Monday 6 October 2014

Credit - Sprezzatura

"When you can't make them see the light, make them feel the heat." - Ronald Reagan

Listening with interest to the latest comments from our "Generous Gambler" aka Mario Draghi and the disappointment that followed his ECB conference with a significant wobble in European equities by more than 2% (given he didn't specify the size of the potential ABS program), we reminded ourselves for our chosen title and analogy of the Italian word originating from Baldassare Castiglione's "The Book of the Courtier" published in 1528. Sprezzatura is defined as the ability of the courtier to display "an easy facility in accomplishing difficult actions which hides the conscious effort that went into them" according to Wikipedia. In plain English, the word has entered the Oxford English Dictionary defined as "studied carelessness".

What we find of interest in our chosen analogy is that Castiglione wrote his book as the portrayal of an idealized courtier - one who could successfully keep the support of his ruler, in our European case, the support of Germany. 

It seems our "Generous Gambler" is losing his "Sprezzatura" we think when we hear about the rising German dissent for degrading further the quality of the ECB's balance sheet as indicated by the comment of Jurgen Stark, the former chief economist of the ECB:
“The ECB’s decision to double down on stimulus is an act of desperation. Its willingness to buy ABSs is especially risky and creates joint liability, with European taxpayers on the hook. The ECB lacks the democratic legitimacy to take such far-reaching decisions,” - Jurgen Stark

Of course it is of no surprise to us to see growing German dissent as we have long argued Germany holds the key to the unravelling of the European game. The essence of "sprezzatura" is making difficult tasks seem effortless: "whatever it takes", "believe me it will be enough", etc. 

Those who possess sprezzatura need to be able to deceive people convincingly. As of late our "Generous Gambler" hasn't. Also as per Wikipedia, Sprezzatura's negative attribute is "the art of acting deviously":
"This "art" created a "self-fulfilling culture of suspicion" because courtiers had to be diligent in maintaining their façades. "The by-product of the courtier's performance is that the achievement of sprezzatura may require him to deny or disparage his nature". Consequently, sprezzatura also had its downsides, since courtiers who excelled at sprezzatura risked losing themselves to the façade they put on for their peers."  - source Wikipedia

The "Sprezzatura" performance of our "Generous Gambler" Mario Draghi made us remind ourselves our quote from our conversation "Sympathy for the Devil"given that, in order to achieve "sprezzatura", it required Mario Draghi to deny or disparage his nature:
"The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.

While the euro has indeed fallen by more than 9% against the US dollar since May, it won't be enough to sustain economic expansion we think, which unsurprisingly is falling, a subject we will discuss in this conversation as well as our continuous nervousness with the continuation in the rally in the US dollar, meaning tightening and dollar scarcity and the confirmation that CCCs credit being indeed the canaries in the risky asset coal mine.

As we posited in our previous conversation, as years have gone by in the European tragedy, we have become somewhat immunized from our great magician's spells and "sprezzatura" tricks.

It appears though that, we are not the only ones being less "receptive" to the "sprezzatura" skills of our "Generous Gambler" given that at the latest 2014 Global Macro Conference in London from Bank of America Merrill Lynch, some clients revealed their strong convictions through a survey, one being that bank lending will not step up post EU stress tests (83%) and that EUR will be the worst performing (32.7%) over the next three months:
"1. Will stress tests prove to be a turning point for market confidence in the balance sheets of European banks?
a.  Yes  37%
b.  No  63%

2.   Will bank lending step up meaningfully after the stress tests?
a.  Yes  17%
b.  No  83%" 

Which currency do you expect to be the worst performing over the next 3 months?
1. JPY  16.3%
2. EUR 32.7%
3. RUB  20.4%   
4. BRL  18.4%
5. SEK 9.2%
6. Other (specify) 3.1% "
- source Bank of America Merrill Lynch

Taking on the first subject of our conversation, the continuous fall of the Euro won't be enough to sustain economic expansion, we read with interest Natixis take on the subject from their note from the 18th of September entitled "What is the correlation between the euro's exchange rate and growth in the euro zone?":
"A 10% depreciation of the euro:
• Increases euro-zone exports by 4.2% (given the increase in their relative price);
• Increases euro-zone imports by 3.1% (given their relative price);
• Therefore increases the euro zone’s level of GDP by only 0.2 percentage point.
Historical relationship between the relative growth of the euro zone and the euro’s exchange rate
We look at the link between growth in the euro zone relative to the United States and to the world (Chart 9A) and the euro’s exchange rate. 
Chart 9B shows that growth in the euro zone relative to the United States was high in 2001 (with a weak euro) but also in 2006-2007 (with a strong euro), and then declined while the euro depreciated. 
Chart 9C shows that growth in the euro zone relative to the world fell from 2001 to 2003 (with a weak euro) and has since been stable. We see no link between the relative growth of the euro zone and the euro’s exchange rate.
The divergent prospects for growth and interest rates between the United States and the euro zone explain the euro’s depreciation despite the euro zone’s external surplus. Is the euro’s depreciation good news if we take into account the weight of the euro zone’s necessary imports? First we looked at the elasticities of euro-zone export and import volumes and prices to the exchange rate. We saw a slightly positive effect of the euro’s depreciation on real GDP in the euro zone. Next we looked at the link between euro-zone growth relative to the United States and the world and the euro’s exchange rate. It appears no such link exists." - source Natixis

