Tuesday, 1 July 2014

Credit - The Molotov Cocktail

"Incendiary capitalism is carrying its out evil works more dangerously than ever, and is doing so in the increasingly dangerous neighborhood of the powder kegs that are the great European military powers." - Karl Liebknecht, German politician, 1871-1919.

Looking at the dismal US GDP print for the 1st quarter at -2.9%r while enjoying the latest yield compression in US yields, thanks to our contrarian take since January 2014, and seeing the increasing trouble brewing in the Middle-East, with German businesses unsupportive of the sanctions against Russia according to Michael Harms, chairman of the Russian-German Trade Chamber, in conjunction with the complacency and lack of liquidity in the credit space, we reminded ourselves of the Molotov-Ribbentrop pact prior to the Second World War and the aforementioned explosive "Molotov Cocktail" created by the Finns during the Winter War which was highly effective against Russian tanks. 

When it comes to Germany's relationship with Russia, this relationship is very important for German companies as we highlighted in in our July 2012 conversation "The Game of The Century":
The European Union’s seven former communist members outside the common currency will have an average budget shortfall of 2.6 percent of gross domestic product and an average debt load of 44.7 percent of GDP this year, the European Commission estimates. That compares with 3.2 percent and 91.8 percent for the euro region according to Bloomberg. No wonder Germany, frustrated in the West, is increasingly looking more and more to the East:

"Russia is important for German companies. In 2011, there was a 30 per cent increase in trade between Germany and Russia, with a total volume of 75 billion euros. German economic representatives have been talking about the huge potential of the Russian economy for many years, and it is seen as advantageous that Russia is nearly as important for trade as Poland. In 2011, Russia ranked 12th in German exports behind Poland (10th) and before the Czech Republic (13th)."
"Russia is Germany’s biggest supplier of gas and oil, providing around 40 per cent of its gas and 34 per cent of its oil supply in 2011. With the government’s decision to stop producing nuclear energy by 2022, German demand for gas will increase in the short and medium term." - Source An Alienated Partnership - Vestnik Kazkaza - 7th of July 2012.
As we indicated in our conversation "Eastern promises" on the 9th of June:
"We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed."

In relation to the German and Russian relationship, credit wise, it will be interesting to look at the outcome for the planned €5.1 billion sale of RWE Dea, the Oil and Gas business unit of Germany's utility giant RWE to a Russian group. Again, the "devil" is indeed in the "details" and like any good behavioral psychologist would tell you (and what we have kept doing) are as follows:
Try to watch the process, rather than focusing on the content given RWE (BBB+) is burdened by €31.5 billion of debt and posted a net loss of €2.8 billion in 2013. We would be very surprise to see Merkel blocking such a transaction given the deleveraging needs of its giant utility company RWE. It is just posturing, we think.

One of the reasons behind our chosen title is due to the increasing risks posed by the growing tensions in the Middle-East which could lead to another spike in oil prices, which would be of course highly damageable for growth in general and consumption in particular. The other being Financial Contingent Capital notes also called CoCos which we will discuss in this week's conversation as we think that as the quote above goes, they are akin to incendiary capitalism or most likely a "Credit Molotov Cocktail", but we ramble again.

When it comes to Middle-Eastern trouble brewing, oil prices are indeed the "Molotov Cocktail" for triggering recessions. As past history has shown, what matters is the velocity of the increase in the oil prices, given that a price appreciation greater than 100% to the "Real Price of Oil" has been a leading indicator for every US recession over the past 40 years. As displayed in the below chart, no need to press the "panic" button yet, but it is worth closely paying attention to oil prices going forward with the evolution of the geopolitical situation:
These spot crude oil and oil product inflation-adjusted values are derived using Bloomberg's proprietary data. Each index is calculated by dividing a spot  ticker by the U.S. Urban consumer price index.

What has been as well of interest has been the growing relationship between oil and gold in conjunction with inflation expectations with the continuation of the Fed's grand monetary experience as displayed below in this Bloomberg graph:
"Prior to 2000, Brent had little observed relationship to gold, a financial asset traditionally viewed as a hedge against inflation. While Brent prices have been heavily influenced by geopolitics and security challenges, the relationship between Brent and gold has become more pronounced in recent years, with Brent possibly emerging as the liquid complement to the hard asset. This may also have provided an inflation hedge as monetary accommodation has driven commodity prices." - source Bloomberg

The famous "great accommodation" play can indeed be seen in the close relationship between brent prices and money supply as displayed by Bloomberg:
"Accommodative monetary policy has helped support crude oil pices in recent years. A likely tapering of that policy and other stimulus measures may have a humbling effect on broader commodity markets. Stagnating money supply growth provides a challenge for higher oil prices without an improving global economy and demand. The BI study examines the relationship between the price of Brent and money supply. Lower gasoline prices are a likely result of lower Brent." - source Bloomberg

In our conversation "St Elmo's fire" (yet another incendiary reference), we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 had been announced - source Bloomberg:

