Tuesday, 14 October 2014

Credit - Actus Tragicus

"We live in an age of mediocrity." - Lauren Bacall

Looking at the dismal European data coming out of Europe with a plunging German Zew index in the October survey declining 10 month in a row ( -3.6 this month from 6.9 in September),  with German industrial output falling by 4% during the course of August (the biggest drop since January 2009) and weaker inflation in Europe with Spanish September HICP inflation coming in at -0.3% YoY, and French HICP inflation falling to 0.4% YoY (from 0.5% YoY in the previous month), with prices down 0.4% MoM and Eurozone Industrial Production coming at  -1.8% (below the expected -1.6%) in conjunction with new record lows on the German 10 year yield coming at 0.85%, we decided therefore to use another musical analogy, this time around drifting towards one of our favorite classical masterpieces, BWV 106, also known as Actus Tragicus, being a sacred cantata composed by Johann Sebastian Bach in 1708 when he was 22 years old in Mühlhausen and intended for a funeral. In the end it might be the most appropriate funeral cantata that could be used for the euro at some point given the growing dissent in both Italy and Germany, as well as the very open opposition between Mr Mario Draghi and Mr Jens Weidmann. Very few musical pieces touch our soul, arguably the first movement of BWV 106 aka "Actus Tragicus" is one of them, but we ramble again...

The tragedy playing out, of course, is the growing divergence between asset prices and economic fundamentals with central banks meddling with the most important variable in the capitalist system namely interest levels, more simply the "price of money", leading of course to "mis-allocation" of capital in the grand scheme of things. While large corporates in Europe have had no problem in gaining access to "credit", SMEs in Europe have been starved by the precipitation of the credit crunch leading to massive unemployment which has been accentuated by European banks deleveraging thanks to the EBA's fateful decision of "forcing" bank to reach 9% core tier one level by June 2012. We will not come back to that much commented and evident outcome which we have discussed at length on this blog.

What is of course of interest (and once again no surprise to us) is to see a continuation of the rally in US treasuries, which we had foreseen thanks to our contrarian stance which we indicated well in advance given our deflationary "bias" and our  "somewhat" understanding of the macro outlook. Since early 2014 we have indicated our long duration exposure, which we have partly played via ETF ZROZ as an illustration of us playing and understanding the "macro" game.

In this conversation, once again we have decided to focus on the credit cycle and where we stand when it comes to look at the "Global Credit Channel Clock", as designed by our good friend Cyril Castelli from Rcube Global Asset Management:

Last month we indicated the following in our conversation "Sympathy for the Devil":

"Whereas Europe sits more closely towards the lower right quadrant, it is increasingly clear that the US is showing increasing leverage in the corporate space, indicating a move towards the higher quadrant on the left of the Global Credit Channel Clock we think. What we have been seeing is indeed a flattening yield curve in the US with re-leveraging courtesy of buy-backs financed by debt issuance which is the point we made in last week Chart of the Day." - Macronomics, 9th of September 2014

We also argued:
"The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters."

Interestingly enough, high-yield outflows have continued for a 6th week in a row according to Bank of America Merrill Lynch's most recent Follow the Flow note published on the 10th of October and entitled "More in safety, less in yield":
"High-yield funds outflows continue for the sixth week
Even though US-domiciled HY funds flows bounced back, Euro-domiciled funds continued to see more outflows; the sixth week in a row. High-grade credit and money-market fund flows were on the positive side though, with the latter seeing the largest inflow so far this year. Note that over the past week, government bond funds saw a $1.9bn inflow, the largest in eight weeks.
Credit flows (week ending 8th October)
HG: +$1.5bn (+0.2%) over the last week, ETF: -$117mn w-o-w
HY: -$1.2bn (-0.5%) over the last week, ETF: -$114mn w-o-w
Loans: -$112mn (-1.3%) over the last week
Same patterns for another week in European credit funds, with more inflows into high-grade funds and more outflows from high-yield. "However, fund flows into W.E. regional funds (that we believe are more €-bond focused) have seen another inflow (of $478mn) last week. On the duration front, high-grade credit flows have been concentrated in the mid and long-term funds, with outflows continuing from the short-end for a second week.

