Sunday 25 January 2015

Credit - Stimulant psychosis

"Every form of addiction is bad, no matter whether the narcotic be alcohol or morphine or idealism." - Carl Jung
Watching with interest our "Generous Gambler" aka Mario Draghi finally firing his "Chekhov's gun" and unleashing QE in Europe, pushing in effect more government bonds towards negative yields, we reminded ourselves, when choosing this week's analogy for our title of a specific kind of psychotic disorder called "Stimulant psychosis" that occurs in some people who use stimulant drugs:
"Stimulant psychosis commonly occurs in people who abuse stimulants, but it also occurs in some patients taking therapeutic doses of stimulant drugs under medical supervision." - source Wikipedia

While the symptoms of stimulant psychosis may vary slightly depending on the drug ingested, it generally include the symptoms of organic psychosis including hallucinations, delusions, thought disorder, and, in extreme cases, catatonia. We can already see in the MSM (Mainstream media) and in most of the comments from the European political "elite" symptoms of hallucinations, delusions and of course thought disorder of the highest order but we ramble again...

As a reminder of our conversation "Pascal's Wager" from October 2014, we pointed out the strength of the deflationary forces at play:
"In terms of the implication for Europe (as discussed in the "Coffin Corner"), the aggressiveness of the Japanese reflationary stance spells indeed more deflation for Europe, unless the ECB of course decides to engage as well in a QE of its own:
"Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think." - Macronomics - 27th of April 2013."
Of course in this week's conversation, we would like to review the supposed impact of what QE will bring to Europe, and we would like to point out the implications of the unleashing of the "Chekhov's gun by our "Generous Gambler" and the major difference between QE in Europe versus QE in the US, because once again the Devil is indeed in the details. 

  • The ECB has become the world's fastest QE gunslinger!
  •  Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors.
  • The on-going "Stimulant psychosis" experience led by our central banks deities is leading to more pronounced "Cantillon Effects" aka asset price inflation on a grand scale.
  • 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"
  • The result of course is that the unquenchable hunt for yield is not only pushing investors towards the higher quality spectrum but also extending duration exposure
  • When it comes to the "euthanasia of the rentier", what our central bankers deities are not realizing is that capital with ZIRP is not being deployed but merely destroyed
  • We would like to re-iterate, investors shorting US Treasuries will continue to be punished!
  •  European QE, the Devil is the detail and the future of the Euro lies in Germany's liability exposure

Talking about the Devil, it reminds us as well of the quote we used back in September 2014 in our conversation "Sympathy for the Devil":
"The greatest trick European central bankers ever pulled was to convince the world that default risk didn't exist" - Macronomics.
In fact in our previous conversation we indicated the following:
"Investors have indeed Sympathy for the Devil we think, as they continue to pile up with much abandon and more and more getting "carried away" in their insatiable hunt for yield. In that sense Baudelaire's 1869 poem rings eerily familiar with the current investment situation in the sense that investors have been giving our "Generous Gambler" the benefit of the doubt (OMT - and now full blown QE) and shown their sympathy and their blind beliefs in "implicit" guarantees, rather than "explicit" (such as the German Constitution as we argued in various conversations):
"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
But as years have gone by in the European tragedy, we have become somewhat immunized from our great magician's spells. Many investors have indeed shown the greatest sympathy in respect to piling up on European Government Debt in the process, while banks have been shedding assets leading to outright credit contractions leading in the past two years European banks to cut their lending to businesses by about 8.5 per cent." - source Macronomics, 9th of September 2014
  • The ECB has become the world's fastest QE gunslinger!

While we pointed out in our conversation "Chekhov's gun" that the BOJ and the FED had been QE fast drawers with the SNB front running aggressively the ECB as of late, as pointed out by Bank of America Merrill Lynch European Credit Strategist note from the 23rd of January entitled "QE Sera, Sera", the ECB has become the fastest gunslinger around:
"And so it begins…
The dawn of QE in Europe. Yesterday’s ECB meeting lived up to expectations, plus more. The central bank unveiled asset purchases of €60bn a month across Eurozone sovereign, agency, covered and asset-backed bonds. Banks were boosted by the TLTRO being made cheaper and thus more tempting. But the biggest victory for Draghi, in our view, was the open-ended feel that he was able to convey towards the programme.
Risk assets gave the ECB a vote of confidence by the end of the day, and understandably so – the ECB will likely now have the fastest growing balance sheet across the globe (chart 1). 
Stocks finished up yesterday, sub banks rallied and high-yield tightened. CCCs in particular were very strong, up 2-3pts, the first time in a number of months that the asset class has seen a big move.
But what of credit?
For credit investors, there was no pledge to buy corporate bonds. We had wondered whether the ECB might “tag on” corporate purchases just to make their asset gathering process easier. The dream could still live on if the ECB struggle to buy €60bn a month (note our rates team’s net Eurozone government bond issuance forecast of only €275bn this year). But for now, credit will not be bought.
Yet, there were few signs of weakness, or knee-jerk moves wider in corporate bonds yesterday. If anything, the need for income remains as intense as ever in Europe, with the backdrop of huge amounts of negative yielding government debt (chart 3), and note that the Danish Central bank lowered its deposit rate yesterday (the second cut in a week!). 
The race below zero by central banks is in full force, and so is the movement of money “up the value chain” in search of positive returns. Credit should benefit tremendously from this over time, we think.
The ECB is also becoming a prolific asset gatherer just at a time when financing needs, generally, are in decline. Sovereign funding needs have shrunk as budget deficits have reduced, bank funding needs have also dwindled amid deleveraging and the ECB’s focus on rejuvenating the loan market will mean less corporate supply over time, especially in high-yield (note SME lending rates are falling quickly now, chart 2).
 Chart 4 shows the net supply of fixed-income instruments in Europe on a yearly basis (we use sovereign debt, covered, senior banks and quasi-sovereigns), versus the net growth in the ECB’s balance sheet.

