching record low levels this week towards the 1.16% yield level  and the Itraxx Financial Senior 5 year CDS index (indicative of credit risk for financials in Europe) have been dramatically falling towards 140 in the last couple of weeks while volatility remains muted at 18 for the V2X index - 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:

We already indicated that divergence between the US PMI and European PMI divergence which we explained in our conversation "Growth divergence between the USA and Europe", was here to stay in 2013. This divergence can be seen as well in the difference in credit spreads risk gauges such as the Itraxx Main Europe CDS index and its US CDX counterpart - source Bloomberg:

What has been interesting has been the strong correlation between the US, High Yield and equities (S&P 500) since the beginning of the year. We have also noticed the strong rebound in Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD - source Bloomberg:
Talking about Pain and Gain, whereas March was brutal for investment grade, the rebound in April has indeed been very significant. As one can see the correlation between High Yield and equities seems to be stronger than ever as both the S&P 500 and the ETF HYG seems to be perfectly moving in synch.

But, if we focus our attention this week on credit, we would have to say that the unintended consequences of "steroids" induced policies from Central Banks is pushing investors more and more up the risk spectrum as everyone is seeking higher returns as indicated by Fitch recent European High Yield Chart book:
"As yields continue to compress in high yield, the risk-reward proposition for the investor becomes increasingly difficult to justify, shifting the dynamics in favour of issuers. European non-financial BBs now trade equal to equivalent US BBs, despite materially weaker growth, greater policy volatility and uncertain liquidity. European Bs continue to offer premia, though these too are tightening. Global monetary stimulus from quantitative easing in the US, the UK, and Japan together with an expected ECB rate leaves little choice for investors other than to move out along the maturity curve and go down the credit spectrum to seek diversification as they satisfy return objectives.
Deteriorating credit quality poses a risk to the market, but this is largely expected to translate into a migration of ratings to lower levels rather than any substantial increase in the default rate. The legacy loan market is at greater risk of rising defaults due to the concentration of riskier borrowers from 2006 and 2007 who were able to access tighter spreads and higher levels of leverage than the high-yield market could accommodate at the time.
However, further spread compression may entice riskier lower B‟ or CCC rated issuers from the leveraged loan market to issue high-yield bonds. Such developments tend to signal the end of cycle in European high yield and a period of yield and spread widening together with subdued new issuance. To date in 2013, the market is accepting lower quality instruments from higher quality borrowers, such as Sunrise Communications Holdings SA (BB−/Stable) recent PIK note (B− instrument rating). When the market tests low-quality instruments from low-quality borrowers the cycle will be set to return." - source Fitch

The European and US High Yield Market, new issuance and yields - source Fitch:

Using again our "Pain & Gain" title analogy, we would like to further delve into our analysis of the "Japonification" of credit in Europe and the difference with the US where we are seeing re-leveraging at play in the credit space.

For instance, many pundits are wondering how come peripheral EMU bond yields and peripheral bonds have been performing so strongly when indices such as the FTSE Italian bank index is still flat at 10,000.

For us, it is very simple, deleveraging is generally bad for equities and in particular financial stocks, but good for credit assets. We discussed this very subject back in April 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"When companies turn conservative and start reducing debt, credit holders benefit and equity holders lose out."

Why would we have had a rally in Italian banks? It doesn't make sense. For us a bank is a leverage play on the economy, it is the second derivative of a sovereign. No credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and no earnings for banks. Banks in peripheral countries had no choice but to shrink their loan books, reducing therefore their profitability and ROE.

European Banks ROE by countries from 2005 to 2011 - source Bloomberg - Macronomics:
Nota Bene: 2011 data for Germany not available. McKinsey & Co. said in its bank sector annual report. European bank average returns on equity were 15% to 17% in 2005-07, vs. 7% to 9% currently. With the revenue outlook poor, further cost cuts remain a key profitability lever. Median ROE in 2011 in the European Union was 2.2%.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 1.2% inflation rate is telling you hence the ECB rate cut this week. But, once again ECB is behind the curve courtesy of the stupid European Banking Association decision of imposing a 9% Core Tier 1 threshold to European banks to be reached by June 2012, which precipitated a credit crunch in peripheral countries, leading to a surge in unemployment, bankruptcies and rapid rise in nonperforming loans.

