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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