The bottom line is that the ECB is expanding its balance sheet just at a time when assets are being produced at a slower rate. As central banks exacerbate the demand/supply imbalance in asset markets, we see this as a backdrop for prices generally to rise, and by extension – credit spreads to rally." - source Bank of America Merrill Lynch
Of course we agree with the above when it comes to the value proposition of credit in Europe thanks to the on-going "japanification" process, with the slow "euthanasia of the rentier" to paraphrase Keynes from his 1936 "General Theory" book. On that subject we read with interest Andrew McKillop's January 2013 article entitled "Keynes Said: Euthanize The Rentiers, Instead We Euthanized The Economy":
"The bases of the French Revolution of 1789 had been set because even at that time, rentiers were struggling to defend the purchasing power of their interest income and at least preserve the capital value of their wealth. This put them in open conflict with the "traditional rentiers" of the monarchy, nobility, religious orders, and a few other players, who for political survival engaged in creating new and allied rentiers, giving them what French call "une rente de situation" for their personal political benefit, as well as personal financial or economic benefit. This was nothing to do with the national interest, it almost goes without saying.
Inflation is the first enemy of the rentier, but was also the friend of the state - basically the monarchy - in France throughout the 18th century. The very first "asset bubble" organized for and on behalf of the French monarchy by Scotsman John Law, before 1720, the Mississippi Company bubble, was aimed at destroying the real cost of debt owed by the monarchy and its associated nobility, to "the rentiers". Law's action, a Ponzi-type scam, had overkill effects. Some historians argue this first modern asset bubble, aimed at firstly inflating paper asset values, exchanging them against debt owed by the monarchy to rentiers, and then collapsing the bubble helped sow the seeds of the 1789 revolution through decades-long unwillingness of "the rentiers" to lend, after this asset implosion.
Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment. As early as 1820, this was a major theme of David Ricardo. Today, especially in Japan, it is intense daily action by the state and its central bank, seeking by all means to create inflation because "when there is inflation, the economy is still alive", and of course the cost of debt in real terms will fall.
This underlines the fatal flaw in Keynesian-type economics: high inflation, and-or extremely low or zero interest rates, "for prime borrowers", firstly needs rentiers to supply the capital to borrow. Before that, the capital has to be formed or accumulated. If both processes are unsure, uncertain, or inoperative the result can only be economic decline.
The problem today is starkly simple. Without massive money printing and issue, the dearth of capital would be so striking that the New Poverty of the world would be impossible to ignore. The global banking system, at latest since 2008, has vastly overvalued collateral or "assets", and a long-term basic trend, intensifying since 2008 of deflating balance sheets. Governments of all major OECD countries with a combined GDP of about one-half of the world's total output, through their central banks, are each day back-stopping the banks, which are insolvent institutions, flooding them with sovereign debt and fiat money, and manipulating credit markets to maintain apparent valuations.
Without this "window dressing", the reality is that the private sector economy is still contracting four years after the credit bubble burst. It is only concealed by the expansion of government spending and fiat money issue. Governments possibly do not understand they are in the midst of an economic collapse and will be the last to admit it, but as in previous epic struggles between the vested interests in play in a society and its economy, for example in the run-up to the French Revolution, the manipulation of credit, values, money and prices has made it impossible to accurately monitor the economy." - source  Andrew McKillop
When it comes to our contrarian take on US yields since early January 2014 we argued the following in our conversation "Supervaluationism" back in May 2014 it comes from us agreeing with Antal Fekete's take from his paper "Bonds Defy Dire Forecasts but they are not defying logic":
"The behavior of the bond market has been consistent with Keynesianism. By his compassionate phrase “euthanasia of the rentier” Keynes meant the reduction of the rate of interest, to zero if need be, as part of the official monetary policy to deprive the coupon-clipping class of its “unearned” income. Perhaps it is not a waste of time to repeat my argument why, in following Keynes’ recipe, the Fed is acting contrary to purpose. While wanting to induce inflation, it induces deflation.The main tenet of Keynesianism is that the government has the power to manipulate interest rates as it pleases, in order to keep unemployment in check. Keynes argued that the free market economy was unstable as it was open to the swings of irrational investor optimism or pessimism that would result in unpredictable and wild fluctuation of output, employment and prices. Wise politicians guided by brilliant economists − such as, first and foremost, himself  −  had to have the power “to prime the pump” (read: to pump up the money supply) as well as the power to “fine-tune” (read: to suppress) the rate of interest. They had to have these powers to induce the right amount of spending needed to put people to work, to entice entrepreneurs with ‘teaser interest rates’ to go ahead with projects they would otherwise hesitate to undertake. Above all, politicians had to have the power to unbalance the budget in order to be able to help themselves to unlimited funds to spend on public works, in case private enterprise still failed to come through with the money.However, Keynes completely ignored the constraints of finance, including the elementary fact that ex nihilo nihil fit (nothing comes from nothing). In particular, he ignored the fact that there is obstruction to suppressing the rate of interest (namely, the rising of the bond price beyond all bounds) and, likewise, there is obstruction to suppressing the bond price (namely, the rising of the rate of interest beyond all bounds). Thus, then, while Keynes was hell-bent on impounding the “unearned” interest income of the “parasitic” rentiers with his left hand, he would inadvertently grant unprecedented capital gains to them in the form of exorbitant bond price with his right." - Antal Fekete
  •  Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors.
In our October conversation "Actus Tragicus" we disagreed with Bank of America Merrill Lynch' s credit team in their Credit Market Strategist note from the 10th of October entitled "Breaking up is so easy to do":
"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." - source Bank of America Merrill Lynch

We correctly argued at the time:
"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...)."
"When the facts change, I change my mind. What do you do, sir? - Sir John Maynard Keynes
 What is of interest is that, when the facts change, Bank of America Merrill Lynch do change their mind given that in their latest Credit Market Strategist note from the 23rd of January 2015 entitled "All but corporate bonds" they argued the following:
"US IG credit benefits from the ECB action as investors are sent our way. First, the greater than expected expansion of the ECB’s balance sheet implies that for non-official European fixed income investors the investment opportunity set shrinks. The effect is that more European investors will be forced into US IG. Second, while the absence corporate bond purchases removes the potential for a big move tighter in spreads, in the short term certain sectors in US credit could benefit as investors unwind their expressed views that the ECB would buy corporate bonds. For example an investor that wanted exposure to a certain name that had both EUR and USD bonds outstanding might have been willing to give up spread by buying the EUR bond, in order to profit more from an ECB corporate bond buying announcement. Now with that upside potential eliminated the investor may rationally swap to the generally more attractive credit spreads offered in USD tranches."

- source Bank of America Merrill Lynch

  • The on-going "Stimulant psychosis" experience led by our central banks deities is leading to more pronounced "Cantillon Effects" aka asset price inflation on a grand scale.

As we posited in our conversation "Pascal's Wager":
"The only "rational" explanation coming from the impressive surge in asset prices (stocks, art, classic cars, etc.) courtesy of QEs and monetary base expansion has been to choose (B), belief that indeed, our central bankers are "Gods"."
To further illustrate the "inflationary" bias of current monetary policies on asset price bubbles coinciding with "exogenous" (central banks) monetary policy, apart from the Art market, one could simply look at the price evolution of "classic cars" clearly indicative of "pure" Cantillon Effects (detached from the capital structure). To that effect and courtesy of United Kingdom Classic Cars magazine  please find enclosed a good illustration of this "effect" on the price evolution of a Citroën DS classic car:
- source Classic Cars Magazine

"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

This is what we wrote in June 2014 in our conversation "Deus Deceptor" when it comes to the value proposition of investment grade credit we discussed as well in "Quality Street":
"The "japanification" 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)."

  • The result of course is that the unquenchable hunt for yield is not only pushing investors towards the higher quality spectrum but, also extending duration exposure:

The result of course is that the unquenchable hunt for yield is not only pushing investors towards the higher quality spectrum which is in great demand as indicated by the additional +$1.2 billion in Investment Grade inflows in the week ending on the 21st of January versus -$445 million of outflows in High Yield, but, it is also leading to duration extension as indicated by Bank of America Merrill Lynch's chart from their recent Follow the Flow note from the 23rd of January entitled "It's Europe time":
"Quality yield and some growth down the line?
Pre-ECB, the big flows were into European equities, with the expectation that monetary policy will lead to stronger growth down the line. Equity funds saw a $2.3bn inflow, the largest since June last year while the inflow into equity ETFs was the strongest since May’12.
Income remained a dominant theme: investment-grade registered its 57th straight week of inflows. Money market funds have also seen 4 straight weeks of inflows – the best streak since mid-2013 – as negative deposit rates force money “up the value chain”.
High-yield has yet to get a boost from the income theme though: the asset class saw small outflows of $445m over the last week, and has seen $2.4bn outflows YTD.
European commodity funds recorded their biggest inflow ever, with oil stabilizing and with the bid for gold in the wake of the SNB rate cut. EM debt suffered another weekly outflow, the seventh in a row."