Of course Oil has a stronger relationship with currencies markets rather than with 10 year US Treasuries as displayed in the below Bloomberg graph:
"Currencies, equity markets and other commodities may suggest stronger predictive relationships to crude, yet measuring a broader universe of factors may uncover other variables with less clear correlations. Disqualifying certain variables may be as important to investors as identifying those with greater predictive qualities, given that it allows for closer observation of those data that influence the direction of the subject being scrutinized." - source Bloomberg

Moving on to the subject of the Credit Molotov Cocktail and its incendiary capacity of the capitalist system, we reminded ourselves of the wise words of Dr Jochen Felsenheimer from asset management XAIA which we quoted back in September 2011 in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!":
"in the current system, capital market performance takes on immense importance in a system of fiat money, i.e. efficient allocation of said money. The great danger of a flippant approach to the provision of fiat money is that the financial markets are able to decouple from the real economy. And that is just what happened in the past few years. Following the crises of the past ten years, excessive liquidity was pumped into the system in order to cushion the real economic consequences. Only a fraction of this made it to the real economy, as a large part seeped away in the banking system and thus in the capital market. This is why the financial market is growing so quickly while the real economy is only showing moderate growth." - Dr Jochen Felsenheimer

Of course this is exactly what has happened and which can be ascertained by the meteoric rise in risky asset prices overall which can be illustrated by the significant correlation between the US, High Yield and equities (S&P 500). US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:

Another illustration of the effect of our "Deus Deceptors" central bankers can be seen in the compression in yields of European 10 year bonds which have, for some made new record lows - graph source Bloomberg:
From our September 2011 conversation we also reminded ourselves this quote from Dr Jochen Felsenheimer's letter:
"In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen Felsenheimer

Of course this "Credit Molotov Cocktail" induced by central bank easy money has indeed not made its way to the "Real Economy", rest assured the TLTRO will not either given than no sanctions have been debated surrounding the unappropriated use of the latest round of the ECB's generosity for banks not providing cheap funding to the "Real Economy", end of the day the message is clear, keep on deleveraging with our support and "carry on" (in both sense) supporting European government bond yields. End of the day the new TLTRO amounts once more to "Money for Nothing", given all that easiness can be assessed in the lack of transmission to Businesses as effectively real rates have risen as illustrated by Bloomberg:
"Mario Draghi’s newest stimulus package aims to do something previous measures haven’t achieved-- push ultra-low interest rates through to the economy.
The CHART OF THE DAY shows the real cost of borrowing for companies, or bank interest rates adjusted for inflation, rose in most euro-area nations in the 12 months through April, the most recent period for which data is available. While the European Central Bank president cut the benchmark rate by half a percentage point over that period, the effect was largely wiped out by stagnant or falling prices and lenders’ reluctance to pass on the reductions.
Draghi announced policies on June 5 including a negative deposit rate and conditional loans to banks to bolster credit and steer the currency bloc away from deflation. Consumer prices rose 0.5 percent last month, down from 1.2 percent in April 2013 and below the ECB’s goal of just under 2 percent.
“Real rates need to ease further, or the ECB might be forced to do more,” said Frederik Ducrozet, an economist at Credit Agricole CIB in Paris. “While a short period of low inflation might be supportive of households’ purchasing power, higher real rates for longer would impair the recovery.”
Higher financing costs hurt companies’ willingness to invest, curbing output and employment and in turn weighing on consumer prices. Spanish companies paid an average of 1.2 percentage points more in real terms to borrow money in April compared with a year earlier as the cost of bank loans held steady and inflation slowed. A drop in nominal rates in Italy was overwhelmed by a slump in inflation.
Estonia, the Netherlands and Slovakia were the worst hit. Only Portugal, with the biggest decrease in nominal bank rates, and Germany recorded a decline in real borrowing costs. Data wasn’t available for Greece, Malta and Luxembourg. Latvia wasn’t included as it wasn’t part of the euro area in 2013." - source Bloomberg

Euro Consumer Credit? Still trending down falling 3.9% to fresh lows in May - graph source Bloomberg:

Euro Corporate Loans? Same story, an extended decline in May - graph source Bloomberg:

We reminded ourselves of the wise words as well of our good credit friend in 2012:
When somebody has too much debt and cannot reimburse it, how do you bail him out? Obviously by restructuring his debts, which imply losses for his creditors.

But when one lends him more money in order for him to pay back what he owes, he is not bailing him out but rather pushing him in a bigger hole! The game until now has been to "print" more money and to add more debt on the shoulders on the indebted ones, to gain some time in the hope that growth will resume and reduce de facto the weight of the existing debt burden and the additional new debt issued to support the initial debt troubles.

This is a big misunderstanding of debt dynamics and its effects on the economy. When debt becomes too big, which it is now the case in many parts of Europe, the servicing drains all the available cash flows and reduces the growth potential."

Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. We hate sounding like a broken record but: no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits and debt levels.