What is of course of interest is that the euro zone's massive external surplus has never been so large and creating indeed a very large imbalance. This of course, reminded us of Nobel Prize Robert A. Mundell 2000 book "The Euro as a Stabilizer in the International Economic System":
"The EU should also change its attitude towards the balance of international payments. Being a key currency issuer, it has the responsibility to provide the rest of the world with sufficient amount of euros. If it always keeps a surplus status, the euro cannot be an important international key currency. Other countries can obtain euro assets either directly through a trade deficit or a capital account deficit. But such a deficit is not a bad thing for the EU. It will bring seigniorage to the euro zone. The Asian countries traditionally belong to the dollar area. This is mainly because we have a trade surplus with the US or we have net capital inflows from the US. If the euro is going to be widely used in Asia, it should invest or lend more money to Asia. It should also expand its trade relations with Asian countries." - Robert A. Mundell, "The Euro as a Stabilizer in the International Economic System

In addition to the above, Deutsche Bank published today a very interesting report entitled "Euroglut: a new phase of global imbalances":
"This report argues that both “secular stagnation” and “normalization” are incomplete frameworks for understanding the post-crisis world. Instead, “Euroglut” – the global imbalance created by Europe’s massive current account surplus will be the defining variable for the rest of this decade. Euroglut implies three things: a significantly weaker euro (we forecast 0.95 in EUR/USD by end-2017), low long-end yields and exceptionally flat global yield curves, and ongoing inflows into “good” EM assets. In other words, we expect Europe’s huge excess savings combined with aggressive ECB easing to lead to some of the largest capital outflows in the history of financial markets." - source Deutsche Bank

Of course a symptom of this phase of global imbalance has been the very weak aggregate demand in Europe caused by the European crisis and the credit crunch triggered by the EBA in 2012 which accelerated the deleveraging of European banks and the lack of credit transmission to the real economy. 
"What is Euroglut? Euroglut is a global imbalances problem. It refers to the lack of European domestic demand caused by the Eurozone crisis. The clearest evidence of Euroglut is Europe's high unemployment rate combined with a record current account surplus. Both are a reflection of the same problem: an excess of savings over investment opportunities. Euroglut is special for one and only reason: it is very, very big. At around 400bn USD each year, Europe's current account surplus is bigger than China's in the 2000s. If sustained, it would be the largest surplus ever generated in the history of global financial markets. This matters." - source Deutsche Bank

Global Imbalances are indeed larger than before the Great Financial Crisis:
- graph source Deutsche Bank

The Euroglut according to Deutsche Bank:
"Europe has been running a current account surplus over the last two years but also benefited from
portfolio inflows as Eurozone risk premia normalized. This surplus was plugged by outflows in the “other investment” component of the balance of payments. This was mostly related to falling bank liabilities to foreigners. Even though banks reduced their foreign assets (deleveraging), their foreign liabilities dropped by more as foreigners reduced their euro loans and deposits." - source Deutsche Bank

Another issue we mentioned was the crowding-out effect which meant that the incestual relationship between European banks and their governments have led to investments being directed to "carry-trade", with credit not directed where it matters most, namely European SMEs.

On the matter of FX depreciation, in conjunction with Natixis take, Deutsche Bank argues that it will not be an effective tool:
"Domestic policy implications
A domestic implication of euroglut is that FX weakening will not be an effective policy response. Does the euro-area need an even bigger trade surplus? Europe faces a problem of domestic, not external demand. The global environment is hardly conducive to export-led growth either. Japan has engineered a close to 50% appreciation in USD/JPY yet exports have failed to recover. This lack of FX responsiveness does not mean that the ECB doesn't care. Absent fiscal policy or other "animal spirit"-boosting initiatives, there is very little left for the central bank than to push yields and the currency lower. QE in Europe will be ineffective, but it will happen anyway - it is the only tool the ECB has to protect its mandate.