- source Bank of America Merrill Lynch

  • When it comes to the "euthanasia of the rentier", what our central bankers deities are not realizing is that capital with ZIRP is not being deployed but merely destroyed as we have argued in our conversation of November 2012, "The Omnipotence Paradox":

"Fixed Income, Floating Expenses...We are more concerned about the "Profits Cliff" or "Peak margins" effect given that companies can't figure how to make use of their cash hence the flurry of buy-backs which we greatly dislike. Indeed, 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)"
 As illustration of the destruction of capital and the supposed recovery in the US, we would like to point to a small conversation our Macronomics fellow blogger and good cross-asset friend "Sormiou" had with a US derivatives sell-side practitioner on the micro news on the employment front:
"Sormiou": “In less than a week in the US:   SLB (-7k jobs/ 7% workforce)  / BHI (-9k, 12%) / EBAY (-4k / 7%) / AmEXpress (-4k, -8%) Oil sector of course, but not only.   We are  hearing the "wage growth / employment pick-up" consensus argument from many sell-side strategists, but on the micro front, things do not look as rosy to us, even though a few announcements do not make a trend yet... thoughts?”
Him: “First is on the macro level = Yellen (and other doves) have flagged, under-employment is still much too high.  the U6 number (USUDMAER in Bloomberg) is still 11.2% vs 8% pre-crisis.  The U6 is a measure of the unemployed and the "under" employed-those folks who want full time, but can only get part well as people who have been unemployed for so long they have fallen off the headline U3 number of 5.6%.  In fact, underemployment has been a major argument for postponing rate rise by the doves.  Point here is I think you are exactly correct in digging -the U3 headline number of 5.6% is absolutely not telling the entire story! More worrying maybe is the unemployment rate dissected across demographics. Unemployment among US youth is shockingly high.
Second is on a company level as you have flagged. Much of the earnings growth over the past few years can be attributed to cost cutting rather than organic growth to operating income.  Once costs were more "in control" for some companies, they turned to M&A to help generate returns - again to increase / boost slack organic operating income growth.  This earning period I think will certainly be more interesting than the last few because there is only so long you can mask sluggish organic growth...and we are seeing it in a few names that have reported.  In general, earnings are coming in 50bps below estimates (according to FactSet numbers).  Granted, we are still early in the earning cycle so too early to call...but if M&A doesn't get you what you need via a bolt on...and organic growth is still lackluster then the only thing to do is turn to is costs again - which is what I think we are seeing (and what you have flagged).”
Could companies focusing on costs again be the reason on why US Weekly jobless claims in the US are remaining above 300K for the third straight week? This is indeed a point to closely monitor we think, going forward.

  • We would like to re-iterate, investors shorting US Treasuries will continue to be punished!

We would like to re-iterate why investors shorting US Treasuries will continue to be punished because they do not understand the game being played, On that specific matter we will simply quote again Antal Fekete from our July 2014 conversation entitled "Perpetual Motion":

"Moving back to the important notion of the difference between stocks and flows we do agree with Antal Fekete's take in May 2010 in his article "Hyperinflation or Hyperdeflation" being akin to a Black Hole and the possibility of capital being destroyed thanks to ZIRP (as it is mis-allocated towards speculative endeavors) hence the risk of pushing to far the "Perpetual Motion" experience":
"Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it the Black Hole of Zero Interest. When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction -- wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators." - Antal Fekete

  •  European QE, the Devil is the detail and the future of the Euro lies in Germany's liability exposure
In relation to the European QE and the details of the "plan", we would like to quote our good friend and former colleague Anthony Peters, strategist at SwissInvest and regularly featured in IFR from his last post entitled  "On the ECB and mutualisation of risk":

"Yes, I did take time off the desk yesterday afternoon to listen to St Mario's press conference. I heard everything he said and but I didn't understand quite a lot of it. Going into it, I had had a long talk with Ian McBride of Mirexa Capital, a fledgling agency brokerage in the rates space and one of the most experienced people I know in London when it comes to the whys, the  hows and the wherefores of the government bond market.
He made a very strong point that, as far as he was concerned, size didn't matter. To him there was only one critical issue of concern and that was the subject of mutualisation of risk. With it, so he reckons, the Eurozone is headed for stability. Without it, it is doomed in as much as it effectively ceases to be a harmonious, homogenous area. The dream of making a United States of Europe in the image of the United States of America is dead in the water and any claim the euro might have had to be like the dollar has just gone up in a puff of smoke.
As recently as Wednesday night, the Dutch parliament had voted against mutualisation and thus, with the Germans, the Finns and the Austrians also averse, unanimity was never going to be achieved. A split vote was not an option and so there had to be a fudge. The question was, how heavily was the fudge going to be tainted with the flavour of sauerkraut? When I heard Draghi begin to explain the split in loss-sharing, I knew all was not right. Ian titled his analysis of the outcome with "Mario Swings a Big Bat, But Misses the Mutual Ball?" Please permit me to share some of his thoughts:
"Call me a cynic, but you're trying to hide the fact that you failed to force through the most important component of the QE program... namely loss sharing, liability sharing, mutualisation, or whatever you want to call it and you end up with at best 20% loss sharing only, of which only 8% is on government bonds. You hide this shortcoming in the fetching headlines that you will be buying up to €60bil/month combined Public & Private securities. And on top of that you make the program longer than some expected taking it up to at least Sept/2016, having started in Mar/2015. That is in theory €1.14trn of securities you will accumulate. Sounds big right? Then the cherry on the Smoke and Mirror Cake is that you tell everyone you will make the program conditional on achievement of your mandate for price stability. Saying that the program will go on as long as needed. Or open ended if you like."
He continues "To illustrate how big the party is in Berlin tonight... Based on what is clearly a big win on the compromise (I'd say outright victory) that Germany and its allies wrung out of Draghi. Look at some rough numbers for new German joint loss sharing exposure by the end of the Program when and if the ECB and National CBs manage to buy the total of €1.14trn by Sept/2016. Based on the Capital Key, Germany is responsible for 18% of that total or €205.2bn and of that only 8% is held by the ECB with loss sharing. So that means that the total non-Bund exposure for the BUBA is only an additional €16.4bn out of the grand total of €1.14trn bought. It'll be lots of beer and sausages all around!!"
"That tiny 8% is symbolic, but not in any way significant enough to prevent, over time, the segregation/tiering/fragmentation of the credits within the Eurozone borrowers. The Haves vs. the Have Nots. I will expect, when the dust settles and purchases begin, that the credit spreads between the strong and the weak will widen. This is not a program that is designed to float all boats equally."
"It is a divisive piece of policy that Draghi, in my mind, has lost a lot of credibility over. He and other members clearly caved in to the demands of the big bully(s) on the block. And for me, despite the big size headlines and open ended-ness of the program, it comes up short of what is needed to maintain the structural integrity of European Monetary Policy and Fiscal Unity."
So, while they were dancing on the floors of the stock exchanges and while all the high fiving was going on that St Mario and his merry men had finally come to the rescue, wrapped in open-ended QE, it could quite well be that the seeds of the final destruction of that strangest and most incongruous of constructs, the European Single Currency, were yesterday sown.
It might, of course, be that the euro softens a little bit, that inflation is imported to the tune of roughly 2%, that exports pick up enough in order to push Eurozone unemployment down from the current 11½% to 5½-6%, that construction and consumption accelerate, that fiscal revenues rise to the level at which deficits are wiped out and surpluses are achieved without legislative intervention or trimming of benefits and that pigs learn to fly. Or it might be that the whole system falters when driving down the road by hitting a whole pile of cans which had been kicked there over time." - source Anthony Peters - "On the ECB and mutualisation of risk":
This is exactly what has happened with the QE plan put forward by our"Generous Gambler" aka Mario Draghi. Back in July 2012 in our conversation "Europe - The Game of the Century" we argued the following:
"The only possible Nash equilibrium for Germany will be to defect"

While only appearing to be making material sacrifices, German Chancellor Angela Merkel has managed to keep Germany's liabilities unchanged, this is again the case with the present QE, as it was the case with the capped ESM and EFSF.