More in safety, less in yield
Flows have been pointing to “safe” yield rather than any yield, lately. Over the past weeks, the trend has been notable, with more funds added in high-grade credit and government bonds, rather than high-yield credit and equity funds. YTD flows into high-grade and government bond funds have been in ~$65bn, while flows into highyield and equity funds have been a mere $22bn. Put that also on top of the record inflow into money-market funds last week  takes the 2014 YTD figure to $60bn." 

- source Bank of America Merrill Lynch

So much for the "Great Rotation" story of 2014 from bonds to equities...

Of course while the "Actus Tragicus" continue to play out in Europe in the "real economy", US and Europe Investment Grade credit continue to benefit from the flattening of the yield curve. The evolution of flows of course validates the "Great Rotation" namely the gradual move of investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit as we concluded our last conversation.

And what has happened in the last few years courtesy of Central banks generosity has been the multiplication of carry trades in various segments of the market. The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years is likely coming to an end as we move in the US towards the upper quadrant of the "Global Credit Channel Clock".

Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is  the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...).

As we posited in our conversation on the 13th of June 2013 "The end of the goldilocks period of low rates volatility / stable carry trade environment?":
"The huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space."

Looking at the continuation in both outflows from the equities space and the very strong compression in  the long end of core government bond space (US Treasuries and German Bund), it much more likely for us that we are indeed at risk of a significant "repricing" in the equities space.

Facts are as follows:
Commodity markets and the performance of global cyclicals versus defensives continue to point to a very, very subdued global growth environment.
Another "great anomaly" that investors should take into account is that low volatility stocks have provided the best long-term returns such as "Consumer Staples".

When it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:
Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". Investors should had bought Treasuries if they had anticipated the Federal Reserve reduction in its purchases, based on the last two times that the biggest buyer of bonds stepped back from the market (The yield declined by 126 basis points between the end of the first round of Fed purchases in March 2010 and the beginning of the second round in November that year).

Of course our positive stance on Investment Grade Credit which we discussed again in August 2014 in our conversation  "Thermocline - What lies beneath" has been confirmed:
"For those that need to seek comfort in a safe haven, we believe Investment Grade credit while tight from an historical point of view, still benefits from positive exposure thanks to the Japanification process. In that sense, we expect the Fed to keep a dovish tone in this muddling through economic situation in the US meaning that the releveraging process taking place in the US is still positive for credit." - Macronomics, 19th of August 2014.

While it is true that the "interest rate buffer" in case of a surge in rates is nearly exhausted in the current low yield environment, but the environment for investment grade credit is still favorable as highlighted again last week:
"This somewhat validates Nomura's take on the golden age for credit we discussed back in 2012 in our conversation "Deleveraging - Bad for equities but good for credit assets":
"-Corporates around the world have been deleveraging for longer than most people realise, starting around the time of the tech bubble in 2000.
-Deleveraging is generally bad for equities, but good for credit assets.
-In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute).
-As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities." - source Nomura

Of course the current interest rate differential between the US and Europe, supported by a weakening Euro and negative interest rates in the front-end of some European government bond yield curve points towards a larger allocation to US fixed income we think.

On that point we disagree with the latest take from Bank of America Merrill Lynch' s credit team in their recent Credit Market Strategist note from the 10th of October entitled "Breaking up is so easy to do" given they don't see an acceleration into US fixed income:
"Breaking up is easy to do. US-European interest rate differentials are near historical highs whereas credit spread differentials remain near – though notably off - historical lows. With the economies out of sync, and resulting opposite central bank policies, our global interest rate strategists expect the rates differential to increase even further. As our European credit strategist, Barnaby Martin, maintains a constructive outlook for EUR IG, and we are tactically short US IG, clearly we expect the US-EUR spread differential to widen further. 
The push-back. 
Investors’ biggest push-back against this outlook is that, with US yields much higher than global yields we should expect a global allocation change and/or diversion of flows into US fixed income – including credit. The direct effect of such flows would be to dampen interest rate differentials and add strength to US credit at the expense of European credit. Furthermore, as interest rate risk is the key uncertainty for US credit, these flows would provide additional indirect support for US spreads. Hence any divergence between interest rates, credit spreads would be more limited than we are looking for. We think that, while global weakness asserts downward pressure on US yields, the mere existence of wide global yield differentials do not.
Our push-back against the push-back. 
We find it unlikely that the existence of big global yield differentials will accelerate inflows to US fixed income for two reasons. First, while we would indeed expect inflows in a high return environment of both high and declining US yields, with rising US interest rates – which our interest rate strategists expect – returns are much less attractive, despite the higher yields. Second, there appears to be little mean-reversion in interest rate differentials – at least between US and German interest rates. In fact in a statistical sense they appear well characterized as random walks – i.e. can wander far from current levels, in either direction. Thus, even though the difference between US and European interest rates is high, from a statistical point of view we are just as likely to see further meaningful increases from here, as we are to see meaningful decreases." - source Bank of America Merrill Lynch

