Wednesday, 25 March 2015

Credit - The camel's nose

"Experience - the wisdom that enables us to recognise in an undesirable old acquaintance the folly that we have already embraced." - Ambrose Bierce, American journalist.

While watching with interest the epic hunt for yield moving into overdrive courtesy of the ECB's QE, in conjunction with the continuation of the Greek tragedy facing "Zugzwang", we reminded ourselves of the metaphor of the camel's nose when it came to choosing this week's title analogy. Given the "camel's nose" is a metaphor for a situation where the permitting of a small, seemingly innocuous act will open the door for larger, clearly undesirable actions, the increasing spat between Germany and Greece in conjunction with the ECB's QE action rest assured are indeed leading to clearly "undesirable outcomes" hence our chosen title.

In this week's conversation we will focus on credit such as the "unintended" consequences of the ECB's QE on the asset class from both a spread and FX perspective as well as Emerging Markets "value" mostly in Asia rather than LATAM.

  • Credit - Back to Beta or when "bad" is "good" for the credit investor courtesy of the ECB
  • With currency war comes volatility for Investment Grade Credit
  • Will the Euro continue to go South? Watch Italian yields
  • Beware of Emerging Markets Corporate LATAM and favor Asia

  • Credit - Back to Beta or when "bad" is "good" for the credit investor courtesy of the ECB
Early 2015 in January in our conversation "Quality Street" we mentioned the significant inflows into the asset class, particularly through ETF inflows. In our long conversation we mentioned were favoring Investment Grade Credit for Financials versus equities:
"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." - source Macronomics, 16th of January 2015
No surprise that QE has indeed changed our view, but, then again, as we mentioned in our conversation the on-going trend is one of deleveraging for the European financial sector for years to come! Therefore, it was not a surprise to us to see the Eurostoxx 600 Bank sub index displaying some underperformance with a YTD performance of around 14.5% versus 17.50% for the broad Eurostoxx 600 index. But, more interestingly from our "credit" point of view, what is of interest to us is that from a "flow" perspective, Investment Grade credit "inflows" in Europe in particular have been losing steam recently as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 20th of March 2015 entitled "Can't eclipse equities":
"The equity show goes on
Last week was another week of strong asset flows. While credit and government bond funds have seen a slight moderation on their inflow pace, flows into equity funds are getting stronger and stronger. Note that equity fund flows are now averaging almost $5bn a week, over the last eight weeks. This performance eclipses fixed income inflows, which still managed to have a decent inflow of +$3.6bn over the week, down from $5.2bn last week.
High-yield saw another $1bn+ inflow last week, but this was the smallest in three weeks. It was the same for high-grade funds were inflows have been losing steam – this week saw just a $1.5bn inflow.
High-grade inflows carry interesting information when looking across currencies. Outflows from the Sterling funds suggest nervousness over the upcoming elections, while the appetite for European assets is clearly driven by ECB QE (see the chart below).

Note dollar credit was hugely popular with European investors in Jan and Feb, but the enthusiasm tailed-off pre the Fed." - source Bank of America Merrill Lynch
As we pointed out in our conversation of October 2014 "Actus Tragicus", this doesn't come as a surprise to us to see a greater enthusiasm for US dollar credit:
"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. 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...). - source Macronomics, October 2014
Also, the unquenchable appetite for anything having a yield, particularly with the growing support from Japanese international allocations with the GPIF and fellow pensions funds increasing their stake, it clearly points towards a stronger allocation for US Investment Grade Credit versus Europe particularly with €2170 billion of negative yields in the euro area!

As posited by Société Générale in their Multi Asset Portfolio Global Allocation note for the Second Quarter of 2015 entitled "Reducing risk in an expensive world", we agree with their US bonds stance but we disagree on their strong US growth call:
"Negative euro yields make US bonds attractive
Our central economic scenario is for strong growth in the US and tightening by the Federal Reserve, with two rate hikes this year. We expect the impact to be felt mostly at the short end of the curve, as the upside on 10-year rates is capped by very low (read: expensive) sovereign bonds in the eurozone." - source Société Générale
We continue to enjoy our long duration exposure (partially played via ETF ZROZ, up 4.32% YTD) and we disclosed that, recently we added on February's weakness on our long US Treasuries exposure.