As we indicated in our conversation "Eastern promises" on the 9th of June 2012, we still believe that eventually Germany will defect in the end:
"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."

We would like to point out 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 Germany'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."

What do we do sir? 
When the facts haven't changed, we do not change our mind.  In the European QE, there has indeed been no move towards "explicit guarantees" as it would have indeed entailed a significant increase in Germany' s contingent liabilities hence our continued negative stance on the future of the European Union.

On a final note we leave you with Bank of America Merrill Lynch's graph displaying Labor force growth vs US CPI from their Thundering Word note from the 18th of January 2015:

"Technology and demographics (Chart 3) continue to act as secular deflationary forces across the developed world. The end of QE in the US means the Fed is no longer inflating asset values. And investors are increasingly concluding that QE has ended up creating excess supply rather than excess demand. The relentless “lust for yield” continues. In Q1 it is the turn of REITs to be the asset class attracting large speculative inflows in search of Yield & Growth." - source Bank of America Merrill Lynch
"We need to ask whether, in the long term, some individuals with a history of psychosis may do better off medication." - Thomas R. Insel, American scientist
Stay tuned! 

Friday 16 January 2015

Credit - Quality Street

"Quality is not an act, it is a habit."- Aristotle

While mesmerizing at the velocity in the fall in core government bonds including our beloved US 30 year exposure, and the aforementioned flight to "quality", we reminded ourselves of the individual sweets first produced by Mackintosh's in Halifax, West Yorkshire, England in 1936:
"In the early 1930s only the wealthy could afford boxed chocolates made from exotic ingredients from around the world with elaborate packaging that often cost as much as the chocolates themselves. Harold Mackintosh set out to produce boxes of chocolates that could be sold at a reasonable price and would, therefore, be available to working families. His idea was to cover the different toffees with chocolate and present them in low-cost yet attractive boxes. Rather than having each piece separated in the box, which would require more costly packaging, Mackintosh decided to have each piece individually wrapped in colored paper and put into a decorative tin. He also introduced new technology, the world’s first twist-wrapping machine, to wrap each chocolate in a distinctive wrapper. By using a tin, instead of a cardboard box, Mackintosh ensured the chocolate aroma burst out as soon as it was opened and the different textures, colors, shapes and sizes of the sweets made opening the tin and consuming its contents a noisy, vibrant experience that the whole family could enjoy." - source Wikipedia
In similar fashion, our title is a reference to the rapid surge in ETF inflows in 2014 which broke numerous records in terms of inflows as reported by the Financial Times in their article entitled "ETF industry booms in record-breaking year":
"Numerous records for ETF inflows were set in 2014 by providers, and across asset classes and geographies. This was helped by a massive surge in December, when investors allocated $61.5bn of new cash, a monthly record.  The December surge pushed 2014’s net inflows for ETFs (funds and products), to $338.3bn, up 36.1 per cent on the previous year and surpassing the $272.2bn record for inflows set in 2008, according to ETFGI, the consultancy. Deborah Fuhr, founding partner at ETFGI, called 2014 a “truly amazing” year for the industry.
 BlackRock, the world’s biggest fund manager, cemented its position as the leading ETF provider globally after gathering record inflows of $103.6bn, two-thirds more than in 2013.  Mark Wiedman, global head of iShares, the ETF arm of BlackRock, says more investors around the world are embracing the versatility of ETFs, whether for strategic buy-and-hold investments or as precision exposures to express views on virtually any market. Vanguard, the third-largest ETF provider by assets, also enjoyed a record-breaking year, with inflows of $88.7bn in 2014, up almost 47 per cent on the previous year. A variety of other providers including Amundi, Lyxor, FirstTrust, Charles Schwab, UBS and BMO of Canada also had record-breaking inflows." source Financial Times

It is no surprise to read from the same article that when it comes to "Quality Street", investment grade matters:
"Two BlackRock ETFs linked to investment-grade corporate debt were among the best-selling products in Europe, gathering a combined $5bn." - source Financial Times 
One could indeed infer when it comes to our analogy that, in similar fashion to Harold Mackintosh's boxes of chocolates, when it comes to the investment world the surge of the ETF complex is akin to the rapid success of "Quality Street" sweets but we ramble again.

When it comes to credit, one may just look at the latest EPFR data to see that in our "Quality Street", Investment Grade is leading with 56 straight weeks of inflows as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 16th of January 2015 entitled "Positioning for ECB QE":
"Credit flows (week ending 16th January)
HG: +$1.7bn (+0.3%) over the last week, ETF: +$440mn w-o-w
HY: -$755mn (-0.3%) over the last week, ETF: +$132mn w-o-w
Loans: +$9mn (+0.1%) over the last week
Inflows strengthened into high-grade funds, with the strongest pace in 7 weeks, and the 56th consecutive week of inflows. High-yield registered another outflow, marking a continuation of the flight to perceived relatively safe assets amid an eventful previous couple of months. ETF fund flows into credit remained buoyant for another week in IG space, while flows in high-yield through the ETF door were the highest in 11 weeks, perhaps suggesting that ECB QE could reverse the recent negative
Looking at duration, the trend is back to what it was at the end of last year; with unloved short-term funds seeing outflows while mid-term funds continue to remain popular with an inflow of +$1.6bn. Long-term funds are not attracting much attention thus far but the flows are still positive - albeit marginal." - source Bank of America Merrill Lynch

As we were typing our new market musing, came, not the proverbial "sucker punch" which we discussed in August 2012 in our conversation "Sting like a bee - The European fight of the century", but more akin to a nuclear strike on the market with the removal of the Swiss peg.

The SNB punch, EUR/CHF's 30% intraday range picture following the nuclear 10 sigma strike - graph source Bloomberg:

Of course it is of no surprise to hear that after such a massive shock and awe move the demise of some small fishes which are already turning belly-up, in the likes of some FX retail brokers meeting their maker.

"Boxing is the only sport you can get your brain shook, your money took and your name in the undertaker book." - Joe Frazier

No offense to the memory of boxing legend Joe Frazier, but, there is another "leisure" activity that seems to fulfill the above quote we used back in August 2012 we think: "FX Retail brokerage is an activity where you can get your brain shook, your money took and your name in the undertaker book".

So while we are already seeing the small dead fishes resurfacing, we wonder when a big whale will turn up. Rest assured that the SNB's brutal move has had some major financial impact somewhere apart from the FX retail broker space.

In this week's conversation, we will therefore muse around the notion of "Quality".

As a starter, in relation to the Swiss move and the lack of reaction of gold in the process, we read with interest Deutsche Bank's take from their Behavioral Finance Daily Metals Outlook entitled "Gold is still a currency without central bank":
"There are some sections of the gold market where observers are puzzled by the rally in gold prices yesterday. The surge in the value of the Swiss franc, after the SNB abandoned the euro peg, confirmed for them that it was the relatively safer haven, not gold. However, one might also question at what price will come the SNB’s attempt to dissuade safe-haven seekers from coming to Switzerland. Already deposit rates stand at minus 0.75 percent. Ten-year yields, which had halved since the start of the year, halved again yesterday to stand at just 7bp. International competiveness has been eroded and disinflation looks set to be the country’s largest import. Of course, the alternatives might have been worse: after the ECJ backed the principle of ECB sovereign bond purchases, the SNB might have been faced with having to print francs in order to buy many of the euros the ECB might print. This would have proved unsustainable and carried huge economic risks. It is precisely this convoluted relationship that is proving so worrying. Global central banks have continued to set key prices in the financial system, some six years after the crisis – zero benchmark rates, low bond yields, competitive FX rates, and buoyant stock prices. The effort has now become so expansive that the policy of one central bank has undone that of the other. For investors who yearn for a market with less official intervention, gold is once again entering the discussion." - source Deutsche Bank
Exactly, what we posited in our previous conversation when we looked at the "Global Credit Channel Clock". Not only long vol, long government bonds have been rewarding in the early days of 2015, but, gold again is surging again.

