Sunday 27 April 2014

Credit - The Shrinking pie mentality

"I am neither bitter nor cynical but I do wish there was less immaturity in political thinking." -Franklin D. Roosevelt

Reading with interest the latest take on China by both Russell Napier from CLSA in his latest Solid Ground opus as well as Albert Edwards on the similar subject of a potential Chinese devaluation risk which would push the world further into outright deflation, we reminded ourselves of the "Shrinking pie mentality" in relation to our chosen title. Indeed, when the economic pie is frozen or even shrinking, in this competitive devaluation world of ours, it is arguably understandable that a "Winner-take-all" mentality sets in. Shrinking economic growth resulting from the financial crisis means that, from a demographic point of view in Europe with a shrinking working age population, low birth rates and a growing population of older people, it means to us that Europe does indeed face a critical choice: meet their unfunded pension liabilities and go bust, or cut drastically in entitlements in order to compete with emerging countries that don't have these large "legacy" costs associated with aging developed countries. 

When it comes to the benefits of "Quantitative Easing" program which went on in various countries (Japan, United States and the United Kingdom), the possible gains of this uphill battle against strong deflationary trends for a small share of a shrinking pie rarely justify the risks in the long run we think.

In relation to the aforementioned Chinese devaluation, we do agree with both Russell Napier and Albert Edwards that a Chinese devaluation is a strong possibility given that the Chinese have studied carefully Japan's demise from its economic suicide thanks the fateful decision taken to revalue the yen following the Plaza Agreement of 1985 (a subject we discussed with our good credit friend back in March 2011 in our conversation "Fool me once, shame on you; fool me twice, shame on me..."). In its most recent commentary, the US Treasury states that the Yuan is “significantly undervalued” and suggests that it must appreciate if China and the global economy are to "enjoy" stable growth. Unfortunately for the US Treasury the Chinese are not stupid as indicated by this article displaying the Chinese view on the Japanese economic tragedy written in 2003:
"Under US pressure, the Japanese government and banks "honestly" carried out the "Plaza Agreement", starting to interfere the yen exchange market on a large scale together with the US. As a result the exchange rate of yen against US dollars skyrocketed, exceeding 200:1 by the end of 1985, going beyond 150:1 at the beginning of 1987 and nearing 120:1 in early 1988. This means that the Japanese yen had doubled its value against US dollars in less than two years and a half!"People's Daily, September 23 by Professor Jiang Riuping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

Of course we all know what happened next, from the same article:
"By the end of 1989 the Nikkei average stock price had climbed to 389,000 yen, expanding two times in four years! While during 1998 alone the land price around Japan's three major metropolitans rose by 43.8 percent, the Tokyo Rim rising even by 65.3 percent. 

In early 1990s, the economic bubbles created by the yen revaluation suddenly blew up, plunging the nation into an unprecedented recession, from which the country has been trying to struggle out till today. During the recession lasting longer than a decade, almost all the important economic indexes registered the worst post-war record. By then Japan had completely lost its long-term advantageous position held in the after-war pattern of western economic growth, especially that over the US. To some degree we should say, after years of efforts as set out at the "Plaza Agreement", America finally has defeated its biggest rival in the field of international trade." People's Daily, September 23 by Professor Jiang Riuping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

On another point the demise of the Japanese rival was a "blessing" for the US economy which had been under duress due to the Saving & Loans crisis of the 80s. In similar fashion, the US would thrive on a strong revaluation of the yuan, which would no doubt precipitate China into chaos and trigger a full explosion of the credit bubble in China, putting an end to the "controlled demolition" approach from the Chinese authorities. A continued devaluation of the yuan, would of course be highly supportive of the Chinese attempt in gently deflating its credit fuelled bubble, whereas it would export a strong deflationary wave to the rest of the world, putting no doubt a spanner in the QE works of the Fed, the Bank of Japan and soon to be ECB. As we pointed out, the Chinese have learned their "Japanese lesson" unfortunately for the US Treasury and there are no US military bases in China (like the United States have in Japan...). Given the raging "Shrinking pie mentality" in the world today, the US economy won't benefit like it did in the 90s from Chinese committing "economic seppuku" as the Japanese did, as they have learned their "Japanese economic lesson" but we ramble again...