A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse in 2011). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen in the European banking space and other accounting tricks...). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios in peripheral countries.

Therefore in Europe, you have been much better off buying senior financial corporate bonds as part of the reflation "whatever it takes" trade in this deflationary environment than peripheral financial stocks. As seen in Japan in the past, credit outperforms equities in a deflationary environment.
Peripheral banks equities = Pain
Peripheral banks senior financial bonds = Gain

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Macro Research which we introduced in our conversation "The Night of the Yield Hunter":

Whereas credit wise, European peripheral financials are deleveraging, hence the performance of their bonds ("Gain" - Love) rather than their equities ("Pain"- Hate), what we are starting to see in the US is leverage rising as indicated by Fitch, in their recent US High Yield Default insight from March 2013:
"Credit Gains Hit Speed Bump:
In the March 2013 edition of the “Fitch Ratings/Fixed Income Forum Senior Investor Survey,” a majority of investors saw U.S. corporate leverage moving higher over the coming year and expected some credit deterioration across both high grade and high yield. Fitch’s recurring analysis of the aggregate financial performance of a large sample group of speculative grade companies shows that leverage began to turn up in 2012a product of higher debt balances and sluggish EBITDA growth (see Debt / EBITDA chart below).
In the second half of the year, in fact, the number of companies in Fitch’s sample reporting year-over-year increases in EBITDA (approximately 55%) had fallen to the lowest level in three years and was on par with the share reporting year over year increases in total debt (also 55%) (see Companies Reporting Increases in Debt and EBITDA chart below). 
Rating trends further confirm this pattern, offering a more complete picture of the direction of credit quality. Fitch recorded more U.S. corporate downgrades than upgrades in 2012. In the first quarter of this year rating activity was roughly even for speculative grade borrowers, and so it appears that the negative rating drift has stabilized, but trends remain lackluster, especially compared with 2010 and 2011 activity when credit quality was more firmly on the upswing. Also notable, the volume of bonds rated ‘CCC’ or lower is now $237.5 billion, up from $226.5 billion at the end of 2012 and $196.8 billion at the end of 2011. Even absent aggressive precrisis transactions, there is still plenty of organic sensitivity to the subpar domestic and global economic environment. An offset to this is funding. Thanks to the Fed’s commitment to low interest rates and the demand it has created for yield product, companies have been able to successfully push out bond and loan maturities. This provides a meaningful support for keeping default rates low in the near term."

In terms of flattening yield curve, indicative of the credit cycle, we think as credit investors you should start monitoring the flattening of CDS curves. As a market maker commented recently:
"1 year and 2 year CDS curves are flattening, only a matter of time before 3 year versus 5 year curves does the same and flatten."

We have of course seen this movie before in the credit space in the heyday of the credit bubble build up in 2006 and 2007.

So as credit investors, yes we are indeed still dancing as the music is playing, but, given the liquidity levels closer to 2002 than 2007, we'd rather be dancing close to the exit door. As Aristotle put it, our aim, being wise we think, is not to secure pleasure, but to avoid pain, which will no doubt materialise at some point.

On a finale note, Mario Draghi ambitions to revive the real economy and corporate lending that is. The LTROs after all amounted to "Money for Nothing":
"Although LTRO provides cheap funding to European banks, rising unemployment levels and deteriorating credit conditions should consequently lead to a significant rise in Non Performing Loans (NPLs) on banks balance sheet."
Meaning plenty of liquidity impact (steroids) for banks (our European Sun Gym gang which have a taste for blood and money) but confirming our 2011 fears of credit contraction for corporates and households (Italy and Spain) - source Bloomberg:

"Corporate loans across the euro zone fell more than 350 billion euros ($460 billion) to March's total of 4.5 trillion euros from January 2009 highs. ECB President Mario Draghi's lowering of the marginal lending rate and hint at reviving European Asset-backed Securities mark early steps toward enlisting banks to lend-again. An ABS market would enable banks to package new lending into an ABS structure and post with the ECB to access further funding." - source Bloomberg.

