Sunday, 11 May 2014

Credit - Supervaluationism

"Vagueness is at times an indication of nearness to a perfect truth." - Charles Ives

While looking with interest the continuation of the "japonification" of the credit markets with continued spread compression, with the Dow setting up a new record at the close on Friday, and given the numerous discussions surrounding the valuation level reached, we reminded ourselves this week of the supervalutionist theory of vagueness for this week chosen title. Supervaluationism, also called the logic of vagueness, involves the idea that truth and reference need not be logically connected in the normally expected ways. It holds that the future is undetermined (The quality or state of being settled; confirmed state), making borderline statements such as "the market is in a bubble" to retain all the theorems of standard logic while admitting "truth-value gaps". For instance, in the supervaluationist theory of vagueness means that ambiguous statements are true when they come out true under all disambiguations whereas normally, logicians require that a statement be disambiguated before logic is applied. For the supervaluationist, a demonstration that a statement is not true does not guarantee that the statement is false. Meaning for us that, some pundits would argue that the statement "the market is in a bubble" to be a false statement, but not guaranteeing it to be false either.

 You are probably already asking yourself where we are going with the above, for us the lack of volatility and the distortion created by Central Banks meddling with interest rates through ZIRP are inherently destabilizing. The continuation of spread compression in credit and the obvious reduction of dealers' balance sheet and lack of secondary liquidity are evidence of our "supervaluationist" statement we think. Therefore in this week's conversation we will delve further into the meaning of the lack of volatility, which is somewhat a continuation of what we approached in terms of understanding "bubbles" and market dynamics we previously discussed in our conversation "The Cantillon Effects".

The lack of volatility and spread compression is illustrated in the below graph displaying the Itraxx Crossover 5 year generic CDS index (50 European High Yield entities) versus the Eurostoxx 50 Implied volatility since 2008 - graph source Bloomberg:
We are now below 2008 levels for both the Itraxx Crossover index and Eurostoxx volatility.

The small divergence between VIX and its European equivalent V2X - Source Bloomberg:
The highest point reached by VIX in 2011 was 48 whereas V2X was 51. VIX is around 13.81,  and V2X at 16.94. Overall volatility remains muted. 

While European government bonds continue to fall, indicative of the flows rather than a reduction of the stock of debt, which in Europe continues to grow, not helped much by the latest benign inflation figures - graph source Bloomberg:
Yields on Italian and Spanish 10-year bonds hit record lows of 2.90 percent and 2.87 percent respectively on Friday with Irish 10-year bonds falling to 2.65 percent, below the equivalent borrowing costs of the UK.

On another note, equities in Europe have continued to rally and credit spreads have continued to tighten while the 10 year German yield has continued to fall, while volatility (bottom graph) has remained muted
 - graph source Bloomberg:

When it comes to volatilities, they have been repressed, no doubt by central banks intervention as illustrated in the below graph displaying the VIX, the MOVE index, the CVIX index and EM FX volatility index, the JP Morgan EM-VXY - 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.
EM VYX index = JP Morgan EM-VXY tracks volatility in emerging market currencies. The index is based on three-month at-the-money forward options, weighted by market turnover.

As we posited in our conversation "The Anna Karenina Principle" in November 2013:
"The regime change in both lower volatility and lower yields is indicative of the adaptation of the financial system not under biological stress but under central banks "financial repression" ".

We also commented at the time:
"Of course when it comes to the "Anna Karenina principle" as well as Bayesian learning history shows the final phases of rallies have provided some of the biggest gains.
But we are driveling again given in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