What we find of interest is that, for some pundits, the SNB has lost some of its credibility. On the contrary, we think the SNB has in fact regained some credibility by removing the peg and let the market drive freely the level of the CHF currency. As we mused in our November conversation "Chekhov's gun", there are indeed different types of central banks:
"Indeed, when it comes to the ECB we have a case of "Chekhov's gun, whereas when it comes to the Fed and the Bank of Japan it is more akin to Tuco's philosophy: "When you have to shoot, shoot. Don't talk"
In the case of the SNB, we remind ourselves also the points made by Richard Koo quoted in our November conversation:
"The problem is that treating monetary policy like currency intervention also has side effects. Over the last decade it has become standard practice around the world to conduct monetary policy with a minimum of surprises based on careful dialogue with market participants.
Until the mid-1980s, monetary policy decisions tended to be made in closed rooms, something then-Fed chairman Paul Volcker was very good at. In Japan, it was even considered “acceptable” for authorities to openly lie in the lead-up to decisions on the official discount rate (or the timing of snap elections).
Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members."- source Richard Koo, Nomura Research Institute

To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but the fastest gunslinger is no doubt the SNB. The move of the SNB clearly shows a shift towards the mid-1980s kind of monetary policy described by Richard Koo. Some pundits have deemed unacceptable for the SNB to openly-lie in the lead-up to the decision of the removal of the peg, calling in question its credibility. Obviously the violence of the movement should be a stark reminder for "complacent" investors of what to expect when markets cease to be "financially repressed" and manipulated by our central bank deities. What has actually happened, we think, is that the SNB has decided to "defect" from the central banks cartel of "money printers". The SNB has indeed broke rank with the "easy money" gang and decided to shift back to a more 80s orthodox view of conducting monetary affairs. Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. One might therefore wonder if the SNB has not indeed decided intentionally to shift towards "Quality Street" regardless of the deflationary environment rather than continue to embrace the lax monetary policies embraced by many, preferring therefore the short term pains for long term gains.

We concluded our November conversation with the following remarks at the time:
"While it has been easy to somewhat front-run the QE cowboys thanks to "Pascal's Wager", the end of QE in the US coincide with a renewed period of weaker global trade, historically high asset price levels and record low bond yields making it more likely we will see a return of higher volatilities regime in the near future making future equities return questionable and long bond US Treasuries enticing (we are keeping on our very long duration exposure via ETF ZROZ)."

No doubt, that we have indeed seen a return to a higher volatility regime in 2015 but when it comes to future equities return, they are indeed questionable, particularly in the light of Société Générale's recent report on Risk Premium from the 13th of January entitled "High is not always better":
"US equity risk premium – High is not always better
The US equity risk premium (4.3%) is still in attractive territory (above its long-term average of 3.9%) relative to government bonds. However, the internal rate of return on US equities (6.4%) has continued to fall and is now materially below the long-term average (8.9%). This means that US equities are likely to deliver below-average returns going forward. Furthermore, US equities have limited capacity to absorb higher bond yield:

Internal rate of return on US equities is near its lowest level since 1990 The internal rate of return on US equities currently stands at 6.4%, i.e. materially below its historical average of 8.9%. Clearly, the high US equity risk premium is largely due to stubbornly low government bond yields. Our analysis indicates that a 10-year US government bond yield of above 2.55% would make switching from equity to government bonds attractive from a valuation perspective
US long-term growth (3.7%) is also near multi-decade lows. Any recovery in the long-term growth prospects of the US should have a positive impact on US equities. However, our analysis indicates that part of the growth recovery is already reflected in the current valuation." - source Société Générale

When it comes to equities and their performance relative to credit risk in the European space, no doubt "Quality Street" has played out and will continue to perform has indicated by Kepler Cheuvreux in their latest Cross Asset Research note entitled "Crisis and Continuity":
"Higher quality equity continues to outperform. Stocks with high sensitivity to credit continue to under-perform."
The defensive bias in stock behaviour is still apparent. Higher quality equity continues to out-perform. Stocks with high sensitivity to credit continue to under-perform. In particular, we would like to point out two aspects of the recent behaviour of European equity that are especially significant. The first is the differentiation within Europe’s universe of higher quality, lower risk stocks. The second is the under-performance of Europe’s banks and of the compartment of large cap value since last October. The recent improvement in the relative performance of smaller caps is largely the consequence of the weakness of Europe’s category of large cap value stocks" - source Kepler Cheuvreux
Kepler Cheuvreux made also some very interesting remarks when it comes to our "Quality Street" analogy in their report:
"The benefit that Europe’s lower risk equity has derived from the bull market in high quality duration has declined quite notably, indicating the emergence of a deflation risk premium.
In the second place, only the portfolio of lower risk quality stocks out-performed in 2014. The lower risk growth portfolio did not out-perform. The difference relates to two criteria: debt and growth. Stocks with low debt and low expected growth performed best in 2014.
Generally speaking, low risk stocks with high expected growth and comparatively high debt did not perform well. Moreover, the divergence in question has become more apparent in recent months.
The decline in expectations of nominal growth in Europe produced a premium for balance sheet quality in the course of 2014, with particular reference to indebtedness. It also gave rise to the expectation of Central Bank intervention, accelerated by the effects of the collapse of oil prices. The consequence in the credit space since last October is a premium for the liquidity of the IG and quasi-IG beneficiaries of Central Bank intervention.
The behaviour of Europe’s banks is a barometer of the balance of advantage between the forces of deflation and reflation because bank balance sheets are evaluated by reference to the incentive to leverage or deleverage. The investment consensus tends to assume that all forms of Central Bank intervention are good for Banks. However, excess liquidity does not necessarily ensure the expectation of reflation. Precisely, the contradiction of the investment consensus is the conviction that the ECB must engage in GB-QE but that it will fail to raise the rate of nominal growth in the euro zone. The relative performance of Europe’s banking sector, especially that of the cheaper, lower quality EZ banks, has deteriorated since last October even though Central Bank liquidity is driving down bank funding costs and their lending rates.
The equity investor should take note of the message delivered by divergences within the credit space since last October. A collapse in the value of an asset as strategically important as oil produces the expectation of credit stress in the commodity-emerging space which translates into a risk premium for the banking system. There is a link between the under-performance of the banks and of energy stocks. We cannot yet say that the price of oil has bottomed. There is no sense yet of genuine capitulation with respect to oil within the commodity investment community.
The under-performance of large cap value in Europe identifies a crucial weakness of the bullish consensus. In current circumstances the premium for liquidity and for quality benefit lower risk, non-bank equity, including many of Europe’s insurers. We cannot say that the reflation trade in Europe is effective until Europe’s banks begin to out-perform bond proxies in the equity space (see chart 11). 
The performance of Europe’s banks will improve when expectations of the rate of nominal growth in the region begin to revive. We have no yet reached that point." - source Kepler Cheuvreux
This validates our long standing view that a bank is the second derivative to the growth of the economy. A bank is a leverage play on the economy. This is why it is so important to track economic activity, as banks are at the heart of the economic system when it comes to providing the means to its development.

