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!

1 comment:

  1. I hear an Everest fund died in the Swiss Avalanche.
    The oldest one, if I'm not mistaken, is floating in Biscayne



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