As far as we are concerned, the deflationary forces at play and the unemployment levels in Europe cannot be addressed by ZIRP for the following "creative destruction reasons" as indicated by CreditSights in their recent Sovereign Analysis from the 1st of May entitled -If the ECB doesn't mind Spain deficit, nor do we":
"Spanish non-financial corporates alone saved the equivalent of 3.3% of GDP last year. That difference between corporates' revenues and expenses was used to pay down debt. Spanish, non-financial corporates have net debts equivalent to 129% of GDP. But it comes at the expense of Spanish households'. In the process of using revenues to pay down debt, corporates are ensuring that they aren't spending it and in the vast majority of cases won't not generate incomes for households. Those cut backs in investment spending are contributing to the decline in wages and rise in unemployment.
Unemployment has now reached 27.2% as of the first quarter. And wages have fallen by 1% over the past year. The decline in incomes mean that household savings have fallen from 6% of GDP in 2009 to 1% of GDP in 2012 as they have been forced to fall back on savings to be able to maintain spending. While households added €22 bn in financial assets in 2011 they reduced their holding of financial assets by €15 bn in 2012. That swing from saving €22 bn to dis-saving €15 bn contributed €37 bn to household spending and meant that year on year it rose by 0.2% in nominal terms rather than falling by more than 5.5%." - source CreditSights
Since 2008, you have seen creative destruction at play, meaning companies have preserved their margins by doing more with less people. Some job will just not return. What is the benefit of QE and ZIRP on structural unemployment? Zero so far:

ZIRP isn't only a European problem in this credit "japonifiaction" process at play. It is also the case in the US.
In fact productivity in the US has been rising as companies have been indeed preserving their margins by managing very tightly their labor costs and adapting to the low growth environment they face as reported by Shobhana Chandra in her Bloomberg article from the 2nd of May - Productivity in U.S. Rises as Companies Try to Cut Labor Costs:
"The productivity of U.S. workers rose in the first quarter as companies focused on containing labor expenses.
The measure of employee output per hour increased at a 0.7 percent annual rate, after dropping 1.7 percent in the prior three months, a Labor Department report showed today in Washington. The median forecast in a Bloomberg survey of economists called for a 1 percent advance. Expenses per worker increased at a 0.5 percent rate after jumping 4.4 percent.
Employers tried to control expenses by making do with their existing staff as demand grew in the January to March period. The emphasis on wringing efficiency gains may mean hiring will take time to accelerate, particularly as across-the board federal budget cutbacks and higher payroll taxes restrain the world’s largest economy." - source Bloomberg.

By keeping interest low to promote investment, like the Fed is also currently doing, full employment would therefore be "attainable" in the pure Keynesian tradition. For Keynes, the velocity of money should move together with the level of economic activity (and the interest rate). Well guess what. It isn't.

Credit growth is a stock variable and domestic demand is a flow variable.

Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?

The only country in Europe we can think of which tackles efficiently structural unemployment by retraining the labor force is Sweden.

Why would the US labor participation rate in the US increase?
If the cost of capital is not priced but set by central banks, how can capital be efficiently deployed to innovation and not "mis-allocated"?
MV = PQ. (Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.).

Monetary policy at the moment is a desperate race. They are increasing money supply but velocity keeps falling. So the Fed’s problem is best understood as one of trying to bend this velocity curve.

Alan Greenspan made mistakes after mistakes, bubbles after bubbles, central bankers do not understand that negative real rates always lead to a collapse in velocity and a structural decline in Q, namely economic growth rate.

Pain in employment levels - Gain in financial markets.

"Prefer a loss to a dishonest gain; the one brings pain at the moment, the other for all time." - Chilon

Stay tuned!

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