Sunday 16 June 2013

Credit - Lucas critique

"Excess generally causes reaction, and produces a change in the opposite direction, whether it be in the seasons, or in individuals, or in governments." - Plato 

While we mused around Goodhart's law, prior to taking a much needed break, unfortunately interrupted by the unavoidable and repetitive French strikes, we thought this week, on the back of a friend's recommendation, we would make a reference to Lucas critique, named after Robert Lucas' work on macroeconomic policymaking. Robet Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:
"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes.

For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. But a change in security policy, such as eliminating the guards for example, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies." - source Wikipedia

So, as one can infer from the point made above and in continuation to the points made in our conversation "Goodhart's law", Ben Bernanke's policy of driving unemployment rate lower is likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  

In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:
"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - source Wikipedia

In similar fashion to what we posited in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is as we recently discussed.

The issue with NAIRU:
"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed." - source Wikipedia

In respect to our chosen title, and looking at the evolution of inflation expectations, via TIPS, we still believe deflation is currently the on-going problem, not inflation as indicated by Bloomberg's chart displaying 10-year TIPS which have turned positive:
"Treasuries have dropped far enough during the past six weeks that investors no longer have to pay for the privilege of guarding against inflation when they buy 10-year notes.
As the CHART OF THE DAY illustrates, 10-year Treasury Inflation-Protected Securities yielded more than zero for the past two days. The last time that happened was in November 2011, according to data compiled by Bloomberg. Yields on the notes, known as TIPS, fell as low as minus 0.93 percent last December. Investors who bought the securities and held them to maturity were assured of receiving less than they paid before any adjustments to principal and interest payments, reflecting changes in consumer prices. “The idea that you’re going to have inflation, I think, is coming off,” Ira F. Jersey, director of U.S. rates strategy in New York at Credit Suisse AG, said yesterday in an interview on Bloomberg Radio.
The Federal Reserve’s preferred inflation gauge shows the pace of price increases has slowed even though the central bank is buying bonds and holding its key interest rate near zero to aid the U.S. economy. The indicator, the personal consumption expenditure deflator, rose 0.7 percent in April from a year earlier. The increase was the smallest since 2009.
Lower prices for Treasuries may do more to explain the above-zero yield for 10-year TIPS than the inflation outlook, Jersey said. Ten-year notes that aren’t indexed had a negative return of 4.2 percent from May 1 through yesterday, according to data compiled by Bloomberg."  - source Bloomberg

As a reminder in relation to the Taylor Rule and inflation expectations, as indicated in a Bloomberg article from the 15th of November 2012 by John Detrixhe entitled "Citigroup Seeing FX Signals of Early End to Stimulus: Currencies":
"Traditional measures of monetary policy such as the Taylor Rule that are based on growth and inflation suggest the Fed should end its stimulus efforts. John Taylor, an economist at Stanford University, published the formula in 1993. It signals the Fed’s benchmark should be 0.65 percent, or 40 basis points above the upper range of the current target interest rate for overnight loans between banks, assuming an inflation of 1.7 percent, unemployment of 7.9 percent and a nonaccelerating inflation rate of unemployment, or NAIRU, of 5 percent. NAIRU is the lowest unemployment rate an economy can sustain without spurring inflation.
About a year ago, the Taylor Rule model indicated policy rates should be minus 0.47 percent. The Fed has a target for price increases of 2 percent. The consumer-price index increased by that much in October 2012 from a year earlier, the Labor Department said on November 14. If “unemployment rate gets below 7 percent, you could have a Taylor Rule that suggests rates should go up and the question becomes do they overturn the Taylor Rule?” Steven Englander, Citigroup’s New York-based global head of G-10 strategy said. “When perceived commitments are at stake, it’s a nightmare.” - source Bloomberg

As far as we are concerned when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion, but we ramble again

Therefore in this week's conversation, after a quick market overview, we would like to touch again on the deflationary forces at play, given, as Plato's quote rightly said, excess generally causes reaction, and produces a change in the opposite direction .Our "omnipotent" central bankers, and investors alike should pay more attention to this quote...

In our quick market overview, we will not delve too much into the recent surge in rates volatility which has spilled over other asset classes given we have tackle this issue in our post from the 13th of June entitled "The end of the goldilocks period of low rates volatility / stable carry trade environment"

The recent move in the MOVE and CVIX indices are now starting to spillover to the equities sphere. We have added the VIX index to our previous chart - source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

The spike in volatility in Japan has been preceding the widening move in CDS Spreads of the Itraxx Japan, a move we saw coming:
"Should the volatility in the Japanese space continue to trend higher, which is currently the case, we would expect credit spreads to continue to widen, particularly for Japanese financials." - Macronomics, Japanese Whispers, 25th of May 2013.
Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Itraxx Japan 5 year CDS since January 2010 until today - source Bloomberg:
Back on the 25th of May the Itraxx Japan CDS, we indicated that a surge in volatility in Japan would lead to a surge of Japanese credit risk. The Itraxx Japan has surged from 82 bps to 111 bps in the continuation of this surge in equity volatility.