As an illustration of the lack of the Fed progress we think in recent years has been no doubt in the Employment to population ratio as displayed in the below Bloomberg graph:
Does the recent uptick is indicative of the recovery finally taking shape in the US? The jury is out there and the next employment figures to be released in the coming months will be key particularly hourly wages data when it comes to validating the "escape velocity" plight of the US economy. But, as Roosevelt, we are neither bitter nor cynical, we are just merely economic observers and when we see that the US housing market which saw sales of previously owned properties tumbling in March by 7.5% from a year earlier to the slowest pace in 20 months while purchases of new houses sank 14.5% from February as reported by Bloomberg, we have our doubts on the "escape plan".

As we indicated last week, US Family Housing Starts has been falling in conjunction with US Furniture sales, as well as the Baltic Dry Index pointing, to some important "crosswind" in this much vaunted US recovery.

One of the prime reason of our disbelief in the much hyped global recovery has been indicated by our regular observation of the shipping space where, for instance the Drewry Hong-Kong-Los Angeles container rate benchmark has been displaying clear lack of traction for 10 straight weeks despite numerous rate increases due to overcapacity still largely plaguing the container shipping industry - graph source Bloomberg:
"The Drewry Hong Kong-Los Angeles container rate benchmark fell to $1,900 for the week ended April 23. Rates declined 3.3% after a general rate increase of $300 per 40-foot container implemented April 15 failed to hold due to slack capacity. The three general rate increases ytd have not been sustainable. Rates have remained below $2,000 for 10 straight weeks. Container rates are down 10.4% yoy." - source Bloomberg.

Given the annual rate of inflation in the euro zone was 0.5% in March, well below the ECB’s target of just under 2%, and it has been less than 1% since October, many pundits are tentatively analysing the various forms of QEs which could be attempted in Europe as well as pondering the benefits. Therefore, in this week's conversation, and given the glaring "Shrinking pie mentality" taking place in the world today, we will look closely at this very subject and the potential impact it could have.

In terms of our take on the Euro currency's strength, in our conversation in early January 2014 entitled "Third time's a charm" we argued the following:
"As we move into 2014, our chosen title reflects the third time strategists put forward the case for a weaker euro. So could indeed 2014 see finally the much anticipated weaker euro forecasted by so many pundits?

In terms of our prognosis in both 2012 and 2013, we did not believe in a weakening of the Euro versus the dollar and we reiterated our stance in numerous occasions such as in our conversation from April 2013 "Big in Japan":
"In terms of the EUR/USD, we still think in the second quarter that it should remain in the 1.30 region versus the US dollar, which were our views for the 1st quarter. As we posited in January 2012, when most strategists were bearish on the EUR/USD, the Fed swap lines in conjunction with the FOMC decisions at the time did put a floor to the euro and are delaying a painful adjustment in Europe. The latest decision by Japan will as well prolong the European agony. In the process the European recession can only be prolonged and the European economy will continue to suffer (unemployment rate now at 12%)."

We also added:
"Unless Mario Draghi unleashes in Europe QE to fight off the growing deflationary risks we have been tracking and warning about, we do not see a weakening of the Euro in 2014."

Arguably in recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have significantly diverged as displayed in the below Bloomberg chart:
This seems to indicate that the market clearly anticipates at some point some "nuclear" action from the ECB and also indicative of the tapering effect on the US dollar versus the Euro we think.

But, as shown by the "Japanese experience" the Euro strength may not simply be reversed by the "nuclear" QE option as indicated by Bloomberg:
"The impact of quantitative easing programs on currency is not clear, based on the experience across the U.S., U.K. and Japan. While initial announcements in both the U.S. and U.K were followed by a weakening of domestic currency, Japan's approach failed to stem currency appreciation, which instead followed Premier Shinzo Abe's 2013 reform announcements. The scale of program and type of assets purchased will determine the impact on currency and inflation across the euro zone." - source Bloomberg.

We do agree with Bloomberg, when it comes to QE "size matters".

