Sunday, 14 July 2013

Credit - Simpson's paradox

"Politicians fascinate because they constitute such a paradox; they are an elite that accomplishes mediocrity for the public good." - George Will 

Looking at the growing deterioration in the European space, with Portugal coming back into the forefront, and France losing its final AAA courtesy of French rating agency Fitch, we thought this week we would move back towards "Bayesian" analogies in our chosen title given the practical significance of Simpson's paradox. In decision making situations, it poses the following dilemma, about which data should be consulted in choosing an action, which is, we think an appropriate analogy following all the recent conversation surrounding not only the tapering noises from the Fed but as well the recent "forward guidance" conversations initiated by the ECB. If for example we refer to the unemployment level being a target for the Fed, which we previously discussed as an application of "Goodhart's law", like any other paradoxes, it only appears to be a paradox because of incorrect assumptions, incomplete or misguided information, or most likely because of a lack of understanding of a particular concept, namely the "unintended consequences" of prolonged ZIRP (zero interest rate policy) has had on the real economy (increased productivity and margins preservation mean some jobs will never return) and the effect negative interest rates always had on triggering asset bubbles.

On the application of the Simpson's paradox, it can be seen in the recent "improving" European PMIs: a positive trend appears for separate countries, a negative trend appears when the data are combined. For instance applying similar treatments to different countries, has had similar effect to the real life example from a medical study for kidney stone treatments which shows that different treatments should have been applied to different patient populations. In similar fashion different treatments should have been applied to the different countries in Europe suffering from different issues of course, but we ramble again.

In this week conversation, we would like to look at few gathering storms ahead, given we have already started hurricane season early with Tropical Storm Chantal taking a rare early path, but first our market overview.

Our "Daisy Cutter" effect as displayed by the evolution of the Merrill Lynch MOVE  index, has been receding as of late. But, it is still displaying signs of high volatility in the fixed income space - graph 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.

Of course, in that context of receding bond volatility, the rebound in Investment Grade Credit and High Yield as indicative by the price action of the most liquid and active ETFs in the credit space namely the LQD (Investment Grade) and HYG (High Yield) ETFs, graph source Bloomberg:
Investors who thought ETFs as a fast and easy way to trade corporate bonds, had the pleasant surprise in the recent sell-off to discover that accessibility doesn't equate liquidity given that as reported in Bloomberg by Lisa Abramowicz and Mary Childs on the 8th of July in their article entitled "Crowded ETF Exit Proving Costly as Bonds Trail", the early exit comes with a cost:
"Investors who sought exchange-traded funds as a faster way to trade corporate bonds are finding that they can be as expensive to trade as the underlying debt.
As trading in the three-biggest credit ETFs surged to unprecedented levels last month amid the market’s biggest losses since 2008, the funds’ shares dropped as much as 1.1 percentage points more than the net value of the less-traded securities they hold. The two largest high-yield bond ETFs have lost about 6 percent since reaching a five-year high May 8. That’s about 2 percentage points more than the loss for the Bank of America Merrill Lynch U.S. High Yield Index.
The gap reflects the extra charge investors paid for a speedier exit in a declining market by using ETFs that trade like stocks rather than buying and selling the less-liquid debt.
Investors yanked about $1.83 billion of shares from the two-biggest junk ETFs last month, forcing sales of their holdings a ta time when demand was evaporating. “Just buying ETFs doesn’t solve the liquidity problem,” said Andrew Feltus, a money manager who helps oversee about $37 billion in U.S. fixed-income assets at Pioneer Investment Management Inc. in Boston. “You’re almost outsourcing your liquidity, because now your creator is the guy who’s going to have to go out and source the bonds in order to get it to work.”" - source Bloomberg

It is evident that liquidity comes with a price, given the low level of inventories sitting on market makers balance sheet, so it doesn't come much as a surprise that price performance is deeply affected by the significant volatility and outflows witnessed as of late:
"Shares of BlackRock Inc.’s $13.7 billion iShares iBoxx $ High Yield Corporate Bond ETF, the biggest of its kind, plummeted 4.3 percent in the six days ended June 24, while the net value of its assets dropped 3 percent, data compiled by Bloomberg show. The fund’s share price fell to the lowest level in 12 months on June 24, to $89.04. The lowest value last month for the underlying assets was $89.66, the data show." -source Bloomberg.