More interestingly the surge in bond volatility has led to some serious outflows in the fixed income space. For instance, as indicated by Credit Suisse, the ICI fund flow data which was out for week ended June 5; showed equity mutual fund outflow of -$942m;  the big number was bond outflow of - $10.9bn. It was second-largest bond mutual fund outflow in history of weekly ICI series, which extends back to Jan 2007:
"The Investment Company Institute estimated that bond mutual funds posted a huge net outflow of $10.9bn in the week ended June 5. This was the second largest weekly outflow in the history of this series, which extends back through 2007. The largest outflow recorded was during the darkest days of the financial crisis, in the week ended October 15, 2008 (-$17.6bn). Investors apparently didn’t rotate into equity mutual funds in early June, as equities also saw a net outflow, albeit a much smaller one. In the week ended June 5, investors withdrew a net of $942mn from equity mutual funds.  Hybrid mutual funds posted a small net inflow of $347mn in that week." - source Credit Suisse

So much for the "great rotation" story: 
"Since the beginning of the year we have not bought into the story of the "Great Rotation" from bonds to equities. One of the reason being on one hand demography with the growing numbers of baby boomers retiring, the other one being pension asset allocation trends." - Macronomics, "Goodhart's law".

We will touch more on the deflationary forces at play and the importance of demography after our overview.

When one looks at the relative performance of the S&P 500 versus MSCI Emerging, one can easily see EM equities have been clearly lagging. Emerging markets (MXEF) continue to underperform developed markets  - source Bloomberg:
The absolute spread between the S&P 500 and MSCI Emerging Markets has touched a record low level.

"QE tapering"soon? We do not think so. Markets participants have had much lower inflation expectations in the world, leading to a significantly growing divergence between the S&P 500 and the US 10 year breakeven, indicative of the deflationary forces at play,  graph source Bloomberg (5th of June 2013):

While some central bankers are busy trying to ignite inflationary expectations with various QE programs, the YTD movements in 5year forward breakeven rates which have been falling are indicative of the strength of the deflationary forces at play - source Bloomberg:

We recently commented that Investment Grade is a more volatility sensitive asset to interest rate changes meaning a surge in the MOVE index is leading to increasing volatility in the investment grade bond space where record lows yields on long bonds can lead to some vicious losses on highly interest sensitive long bonds (Apple 30 year bond being a good example of the repricing risk)., High Yield is a more default sensitive asset. The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has weakened dramatically recently. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:
We recently commented on the latest sell-off in the ETF High Yield credit space with our good cross asset  friend in our conversation "High Yield ETF - The Fast and The Furious":
"If you do not believe in the "tapering QE" scenario, which led to a recent surge in US yields on government bonds and this recent sell-off on credit, then the relative value of High Yield, is starting to be compelling again (6.50% in YTM - yield to maturity versus S&P 500)." - source Bloomberg.

So if you do not believe in the "tapering", like ourselves, and like Mr. Jeff Gundlach, maybe at these levels the ETF HYG is starting to be compelling again. Mr Gundlach's opinion is that the Fed is likely to step in and actually increase QE to try and hold rates down, given mortgage rates have spiked substantially over the last month from a low of around 3.5% to around 4.3% today.

Moving on to the subject of the deflationary forces at play, shipping has always been for us, the best significant example of the reflationary attempts of our "omnipotent" central bankers. For instance, containership lines have announced eight rate increases, totaling $3,650, but have failed to maintain the momentum because of the weak global economy and the excess capacity which has yet to be cleared in similar fashion to the housing shadow inventory plaguing US banks balance sheet, graph source Bloomberg:
"Containership lines have announced eight rate increases, totaling $3,650, on Asia-U.S. routes since the beginning of 2012. The increases have largely failed to hold because of excess capacity and a weak global economy. As such, benchmark Hong Kong-Los Angeles rates have only risen by 36% since the end of 2011 and are down 11.6% ytd. In a Bear Case scenario, operators will continue struggling to sustain rate increases. The Drewry Hong Kong-Los Angeles 40-foot container rate benchmark was broadly unchanged in the week ending June 12, remaining below the $2,000 mark for the third time in 2013. Rates are down 27.5% yoy and 11.6% ytd, even with three rate increases, as slack capacity pressures pricing. Carriers are expected to raise rates by $400 per 40-foot equivalent on containers from Asia to the U.S. West Coast, and by $600 to all other destinations, effective July 1. " - source Bloomberg.

