Monday 23 June 2014

Credit - Deus Deceptor

"The senses deceive from time to time, and it is prudent never to trust wholly those who have deceived us even once." - Rene Descartes, French philosopher

Watching with interest the EONIA index posting new lows (1.5 bps) in the European space, spelling "death by a thousand rate cuts" for European money markets funds, meaning so far that they are only managing to survive by taking increasing interest rate exposure through Euribors, we decided to use another reference to central bankers' deception tricks in our chosen title this time around namely Deus Deceptor being a "deceptive god". 

Evolution of the Eonia index - graph source Bloomberg:

We had already used a reference to a great text from French poet Charles Baudelaire "Generous Gambler" aka Mario Draghi, but, this week we decided to refer to French philosopher René Descartes given he was accused of blasphemy by Protestants in 1643 and 1647 as he was positing an omnipotent God of malevolent intent (could we use this as an analogy to the central bankers of today?). 

The evil demon, sometimes referred to as the evil genius is a concept in Cartesian philosophy:
"In his 1641 Meditations on First Philosophy, René Descartes hypothesized the existence of an evil demon, a personification who is "as clever and deceitful as he is powerful, who has directed his entire effort to misleading me."" - source Wikipedia

Most Cartesian scholars opine that the evil demon is also "omnipotent" (hence the blasphemy as god is only considered as being "omnipotent"), and thus capable of altering mathematics and the fundamentals of logic. In Cartesian philosophy, sensation and the perception of reality are thought to be the source of untruth and illusions, with the only reliable truths to be had in the existence of a metaphysical mind. 

In similar fashion we already touched on the "Omnipotence Paradox" back in November 2012:
"1. A deity is able to do absolutely anything, even the logically impossible, i.e., pure agency.
2. A deity is able to do anything that it chooses to do.
3. A deity is able to do anything that is in accord with its own nature (thus, for instance, if it is a logical consequence of a deity's nature that what it speaks is truth, then it is not able to lie).
4. Hold that it is part of a deity's nature to be consistent and that it would be inconsistent for said deity to go against its own laws unless there was a reason to do so.
5. A deity is able to do anything that corresponds with its omniscience and therefore with its worldplan." - source Wikipedia.

But in terms of blasphemy and the "evil" intent of the central bankers both Descartes and the Cartesian scholars were wrong for the simple reason that central bankers are not omnipotent. Although, our "Deus Deceptors" of the central banking world, have indeed managed to altering mathematics (probability of default risk for the time being) and the fundamentals of logic, no doubt about that. 

"The gazing populace receives greedily, without examination, whatever soothes superstition and promotes wonder". - David Hume

Back in 2012 in our conversation we also argued:
"The "unintended consequences" of the zero rate boundaries being tackled by our "omnipotent" central banks "deities" is that capital is no longer being deployed but destroyed (buy-backs being a good indicator of the lack of investment perspectives)."

In this week's conversation we will look at the development in the credit space, which is a continuation of the "japonification" process with continued spread compression as the "yield frenzy" goes on as we move towards the close of the 1st semester of 2014 as well as some perspectives for the second semester 2014. 

Our take on Credit:
Credit, no doubt has had yet another great run in the first half of 2014, which comes to us as no surprise given the performance of credit in a deleveraging environment as it happened before in Japan.

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

The "japonification" process in the government bond space continues to support the bid for credit, with the caveat that for the investment grade class, there is no more interest rate buffer meaning investors are "obliged" to take risks outside their comfort zone (in untested areas such as CoCos - contingent convertibles financials bonds).

"Japonification" illustrated with German 2 year yields versus Japan coming close to negative again - graph source Bloomberg:

The strong convergence between the CDX index in the US representative of Investment Grade credit risk and its European counterpart the Itraxx Main Europe 5 year CDS index - graph source Bloomberg:

And the same picture since 2006 - graph source Bloomberg:
Could we go back to negative territory in terms of spread difference between Europe Investment Grade risk and the US like we did previously? We certainly can and will, given that back in January we expected more M&A and LBOs to materialise in 2014 as we move towards a later stage in the cycle we expect the US  to releverage at a faster pace.

Credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities.

When it comes to High Yield and volatility, the spread compression has followed the compression in Eurostoxx Implied volatility as displayed in the below Bloomberg graph:
Of course there is more compression to come in both as ample central bank liquidity thanks to our "Deus Deceptors" who have managed to suppressed volatility and led to yield starvation meaning investors are reaching out for yield by taking additional risks down the credit quality spectrum.