When it comes to volatility, we agree with BNP Paribas's recent note from the 7th of May entitled "Volatility is An Iceberg". After all we used a similar analogy quoting Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit": "That Which is Seen, and That Which is Not Seen". In similar fashion, in volatility there is indeed the visible part and the invisible part:
"-Think of Volatility as an Iceberg: There is the Visible part reflected in daily returns of asset prices and there is the Invisible part that is submerged under water. Water is to an iceberg what Liquidity by central banks, excess cash on balance sheet, government current account surplus or excess reserves, lows geopolitical tensions are to asset prices. Low volatility does not mean no volatility, it simply means less Visible vol.
-"Stability is inherently destabilizing“: The key message in this chart can be summarized with the quote of Hyman Minsky "Stability is inherently destabilizing" where one can replace 'stability' with 'low volatility'. 3mth implied volatility continue to be supressed across asset classes as the per the clustering effect at the bottom of the chart. This is most significant in EURUSD volatility as the gravitational put of deleveraging forces and dovish ECB rhetoric are offset by current account surplus and strong trade flows couple with large inflows into European fixed incomes and equities. In addition, EM equities, commodities and rates implied volatility are recoupling downward to already subdued DM equity vols.
-The fundamental drivers of low volatility aside from the distortive effects of QE are important to consider. After a debt/credit crisis, there is always a process of 'balance sheet repair', deleveraging and natural selection of more risk averse and conservative investors, businesses, management and governments that usually drive earnings and economic volatility down. You see this with the
Credit Cycle clock where credit outperforms equity at 12 o'clock, then a co-recovery phase at 3 o'clock that eventually leads to releveraging phase at 6 o'clock when debt funded buyback and LBOs booms outpace cash flow growth where investors gravitate from 'hunt for yield' to 'hunt for return/capex. This, inexorably, leads to the next crisis at 9 o'clock aka "Mynski Moment"... We think Europe is at 2.30pm and US is at 5pm and EM at 9pm and this is corroborated by the current state of cross asset volatility. Take the SPX for example, with $1.7 trill of cash on balance sheet out of $18trill of market cap, 'equity easing/share buyback' of $40bn a month and record FCF/dividends generation and accumulation, it is tough to see volatility explode endogenously especially when you consider that cash has a volatility of ZERO. One can even run a Sum of the Volatility Parts at a macro level to make this casemore explicit.
Companies evolve and adapt in the same way single cell organisms become more complex and resilient multi-cells biological entities. You see this with the structural decline in asset intensity via DM to EM outsourcing of capex in US and German companies, globalization of supply chain and human resource management, Ricardo's labour theory of value, technology processing intensity and output etc...As such, their valuation multiples and intrinsic volatility ought to change structurally. Low volatility is a distortion by central banks but it is also and more importantly a symptom of deleveraging and balance sheet repair of both private and public balance sheet." - source BNP Paribas

But low volatility, thanks to central banks distortion doesn't equate to low risk. On the contrary, as explained recently by JP Morgan on the 2nd of May in their note "Low volatility is not low risk":
"-Most perplexing and challenging for market participants this year has been the tight trading ranges and dramatic falls in volatility in bond, equity, and commodity markets. Low volatility is in principle good for markets and the economy as it boosts confidence and investment. All policy makers have as an objective to reduce uncertainty and to maximize transparency and predictability. But low volatility is no panacea and has a number of downsides. Most importantly, it creates moral hazard as it eliminates caution and thus creates excess risk taking and leverage. This in turn lays the basis for a market reversal, as market participants become too levered and have no defenses anymore against adverse events. In addition, low volatility amid directionless markets destroys trading and liquidity.
-Most dangerous to markets is that low volatility is not the same as low risk. It can be, as fewer shocks depress volatility. But markets can also move in tight trading ranges if the shocks hitting them neatly offset each other. And that is probably what has happened this year. The continued lack of a yield on cash remains a powerful stimulant for financial assets. But economic activity data have seriously disappointed so far this year. By our estimates, Q1 global growth is only coming in near 2%, well down from the 3% we expected at the start of the year. We have kept our growth projections for the rest of the year largely unchanged, balancing off the possibility that Q1 weakness was just due to temporary factors -- suggesting upside from Q2 on -- and the possibility that something more fundamental is going wrong in the world economy.
-Similarly on the monetary policy side, the lack of any change in the zero-interest rate policy in major DMs has depressed volatility in global bond market and currencies. But this low policy volatility is also not the same as low policy risk. Policy makers themselves are facing serious conflicting incentives and signals. At the global level, low growth and inflation suggest the need for continued easy money. But the massive rise in asset prices over the past few years is raising the risk of asset booms and busts that have produced huge economic instability over the past two decades. The US housing market, where activity is weak but prices are up 13% oya, is a microcosm of this conundrum facing the Fed. Our economists this week in GDW comment on other conflicts facing central banks, such as the one between weak growth and falling unemployment in the US, and improving growth but falling inflation in the Euro area. The message is that policy is on hold, but risk is two-sided.
-A return of volatility, resulting from a change in the current balance between bearish and bullish forces, is not automatically a negative for risk markets. Our preferred scenario remains an end to economic growth downgrades and reduced geopolitical risk, which would boost equity prices and push up bond yields. But clearly, bearish forces might come to dominate also. Our main point is that volatility rarely stays this low for long.
-What can we do about this? Low market volatility has boosted the search for yield in fixed income, as discussed last week. A return of vol would threaten this, making up prefer liquid equities over less liquid credit as the main risk asset to own. Elsewhere, given how low implied volatility is in equities, it would make sense to be long here." - source JP Morgan