From a "Macronomics" perspective the impact should indeed be substantial as posited by Deutsche Bank:
"Global impact
Euroglut means that as the world's biggest savers, Europeans will drive international capital flow trends for the rest of this decade. Europe will become the 21st century's largest capital exporter. This statement is close to an accounting identity - a surplus on the current account implies capital outflows elsewhere. Our premise is that the next few years will mark the beginning of very large European purchases of foreign assets. The ECB plays a fundamental role here: by pushing down real yields and creating a domestic "asset shortage", it is incentivizing European reach for yield abroad. Think about policy over the next few years: at least 500bn-1trio of excess cash will be sitting in European bank accounts "earning" a negative rate of 20bps. In the meantime, asset-purchases will drive yields down across the board – there will be nothing with yield left to buy. The asset implications are huge:
1. Currency weakness. As equity, fixed income and FDI outflows pick up, the euro should face broad-based weakening pressure. Our end-2017 forecast for EUR/USD is 95cents.
2. Very flat fixed income curves. What will Europeans buy? With the US Treasury - bund yield spread at record highs, US fixed income should be a primary beneficiary of European demand. "Secular stagnation" implies a low terminal Fed rate resulting in low long-end yields. "Euroglut" suggests that the level of neutral Fed funds doesn't matter. If there is sufficient demand for long-dated instruments, the US 10-yr yield could easily trade below terminal Fed funds. It happened during the 2000s "bond conundrum", it is even more likely now - global imbalances are bigger.
3. Good EM could survive. The Global Financial Crisis has seen a rotation of current account surpluses away from EM to Europe. At face value, this makes EM more vulnerable. But the sum of countries' current account surpluses is larger now than before 2008, so there is more spare capital around. European current account recycling should mean that the marginal demand for EM assets is likely to go up, not down." - source Deutsche Bank

We agree with the above, US investment grade has already seen large inflows and the flattening of the yield curve will continue to be supportive of credit. What we also found of great interest on the subject of the euro, current account surplus and global monetary policies was in a recent note from Exane BNP Paribas from the 2nd of October entitled "A Frankfurt Accord for a lower euro?":
Imagine the unimaginable: Europe and the US agree on a lower euro
The markets' focus is on the ECB taking more credit risk by purchasing Eurozone assets. But what
if the ECB buys US treasuries, instead of buying Eurozone government bonds, as is widely expected to happen sooner or later? This would help the ECB in its endeavour to bring its balance sheet back to 2012 levels (+EUR1trn needed). In other words, the ECB intervenes in FX markets, with the blessing of US authorities. We have coined this hypothetical scheme the ‘Frankfurt Accord’.
This ‘out-of-the-box’ idea is worth considering based on the following reasons:
1) The ECB avoids the legal and political uncertainty of buying Eurozone sovereign debt
2) FX intervention and US treasury buying is within the ECB’s mandate
3) A lower euro would quickly feed into the economy with a positive effect on prices and exports.
4) The main challenge is that the Fed and the US government would have to agree. The benefits for the US would be that it would delay Fed tightening and keep 10-year yields low, thereby supporting the US mortgage and residential real estate markets.

Is it likely to happen?
The ECB buying US sovereign debt is not our main scenario. However, we think that markets currently underestimate the political risk attached to large-scale purchases of EMU sovereign debt and the consequent possibility that the ECB may yet again have to become more creative in its conduct of monetary policy. The appropriate framework for such a political agreement is a G7 FinMin meeting (10 October in Washington, Germany takes over the presidency next year)." - source Exane BNP Paribas

On that interesting scenario unravelling, obviously our "Generous Gambler" Mario Draghi would have to regain his "sprezzatura" and the support of his masters as indicated by Exane BNP Paribas in their interesting note:
"Who has to agree? US treasury, Fed and European politicians
In the G7 context, the implicit political rule is that large-scale FX intervention should first be blessed by the major parties involved. Therefore, the US treasury and Fed would have to agree to the ECB buying US sovereign debt. And of course Eurozone politicians should be on board as well. This was the political procedure followed in 1985 for a lower USD (Plaza accord), and in 1987 to stabilise the USD (Louvre accord). It was also the case in 2000, when the ECB intervened in EURUSD to stabilise the euro, initially on a co-ordinated basis between the ECB, the Fed and BoJ.
Ideally, the Japanese authorities would also agree
The ECB would only be active in US and not Japanese markets. However, in our view, this should not be too much of an obstacle as a weaker USD is in Japan’s interest as well. The more sensitive issue would be EUR-JPY. We believe the currency pair may fall a bit, but given that we expect the BoJ to opt for another round of QE in 2015, we do not see a “brutal” decline. Hence, the ECB buying US treasuries may not be that much of a problem for Japan.
The most delicate country to deal with is China
A higher USD leads automatically to a Chinese currency appreciation vis-a-vis the Eurozone. This is not necessarily China’s preferred policy mix. Authorities would most likely prefer a supportive export environment through a low currency, which allows them to tighten monetary conditions domestically to counter developments in shadow banking and the property sector. So in a way, a significantly higher USD increases the risks for a Chinese devaluation of the RMB against the USD."  - source Exane BNP Paribas