Of course high unemployment which continues to plague developed economies will continue to weight on the economic recovery in general and shipping in particular, graph source Bloomberg:
"Unemployment within the euro zone is expected to increase to 12.2% in 2013 from 11.4% in 2012, and remain broadly unchanged at 12.4% in 2015, according to consensus forecasts. Falling unemployment is crucial for expanding global demand for goods, soaking up excess capacity and firming shipping rates. The recovery in the shipping industry will not be fully realized without improving unemployment trends." - source Bloomberg.

Deflationary forces at play in the shipping space? You bet!
This is what was indicated by Rob Sheridan and Isaac Arnsdorf in their Bloomberg article from the 7th of June - Panamaxes Have Longest Losing Streak as Glut Magnifies Downturn:
"Rates for ships hauling coal and grains posted the longest losing streak on record as the merchant fleet’s largest glut magnified seasonal declines in demand from South America and India.
Earnings for Panamaxes fell 0.1 percent to $6,078 a day, the 32nd drop in a row and the longest stretch in data going back to 1999, according to the Baltic Exchange, the London-based publisher of shipping costs on more than 50 trade routes. Panamaxes can carry about 75,000 metric tons of dry-bulk commodities." - source Bloomberg.

We still are seeing creative destruction at play and deflationary forces in the shipping space as the gradual excesses of too many ships built on ship credit are being dealt with, graph source Bloomberg:
"Excess capacity and depressed charter rates have increased the number of container ships sent to be scrapped by 538% since June 2005. This is creating a more efficient fleet as older ships are replaced by newer models. For instance, Maersk is set to introduce triple-E ships that consume about 35% less fuel per container and are able to carry 16% more boxes. In May, the total number of scrapped container vessels surpassed tankers." - source Bloomberg

Global Economic growth remains weak and vulnerable as indicated by the dry bulk market:
"The dry bulk market continued to show weakness, as time charter rates fell for most carriers in 1Q. Dry bulk rates declined 36% yoy on average and were down 10% sequentially. Torm (down 14.2% yoy) and D/S Norden's (20.2% lower yoy) dry bulk rates decreased the least. D/S Norden noted dry bulk fleet growth has moderated, and scrapping will continue as long as rates remain low. The Baltic Dry Index declined 8.2% yoy in 1Q, and fell 16.5% from 4Q." - source Bloomberg.

In similar fashion to the extend and pretend game being played by banks relating to their real estate exposure and negative equity, some German banks, which total exposure to shipping loans amount to 125 billion USD with a nonperforming ratio of 65%, have resorted to avoid recognizing the losses by acquiring some ships in a bid to salvage their bad loans as reported by Nicholas Brautlecht in Bloomberg on June 13 in his article "Commerzbank Acquires First Ships in Bid to Salvage Bad Loans":
"Commerzbank AG, the German lender whose soured shipping loans prompted a ratings downgrade by Standard & Poor’s last month, is taking the helm as it tries to salvage some of the 4.5 billion euros ($6 billion) it holds in bad debt from the crisis-hit industry.
It plans to take over two feeder ships from debtors this month, holding off on a sale until values recover, said Stefan Otto, 42, the head of the shipping unit. The vessels, which can transport as many as 3,000 standard 20-foot containers, or TEU, are the first the Frankfurt-based bank will actively manage as part of a goal to reduce shipping losses and exit ship financing.
“We focus on ships where we see significantly more upside than downside in the future, and where it seems smarter to hold them for a limited time period and wait with the divestment until the value has increased,” said Otto in an interview, declining to reveal the value or the names of the ships.
The collapse of Lehman Brothers Holdings Inc. in September 2008 and the ensuing sovereign-debt crisis propelled the shipping industry into a slump from which it has yet to recover, suffocating demand and generating a glut of vessels. Commerzbank decided a year ago to wind down its shipping portfolio to stem the losses.
The company, which had shipping loans of 18 billion euros in the first quarter, became the world’s second-biggest financier of ships with the 2009 acquisition of Dresdner Bank. Norddeutsche Landesbank Girozentrale has a similar-sized loan portfolio, while leader HSH Nordbank AG’s ship loans stood at 27 billion euros in the first quarter." - source Bloomberg

Given that Container ships make up more than one-third of Commerzbank’s 18 billion-euro shipping loan portfolio and looking at the trend in Dry Bulk Cargo described above, and that Commerzbank has had its 5th capital increase in four years, you can expect additional pressure to come for Germany's second largest bank. By 2016, Commerzbank wants to further reduce its portfolio by 4 billion euros to about 14 billion euros, while a date for a complete exit is too difficult to predict according to Stefan Otto. Exit? What exit?