When it comes to Investment Grade credit we agree with Société Générale's underweight European Investment Grade Credit and their overweight US Investment Grade Credit as US returns have been so far more appealing in that space:
- source Société Générale
But as far as the "camel's nose" analogy goes, the clearly undesirable actions of the ECB from their QE have indeed pushed back European investors in the "BETA" play or to put it simply, given the disappearance of the "interest rate buffer" in the Investment Grade space, "bad" namely lesser quality bonds have indeed become "good", more appealing than "quality" bonds such as Investment Grade in the European space.

This was clearly indicated in Société Générale's Credit Market Wrap-up of the 10th of March entitled "A corporate is not a custodian: how falling government yields could hurt credit":
The fall in government bond yields in Europe has helped credit spreads tighten since 2010, as investors have moved to credit to get higher yields. But if corporate bond yields cannot fall below zero, then falling bond government yields may eventually drive spreads wider. BBBs and high yield can continue to outperform AAs and As as a result.
Corporate bond yields in Europe have dropped precipitously since October 2008, falling from just over 8% to just over 1% now. 3.8% of the drop was due to a fall in underlying government bond yields; 3.16% of the drop was due to a tightening in credit spreads. So clearly falling government bond yields have been kind to the credit spread market as well.
This may be about to change, however. The lowest corporate yield in the iBoxx index is currently at just 7bp, and clients have a strong reluctance to get paid nothing – or worse, pay something – in order to lend corporates or banks money by buying their bonds. As one client told us a fortnight ago, “A corporate is not a custodian” – meaning he is not willing to pay to park his money even in AA short dated credits.
Herein lies a potential problem, which we call the “lower limit problem.” European benchmark bond yields (i.e. Bunds) are negative out to the 7yr area, and are likely to go even more negative.
This lower limit problem means two things for investors. First, lower rated bonds (with wider spreads and higher yields) are likely to continue to outperform higher rated bonds (with tighter spreads and lower yields).
Second, USD bonds (both from US and European issuers, and also quite possibly from emerging market issuers) are likely to outperform EUR issues, at least in investment grade.
When are falling yields likely to become a problem for high grade European credit? Chart 1 below shows the distribution of European corporate bond yields. Each bar shows the percentage of bonds in the index with a yield below this level. The second bar from the left, for example, shows that 4% of the bonds in the index have a yield between 10bp and 20bp, which means that a further 10bp drop in government yields could lead these issues to hit the lower limit problem.
The lower limit problem has significant implications for credit investors. To avoid it, European investors ought to move down the rating scale, while global investors should consider increasing their dollar-denominated holdings." - source Société Générale
Camel's nose or undesirable outcome for Credit investors? Yes indeed!