In particular when one relates to the "japanification" of Europe and the deflationary risk we have been mentioning on a regular basis in our conversations. We did read with interest the comments on this very subject from Mansoor Mohi-uddin from UBS in the Financial Times back in November 2013:
"During Japan’s two lost decades, domestic banks were too weak to cut non-performing loans and absorb the losses. That prevented them from supplying fresh credit to the economy. Only when Tokyo began substantially recapitalising the financial sector – a full 13 years after the country’s bubble burst in 1990 – were Japanese banks able to start expanding their loan books.
Deflation risk
The eurozone’s banks are in a similar position to Japan’s in the 1990s. Six years after the credit crunch began in the western economies, eurozone banks have only hesitantly shrunk their balance sheets. Loans-to-deposit ratios remain roughly 110 per cent, at levels comparable to Japan’s ratios during its first lost decade. In contrast, US banks, forcefully recapitalised by the US Treasury in 2008, have been able to reduce bad credit and now only have loans accounting for 75 per cent of deposits. That rapid deleveraging has allowed the financial sector to provide stronger credit growth to the US economy.
Tokyo’s inability to strengthen quickly its banking sector led to Japan’s economy falling into recession frequently throughout the 1990s and 2000s. In addition, the country suffered entrenched deflation for most of the past decade.
Likewise, the eurozone has already endured two recessions since the credit crunch started in 2007, with the second downturn lasting six consecutive quarters until this year. Furthermore, the eurozone’s latest inflation data show consumer prices are increasing only 0.7 per cent year on year, increasing fears that the region will also fall into deflation.

Paradoxically, such economic weakness has been accompanied by persistent exchange rate strength. In both economies faltering gross domestic product growth has constrained demand for imports. Until the 2011 earthquake, Japan ran consistently large trade surpluses. That year the yen hit an all-time high of Y75 against the dollar. Similarly, the eurozone’s trade balance has become strongly positive over the past couple of years, pushing the euro up to a two-year high of $1.38 last month." - "ECB must act to prevent euro aping strong yen" - Financial Times, Mansoor Mohi-uddin, UBS.

Of course many see the continuation of the strong euro as a catalyst of QE in Europe as indicated by Bloomberg:
"Mario Draghi's April 12 assertion that "a strengthening of the exchange rate requires further monetary stimulus. That is an important dimension for our price stability" suggests the likelihood of quantitative easing is increasing. According to Bank of France Governor Christian Noyer, inflation would be running at 1% absent the exchange rate's strength, twice March's 0.5% figure. Implementing a QE program would boost liquidity, and likely profit, at euro-area banks." - source Bloomberg.

Yes, implementing QE would no doubt boost liquidity but would, in similar fashion to the LTROs amount to "Money for Nothing" we think unless proper unconventional measures were taken such as helping out the deleveraging process of the private sector in peripheral countries. On that point we do not think that the Euro Sovereign-Loan Yield link may be restored as the LTRO runs down as posited by Bloomberg:
"A key goal of future ECB activity is to reopen lending channels to small and medium-sized enterprises across southern Europe. While attempts to invigorate the combined $2 trillion corporate loan markets of Italy and Spain have failed to drive new business loan rates lower, some sovereign and asset yields are at record lows. Until 2009, the correlation between sovereign yields and corporate loan pricing was meaningful. Re-establishing this would lower borrowing costs." - source Bloomberg.

No matter how large QEs where in the US, we have yet to see the transmission of credit for small businesses, which are essential for a strong recovery scenario in employment figures as shown in the below graph from a recent note from Bank of America Merrill Lynch entitled "When the tide turns" from the 25th of April 2014:

Of course the big beneficiaries of a QE in Europe would be the pure high beta play namely banks as posited by Bank of America Merrill Lynch in their recent European Banks Strategy note entitled QE without a real AQR:
"QE makes risk assets go up
There is a lively debate as to what Quantitative Easing actually is but we believe the market has a rule of thumb that is being applied to the euro area QE debate, which is that QE makes risk assets go up. Riskier assets tend to go up by more. Banks are risk assets and have behaved according to this rule YTD. Using a low starting price-to-tangible book multiple as a proxy for a bank being riskier, Chart 3 shows the riskier banks have strongly outperformed (bottom ten vs top ten by 23 percentage points YTD)"
- source Bank of America Merrill Lynch

European banks have already benefited from the "whatever it takes" carry trade which they set up following Mario Draghi's July 2012 comments and have purchased large quantities of peripheral government bonds, boosting their earnings in the process thanks to the central bank's generosity and of course not severing the link to the sovereign but increasing it drastically in the process.