More interestingly the latest "marketing campaign" coming out from a European Central bank near you aka "Forward guidance" have had so far the desired effect in limiting the surge of European Government Bonds yields as indicated in the below graph with German 10 year yields falling below the 1.60% level and French yields now around 2.20% - source Bloomberg:
But looking at the gathering storms from Portugal, and with Italy's sovereign credit downgrade to BBB (negative outlook) from BBB+, the on-going "complacency" should not be taken for granted given the rising political tensions taking back center stage again. While Italy's downgrade, for bond indices is not an issue, Spain's downgrade would be problematic as it is currently sitting just above junk territory (BBB- / Baa3 / BBB).

In relation to the US dollar, this week saw the dollar index receding overall with gold bouncing back somewhat from the low point touched previously - graph source Bloomberg:

The volatility from the fixed income space has been spilling over the FX space, leading to some impressive proverbial "sucker punches" such as the one delivered to the Australian dollar this week, on the back of Chinese weaker growth prospects - AUD/USD intraday movements on the 12th of July - graph source Bloomberg:

An interesting graph we have been tracking with much interest displays the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:

Moving on to the subject of gathering storms ahead, rising interest rates and oil prices could indeed derail the consequent surge in US equities we have seen so far. Monitoring the impact rising gasoline prices are essential given the weak tone the US recovery has had so far, which has been further impacted by rising mortgage rates.

As far as Europe is concerned, our "Simpson's paradox" clearly indicates that the trend is negative, regardless of the latest "improving" economic data. 

The clear and present danger no doubt, comes from the austerity fatigue which is leading to political risks and turmoil as witnessed in Portugal and the recent slush funds scandal coming from Spain which could bring the Spanish government down.

The key issue of course for Europe is indeed unemployment which continues to rise, creating tensions in the process. On that subject CITI, in their latest Global Economic View from the 11th of July entitled "The euro area isn't working" is fairly clear on the subject:
"The euro area (EA) isn’t working. Quite literally. Roughly seven million more people are unemployed in the EA currently than in 2007 and in recent quarters the number of unemployed persons has been rising by almost half a million per quarter. Since the crisis started, unemployment has risen by 50% in the EA, doubled in Italy, tripled in Greece and Spain, and quadrupled in Portugal. It is now at record highs in all GIIPSSC countries (Greece, Ireland, Italy, Portugal, Spain, Slovenia, and Cyprus) except Ireland, as well as in the EA as whole. This is despite the fact that employment and labour force participation were relatively low in some of these countries even before the crisis.
(Un)employment matters greatly. In addition to its high social costs, unemployment makes it harder to repair the public finances, leads to skill degradation and creates the risk of greater social dislocation and social unrest. In this piece we consider past and prospective labour market reforms and the outlook for unemployment in the EA.
We conclude that unemployment is likely to remain very high for a long time. In the euro area as a whole, unemployment may still be above 10% at the end of this decade and in Spain maybe twice that. This is despite quite extensive labour market reforms in the EA in recent years, particularly in Greece, Portugal and Spain. In all three countries and in Ireland unit labour costs have fallen significantly. Models and precedents for how labour markets and labour market reforms can work in Europe also exist, even though the initial conditions in the precedent countries were generally more favourable than they are in the EA today." - source CITI.

Of course the most illustrative picture of the European "lost generation" can be seen in the below CITI graph:
"Long-term unemployment and youth unemployment – probably the most economically and socially harmful forms of unemployment – are particularly high in many EA countries. Conventional measures of youth unemployment suggesting that more than half of under-25 year olds are unemployed are misleading. The ‘NEET’ (not in employment, education, or training) measure of youth unemployment is more appropriate and less dramatic, but still sobering: in 2012, around one fifth of young persons in Italy, Greece, Spain and Ireland were NEETs (Figure 2) and the NEET ratio has risen in all EU countries since 2008. Meanwhile, the number of people in the EA that have been unemployed for more than 12 months has almost doubled in the last 5 years to nearly 9m people." - source CITI