As we wrote back in our conversation "The Shrinking pie mentality" in April this year, China is more likely to seek a weaker RMB against the USD to avoid bursting its credit bubble à la Japan and  its Nikkei 39,000 of 1989:  
In relation to the aforementioned Chinese devaluation, we do agree with both Russell Napier and Albert Edwards that a Chinese devaluation is a strong possibility given that the Chinese have studied carefully Japan's demise from its economic suicide thanks the fateful decision taken to revalue the yen following the Plaza Agreement of 1985 (a subject we discussed with our good credit friend back in March 2011 in our conversation "Fool me once, shame on you; fool me twice, shame on me..."). In its most recent commentary, the US Treasury states that the Yuan is “significantly undervalued” and suggests that it must appreciate if China and the global economy are to "enjoy" stable growth. Unfortunately for the US Treasury the Chinese are not stupid as indicated by this article displaying the Chinese view on the Japanese economic tragedy written in 2003:
"Under US pressure, the Japanese government and banks "honestly" carried out the "Plaza Agreement", starting to interfere the yen exchange market on a large scale together with the US. As a result the exchange rate of yen against US dollars skyrocketed, exceeding 200:1 by the end of 1985, going beyond 150:1 at the beginning of 1987 and nearing 120:1 in early 1988. This means that the Japanese yen had doubled its value against US dollars in less than two years and a half!"People's Daily, September 23 by Professor Jiang Riuping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

In order to fulfill its balance sheet expansion the ECB could possibly apply similar intervention levels as did the Bank of Japan and the SNB in order to lower their currency as indicated by Exane BNP Paribas:
Applying similar intervention amounts to the euro (as a % of daily FX turnover) points to annual ECB purchases of between EUR400bn (SNB) and EUR800bn (BoJ). In the current context, with the EUR-USD already having turned, we believe intervention sizes suggested by the BoJ’s precedent overstate what is needed to manage down EURUSD.
As the ECB committed itself to expanding its balance sheet by EUR1tr, the ECB’s FX intervention would have to be unsterilized. Hence, US treasury purchases would lead directly to a balance sheet expansion.
In terms of ECB balance sheet composition, the ratio of FX assets / euro denominated assets has been declining since the start of the Eurozone. Expanding them by EUR500bn would lead to a ratio of 38%, all else being equal.
- source Exane BNP Paribas

And Exane BNP Paribas to conclude their interesting intellectual exercise with the following comments:
"ECB easing has to start now
Given current inflation and growth readings, it is quite clear that ECB easing has to start now, and not vaguely at some point next year. This is of course already happening, as ABS and covered bond purchases are set to start in October. As we are not too sure whether the US would subscribe to rapid monetary tightening as of now, it could be that a broad based agreement cannot be reached this side of Christmas.
Nevertheless, keep an eye on the G7 meeting on October 10. Next year, Germany takes over the G7 presidency, so perhaps our imaginative agreement would have a German name. Is it all likely to happen? Our spontaneous reaction was that ‘this is a banana republic approach’. However, the more we think about it, the more we like it…" - source Exane BNP Paribas

Taking on the second subject of our conversation, being our continuous nervousness with the continuation in the rally in the US dollar, meaning tightening and dollar scarcity, Bank of America Merrill Lynch came with interesting comments on the 3rd of October in their US Economic Weekly note entitled "Greenback grief":
"What kind of reaction?
Recent work finds that a 10% appreciation of the trade-weighted dollar leads to about a 0.3pp decline in GDP growth over four quarters, and a 0.25pp drop in inflation. 
As other currencies weaken, those economies should benefit, all else equal. But that effect happens only with a lag, and recent data have softened in several large economies, with the global outlook now looking less favorable. This creates a one-two punch for US exports, as both price and income channels work against them. Also, with a much larger share of corporate profits than GDP exposed globally, a strong dollar could have a bigger drag on stock prices, which might feed back adversely into confidence and spending.
On the inflation side, the Fed has undershot its target for much of the post-crisis period. Inflation accelerated somewhat earlier this year, but now seems stuck at 1.5%. If a dollar appreciation started to push down inflation —particularly core, and not just cheap imported energy and food — it would almost certainly stop Fed discussion of normalizing rates dead in its tracks. In our view, the Fed will not hike until inflation is expected to be on a sustainable path toward the 2% target. Indeed, pushing inflation down toward 1.2% or lower in the past has led to more easing not tightening. Markets may be expecting a further appreciation, but do not appear to be pricing in a shift from modest jawboning to a meaningful shift in Fed communications away from rate hikes next year." - source Bank of America Merrill Lynch