Furthermore, since the European financial sector stress of 2011 which first started in the credit space, financials senior and particularly low beta credit have clearly outperformed financial equities in Europe. This can be ascertained by looking at the Eurostoxx Banks vs Itraxx Senior Financial index (roll adjusted) particularly since late 2013 whereas European banks stocks have been trading sideways - graph source Bloomberg:
- source Bloomberg

We continue to view European Investment Grade credit particularly in the financial space to be more appealing than equities (QE might change this view and boost banks equities). We expect further earning headwinds and surprises with additional goodwill writedowns particularly for European banks having significant Eastern Europe exposure. US banks earnings have erred so far on the weak side. We expect a similar picture in Europe.

The underperformance of equities versus credit in Europe for the banking sector is not surprising given the deleveraging and continued consolidation of the bloated sector as highlighted by Société Générale in their European Banks note from the 9th of January:
"€600bn of lost corporate lending
The European corporate loan book has shrunk by €600bn since 2009, the point at which corporate credit volumes began to retreat. Around €450bn of this shrinkage has taken place in the last three years – the period of austere governments and regulators. Almost all of this correction is down to three banking systems: Spain (€400bn lost from peak), Italy (€100bn lost) and Greece (€30bn lost).
Over this same period, outstanding debt securities issued by non-financial institutions have increased by c.€200bn, from €850bn to €1,050bn. This has plugged some of the gap, but of course it has been more geared to the core eurozone markets. The periphery has seen less replacement of the banking balance sheet by debt markets.
Corporate credit levels have been in decline. They also remain in decline in 9 out of 18 of the eurozone lending markets we outline below.
However, it is not all gloom. In Germany and France, corporate loan books have actually been growing very modestly since 2013. The volume increase is still slight (1-2%), but the cycle has at least turned.
€7tn of lost assets and 800 lost banks
Shifting up from loans to overall balance sheet, the trend is just as clear. The total euro area banking system has shed €7tn in assets since 2008. The first chunk of assets fell away in 2008-09 (typically non-lending assets – subprime, etc.). The second chunk of assets has been falling away since 2011.
At the total balance sheet level, it is actually Germany that has seen the lion’s share of the balance sheet decline. This is largely linked to the non-lending assets that fell away in 2008-09.
As well as the €7tn in lost assets, the banking system has lost 800 banking institutions. Obviously this takes us well into the tail of banks, with the 150 banks lost in Germany (to 1,734 institutions in 2013) generating few headlines. 
However, consolidation is a theme that cannot be overlooked." - source Société Générale

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth.

Indeed, consolidation will carry on and pain will be inflicted on subordinated bondholders in the European banking space. On a side note we have yet to hear about the fate of Italian fallen giant Banca Monte dei Paschi di Siena which fell today another 2.4% to 45.25 cents. MPS has fallen around 66% in the past six months, leaving the third Italian bank with a market value of just 2.35 billion euros.

It is not surprising to see that there has indeed been a correlation with the severity of the contraction of credit with the rise of unemployment and economic disarray in peripheral countries, which was precipitated by the stupidity of European regulators as we discussed on numerous occasions in our posts when relating to the fateful decision of the EBA:
"What accelerated the "credit crunch" was the EBA's decision for banks to reach a certain capital threshold by June 2012 (for the EBA June 2012 core tier one capital target of 9%, banks needed to raise at least 106 billion euros according to the EBA's calculations)
On a final note, to conclude our note, we would recommend you stay on "Quality Street" (your are less likely to be mugged...) as indicated by this chart coming from the Kepler Cheuvreux report quoted above indicating the evolution of the premium for Quality and Liquidity in particular since October:
"We emphasise the reinforcement of the premium for quality and for liquidity in both the credit and equity space since last October." - source Kepler Cheuvreux
 "Quality is never an accident. It is always the result of intelligent effort." - John Ruskin, English writer
Stay tuned!

Tuesday 6 January 2015

The Fright of the Bumblebee

"It's about focusing on the fight and not the fright." - Robin Roberts, American athlete
Looking with interest at the plunge in the Euro with the resurgence of "Grexit" (the risk of a Greek exit from the euro) as well as the continuation in the fall in oil prices and early 2015 market turmoil, we remembered the wise words of our "Generous Gambler" aka Mario Draghi in relation to Bumblebee and the European currency when choosing our title for our first 2015 post:
"The euro is like a bumblebee - it shouldn't fly, but it does," - Mario Draghi
Of course our title reference is a veiled reference, already used by many pundits to Nikolai Andreyevich Rimsky-Korsakov's orchestral opera interlude "Flight of the Bumblebee composed in 1899-1900. But, there is more to our chosen title than from the choice of the word "Fright" instead of "Flight". The 1936 radio program about fictional hero "The Green Hornet" also used "Flight of the Bumblebee" as its theme music. When it comes to "stinging analogies", no doubt this year the "greenback" aka the US dollar could indeed be stinging even more Emerging Markets investors who got "carried" away by many years of negative real interests rates inflicted on them by the Fed.

When it comes to the European QE and the musical analogy from our title, we hope our "Generous Gambler" (aka Mario Draghi) is indeed a violin expert because the road to become a virtuoso goes through playing the "Flight of the Bumblebee". It is according to the Guinness World Records, the fastest violin tune around and the expert fiddler needs to play it the fastest way possible (around 1 minute and twenty seconds). With nearly uninterrupted runs of chromatic sixteenth notes for the "Flight of the Bumblebee", it requires a great deal of skill to perform. Same thing goes with QE. So good luck with that, dear central banker "virtuoso" in training!

When it comes to global deflation risk which can be ascertained by the continued fall in sovereign bond yields making new lows on a daily basis, we think investors, as per our initial quote, should be focusing on the "fight against deflation", rather than on the "fright" in Europe coming from a "Grexit" risk. We have long been sitting in the deflationary camp as our readers know by now from our numerous musings. We haven't changed our stance in early 2015. 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. We will continue to play it in 2015 rest assured but, we ramble again...

In our first conversation of 2015 we would like to look at where we stand in the credit cycle and what it means in terms of "allocation. We also discuss the need to refocus on potential additional goodwill writedowns for European banks (particularly the ones exposed to Eastern Europe, Russia and Ukraine). We will also touch on the oil conundrum and the repercussions it can have with a rising dollar in the coming months.

As a starter, we have decided to look at early on in 2015 where we stand in the credit cycle by looking at the "Global Credit Channel Clock", as designed by our good friend Cyril Castelli from Rcube Global Asset Management:
In terms of "allocation", we think we are looking more towards the upper left part of the Credit Channel Clock which means:
-a continuation of flattening yield curves, 
-being long volatility as we enter a higher volatility regime
-a continued exposure to US long government bonds. Long dated US government bonds from a carry and roll-down perspective continue to be enticing at current levels compared to the "unattractiveness" of the mighty German 10 year bund indicating a clear "japanification" process in Europe.
-adding again some gold exposure in early 2015. We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it is going to be working again nicely in the first part of 2015:
"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."

What we have been seeing is indeed the continuation of a flattening yield curve in the US with re-leveraging courtesy of buy-backs financed by debt issuance.

When it comes to assessing the re-leveraging, we read with interest CITI's Credit Strategy note for Q1 2015 entitled "The State of the Credit Markets". 
"Company Re-Leveraging Very Dramatic
We calculated leverage for two baskets of names — the overall IG universe updated quarterly since ’06, and for a basket comprised of credits that held an IG rating at any time since ’06 (to capture falling angels). Either way, it doesn’t look good.