This was further highlighted recently by Société Générale in their latest Credit Market Wrap-up on the 24th of March entitled "What European credit investors can learn from Capybaras":
"Quantitative easing is supposed to work this way: the ECB buys bonds from the banks; the banks then replace the bonds with loans to lower-rated companies, and thus reflate the economy. There are signs that bank lending is getting easier, but as our economists have highlighted, we will need to wait for the next quarterly ECB lending survey on 14 April for confirmation of this trend.
So much for the intended consequence of QE. What we are also seeing is two unintended consequences. The first is that the senior debt market in Europe is shrinking, because as banks expect to hold fewer securities, they need less financing. We warned of this back in September last year (in “Honey I shrunk the banks in the index”), but as we showed in yesterday’s credit daily (see “Poised for better days”), the amount of senior debt issued by European banks has contracted by almost a third vs the same period last year. Total senior bank issuance in euros has declined by less than a tenth, but only because senior issuance from US banks has more than doubled.
The second consequence is potentially even more serious. Because government bond yields continue to fall, and because investors are reluctant to buy corporate bonds at a yield of zero or less, highly-rated credit could actually see spreads to benchmarks rise due to QE. We call this the “lower limit problem,” and discussed it first a fortnight ago in “A corporate is not a custodian.”
There are signs that this is happening. Chart 1 shows the percentage changes in the iBoxx European investment grade and high yield indices by ratings class. The chart has been smoothed to account for monthly reweightings (like the one in March which made BB spreads jump and BBB spreads tighten). All ratings classes have generally moved in the same direction, but even in early February the AA and A ratings classes underperformed the three B ratings classes. Moreover, in the sell-off since early March, the percentage widening in AA and Single A debt has been bigger than in BBBs.
If AA and Single A issuers are squeezed out of the debt markets, it’s even possible to imagine them returning to the banks. So bank loans in Europe do grow – but to the highest-rated rather than to the lowest-rated customers.
How should investors hedge against this happening? Within Europe, we recommend buying longer-dated, lower-rated bonds, not only because of the law of unintended consequences, but also because we think beta is going to drive markets (as we argued in our Credit Strategy weekly of 6 March). Within global portfolios, we think it makes more sense to move to higher beta credit markets outside of Europe, such as the US, and even emerging markets (such as the markets highlighted in our 13 March Credit Weekly)." - source Société Générale
The "camel's nose" issue of course is, that in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger! Be careful what you wish for...

In fact since the ECB started it's QE on the 9th of March, bonds spreads have widened on an almost daily basis according to Bank of America Merrill Lynch European Credit Strategist note from the 20th of March entitled "Does credit have the FX factor?":
"A bond too far…or a bund too far?
Was the last fortnight a classic case of “buy the rumour, sell the fact” in credit?
Since QE began on the 9th, bond spreads have widened on an almost daily basis. €40bn+ of supply this month hasn’t helped, but neither have bunds. When government yields fall this quickly, the natural response is that credit spreads get pushed higher.
July 2014 levels, anyone?
Such has been the move in bunds that credit spreads in some parts of the highgrade market are now back to July 2014 levels. The big underperformers have been high-quality duration (look at 7-10yr single-As) and short-call corporate hybrids. These look interesting again, in our view. The extent of the move, combined with lower supply in April, should help limit underperformance from here, we think." - source Bank of America Merrill Lynch
Of course the ECB has been partly responsible for the "instability" in the credit space as indicated by Bank of America Merrill Lynch in their note:
"The story of spread widening lately is more than just about supply. An important catalyst, in our view, has been the speed at which government bond yields have fallen (bunds in particular). Credit spreads are simply the difference between corporate bond yields and government bond yields. Over the last fortnight, the decline in longer-dated bund yields has been drastic, and likely exacerbated by the early days of ECB buying. The ECB looks to have bought longer-duration debt so far. Accordingly, the 30yr bund yield has declined from 1% to 64bp. But credit yields haven’t been able to keep pace with the sharp fall in government bond yields, and so the result has been wider bond spreads. This is why high quality duration has been the big underperformer in credit (plus it was also a very crowded long),
The moves are far from noise as well. Investment-grade valuations have repriced 10% post the ECB, with every part of the market seeing widening (chart 1).
But the big underperformers have been high quality credit and duration. BBBs and high-yield, in contrast, have experienced relatively less pain over the last fortnight." - source Bank of America Merrill Lynch
What we find of interest from a pure "regional macro" perspective is that whereas in the last couple of years European credit has clearly outperformed equities, it seems to us that the ECB's actions have reversed the trend by pushing yields towards negative territory and very significant inflows and performances in the European equities space. At this juncture given the different paths followed by the ECB and the Fed, it seems reasonable to switch from favoring European Credit towards US Credit and, in the equities space, to favor European Equities rather than US equities as a whole.

  • With currency war comes volatility for Investment Grade Credit
The significant rise in FX volatility (which has yet to spill over into equities in true "camel's nose" fashion) is a significant factor to take into account when it comes to driving credit spreads. 