Of course European politicians have once again demonstrated the Simpson's paradox in terms of "allocation" given the mediocre amounts involved in the latest EU Council decision of putting youth unemployment as its first agenda item and the focus for EU structural funds spending as displayed in the below figure:
"The financial amounts involved are ‘de minimis’. Thus, the funds allocated to the YEI under the new EU budget for 2014-20 are a mere €8bn over seven years (funds are meant to be spent in 2014-5 already), less than 1% of the total 2014-20 EU budget and less than 0.1% of EA GDP in 2012. For comparison, the new EU budget envisages spending more than 30 times on each farmer what will be spent on each unemployed youth. And due to the recent attention that the topic of youth unemployment has received, there are proportionally more funds available to fight youth unemployment than unemployment more generally.
The €8bn figure understates the total amount of resources available to fight youth unemployment (or employment), as a number of other ‘pots’ of money are used at least in part to support employment (notably the European Social Fund and some of the funds left unspent in the EU budget) and the EIB is supposed to give preference to projects supporting employment prospects. But the conclusion remains that the scale of the external help available is very limited and unlikely to make a noticeable dent in the employment numbers. "- source CITI

And CITI to conclude their recent note:
"One risk is that reform efforts will run out of steam before EA economies have become competitive, so that even these forecasts would prove optimistic. An even more worrying risk is that continued high unemployment will raise the prospect of widespread social unrest. ILO (2012) noted that its ‘social unrest index’ had risen by more in the EU than in any other region since 2006/7. Even if the more extreme reflections of public dissatisfaction are avoided, these factors will likely have a significant impact on political decisions and outcomes, and on growth prospects.
‘Austerity fatigue’ is often closely related to ‘unemployment fatigue’ and before long could become ‘debt service fatigue’, a risk we have been highlighting repeatedly in recent years. These considerations all play a major role in our assessment that sovereign debt restructuring will be a material risk for a number of EA economies with high public debt." - source CITI

Another point we would like to make as well in terms of the credit cycle, as we indicated in our conversation "What-We Worry?", we think it is much shorter this time around. For instance creditworthiness in the US is deteriorating at the fastest pace since 2009 with earnings growth slowing as yields rise from record low as indicated by Matt Robinson in Bloomberg on the 26th of June in his article - Ratings Ratio Worst Since 2009 as Profits Slow:
"The ratio of upgrades to downgrades fell to 0.89 times in the first five months of the year after reaching a post-crisis high of 1.55 times in 2010, according to data from Moody’s Capital Markets Group. At Standard & Poor’s, the proportion has declined to 0.83 as of last week from 1 a year earlier.
The Federal Reserve has pumped more than $2.5 trillion into the financial system since markets froze in 2008, helping companies improve profitability by lowering their borrowing costs. Policy makers are considering curtailing $85 billion in monthly bond buying intended to prop up the economy as analysts surveyed by Bloomberg forecast earnings growth of 2.5 percent in the current quarter, the least in a year.
The trend of improving credit quality has slowed as profits are slowing,” Ben Garber, an economist at Moody’s Analytics in New York, said in a telephone interview. “As the recovery matures, companies are liable to get more aggressive in taking on share buybacks and dividends.”
Rather than using cash to pay down debt, companies in the S&P 500 Index are attempting to boost their share prices by buying back almost $700 billion of stock this year, approaching the 2007 record of $731 billion, said Rob Leiphart, an analyst at equity researcher Birinyi Associates in Westport, Connecticut.
Borrowers controlled by buyout firms are on pace to raise more than $72.7 billion this year through dividends financed by bank loans, surpassing last year’s record of $48.8 billion, according to S&P Capital IQ Leveraged Commentary & Data.
After cutting expenses as much as they could to improve profitability, companies “will need to see further revenue growth to boost earnings from here,” Anthony Valeri, a market strategist in San Diego with LPL Financial Corp., which oversees $350 billion, said in a telephone interview." - source Bloomberg.

