Tuesday, 12 August 2014

Credit - Cognitive dissonance

"The difference between stupidity and genius is that genius has its limits." - Albert Einstein

Watching with interest the significant compression of German bund towards the 1% level as deflationary forces à la Japan gather strengths in the European space with disappointing ZEW index pointing to lower growth in conjunction with Russian sanctions hitting hard some European economies, we decided to venture once more towards psychology when it came to choosing this week's analogy for our title (We already touched on the subject of cognitive bias in our "Dunning-Kruger effect" conversation. Cognitive dissonance in psychology which is when people are confronted with information that is inconsistent with their beliefs. For instance, in the case of Europe, the much vaunted "recovery" is no doubt going to be tested by the next GDP prints in the European space with France, no doubt straying towards recession in similar fashion to its Italian neighbor we think (-0.2%). Of course the prophecy of the "recovery" will fail in similar fashion to what was illustrated in Leon Festinger's 1956 book "When Prophecy Fails", which was an early version of cognitive dissonance. A good illustration of "Cognitive dissonance" is in the belief that having a single European banking supervisor will be supportive of lending in peripheral countries as indicated by the ECB and reported in Bloomberg by Maxime Sbaihi in Bloomberg:
"The transfer of power to a single European bank supervisor should be a game changer. The ECB is hoping to do more than simply strengthen financial stability. It also envisions unified authority as a tool to repair the broken channels of monetary policy transmission, prompting banks to make their comeback at the periphery and improve credit conditions there. The central bank timidly expressed this wish in its latest financial integration report, stating that “the banking union is expected to contribute indirectly to the return of crossborder credit flows.” - source Bloomberg
We beg to ask where the demand is going to come from? Yet another illustration of "Cognitive dissonance" from the ECB, or more akin to "wishful thinking" we think, but as always we ramble and rant.

In this week's conversation we will look at "Cognitive dissonance" informations which we think are inconsistent with many pundits' beliefs in the much vaunted "recovery" and cautious signs coming from various indicators for risky assets in the coming months we think.

Like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content. Not only as human beings we suffer, from optimism bias, but we suffer as well from "deception" and we also all play "deceit" to some extent. We are all "great pretenders", some way or another.

After all, one only need to look at the German 2 year yield  turning negative again to realize that credit wise Europe is indeed turning Japanese. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes indicative of the deflationary forces at play we have been discussing over and over again - source Bloomberg:
Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation which is what we are seeing in Europe and what a 0.4% inflation rate is telling you. It is still the "D" world (Deflation - Deleveraging).

As we indicated in our conversation of November 2013 entitled "Squaring the Circle", when it comes to optimism bias and "Cognitive dissonance" we reminded ourselves of the "wise" words from Olli Rehn:
“I’m sure that we will be able to find a satisfactory solution as regards to how to ensure the fiscal gaps will be filled and the fiscal targets will be met.” - Olli Rehn

We also pointed out at the time:
"As far the "optimism bias is concerned, a majority of analysts believe the German Constitutional court will allow the OMT to stand on the basis that EU treaty allows for purchases in the secondary bond market. We beg to differ. 
Once a debt is a contingent liability, for instance "super senior" there is no turning back, but the ESM being capped and the OMT yet to be firmly backed by Germany, the nuclear option is still an option rather than a reality."

In this previous conversation we also argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months. Looking at the fall in Sotheby's stock price on the 8th of August following a second-quarter profit fall of 15% with the share plunging 11% after its earnings miss, we wonder if indeed the S&P 500 is indeed not vulnerable down the line using the aforementioned relationship we discussed - graph source Bloomberg:
Mind the gap...Also note that Sotheby's private sales fall by 50% in first half of 2014 as reported by Philip Boroff in Artnet on the 12th of August in his article entitled "What Sotheby’s Doesn’t Want You To Know About Its Private Sales":
"Sotheby’s private sales have plunged following the auctioneer’s public feud with activist investor Daniel Loeb.
Long a focus of company executives, private sales tumbled 48 percent in the first half of the year, according to an August 8 Securities and Exchange Commission filing. The value of private transactions, in which Sotheby’s discretely brokers art and other collectibles to one prospective purchaser at a time, dived to $294 million in the first half of 2014 from $561 million a year earlier. It was the lowest private sales total since 2010. The drop contributed to a 15 percent decline in quarterly earnings and an 8 percent drop in Sotheby’s stock on Friday. The shares are off 15 percent in the past year, as the benchmark Standard & Poor’s 500 Index rallied 15 percent." - source Artnet.

The role of Sotheby's stock price  as an indicator was as well confirmed by our good friends at Rcube Global Asset Management  back in our November conversation but them using MSCI World as a reference - graph source Bloomberg:
"The Art market has always been an interesting indicator. The only major public auction house is Sotheby's since its floatation in the mid-1980s. It has proved a timely indicator of potential global stock markets reversal.
Whenever its price reached 50 or so with sky high valuations, a reversal was not far away. We can also take notice of the extremely weak jewelry and contemporary art auctions recently."

Another "Cognitive dissonance" sign which has been put forward by our friends at Rcube Global Asset Management  in their latest monthly review is another warning coming from the MSCI World:
"According to various measures, bullishness in the US was back to January's levels and at historical extremes. Leverage also seemed to have increased in June to new highs, while the MSCI World had just reached its 2007 top." - source Rcube Global Asset Management 

While in our last conversation "Nimrod" we discussed the outflows in the High Yield space through the ETFs markets in general and ETF HYG in particular, while recently there was some price recovery, we have to agree with our friends from Rcube Global Macro Asset Management namely that the massive increase in shares repurchase indicates that High Yield spread should be considered too tight.