But, when it comes to US High Yield, as far as we are concerned, it is "priced to perfection" and we cannot see the risk justifying the rewards anymore as displayed in the below Bloomberg graph illustrating the average High Yield Spread to Treasuries (Option Adjusted Spread - OAS):

Credit wise we agree with Société Générale weekly credit strategy note from the 20th of June when it comes to additional performance from the credit space and prefer European High Yield therefore to US High Yield which appears to us somewhat "richer" in terms of valuation.
"Credit fundamentals should remain strong (corporates are now in much more solid shape than pre-2008), and technicals supportive. That means that credit stands to gain further particularly HY, even if most market participants feel the asset class (IG and HY) is too rich. After all, it’s the bund’s fault as spreads remain much wider than pre-crisis (in IG, less so in HY). High yield names, corporate hybrids and AT1/Cocos stand to be the outperformers. After all, finding investments that yield over 5% are becoming increasingly rare, not even the recent issues by Greece or Cyprus (out this week) paid that. The great credit run is far from over, but even if the pace has slowed down, we expect the rally to continue with further compression between high and low beta names and sectors." -source Société Générale

Our take on US treasuries:
From a tail risk perspective and as a hedge with decent carry, we are staying long duration, a position we have taken on the ETF ZROZ - PIMCO 25+ Year Zero Coupon US Treasury Index Exchange-Traded Fund, a position we entered around 90 in terms of price level early in 2014 - graph source Bloomberg:
The contrarian 10% trade which we discussed in January.

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."
We do indeed learn a lot from our "Deus Deceptors and their magic tricks... 

While every sell-side and most buy-side strategists and their dogs expect US 10 year yields to end 2014 at a level of around 3.25%, we are more incline to be contrarian on that matter for now until the facts change, before we change our facts to paraphrase Keynes. So we disagree with the consensus and agree at least with Nomura's take on UST as posited in their latest Japan Navigator from the 23rd of June:
"UST rates remain low but for different reasons
Many investors see low UST rates as reflecting economic weakness
We held a seminar primarily for equity investors in Tokyo this week. In a questionnaire given to seminar participants, we asked about the main factors to which they attribute the decline in UST rates since January. We also gave the same questionnaire to bond investors on our website. The results are shown in Figure 3.
More bond investors chose the second answer, which suggests that they consider low UST rates as being caused by structural reasons. Although fewer stock investors chose the second answer, over a half of respondents chose either the first or second answers in both groups. To the extent that these answers refer to slowing growth and/or slowing inflation, they are consistent with a weak stock market. In contrast, the third and fourth answers imply that yields are kept unjustifiably low relative to economic and inflation outlooks. They look consistent with a strong stock market.

We believe UST rates have been kept low for different reasons after mid-April
UST rates have remained low since January, but for different reasons before and after mid-April, in our opinion. Considering that the S&P 500 trended below end-2013 levels until mid-April, we believe UST rates were kept down largely by factors [1] and/or [2] until then. However, as stock prices continued to set new highs subsequently, we believe rates remained low more because of factors [3] and [4].

Considering that the strong bond and stock trend was more pronounced following the ECB announcement of a rate cut and the possibility of additional easing, and that the UST yield curve priced in a rate hike that was later than Fed guidance and lower neutral policy rates, factor [4] may have had a greater impact, in our view. As the ECB and BOJ continue to supply long-term funds at low rates, carry flows from the euro area and Japan into the UK, US and Oceania are likely to have a more material impact on these markets, in our view." - source Nomura

Welcome to a "Macro World"...

Our take on EUR/USD:
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 increasingly 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.

For us the divergence is as well an illustration of the difference in the inflation outlook between the US and Europe as shown in the below Bloomberg graph:

While many pundits point out to the interest rate differential which should lead therefore going forward to a lower euro. We disagree and expect Euro to strengthen during the second part of 2014 towards 1.40 (we therefore share the same views as Steen Jakobsen Chief Economist & CIO, Saxo Bank A/S). A very interesting explanation on why the Euro appears to be the new "widow maker" (in similar fashion to the short JGB trade) comes from Paul Donovan, senior economist at UBS as reported in the Jakarta Post:
"A key part of the explanation for the Euro’s defiance of divergent monetary policy lies in a revolution that has taken place in the world economy. Put simply, globalization has collapsed dramatically since 2007, and that collapse in globalization has profound implications for financial markets

The collapse in globalization is nothing to do with global trade. Global exports (as a share of the world economy) are at a higher level than they were in 2007 — here there has been a complete recovery. Instead the collapse has taken place in the realm of global capital flows. Global capital flows (again as a share of the world economy) are running at roughly a third of their pre-crisis peak, and around half the levels seen in the decade before the global financial crisis

The collapse of global capital flows has been brought about by several factors coming together. Investors, in particular banks, are more regulated than before the crisis. With that regulation has come about a bias to investment in domestic markets — in some cases as an unintended consequence of regulation, in some cases as a direct policy objective. In addition the more political nature of several developed financial markets has acted as a deterrent to international investors, who are likely to have less understanding of politics in remote markets. 

When capital flows were abundant, an economy with a current account deficit did not have too many problems finding the capital inflows necessary to finance the current account position. Only a tiny proportion of the huge amount of capital sloshing around the world had to be diverted to provide the funding. Now, with capital flows reduced to a thin trickle, a current account deficit country has to work a lot harder to attract the capital that they need. Crudely put, it is three times more difficult to finance a current-account deficit, now that capital flows are one third their pre-crisis levels. 