So not only the rally seen so far has been boosted by a "Simpson's paradox", leading to a surge in the "wealth effect" courtesy of our "omnipotent" central bankers, but "steroids" have also been used in this liquidity "alkaloid" induced equity rally as indicated by the impressive surge in stocks buy backs. Graph source Bloomberg:
"Companies focused on buying back shares may provide U.S. investors with “an enduring recipe for success,” according to Jeffrey Kleintop, LPL Financial Holdings Inc.’s chief market strategist. As the CHART OF THE DAY shows, the Standard & Poor’s 500 Buyback Index beat the S&P 500 from its introduction on Nov. 29 through the end of June. The newer gauge rose 24 percent in the seven-month period and came out ahead by 10.5 percentage points. “We expect it to outperform in the second half as well,” Kleintop wrote two days ago in a report. Many companies will turn to buybacks to increase earnings per share at a time of slower revenue growth, he wrote.
Sales rose 1.3 percent for S&P 500 companies last quarter after increasing 0.6 percent in the first quarter, according to data compiled by Bloomberg from analyst estimates and earnings reports. Profit growth slowed to 1.8 percent from 2.7 percent.
The buyback index consists of about 100 companies in the S&P 500 that had the highest repurchase ratios in the previous four quarters. The ratios are calculated by dividing the total dollar amount spent on a company’s shares by its market value when the 12-month period began. Each stock has an equal weight. Investors who mirror the index stand to benefit from its composition, the Boston-based strategist wrote. Companies that cater to consumers and depend on discretionary income amount to 26 percent of the buyback gauge, according to data compiled by S&P Dow Jones Indices. Consumer-discretionary stocks are the top performers this year among the 10 main industry groups in the S&P 500, where they only have a 12 percent weight." - source Bloomberg.

We would not call "buy backs" an "enduring recipe for success", us being credit investors, given the debilitating effect they can have on a corporate balance sheet and long term ratings, taking into account as well the cash burn effect. But then again, everyone is entitled to their own opinion...

On a final note, our good credit friend made the following great comments relating to reasons of the Fed's tapering:
"There have been a lot of talks recently about the FED decision to possibly reduce its liquidity injection at the end of the summer. Some market participants still think the FED will not taper as the economy is not yet on a very strong footing, and because the various thresholds announced by B. Bernanke (unemployment level, inflation,…) are still far from being reached. These arguments are undeniably right and strong, but one must consider other information prior to declare the “tapper” off.

First of all, B. Bernanke has explicitly announced that the FED will not look at economic data over the next few months, but rather at the trend which has developed.

Second, and more importantly, the FED currently owns about 33% of the outstanding US Federal debt. As funding needs of the US Treasury are diminishing following the sequester, there is less issuance and the FED ownership of bonds in percentage is rising quicker. Should the Central Bank continue buying the same amounts of bonds, it will own 40% of the outstanding in 2014, then north of 50% in 2015. The subsequent volatility on the interest rate market will increase drastically as the liquidity of the bond market disappears, and the currency could debase very quickly, creating a new crisis.

Third, and also a cause of concern, the bond market repo activity is facing an increasing number of failures (fails to deliver are on the rise exponentially) due to the large FED holding, which has ripple effect on the overall bond market activity. 

Fourth, and finally, economic growth in a society based on consumption requires credit. In order for credit to grow, or in other words banks to lend, collateral must be available. Since the 2007-2008 financial crisis, high quality collateral has slowly but surely become less available. If Central Banks continue to buy various government bonds (and US Treasuries are among those bonds), the available collateral will trend lower and the economy will stall, or worst spiral down as a credit crunch will occur at some point. So the FED has no other choice than to slow and even stop its QE if it wants the game to go on.

To resume, the FED may have more incentive to tapper and even stop its QE over time than to continue it, even if the economy slows down and some asset prices move lower. Apparently, it is the price to pay if one wants to avoid bigger problems in the future. The only remaining question is the following : “Is it the right time to do the tapper, or did the CB already crossed an invisible dangerous line?”  The way asset prices will behave and re-price in the coming weeks/months will give us the answer (nice retreat or collapse)."

"The words of truth are always paradoxical." - Lao Tzu 
Stay tuned!

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