Massive outflows recently as pointed out by Bank of America Merrill Lynch in their recent Flow Show note from the 7th of August entitled "Credit Capitulation":
"Biggest week of outflows ($11.4bn) from HY bond funds EVER in dollar terms; 4thlargest week of HY outflows as % AUM ever (Chart 1)"
- source Bank of America Merrill Lynch

But recent price "recovery" of ETF HYG and another illustration of "Cognitive Dissonance" - graph source Bloomberg:
HYG and JNK are the two largest High Yield ETFs accounting for 80% of assets.

Nasdaq Buyback achievers vs Standard & Poor's 500 index - graph source Bloomberg:
The Nasdaq gauge consists of companies that repurchased at least 5 percent of their shares in the previous 12 months. The US equities market has been increasingly being boosted by buybacks, yet another artificial jab in the on-going liquidity induced rally. Repurchases are largely designed “to boost earnings per share as revenue growth slows.

For our friends at Rcube Global Asset Management, corporate credit spreads are far too tight on US HY bonds, when we consider the massive increase in shares repurchase activity:
A measure of balance sheet leverage, which compares net equity issuance to corporate cash flows, also shows that HY spreads are too tight.

While spreads have narrowed massively over the last 2.5 years, liquidity has clearly not followed. The liquidity spread shown in the chart below measures changes in the short‐term differences in the bid and ask prices on 3‐Month US Treasuries, which reflects liquidity in financial markets. A widening spread signals illiquidity in the market, which is associated with growing stress.

What is interesting in the current episode is that despite much better fundamentals since the 2008 meltdown, strong inflows and tightening spreads, liquidity clearly has not improved.

Another illustration of the "liquidity risk" can be seen in the levels of inventory sitting on US primary Dealers as an illustration as displayed by Bank of America Merrill Lynch in their European Credit Stategist report from the 11th of August entitled "When it turns...":
“When it turns…”
“…it’s gonna be nasty” is the punchline in credit, used to describe today’s world of growing buyside assets and lower street liquidity. Admittedly, street bids have been somewhat of a rarity over the last few trading session, and the move wider – especially in Crossover – has been eye-catching.
But it’s easy to spin the party line on liquidity during a big risk-off moment. Dealer holdings of corporate bonds are clearly way down on where they were in the ’06 and ’07 era (chart 12), but banks are also more nimble in managing their mark-to-market risks, and overall exposures on their securities portfolios." - source Bank of America Merrill Lynch.

Another "Cognitive dissonance" indicator is also coming from the same Bank of America Merrill Lynch, pointing towards a change in the Business cycle in Europe turning South:
“It’s not me, it’s you!”
In our view, the risks for credit over the next few months stem more from continued equity weakness, than from any big changes in credit fundamentals. For spreads to tighten materially again, we think European equities need to stabilize. But as our equity team has been pointing out, stocks are currently undergoing a rotation from high-beta into defensives, due to the business cycle having moved from the Boom to Slowdown phase.
What does a rotation in equities look like? Bring up a chart of European Auto stocks (SXAP) against the Food and Beverage index (SX3P). Autos have underperformed by almost 8% this year, after having outperformed the Food and Beverage sector by 17% last year.
The bad news is that business cycle phases tend to last for some time, with the European cycle having only just rolled over earlier this year (and more recently for the periphery, as chart 3 shows).
While geopolitical risks and sanctions will only serve to dull the growth outlook in Europe further, the good news is that China is strongly surprising to the upside.
We think this has the potential to help lift growth expectations in Europe sooner.
But weak equities aren’t enough for us to suddenly become big bears on credit, though, although we admit the longer equities struggle the tougher it will be to get near to our big spread tightening targets for year-end, especially for high-yield credit." - source Bank of America Merrill Lynch.

On the potential rebound from China which would help lift growth expectations in Europe sooner, we disagree with Bank of America's take. Also, from the latest US Trace information is showing from the High Yield market, investors are selling CCC exposure to move up the rating chain towards single Bs which also can be seen in the resilient flows seen in the investment grade space as investors are playing "defense" in similar fashion to some players in the equities space. In the on-going European "Japonification" process as we pointed out in numerous conversations, credit can indeed outperform equities (see our conversation "Deleveraging - Bad for equities but good for credit assets") when of course management stays conservative and protects its balance sheet rather than "releverage".

On a final note, given Japan’s 10-year government bond yields around 0.51% today after reaching an all-time low of  0.315% in April 2013 and given it hasn’t been above 2 percent since May 2006, and that Switzerland is the only other country whose 10-year yields are below 1 percent, according to data of 25 developed nations tracked by Bloomberg, you can indeed expect Germany to join shortly the below 1% club. Another indicator we have tracking on our side has been the 30 year Swiss yield relative to Japan which is now as well getting close to the 1% level - graph source Bloomberg:
Since the beginning of the year, and in similar fashion to other Core long bonds, Swiss long yields have fallen significantly. For instance Swiss 30 year bonds have fallen by 63 bps relative to Japan 30 year bonds. We expect this divergence to increase.

"A man should look for what is, and not for what he thinks should be." - Albert Einstein

Stay tuned!

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