This helps to explain the Euro. The Euro area is a current account surplus area. The United States is a current-account deficit area. The interest rate differential argues for a weaker Euro. The current account position argues for a stronger Euro. These two forces battle it out in the foreign exchange markets, and the result is less Euro weakness than many had expected. 

This new model for foreign exchange has implications that reach far beyond the errors of Euro/dollar forecasting. Reduced capital flows means reduced capital inflows into Asian markets — something that has already slowed the pace of foreign exchange reserve accumulation. Reduced capital flow may mean a less efficient global allocation of capital resources. Global capital flows have been hidden from the headlines, but the collapse of globalization may turn out to be one of the most important economic changes of the past decade." - source Paul Donovan, senior economist UBS - the Jakarta Post.

Given that Europe's current-account balance, a broad measure of an economy's international financial position, increased in adjusted terms to a surplus of 21.5 billion euros ($29.26 billion) in April, after an upwardly revised surplus of EUR19.6 billion in March, we expect the Euro to trade higher in the coming months, not lower. (The balance reflected a EUR16.9 billion surplus for goods and a EUR10 billion surplus for services).

Also, for the 12-month period that ended in April 2014, the cumulated surplus was 2.6% of the euro zone's gross domestic product, higher than the 1.9% in the 12 months ended April 2013, so regardless of the interest rate differential put forward, we have a hard time believing in a weaker euro for now, unless of course the European "Deus Deceptor" in chief Mario Draghi unleashes a €1 trillion QE but we do not see that happening anytime soon.

Our take on Japan:
Moving on to our take on Japan, given it has been seriously lagging in terms of equities performance since the beginning of the year being down -5.66%, the Nikkei has indeed rallied significantly in one month (+9.67%) while the Japanese yen have been lagging and holding in a tight range pattern around 102. What has been interesting as of late has been the disconnect between the Nikkei index and the JPY/USD as indicated in the below graph where we have been monitoring the USD/JPY exchange rate, the Nikkei index and the credit risk Itraxx Japan CDS spread (inverted) - source Bloomberg:
Credit spreads have led the significant rally seen in equities and the depreciation of the Japanese yen by the Bank of Japan has further supported the rally in both asset classes in 2013. A typical central bank's intervention, the "reflation trade" lifting risky assets, reducing perceived credit risk and suppressing volatility. As a result of aggressive quantitative easing, we think credit risk itself could even go lower due to the wealth effect on company assets and greater ease procuring large amounts of funds via debt financing. 

But, when it comes to Japan, there is hope, we think as displayed in the below growth showing somewhat an increase in bank lending - graph source Bloomberg:
The boost in the money supply has drastically reduced the yen effective exchange rate while bank lending has been gradually climbing.

What so far has been hindering the Japanese reflation story has been Mrs Watanabe's household savings even though the dollar-yen rate has been seriously impacted by the Bank of Japan's aggressive monetary stance as displayed in the below Bloomberg graph:

Of course the depreciation story has led as well Japanese CPI higher in conjunction with higher durable goods prices and furniture and utensils prices - graph source Bloomberg:

So all in all, we plan to re-enter the Nikkei play currency hedged in Euro again very shortly as we believe Japan is poised for a rebound. We plan to go long Nikkei but in Euros via a quanto ETF in that respect.

The story for  the remainder of 2014 in Europe is still France:
This is what we argued in January 2013 and this is still what we are arguing now. While French politicians are benefiting from low rates on French debt issuance courtesy of on-going Japanese support, but, on the economic data front France is increasingly showing signs of growing stress. 

France should be seen as the new barometer for Euro Risk. With Industrial Production at -2%, the French government is seriously in denial when it comes to growth assumptions: 1% in 2014 (down from 1.2%) and 2% in 2015 is way over optimistic we think. 

A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 48.2 for Services PMI is indicating contraction (the lowest level reached in February 2009  was at 40.2).

French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tell the story on its own, we think - source Bloomberg:
An industrial production at -3.3% equals zero growth.

If the Services PMI contracts, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

Normally "entrepreneurial economy" can’t do that well as long when they are entrepreneurs in the picture but in the special case of France, given French civil servants have done their best to "kill" the entrepreneurs in France with great success, the economy will continue to linger.

A tight credit channel, high inventory levels vs. order books, depressed consumer sentiment and a forced fiscal tightening create a dangerous economic environment for an already weak economy.

On a final note we leave you with Bank of America Merrill Lynch's latest graph from the Thundering Word from the 19th of June displaying the infatuation with "yield" (it reminds us of our Dark Crystal reference from our March 2013 conversation "The Yield Skeksis"):

"Men still have to be governed by deception." - Georg C. Lichtenberg, German scientist

Stay tuned!

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