Unfortunately, we think that flow matters and interestingly another note from Bank of America Merrill Lynch from their Liquid Insight team from the 10th of October entitled "Investing in a sub-zero world" makes some interesting contrarian points which we agree with when it comes to the amount at stake when it comes to "financial repression" in Europe:
"We take a look at the broader challenge to portfolio managers posed by negative yields. Since the ECB decided to first venture into negative rates in June 2014, 30% of the EUR domestic government bond market now trades at negative yields (by notional). For German government bonds this number is 46%. Investors need to move as far as the 4y part of the curve to see positive yields. Expressed another way: investors are willing to pay euro area governments to look after €1.3tn (when including bills). To avoid paying negative rates, investors have to either take more duration risk or more credit risk" - source Bank of America Merrill Lynch

From the same note:
"€1tn looking for a new home
We focus on the impact of negative yields on bank treasury and central bank portfolios for a number of reasons: (1) both tend to get managed against relatively restrictive benchmarks in terms of duration and credit risk; (2) both will therefore be disproportionately affected by negative rates compared to a mutual fund or an insurance company; (3) both have anecdotally reacted strongly to the rate cuts in June and September.
Table 1 shows our estimates of what a typical central bank, peripheral bank, core bank, and non-euro-area bank treasury portfolio looks like. 
Table 2 shows what has likely happened to the weighted average yield of these portfolios since the beginning of June, when the ECB had not yet ventured into negative rates, as well as the amount of assets in each portfolio that now trade at negative yields.

Unlike mutual funds which receive investors’ funds with the specific mandate to replicate (and preferably outperform) the risk-reward profile of a specific benchmark, or indeed an ALM manager who is trying to match specific liabilities, central banks and bank treasuries can be thought of as total return investors subject to a liquidity mandate. As such, they can be expected to take steps to avoid paying negative rates on the roughly €1tn of their holdings that have moved into negative rates since the beginning of June.

€400-600bn of additional demand for risk
Table 2 also shows how much demand for additional risk the ECB has potentially generated through its decision to cut rates into negative territory. 

If bank and central bank portfolios were to try and offset the hit to interest income since the beginning of June, this would generate demand for duration or peripheral risk or a mix of the two between € 400-600bn.
Clearly this number is an exaggeration of what bank treasurers and central bank portfolio managers are actually likely to do. Some will be uncomfortable taking so much additional duration and/or credit risk. Banks that are not capital constrained may decide not to accumulate zero risk-weighted assets but instead lend to the real economy. Other banks may decide to take steps to encourage deposit outflows to reduce investment needs.
Yet, what this exercise shows very clearly is that even in the absence of QE, the ECB is creating a pseudo-portfolio effect, achieved in the US and the UK through the outright purchase of government bonds. With the ECB now actively targeting a balance sheet expansion, we expect yields to move further into negative territory, aggravating the challenges for investors outlined aboveTherefore, over time we may well see a migration into risk approaching these numbers above." - source Bank of America Merrill Lynch

We therefore do think (and so far flows in US investment grade are validating this move) that interest rate differential will indeed accelerate inflows towards US fixed income, contrary to Bank of America Merrill Lynch's views. We do not expect a rapid rise in US interest rates but a continuation of the flattening of the US yield curve and a continuation in US 10 year and 30 year yield compression and therefore performance, meaning an extension in credit and duration exposure of investors towards US investment grade as per the "Global Credit Channel Clock" (although the releveraging of US corporates means it is getting more and more late in the credit game...).

Of course the issue in Europe when it comes to the real economy has been weak aggregate demand plagued by high unemployment levels and the continuation of the "deleveraging" à la Japan.