As an illustration of the significance of the performance from the beta play set up by the ECB can be seen in French bank BNP's stock price performance as displayed by Bloomberg:
"Since Mario Draghi's July 2012 "whatever it takes" pledge, the correlation between falling Italian and Spanish yields and appreciating bank stocks has strengthened. While there may be some scope for further falls in rates, much of the recovery in confidence has now taken place, questioning the extent to which further declining yields can act as a catalyst for bank stock appreciation. BNP, only 7% of the Euro Stoxx 600, moves in tandem with the index, offering a good proxy." - source Bloomberg.

The European Banking Union was sold to the public on the premises it was supposed to break the link between sovereigns and financials and reignite lending. It looks to us, it hasn't happened and won't happen any time soon as displayed by the below graph from Bank of America Merrill Lynch's note on QE and the AQR:
- source Bank of America Merrill Lynch

The recent Portuguese auction is reflecting a return of confidence thanks to Mario Draghi's magical talents as displayed in the below Bloomberg graph:
"The Portuguese republic has successfully placed 10-year debt for the first time since January 2011, with an accepted yield of 3.575%, very nearly half the level required last time a placement was made. A bid-to-cover ratio of 3.5x underlines investor interest, a key positive as Portugal has 37 billion euros ($51 billion) of debt maturing by end-2015. A key read across for periphery banks is likely to be cheaper access to liquidity, which can help kickstart lending." - source Bloomberg.

Kickstart lending...
It has not happened in the US for small businesses and from a conversation with a friend who is a small business owner in Tokyo it hasn't happened there either. Small businesses in Japan cannot easily get credit lines to fund expansion. Only large corporates are able to access credit it seems.

When it comes to loan growth in the Euro area, we agree with Bank of America Merrill Lynch's take on QE in their recent European Banks Strategy note entitled QE without a real AQR:
"Capital works better than QE
We see the AQR as an opportunity for the ECB to jump-start bank lending more effectively than QE, if it were to be used to drive bank recapitalisation. The evidence to date is not reassuring in this regard. 

Less effective this way
We believe that QE without something to accelerate banks becoming confident enough in themselves is likely to be significantly less impactful on the real economy than one stapled to bank recapitalisation. While share prices would in our view likely respond positively to QE, banks’ behaviours are set to be slower to change. As a result, euro area growth is set to remain well below that of other major economies through 2015 (Chart 13)" 
- source Bank of America Merrill Lynch

The reason for the continued divergence in funding terms for corporates loans in the European space is due to the pace of deleveraging and the loss recognition process and rising nonperforming loans hence our "japonification" stance when it comes to assessing European woes and our well documented deflation bias. The below chart from Bloomberg highlights the difference in funding terms in various European countries:
"The disparity in cost of and access to corporate credit between north and south Europe was cited by Mario Draghi at the time of the ECB's November statement as a reason for the need to cut. New business rates and gross loan flows will remain a vital indicator that will inform policy decisions. If and when the ECB manages to reinvigorate the asset-backed market to unlock corporate credit, the differential between northern and southern rates will also be a key determinant of success." - source Bloomberg

To that effect, cleaning up banks' balance sheet would not be purely accelerated by QE in Europe, but banks recapitalization needs would be "reduced" by rising share prices in the financial space. When it comes to capital needs for European peripheral banks and rising nonperforming loans the race is on as displayed in the below graph from Bloomberg:
"Aggregate bad debt across the banks of Greece, Ireland, Italy, Portugal and Spain exceeded $925 billion at the end of 2Q13, 300% higher than in 2008, according to IMF data. As banks continue to prepare for the ECB's asset quality review in late 2014, and levels of restructured loans and various foreborne assets come under new scrutiny, many of these loans may be considered for sale. Italy and Spain will likely be a focus for private equity and distressed debt investors." - source Bloomberg.