On the specific point of FX volatility on credit spreads, we read with interest the second part of Bank of America Merrill Lynch's European Credit Strategy note from the 20th of March entitled "Does credit have the FX factor?":
"When it comes to thinking about overall currency risk, three factors play a part:
  • Firstly, the size of foreign sales exposure. Do companies in high grade with exposure to a weakening currency say, have 2% sales exposure to that region, or 20%? Clearly, the latter means more currency risk.
  • Secondly, the face value of debt impacted. Do credits with a material sales exposure to a weakening currency make up a small part or a large part of the high-grade market? Again, the latter means more currency risk.
  • Finally, currency volatility. Other things being equal, the more volatile currencies, the greater the currency risk for high-grade." - source Bank of America Merrill Lynch

The rise in FX volatility has been evident since the second semester of 2014 as displayed in a Bank of America Merrill Lynch graph:
- source Bank of America Merrill Lynch

The increased in volatility in FX is an important factor to take into account going forward, from an issuance perspective as clearly indicated in Bank of America Merrill Lynch's note:
"A growing theme for credit investors to watch
Table 5 highlighted that currency volatility is an important risk for the IG nonfinancial market (weighted sales exposure to the Eurozone was below 50%).

Looking forward, we expect this theme to only grow in importance. Amid QE and negative yields in Europe, multinational companies from around the world (not just US issuers) are increasingly looking at issuing Euro corporate bonds. This points to the credit market becoming a lot more global over the next few years, and transitioning away from a market of domestic issuers." - source Bank of America Merrill Lynch
The rise in FX volatility, from a "liquidity" perspective (which has been once again the topic du jour in the BIS's most recent report) is of great importance when it comes to potentially triggering outflows in asset classes. Of course the recurring liquidity risk in credit markets has been amplified by the acceleration in disintermediation as well as the reduction in market making activities due to regulatory pressures, deleveraging and balance sheet constraints, leading of course to a growing sense of a nasty build-up in "instability" in true Minsky fashion or camel's nose but we ramble again...

 As per our quote used in the conversation "The Unbearable Lightness of Credit":
Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital
Furthermore, the continuing rise in the US dollar is a cause for concern. We warned about the dollar being undervalued in October 2013 in our conversation "Bread and Circuses":
"When you get both a fast improving current account for the US as well as an improving budget balance in the US, this will lead to fewer dollars available to the rest of the world in the next few years.
The two points above always lead to international liquidity crisis over a long time. Liquidity crisis always lead to financial crisis. Why? The US Current account is the primary source of liquidity for other countries given the US doesn't have a foreign trade constraint." - source Macronomics, October 2013.
Of course, the "camel's nose" impact on the US dollar is that, as ECB’s purchases bonds relentlessly, it will add more negative signs to the "shrinking" universe of European bond yields, therefore the euro should in essence continue to weaken.