As we have argued in our conversation "Dumb buffers", taking ownership from debtors will not change the fact that Commerzbank's outlook due to its shipping exposure remains deeply concerning:
"Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book".

Size matters? In shipping it does as indicated by Deutsche Bank in their 7th of June report on the Container Shipping industry, (a point we had made back in August 2012 in our conversation "The link between consumer spending, housing, credit and shipping"):
What are the competitive advantages of the ultra-large vessels?
"Breakeven point is substantially lower in the ultra-large vessels
Container ships have become larger because they can take advantage of economies of scale, diluting the operating costs of the vessel among a larger number of containers. We estimate the freight rates at which a 18k TEU vessels could reach cash breakeven in Asia-Europe trades (USD916) is 21% lower than a 8.5k TEU vessel (USD1,160) and 28% lower than a 6.5k TEU vessel (USD1,268) (calculations made at 18 knot speed, 90% load factor and bunker price USD650/ton)."  - Source Deutsche Bank.

In this deflationary environment, as we repeatedly pointed out, only the strongest will survive. In the shipping space,  Maersk Line, will be the biggest beneficiary we think and agree with Deutsche Bank:
"Given the current order book for new vessels in the sector, the operation of truly ultra large vessels, those larger than 14k TEU, looks almost like a de-facto oligopoly mainly in the hands of Maersk Line, MSC and CSCL, which together will have 78% of the capacity in the segment by 2016, versus a total market share of 33%. This data is based on the global order book as of 11 January 2013 (source Alphaliner) and it does not include the latest order for five 18,000TEU vessels made by CSCL, on which we comment in the specific company pages below in this report." - source Bloomberg

What are "inflationistas" of the world and "tapering believers" fail to take into account in their analysis is the importance of demography we think in true Lucas critique fashion. Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":
"The older a country’s population, the lower its inflation rate, posing a challenge for central banks in the world’s industrial nations, according to a UBS AG report.
Singapore-based economist Andrew Cates of the Swiss bank’s global macro team plotted average inflation levels over the last five years against changes in the dependency ratio, which compares the very old and very young to the working-age population.
The resulting chart showed nations that have aged in recent years typically faced very low inflation and, in the case of Japan, deflation. By contrast, those that have been getting younger, such as India, Turkey and Brazil, have relatively strong price pressures.
“Since ageing demographics will now start to feature more prominently in the outlook for many major developed and developing countries this is clearly of some significance for how inflation might evolve,” said Cates in a May 30 report.
The finding clashes with the view of economics textbooks, according to Cates, which tend to say a slowdown in population growth should put upward pressure on wages -- and therefore inflation -- as labor supply shrinks. Still, this ignores how demographics influence demand for durable goods and property, Cates said.
He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.
By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.
“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg

On a final note, dormant inflation in the US is giving plenty of time to the Fed, as indicated as well by the current trajectory of TIPS, graph source Bloomberg:
"The Federal Reserve may be able to take its time in adopting a more restrictive monetary policy because inflation is relatively tame, according to Pavilion Global Markets Ltd.
As the CHART OF THE DAY illustrates, the U.S. core consumer price index’s increase since the latest recession ended in June 2009 is the smallest for any multiyear recovery since the 1970s. The gauge of prices excluding food and energy rose 6.3 percent through April, according to the Labor Department.
“There is no pressure on inflation that could lead the Fed to act more quickly than it would like” in scaling back a bond-buying program and raising interest rates, Pierre Lapointe, the Montreal-based head of global strategy and research at Pavilion, and two colleagues wrote yesterday in a report.
Core consumer prices were 7 percent higher at the same point in the previous recovery, which started in December 2001, as the chart shows. The biggest increase in the inflation gauge was 29 percent, posted in a recovery that began in April 1975.
These and other inflation statistics are at odds with the magnitude of losses in U.S. bonds, according to David R. Kotok, chief investment officer at Cumberland Advisors. The decline in 10-year Treasury notes sent their yield surging 60 basis points from this year’s low, reached on May 2, through yesterday. Each
basis point amounts to 0.01 percentage point. “The bond-market adjustment is too extreme and has created
bargains,” Kotok wrote. He added that Cumberland, a firm that’s based in Sarasota, Florida, is buying tax-free bonds and taking more interest-rate risk with its holdings." - source Bloomberg.

"We are not retreating - we are advancing in another direction." - Douglas MacArthur 

Stay tuned!

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