As we pointed out last week, Europe is indeed for sale on a "fire sale" mode at least for banks.
"The deleveraging for Italian banks has hardly run its course and in similar fashion to the Italian government shedding real estate and its car fleet, Italian banks are as well busy shedding non-performing loans backed by real estate" - Macronomics 

"The non-performing loan ratio for all domestic EU lenders tripled on average to more than 4.5% at the end of 1H13, from full-year 2007. The coverage ratio (provisions as a percentage of bad debt) also fell by a third to 43%, as income statement charges failed to keep pace with ballooning bad debt. The imminent ECB asset quality review in the euro zone may require banks to reclassify more loans as bad debt, prompting pre-emptive portfolio sales." - source Bloomberg

In similar fashion to what we wrote about Japan in general and credit versus equities in particular in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets":
"Financial credit may be the next big opportunity
The build-up of corporate leverage in the 2000s was confined to financials which, unlike other corporates, had escaped unscarred from the 2001 experience. However, this changed in 2008. Judging by the experience of G3 (US, EU, Japan) non-financial corporates, there should be significant deleveraging in banks going forward. Indeed, regulatory pressures are also pushing in that direction. All else being equal, this should be bullish for financial credit." - source Nomura

Credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities. No wonder the riskiest part of CLO have returned 16% in 2013 as indicated by Kristen Haunss in Bloomberg in her article "CLO Returns at 16% for Risky Slices Buoys Loans":
"The riskiest portions of specialized loan funds that have helped finance the biggest buyouts in history are luring investors with returns that exceed even junk bonds.
The equity slices of U.S. collateralized loan obligations, which get whatever money is left-over after more senior investors are paid, returned an average 16 percent last year, according to JPMorgan Chase & Co. data on funds raised since the end of 2008. That compares with 7.4 percent for the Bank of America Merrill Lynch U.S. High-Yield Index of bonds.
Investors say the prospect for above-average returns remains, even as the Federal Reserve starts to flag that it will raise interest rates as soon as next year. Demand for the equity slices of CLOs is helping fuel issuance, providing money for the neediest borrowers." - source Bloomberg

Of course thanks to these stellar returns as per the same article, the asset class has been booming:
"Investors poured a record $61.3 billion into leveraged loan mutual funds last year, according to Morningstar Inc. data, as they sought protection against rising rates. CLOs were the largest buyers of high-yield loans in 2013, with a 53 percent market share, according to the New York-based Loan Syndications and Trading Association.
Sales of CLOs reached $82 billion in 2013, the third-largest year on record, and have topped $32 billion in 2014, according to RBS." - source Bloomberg.

When it comes playing credit, we have to confide that, indeed we did participate and bought some junior subordinated debt from a French bank in October 2011 at a cash price of around 94.5 for a perpetual bond paying a nice 12.5% coupon seeing it rise meteorically to 138 cash price, a 46% appreciation with limited volatility, hence applying our lesson learned from the Japanese experience thanks to our continued study of central bank magic...

In the case of credit, if indeed the ECB does indeed embark on QE, another big beneficiary will no doubt be in the financial bond space as indicated by Citi in their credit weekly commentary entitled "How would ECB impact credit":
"So if the ECB wanted a serious percentage of any QE programme to be made up of private assets, then it seems quite probable that that would have to extend beyond secured assets.
Unsecured bank debt would seem the most obvious candidate for them to turn to next. The rationale for lowering bank funding costs is obviously that: 1) it would facilitate further recapitalization (now that revenues from the periphery-sovereigndebt-carry trade are fading), 2) it would lower the rate at which is it efficient for banks to lend without distorting the market-based allocation of credit, and 3) that the ECB through its comprehensive assessment should have a decent insight into the quality of the collateral that it would implicitly be buying into.
Although more probable than we previously thought, we still think it is less likely that the ECB would extend any purchases to regular non-financial bonds. It might suit a political purpose, but from an economic perspective we struggle to see much merit in lowering what are already record low funding levels for the large investment grade non-financials.
That said, even if the ECB chose not to buy them directly, by purchasing assets which fund managers hold interchangeably with non-financial bonds, the impact on non-financial spreads would be significant even at these tight levels." - source Citi

Given last week we indicated that Italian banks have relied more on debt issuance for their funding needs and given the significant rise in nonperforming loans on Italian banks balance sheet, should the ECB embark on a QE spree, you should rightly expect a strong outperformance of Italian financial bonds which be prime beneficiary of the central bank's renewed generosity. 