Indeed, end of the low volatility regime period generally leads to a strong and sudden crash in prices, bringing us to our "supervaluationist" statement of the market being in a bubble, which has been the question asked recently by Deutsche Bank in their recent Quant View report from the 3rd of April entitled "Are we in a tech bubble yet again?":
"Recently there has been a wave of buyouts, acquisitions and initial public offerings of technology and social media companies. With tech startups at multi-billion dollar valuations and with a growing number of technology billionaires in their twenties and thirties, it’s not surprising that many investment managers are asking if we are in the midst of yet another technology bubble. One of the most cited charts that support this argument is Figure 1 below. It shows the outperformance of the NASDAQ index (compared to other US indices) during the Dot-Com bubble of the late nineties. Interestingly, the outperformance in the NASDAQ during the Dot-Com Bubble appears eerily similar to the outperformance in the NASDAQ in more recent periods. Could this suggest the onset of yet another technology bubble?
This is not an easy question to answer especially since there is no formal “definition” of 
a bubble. However, merely comparing the performance of the wealth curves in isolation 
lacks the empirical and analytical rigor to determine the presence of a technology 
bubble. As such, in the month’s novel edition of the quantview, we analyze various 
quantitative, fundamental, market, and sector indicators to help answer this question. 
Additionally, we teamed up with our fundamental technology analysts to incorporate 
their valuations and analysis on answering this question. In short, our findings suggest that we are NOT in the midst of a technology bubble and here’s why:
1. Compared to the Dot-Com Bubble, tech stocks are 
currently cheaper
We start by simply analyzing whether technology stocks are currently trading at similar 
multiples compared to the Dot-Com bubble. To do this, we simply calculate the 
aggregate earnings yield for the entire technology sector over time. We define our 
technology sector as the stocks in the Russell 3000 with a MSCI GICS code of 45 (i.e. 
Information Technology Sector) Recall that earnings yield is simply the inverse of 
trailing 12 month price-to-earnings. A relatively lower earnings yield (i.e. higher PE) 
signals that a stock or sector is relatively expensive. We compute the aggregate 
earnings yield overtime for the entire information technology GICS sector (Figure 2). 
Interestingly, our findings show that the technology sector was significantly more 
expensive during the Dot-Com Bubble than in recent periods.
Additionally, we computed the aggregate time-series earnings yield for each industry 
group within the technology sector to determine if a certain industry group within 
technology was expensive . Note that the technology 
sector has three industry groups: Software & Services, Technology Hardware & 
Equipment, and Semiconductors & Semiconductor Equipment. The results show that 
even at the industry group level, technology stocks were significantly more expensive 
during the Dot-Com Bubble. In conclusion, our findings indicate that in aggregate, 
technology stocks were significantly more expensive during the Dot-Com bubble.

In their report Deutsche Bank goes into more details about the many reasons why they think we are not in a midst of a technology bubble, which for us is indeed illustrative of "supervaluationism we think given that for the supervaluationist, a demonstration that a statement is not true does not guarantee that the statement is false, meaning for us that their demonstration might be valid, it does not guarantee we are not in a bubble, created once more by "easy money".

On a side note, we recently pointed out the strength of the performance of US long bonds as well as the "Great Rotation" from Institutional Investors to Private Clients". As posited by Cam Hui on his blog "Humble Student of the Markets", the "great rotation" has indeed been triggered somewhat by defined benefit pension funds locking in their profits. One of the chief reason therefore behind this rotation has been coming from US Corporate pensions, as indicated by Gertrude Chavez-Dreyfuss and Richard Leong in Reuters in their article from the 24th of April entitled "US Corporate pensions bet on bonds even as prices seen falling":
"Major U.S. companies including Clorox and Kraft are favoring more bonds in the mix for their employees' defined benefit pension plans, even amid signs the three-decade bull run in bonds is on its last legs.
The $2.5 trillion U.S. corporate pension market enjoyed a robust recovery in 2013, paced by stocks, as the Standard & Poor's 500 Index rose the most since 1997. That helped pension funds close a funding hole that opened after the global credit crisis of 2008, so that the average corporate pension was funded at about 95 percent at the end of 2013, compared with 75 percent at the end of 2012, Mercer Investments data show.
Now that they're more confident that they have the money to meet their pension obligations, corporate pension managers are pulling back from the perceived risk of the stock market and buying U.S. government and corporate bonds, even though many expect bond prices to fall in coming years.
"Even if interest rates rise more than the market predicts, you do get the income component that offsets the price loss of those bonds," said Gary Veerman, managing director of U.S. Client Solutions Group at BlackRock in New York, which has $4.4 trillion under management, of which two-thirds are retirement-related assets. Veerman's group advises corporate treasurers how to manage their pensions.
The allocation to bonds by the top 100 publicly-listed U.S. companies in their defined benefit pension plans increased to a median of 39.6 percent in 2013 from 35.9 percent in 2010. Stock allocation in the plans fell to 40.9 percent in 2013 from 44.6 percent in 2010, according to global consulting firm Milliman." 
"Now they're in a position to say: 'I don't need all those equities because my funding status is in the mid- to low-90s,'" said Dan Tremblay, director of institutional fixed-income solutions at Fidelity unit Pyramis in Merrimack, New Hampshire, which manages more than $200 billion.
Because many defined benefit plans are closed to new workers, managers are more concerned with having a steady stream of income every year to meet their annual payout than generating an above average market return or even meet the historical 6% - 8% returns on equities. Retirement plans offered to new workers are mainly 401(k) plans in which the worker is responsible for making investment allocation decisions.
Federal Reserve data show private pensions began reducing risk in the second half of 2013, shedding $11.3 billion in stocks and loading up on more than $100 billion in Treasuries, agency debt and corporate bonds. Tremblay believes this trend could last for a decade." - source Reuters.