What’s Driving the Rise? Not Cap-Ex
Of course, if leverage is going up today because it’s funding tomorrow’s growth that might not be a bad thing. Unfortunately, that’s not what’s going on.
Leverage Likely to Continue Rising
In theory, a company that buys its own shares will boost its EPS, but unfortunately its default risk is likely to rise as well. This may not be good for share price. But recently buybacks are up while default risk is down." - source CITI
Taking into account central banks generosity with them providing abundant liquidity, it has indeed reduced default risk down as indicated by CITI but, a continuation in the fall of oil prices and a continued rise of the "Green Hornet" aka the US dollar could indeed put a serious dent in the trend in the Energy HY space in general and in the EM $ Corporate space in particular. 

When it comes to the switch towards a higher volatility regime in the credit space, it can be ascertained from the surge in the High-Grade space as indicated in the recent CITI note:
"QE has certainly had a downward influence on volatility, but by some measures vol has actually increased. For example, we have seen more meaningful drawdowns in recent years relative to previous periods at the same point in the credit cycle.

More Volatility in Other Markets as Well
And it’s not just drawdowns in credit, as we’ve seen similar trends in HY, EM, and the Treasury volatility markets. For example, in aggregate these markets had 15 meaningful jumps in risk back in the ’03-’07 period, vs. 27 in the current environment.
Choppy Price Action Likely in the Future
Less diversity and limited dealer balance sheets create volatility, and for a variety of reasons we see little reason why either of these trends will change in the period ahead. Drawdown frequency will remain elevated."
-source CITI

Indeed, as well as CITI, we have always highlighted the risk in the liquidity factor not being priced accordingly. 
"Investment Grade credit is like a bumblebee - it shouldn't fly, but it does" - Macronomics
When it comes to performances and flows, as we rightly pointed out in 2014, in the credit space, Investment Grade was a big winner with more than $66 billion added to the asset class according to Bank of America Merrill Lynch latest Follow the Flow note entitled "2014: The year of quality yield":
"High-grade credit dominates in 2014
With ECB QE around the corner, and the growth outlook in Europe still low, High Grade credit was the dominant asset class in 2014, amid a search for quality yield. More than $66bn was added to the asset class in 2014, setting a record year with not a single week of outflow. Inflows into government bond funds in 2014 also surpassed any other year historically, with an $18bn inflow.
However, flows elsewhere were not as upbeat. High-yield credit had $11bn of outflows, while equity funds had only $11bn of inflows. Notably, 2014 was the year of two halves; while equity funds saw $44bn of inflows in H1, during the second half they saw $33bn of outflows. For high-yield, it was the same, with $17bn of inflows to start, but $28bn of outflows to finish the year." 
- source Bank of America Merrill Lynch

So much for the "Great Rotation" story of early 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 due to lack of alternative with institutional money moving up the quality spectrum as discussed back in 2014. The current "deflationary" environment is indeed a golden age for credit, much more in Europe  compared to equities where Investment Grade has had its second best performance in 2014 since 2009 (above 7% versus 5% for European High Yield) and with the largest issuance number since 2007:
"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

Given the re-leveraging has been more pronounced in the US when it comes to Investment Grade credit, European Investment Grade is still more enticing than European equities in the on-going "japanification" process as we wrote in our conversation the "Hidden Fortress" in November:
"When it comes to Europe, the deleveraging continues and amounts to goldilocks period for credit particularly in the banking space whereas banking equities will continue to underperform we think." - source Macronomics
But, as we pointed out in our conversation "Actus Tragicus" in 2014, flattening yield curves are still "credit supportive":
"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." - Macronomics
When it comes to the fresh sell-off in equities, we argued in our October conversation the following:
"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." - Macronomics, October 2014
We also added credit wise:
"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.
To avoid paying negative rates, investors have to either take more duration risk or more credit risk." - source Macronomics
We concluded at the time:
"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...)."
The weaker macro outlook as part of the "Japanification" process is supportive of credit and the continuation of lower yields. In fact when it comes to the economic activity outlook, as indicated by Société Générale from their 2014 review, it peaked during the summer:
"World economy growth
-Growth momentum peaked over the summer
-US doing the heavy lifting, India shines among BRICs"
- source Société Générale

When it comes to High Yield price behavior CCCs have been indeed the canary in the credit coal mine in 2014 during the second semester as we pointed out in our conversation "Wall of Voodoo", (even single Bs weren't spared).

As a reminder and going forward, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger!

Furthermore, the European High Yield space has seen further from Eastern Europe worries, with more downgrades on the horizon in the financial space given Austrian bank Raiffeisen has become the 12th largest financial issuer in Bank of America Merrill Lynch €HY indices thanks to the downgrade of Raiffeisen's dated subordinated debt (rated Ba1/BBB-/NR) dropped into High Yield territory following Moody's downgrade of RBI (Raiffeisen Bank International) standalone rating on the 23rd of December. For some Christmas does come early. According to Bank of America Merrill Lynch's note from the 5th of January 2015, over €2 billion of RBI sub debt has entered the BofAML HY indices this month, equivalent to 2.5% of the Euro HY Fins index and 0.7% of the generic Euro HY index overall:
"Raiffeisen: more questions than answers
Raiffeisen T2 bonds have dropped by 7-12pts in Q4 following macro developments in Russia; the outlook for this market, which historically has been the group’s most profitable one, remains challenging and uncertain. RBI’s Q4 results (25 March) are likely to be messy, with higher impairment charges and potential write-down of DTAs and goodwill in Poland and possibly Russia, where a second impairment test is being conducted. RBI will likely end the year with CET1 less than 10%, given the RUB decline in Q4. Questions also remain over its long-term strategy; for instance, Reuters reported recently that the bank may sell its Polish unit, so far considered strategic." - source Bank of America Merrill Lynch
So get ready for some additional goodwill writedowns in the European banking space, a pet subject of ours which we discussed in our conversation in November 2011 entitled "Goodwill Hunting Redux":
"Goodwill is an accounting convention that represents the amount paid for an acquisition over and above its book value. Under the accounting rules European banks use, the International Financial Reporting Standards, companies have to write down goodwill on their balance sheets if the underlying assets have permanently deteriorated in value."
Banks that paid a premium for businesses when the outlook was better will need to reassess the goodwill on their balance sheets. We already discussed Austria's exposure to Eastern Europe ("Long hope - Short faith"). Erste Bank in fact, wrote down the value of its Hungarian and Romanian units by a combined 939 million euros in October 2011. It will happen again in 2015 rest assured.

In December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet"), this is what we discussed as a reminder:
"Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks.
The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks."
On another note, you should also track deferred-tax assets aka DTAs in banking lingo, as it represents what a bank estimates it will save on taxes in the future assuming it will be profitable of course. In case of crisis, of course these "assets" are pretty much worth zero. Why is it important? Because DTAs were allowed in European banks to be counted as part of their regulatory capital (unlike goodwill) before Basel III regime but, in some instance were converted as tax credits (Italy and Spain) therefore counting towards a bank's capital cushion, therefore allowed under the new regime. For Spanish bank Liberbank DTAs make up 50% of its "capital", for Caixabank, 20%, for Bankia 80% of tangible book value. As a reminder, the government of Spain authorised some Spanish banks to reclassify €30 bn worth of DTAs as tax credits to bolster their regulatory capital in November 2013 ahead of 2014 ECB's stress tests.