As per Nomura's take in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets" remember this:
"Unlike corporates, financials have just started what is likely to be a long deleveraging process, suggesting opportunities in financial credit.
-As dealers, they will carry lower inventories. As investors, they will have less demand for assets. And they will be supplying assets to the market." - source Nomura

On a side note, those who listened to us have done well so far in 2014 given we hinted  a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":
"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. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

In fact, US thirty-year debt has gained 10.3 percent from Dec. 31 through yesterday, the most for the period based on Bank of America Merrill Lynch data that go back to 1988 as reported by Bloomberg by Wes Goodman in his article entitled "Treasury Long Bond's Record Year-to-Date Return Four Times S&P:
"A rally in 30-year Treasuries has pushed returns past 10 percent in 2014, the best start to a year in at least two and a half decades.
“It’s going to continue for some time,” said Yusuke Ito, a senior fund manager in Tokyo at Mizuho Asset Management Co., which has the equivalent of $39.1 billion in assets. “The pace of the recovery is not enough to generate inflationary pressure.”
Long bonds climbed 10.3 percent from Dec. 31 through yesterday, the most for the period based on Bank of America Merrill Lynch data that go back to 1988. The broad market rose 2.1 percent and the Standard & Poor’s 500 Index returned 2.3 percent. While bonds gained on the outlook for slow inflation, shorter notes lagged behind on speculation the Federal Reserve will raise interest rates in the years ahead." - source Bloomberg.
We have to confide we have also been playing this game via ETF ZROZ (we do indeed learn a lot from our central bankers and their magic tricks...).

On a final note, when it comes to the "Shrinking pie mentality", exporting deflation  and China, given that in a Pareto efficient economic allocation, "no one can be made better off without at least one individual worse off", we have interestingly noted that China's services have recently replaced manufacturing and construction as per Bloomberg's recent Chart of the Day from the 22nd of April:
"Services have replaced manufacturing and construction as the biggest part of China’s economy, a sign that the Communist Party’s goal of getting people to spend rather than just make cheap exports is working.
The CHART OF THE DAY tracks contributions from services, industry and agriculture to gross domestic product since 1992, with sectors such as real estate, retailing and finance overtaking manufacturing last year for the first time since at least 1978, with a 46 percent to 44 percent proportion. In 1996, the breakdown was 48 percent industry and 33 percent services. Agriculture’s contribution fell by half in the period to 10 percent, according to National Bureau of Statistics data compiled by Bloomberg.
“It’s an irreversible trend that the share of services in the Chinese economy will keep growing,” said Chen Xingdong, the Beijing-based chief China economist at BNP Paribas SA. “The days are gone when everything is manufactured in China,” partly because the younger generation is more demanding and better-
educated, he said.
The lower panel compares urban and rural populations, with cities taking the biggest share starting in 2011, the data show. As recently as 1998, the rural population was twice as big as its urban counterpart, the data show. Of China’s 1.36 billion residents as of 2013, 54 percent lived in cities.
The shift toward services marks a milestone for the government and Premier Li Keqiang, who has made a priority of moving people from farms to cities to spur domestic demand as people accumulate more wealth and spend their money on homes, electronics and entertainment. There is room for more growth: China’s urbanization rate compares to 80 percent in developed nations like the U.S.
“In the past, a Chinese worker basically ate and prepared for work, but now they are pursuing a better lifestyle,” said Chen, who previously worked at the World Bank. Shifts in habits and demographics will put pressure on traditional industries like cement and steel and bring new opportunities to consumer, health-care and education businesses, he said." - source Bloomberg

The winner takes it all. Period.

"We are neither bitter nor cynical but we do wish there was less immaturity in macroeconomic thinking." - Macronomics

Stay tuned!

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