In relation to the subject of Contingent Capital notes also called CoCos, banks have issued more than €30 billion worth of these additional tier-1 instruments in order to build buffers to meet the new Basel rule for total-capital ratios. As indicated by Bloomberg recently CoCos, like European government bonds, are indeed underestimating risk to coupons and par value:
"In many cases these bonds are trading significantly above par. Instruments issued in 2010 to 2012 paid coupons of 6% to 8% and currently offer yields to maturity of 4% (at Credit Suisse) to 6%. The Bank of England suggests investors may be underestimating the likelihood of additional tier 1 instruments, known as CoCos (contingent convertibles), being converted into equity or written down in the event that a bank's capital ratio falls below a pre-defined level. A Bank of England report notes two risks which may not be adequately reflected in current CoCo prices: a lack of disclosure linked to certain elements of capital requirements, and guidelines dictating when a coupon may be cancelled."- source Bloomberg.

Again we reminded ourselves the wise words of Dr Jochen Felsenheimer we quoted in a previous conversation relating to banks, government and mis-pricing of risk:
"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy."

A good illustration of the "japonification" process and the "Credit Molotov Cocktail" and its incendiary capacity in inflicting ultimately significant losses to investors (who are more than ever dipping their toes in untested markets and reaching for yield outside their comfort/risk zone) can be seen in the significant outperformance of the CoCos asset class as related by John Glover in Bloomberg on the 23rd of June in his article "CoCos in Best Debt Returns Win Regulators Plaudits":
"The riskiest debt from European banks is outperforming a gauge of 964 securities from Spain’s Abengoa SA to U.K.’s William Hill Plc, according to Bank of America Merrill Lynch indexes. The new-style contingent capital notes, or CoCos, issued to meet stiffer capital rules, returned 9.12 percent, compared with average gains of 5.86 percent for the broader high-yield bond index of companies in the region." - source Bloomberg.

From the same article, it is clear to us that banks and government are playing the same game when it comes to debt issuance and the duplicity of regulators for banks in issuing more debt rather than true sound capital in the form of more equity
"As long as governments agree to treat AT1s as debt rather than equity, interest payments out of pretax earnings make them cheaper to issue than stock." - source Bloomberg.

We discussed that very subject of equity buffers in our conversation "Dumb buffers" back in March 2013:
"The beauty for the issuer is that the CoCo automatically boosts its Core Tier 1 capital ratio in times of stress rather than being forced into a dilutive right issue during difficult market conditions. Owning a CoCo, according to a recent BNP Paribas note is very similar to selling a Down-and-In put option on the issuing bank’s shares with a knock-in barrier linked to a balance sheet capital ratio as opposed to stock price level.
The issuing bank is effectively buying skew and convexity (crash protection) from the investor, who is exposing himself to losses in stress scenarios. 

It is not a free lunch although a coupon in the region of 7% to 8% is outright appealing in this low rate / low yield environment." - source Macronomics

We were therefore not surprised to see an outperformance of this "Credit Molotov Cocktails". The compression in spreads for some of these issues since issuance as illustrated by Bloomberg:
"Benchmark spreads on Barclays and UBS CoCo bonds have narrowed since issuance, with some more than 300 bps tighter, implying few concerns among investors about credit risk. CoCo's pose risks to bondholders through write-downs if a certain trigger event occurs, often a minimum capital level defined by the regulator. Regulatory discretion to impose losses before a trigger level is reached has been cited as an additional risk, prompting Standard & Poor's to consider cutting credit ratings on the bonds." - source Bloomberg

By issuing more and more CoCos with the complacency and support from regulators given that under European Union rules, banks can count additional Tier 1 debt equivalent to 1.5 percent of assets weighted by risk when calculating certain ratios, banks are indeed issuing more "Molotov Cocktails" rather than building true equity buffers we think.

On a final note we would like to point out that without a significant depreciation of the euro which is not going to happen unless the nuclear QE option is triggered to the tune of at least €1 trillion, there is no such thing as a credit-less recovery in Europe as discussed in our conversation "In the doldrums":
"If credit growth does not return, economic recovery may prove to be difficult in the absence of sizeable real exchange rate depreciation." - Zsolt Darvas - Bruegel Policy Contribution.

"So for us, unless our  "Generous Gambler" aka Mario Draghi goes for the nuclear option, Quantitative Easing that is, and enters fully currency war to depreciate the value of the Euro, there won't be any such thing as a "credit-less" recovery in Europe and we remind ourselves from last week conversation that in the end Germany could defect and refuse QE, the only option left on the table for our poker player at the ECB:
"The crux lies in the movement needed from "implicit" to "explicit" guarantees which would entail a significant increase in German's contingent liabilities. The delaying tactics so far played by Germany seems to validate our stance towards the potential defection of Germany at some point validating in effect the Nash equilibrium concept. We do not see it happening. The German Constitution is more than an "explicit guarantee" it is the "hardest explicit guarantee" between Germany and its citizens. It is hard coded. We have a hard time envisaging that this sacred principle could be broken for the sake of Europe."

"Incendiary capitalism is carrying its out evil works more dangerously than ever, and is doing so in the increasingly dangerous neighborhood of the powder kegs that are the great European banks." - Macronomics.

Stay tuned!

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