Moving on to the subject of oil, we re-read with interest Douglas-Westwood presentation made in February 2014 at Columbia University entitled Oil and Economic Growth. We came across a compelling slide relating to the current issue of persisting oil prices on the industry on page 45 of their thorough report:
"The Industry Needs $100+ Oil Prices
Oil Price Required by Oil Companies to be Free Cash Flow Neutral After Capex and Dividends - source Goldman Sachs
•Costs have outpaced revenues by 2-3% per year. Profitability is down 10-20%.
•The vast majority of public oil & gas companies require oil prices of over $100/bbl to achieve positive free cash flow under current capex and dividend programs
•Nearly half of the industry needs more than $120/bb. The 4th quartile, where most US E&Ps cluster, needs $130/bbl or more." - source Douglas-Westwood
Their very interesting report concludes with the following remarks:
"•Demand-constrained models dominate thinking about oil demand, supply, prices and their effect on the economy
•The data have not supported these models in recent years; the data do fit a supply-constrained model
•A supply-constrained approach will not be applicable if China falters, US short term latent demand is sated, and oil supply growth is robust.
•For a supply-constrained model to be valid, oil must be holding back GDP growth as an implicit element of model construct.
•If the supply-constrained approach is right, then GDP growth depends intrinsically on increasing oil production.
•Without such increases, OECD GDP growth will continue to lag indefinitely, with a long-term GDP growth rate in the 1-2% range entirely plausible, and indeed, likely.
•In turn, if this is true, then current national budget deficit levels and debt levels will prove unsustainable, and a second round of material and lasting adjustment will be necessary." - source Douglas-Westwood
As a reminder, when it comes to our outstandingly rewarding 2014 contrarian stance in relation to our "long duration" exposure (disclosure: long ETF ZROZ since January 2014) 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". So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you and told you in 2014.

As we reminded ourselves in our last 2014 conversation the "QE MacGuffin", the dollar surge and falling oil prices are on top of our 2015 worries. This is related to a particular type of rogue wave (currency crisis) we discussed back in November 2011, the three sisters, that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:
"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: Wave number 1 - Financial crisis Wave number 2 - Sovereign crisis Wave number 3 - Currency crisis In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia." - Macronomics - 15th of November 2011
Wave number 3 - Currency crisis:
We voiced our concerns in June 2013 on the risk of a rapid surging US dollar would cause with the Tapering stance of the Fed on Emerging Markets in our conversation "Singin' in the Rain":
"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013
Monetary inflows and outflows are highly dependent on oil prices. Oil producing countries can either end up a crisis or trigger one.
Since 2000 the relationship between oil prices and the US dollar has strengthened dramatically.

We also added in December:
"A structural slowdown in economic activity like we are seeing is accentuating the fall in oil prices we think. Declining profitability and misdirected investments into unproductive assets and infrastructure projects have been triggered by years of Zero Interest Rate Policy (ZIRP) in Developed Markets (DM). This is having negative consequences in Emerging Markets given oil demand growth has been exclusively supported by strong EM growth. Lower GDP growth trend is therefore pushing for lower oil prices. "
Also please note the following in relation to the HY energy sector. In 1986, oil prices fell hard and fast to below 10 $ starting a regional crisis for the oil patch and the industries serving it. This led to the Texas economy and the banking industry to experience a traumatic crisis due to overextension of credit to energy-related industries. The High Yield rug was pulled out from under the house of card in 1989, triggered by rising interest rates and the collapse in the price of oil and the associated erosion of real estate investments as the economy of the Southeast US slid into recession. So we would watch Texas closely and the HY energy space in the coming months. 

In relation to EM risks and as a reminder of the 1997 Asian currency crisis, investors lured to higher yielding assets due to ZIRP and Fed induced negative interest rates.

What we are witnessing right now is indeed "reverse osmosis" in Emerging Markets, and the osmotic pressure which has been building up is no doubt leading to an "hypertonic solution" when it comes to capital outflows in Emerging Markets as discussed in our August conversation "Osmotic pressure":

"As the Osmosis definition goes:
"When an animal cell is placed in a hypotonic surrounding (or higher water concentration), the water molecules will move into the cell causing the cell to swell. If osmosis continues and becomes excessive the cell will eventually burst. In a plant cell, excessive osmosis is prevented due to the osmotic pressure exerted by the cell wall thereby stabilizing the cell. In fact, osmotic pressure is the main cause of support in plants. However, if a plant cell is placed in a hypertonic surrounding, the cell wall cannot prevent the cell from losing water. It results in cell shrinking (or cell becoming flaccid)." - source Biology Online.
Nota bene: Hypertonic"Hypertonic refers to a greater concentration. In biology, a hypertonic solution is one with a higher concentration of solutes on the outside of the cell. When a cell is immersed into a hypertonic solution, the tendency is for water to flow out of the cell in order to balance the concentration of the solutes." - source Wikipedia
Let us explain:In a normal "macro" osmosis process, the investors naturally move from an area of low solvency concentration (High Default Perceived Potential), through capital flows, to an area of high solvency concentration (Low Default Perceived Potential). The movement of the investor is driven to reduce the pressure from negative interest rates on returns by pouring capital on high yielding assets courtesy of low rates volatility and putting on significant carry trades, generating osmotic pressure and "positive asset correlations" in the process. Applying an external pressure to reverse the natural flow of capital with US rates moving back into positive real interest rates territory, thus, is reverse "macro" osmosis we think. Positive US real rates therefore lead to a hypertonic surrounding in our "macro" reverse osmosis process, therefore preventing Emerging Markets in stemming capital outflows at the moment."
If the fall in oil prices continues to fall rapidly and the dollar continues to rise strongly, then, there is indeed a high risk of "excess osmosis", triggering sovereign defaults in the process.

 It seems to us that the "carry tourists" have forgotten basic rules: 
1. Do not lend to countries with heavy fiscal deficits (like Mexico at the time...). 
2. If you do lend to these countries, make sure they have "friends in high places". 

The LTCM explosion of 1998 came on the back of Russia defaulting. EM exposure following the lending boom of 1996-97: 
"1. By the time Korea fully devalued the won in November-December 1997, the total stock of EM external bonds (public and private) had climbed from just $266 billion at the end of 1994 to $413 billion.
2. From end of 1994 to the end of 1997, foreign banks had racked an additional $276 billion of exposure to EM. Foreign banks EM assets hit an all time high as a share of total credits, at 3.66% up from 2.70% at the end of 1994. By 2000, that figure would be back down to 2.70%.
3. Almost 40% of total net lending to EM from 1994 to 1997 went to just five East Asian economies: Indonesia, Korea, Malaysia, Taiwan and Thailand. Most of that was short-term dollar borrowing by the banks that was lent locally to fund real estate and other long-term ventures creating a massive liability mismatch." - source Creditsights "Crises'R Us, August 2007.
In the light of recent BIS presentation from the 4th of December to the Brookings Institution made by Hyun Song Shin, US dollar credit to non-banks outside the United States has not been trivial to say the least:
Notes: Bank loans include cross-border and locally extended loans to non-banks outside the United States. For China and Hong Kong SAR, locally extended loans are derived from national data on total local lending in foreign currencies on the assumption that 80% are denominated in US dollars. For other non-BIS reporting countries, local US dollar loans to non-banks are proxied by all BIS reporting banks’ gross cross-border US dollar loans to banks in the country. Bonds issued by US national non-bank financial sector entities resident in the Cayman Islands have been excluded.
Sources: IMF, International Financial Statistics; Datastream; BIS international debt statistics and locational banking statistics by residence; authors’ calculations.
- source BIS

On a final note, what matters more than the Fright of the Bumblebee is indeed the sting of "The Green Hornet" aka the US dollar and the velocity of the rise given the redemption profile on international debt securities of EM non-bank corporations:
"Emerging market economies, in billions of US dollars"
- source BIS

Whereas bumblebees are peaceful insects and will only sting when they feel cornered (QE in Europe) or when their hive is disturbed (Grexit), the stings of the Asian giant hornet (Vespa mandarinia japonica) are the most venomous known but that's another story...

"Don't poke a hornet's nest and expect butterflies to come out."
Stay tuned!

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