The weaker macro outlook as part of the "Japanification" process is supportive of credit and the continuation of lower yields. On that specific subject we agree with Nomura's take from their latest Japan Navigator No. 590:
"As bond yields and stock prices apparently moved in line with the three-month cycle in the UST market until the first half of this week, we believed that investors should be positioned for lower stock prices and lower bond yields (bull flattening in the super-long space) until the 28-29 October FOMC meeting, which we view as the next turning point in monetary policy. However, the Fed demonstrated its dovish stance unexpectedly earlier in its 16-17 September meeting minutes, bringing rates lower substantially. Despite this, stock and crude prices continued to move lower this week. This suggests to us that the market has begun to expect changes in the real economy, i.e., a slowdown in the global economy, including the US, and potential easing by the Fed and other central banks, rather than looking at the excess liquidity-driven three-month cycle. This is only a tail risk at this point, but warrants due attention as it could have a substantial market impact. Indeed, we believe investors have added positions by pricing in this risk, likely adding momentum to risk aversion this week."
- source Nomura

Moving back to the subject of the credit cycle, JP Morgan's latest note from the 14th of October entitled "Where we are in the credit cycle?" highlights the situation based on credit fundamentals:
"A credit cycle is generally characterized by a rapid growth in the availability of credit, a decline in the cost of credit, and increased willingness of lenders to accept lower returns and to lend to riskier borrowers. At some point subsequent losses from this risky lending rise, and lenders retrench, leading to credit market stress and often a broader negative economic impact.

When companies have access to plentiful and historically cheap funding there is a risk that they use it in ways that support shareholders while making their credit profiles more risky. There are trends occurring in some credit markets that have historically been associated with a credit cycle that is reaching maturity. These include significant bond issuance, low spreads, a weakening of covenants, declining credit ratings, an increase in M&A activity, less favorable use of proceeds from issuance, and rising dividends and share buybacks. However, the starting point for deterioration is quite strong in some markets, and the extent of deterioration is not consistent across markets, and some are actually improving.
Monetary authorities globally are contributing to easy financing conditions for corporates through both low policy yields and a withdrawal of fixed income product supply through QE. A result of this is, since 2010, there has been a 33% increase in the outstanding amount of US corporate bonds, 166% increase in EM corporate bonds outstanding and 39% increase in European corporate bonds outstanding (figures exclude Financials). Some of this increase is substitution from other funding sources into the bond market. In EM markets some of it reflects a shift in funding from sovereign to state-owned (quasi-sovereign) issuers as well as substitution of syndicated loan facilities in 2012. In all regions low coupons have made the large debt burden more manageable from a cash flow perspective. Still, the rise in debt issuance has impacted leverage.
The key question is where we are in the credit cycle—are we at the 5th inning (for Americans, or halftime for Soccer/Football fans) or the 9th inning/close to full time? This varies by market, as shown below. The US HG market is perhaps the most advanced, exhibiting many signs of maturity. On the opposite end, Japanese credit metrics are improving sharply thanks to improved profitability driven by better growth and the weak yen.

-The credit cycle is not identical across market segments; we see the US High Grade market as most advanced in the cycle and the Japanese market as improving the most rapidly.

-In US High Grade markets the credit cycle is the most advanced, with increasing cash going to shareholders, rising leverage and increasing M&A.
-In US High Yield credit metrics are eroding modestly alongside new-issue quality, but robust corporate liquidity supports continued low default rates.
-In European HG leverage remains near historical highs, as the economic recovery has struggled to gain momentum. Companies are being conservative with dividends and M&A.
-In European HY markets companies are reducing debt but revenue is declining at about a similar rate, such that credit metrics are struggling to improve.
-In EM HG the rise in leverage has been driven by quasi-sovereigns where government policy remains a variable, but non-quasis have been stable.
-In EM HY credit fundamentals have weakened with slow GDP growth. There is still some pressure from commodity sectors, but maturities are light near-term.
-In Japan credit metrics are improving sharply with the pickup in growth and weak Yen. Companies are using the improved cash flow to pay down debt." - source JP Morgan

While the "Actus Tragicus" continues to play out in the deterioration in Europe of economic fundamentals putting additional stain on stretched equities valuation. In the credit space, at least in investment grade, thanks to the "Japanification" process, it continues to be "goldilocks" we think.

On a final note we leave you with the Chart of the day from Bank of America Merrill Lynch note from the 10th of October entitled "Investing in a sub-zero world" displaying our negative yields are indeed moving out the curve:
- source Bank of America Merrill Lynch

"Politicians fascinate because they constitute such a paradox; they are an elite that accomplishes mediocrity for the public good."- George Will, American novelist

Stay tuned!

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