The 5y5y breakevens are now approaching levels at which the Fed has typically engaged in easing via asset purchases. Please keep that in mind. So, with the Fed scheduled to end QE3 by the end of the month, the bar to engage into additional purchases is indeed high making the October 10 central banks meeting a very important event indeed. What is indeed extremely evident to us is that the US yield curve will continue to flatten as it has been all year, in particular in the popular 5-30s part of the curve.

From the same Bank of America Merrill Lynch note, we agree that the velocity of the appreciation of the US dollar matters, particularly on the inflation front, which could postpone the normalization dead in its track:
On the inflation side, the Fed has undershot its target for much of the post-crisis period. Inflation accelerated somewhat earlier this year, but now seems stuck at 1.5%. If a dollar appreciation started to push down inflation —particularly core, and not just cheap imported energy and food — it would almost certainly stop Fed discussion of normalizing rates dead in its tracks. In our view, the Fed will not hike until inflation is expected to be on a sustainable path toward the 2% target. Indeed, pushing inflation down toward 1.2% or lower in the past has led to more easing not tightening. Markets may be expecting a further appreciation, but do not appear to be pricing in a shift from modest jawboning to a meaningful shift in Fed communications away from rate hikes next year." - source Bank of America Merrill Lynch

What is also of interest is that the surging dollar and falling US treasury yields have happened in conjunction with falling commodity prices and particularly a sharp drop in energy prices. This is therefore reinforcing the possibility of coordinate actions from central banks as it seems to us that the deflationary forces are once again taking the upper hand in the eternal struggle (see our post "The Night of the Yield Hunter").

Taking on the third  and last subject of our conversation, namely the confirmation that CCCs in credit  are being indeed the canaries in the risky asset coal mine in continuation of our take from our conversation "Wall of Voodoo", our earlier call was indeed confirmed for this segment of the market when we looked at the price action in the Euro CCC space in September as displayed in Bank of America Merrill Lynch's note from the 2nd of October entitled "The canary in the credit mine":
"In September, the pain was firmly felt in the lower reaches of the credit market. European CCC-rated bonds widened 240bp last month, a 3 standard deviation move, and the worst month of performance for CCCs (-5%) since November 2011 (-8%).
Why the reappraisal of low-quality risk in credit? A lot, we think, has to do with the recent negative credit events of Phones 4U and Banco Espirito Santo. These bonds dropped precipitously, with the effect filtering through to the rest of the market. 
But the ECB’s recent policy salvo (TLTROs, ABS purchases) have also been a subtle admission that Eurozone growth is faltering. None of this is conducive to the performance of low-quality bonds.
Inadvertently, the ECB may have called time on some of the euphoria that had crept into the credit market in 2014. Note that the Euro Stoxx index has been 90% correlated to CCC bond spreads since the start of 2012. But over the last month the two have hugely decoupled, with equities barely correcting." - source Bank of America Merrill Lynch

As a reminder low inflationary environment tend to be the ones where defaults can spike.

On a final note, when it comes to the "credit clock" and leverage in the High Yield space, since mid-2013 the net leverage has increased at a faster space as displayed by the following Goldman Sachs graph from their recent Global Macro Research note entitled "The Credit Trader: Not all dips are buys, but this one is" from the 30th of October:
- source Goldman Sachs

Obviously recent flows in High Yield with -$2.1bn (-0.9%) over the last week and ETF with -$138mn w-o-w counters somewhat the positive take from Goldman Sachs given the star of the again has indeed been investment grade saw $48 billion of inflows in high grade-credit fund in the last week of September with flows being tilted towards mid to long-term funds. EU domiciled funds have continued to see outflows for a fifth week in a row according to the latest Follow the Flow report from Bank of America Merrill Lynch from the 3rd of October.
This is confirming the gradual move of institutional investors from low beta towards higher quality while retail investors continue to be significantly exposed to lower quality credit but that is another story...

“Practise in everything a certain nonchalance that shall conceal design and show that what is done and said is done without effort and almost without thought.” -  Baldassare Castiglione, The Book of the Courtier

Stay tuned!

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