On the 24th of March, CITI estimated in their Quantitative Pension Strategy report the following:
"De-risking Flow Scenarios
Based on the model we introduced in the outlook, we also update the simulation results for pension de-risking flows.
-In our faster with limits de-risking scenario, we could see $213 billion in equity assets being sold and replaced with fixed income assets based on our 2014 baseline projections, representing 7% of total pension assets.
-The updated transition amounts under different models are $40 to $80 billion lower than our initial projections, presumably caused by reduced funded-status estimates and a lower initial equity/debt ratio as of the end of 2013.
-Rebalancing needs could still increase by approximately 50% to 60% over the year based on our updated estimates.
Note that the timing of any potential de-risking or rebalancing flows is likely to be drawn out. Realistically, we would expect such flows to occur over the course of perhaps two to six quarters." - source CITI

What could curtail outflows from pension funds from Equities to Fixed Income could come from Updated Mortality Tables according to another CITI report from the 10th of April:
"The Society of Actuaries released drafts of proposed new mortality tables (RP- 2014) and mortality improvement scales (MP-2014) that provide the basis for determining pension liabilities. These are significant updates.
-The new tables and schedules increase life expectancy at age 65 by 2.0 years for males (from 84.6 years to 86.6 years) and by 2.4 years for females (from 86.4 years to 88.8 years).
-The previous set of mortality tables was published in 2000 (RP-2000), and the most widely used mortality improvement scale (Scale AA) dates back to 1995.
We have estimates that longer life expectancies resulting from the updated mortality tables will increase the value of pension liabilities by 3% to 10% depending on the nature of the plan and prior assumptions.
-If we take Aon Hewitt's estimate of a 7% increase in plan liabilities, that would reduce funded status by approximately 6%, or about half of the improvement experienced in 2013.
-Plan durations should extend, but we do not have good estimates of how much.
With lower funded statuses using the updated tables, it is likely that de-risking flows from equities to fixed income will be lower than they otherwise would have been under the previous mortality regime." - source CITI

On a final note, and in "true" supervaluationism fashion, it seems individuals are backing away from US stock optimism as per Bloomberg's recent Chart of the Day:
"Smaller investors are demonstrating a renewed reluctance to view U.S. stocks favorably as the current bull market extends to a sixth year.
Bulls trailed bears by 0.3 percentage point in the most recent weekly survey by the American Association of Individual Investors after leading by the same margin a week earlier. The figures contrast with this year’s widest gap in favor of the optimists: 19.4 points, set in the week ended Feb. 20.
As the CHART OF THE DAY shows, the latest results are also at odds with a more gradual shift in investors’ attitude toward stocks. The chart displays the 52-week average of the bull-bear gap, which climbed to the highest level since June 2006 before falling this week, along with the Standard & Poor’s 500 Index.
“You see scared individual investors right now,” Justin Walters, co-founder of Bespoke Investment Group LLC, said in an interview yesterday. “Just as they were coming back into the market, they started getting burned” as many of last year’s best-performing stocks tumbled, he said.
Institutions have a more positive outlook, based on the results of weekly surveys of investment advisers by Investors Intelligence. The latest results showed bulls at 55.8 percent, the highest reading since January and almost twice the number in the AAII survey.
Bespoke wrote about the divergence between the bullish readings yesterday. “The emotional individual investor usually ends up being wrong” when the gap is as wide as it is now, the Harrison, New York-based research and money-management firm wrote in a report." - source Bloomberg

"It is a thousand times better to have common sense without education than to have education without common sense." - Robert Green Ingersoll

Stay tuned!

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