  • Will the Euro continue to go South? Watch Italian yields
While in our last conversation we recently pondered on a possible rebound of the Euro versus the US dollar, we continue to think about the extension of the rebound of the Euro given the weaker tone of both the Fed at the last FOMC meeting as well as the weaker macro picture coming from the US as displayed in the latest Durable Good Orders data. For a different perspective, we read with interest Reorient Group David Goldman's take in their note from the 23rd of March in relation to the link between Yields and the Euro currency and why Italy matters:
"Euro vs. USD: It’s the Yield That Counts
Disappearing yields in Europe’s sovereign bond universe are the drivers of the euro exchange rate. The greater the yield, the bigger the impact each of the major European economies’ bond yield exercises on the Euro. Germany, France and Italy each have about US$2 trn in outstanding central government debt. The difference is that Italy contributes most to overall yield. We observe that Italy’s 10-year bond yield shows the most linear relationship to the EUR/USD (in fact, slightly more than 95% during the past year) among the big European issuers.
Extensive econometric testing confirms the visual impression in the above chart: Italy’s 10-year yield has by far the strongest measurable effect on the Euro exchange rate. This result should not be interpreted as evidence that Italy matters much in the great scheme of things. It doesn’t. But it shows that the euro exchange rate depends on the amount of yield available in the currency. As the European Central Bank’s €60 bn per month bond buying program continues, we believe that Eurozone yields will continue to evaporate and the euro will continue to weaken.
If we regress the EUR/USD exchange rate against the German, French and Italian 10-year yields (concurrent and lagged one day), we observe that only the Italian yield shows a high degree of significance (t-statistic above 2.0) after correction for serial correlation. A trend variable is included to test for spurious correlation (the trend is significant, but does not reduce the significance of the Italian yields).
We obtain virtually identical results using Principal Component Decomposition (to eliminate collinearity among the predictors). We also observe that the Granger Causality Test strongly indicates that bond yields lead the exchange rate.
Principal Components Decomposition uses iteration to break down the variation in a universe of security returns into a set of orthogonal (uncorrelated) components. In the test below, we have used returns to the US, German, French and Italian 10-year yields.
The Eigenvalue is a measure of statistical significance; it shows that the first two components are highly significant while the second two components are of dodgy significance (Eigenvalue well below 1.0). The Variance Proportion measures the amount of variation explained by each variable; the common or systemic component of variation explains 59.2% of variation, the 2nd Component an additional 26.6%, and so forth.
The Eigenvectors measure the relative importance of each variable for the components of the universe. In the case of the first Principal Component, all four variables are exposed in the same way. The second Principal Component may be thought of as an “Italian” component, with a factor loading of 0.795 for Italy. The 3rd vector is heavily weighted to the US, and the 4th vector to Germany and France.
If we then regress the Principal Components constructed by the computer with the past 12 months’ daily returns against daily EUR/USD returns, we see that the “Italian” component (2nd Principal Component) has by far the highest t-statistic, or significance. That is a powerful result: it shows that the common (or “systemic”) component of variation of returns to the 10-year bond universe and the “Italian” component have statistical significance, but not the American, German or French components.
- source Reorient Group
Given the weaker tone of US data and the dovish stance of the Fed, we feel that the Euro pullback we discussed last week could continue for a certain period. But, in true camel's nose fashion, one should take into account European government yields and particularly Italy, when it comes to assessing the driver of the Euro going forward as per Reorient Group's note due to the significant impact QE has had on yields so far.

  • Beware of Emerging Markets Corporate LATAM and favor Asia
When it comes to the camel's nose and undesirable actions, the consequences of the negative interest rates imposed to the rest of the world by the Fed led to consequent hot money flows to the rest of the world often mentioned by the BIS and grabbed the attention with the headlines of $9 trillion in USD liabilities outside the United States. The BIS has written much about the buildup of hard currency debt in the corporate sector in emerging markets. We have also voiced our concern in our October 2014 conversation "Sympathy for the Devil" in relation to the particular vulnerability of LATAM and the large part of Brazil High Yield risk representing $30 billion of EM dollar denominated debt issued out of $116 billion with the top sector being energy with $27.7 billion of exposure:

"Given Brazilian growth is clearly stalling with Brazil's GDP shrinking 0.6% in the second quarter from the previous three months, and first-quarter data was revised to a 0.2% contraction, according to the Brazilian Institute of Geography and Statistics with a growth forecast of 0.48% this year and 1.10% next year, we would indeed watch closely the LATAM space in the coming months." - source Macronomics.
A clear illustration of the LATAM non-financial corporate debt issuance spree since QE1 can be seen in Société Générale in their Multi Asset Portfolio Global Allocation note for the Second Quarter of 2015 entitled "Reducing risk in an expensive world":
"The US dollar continues to strengthen against EM currencies.
This is a potentially destabilizing factor for EM corporates, which have borrowed heavily on international markets since the Fed’s first QE in 2009. Latam appears the most at risk from this standpoint." - source Société Générale

So does the dollar strengthening makes Emerging Markets non-financial corporates a no go zone? We would agree with Société Générale that while LATAM appears to be the most vulnerable, Asia seems to be still a good value play given they are positively impacted by the fall in oil prices by more importantly by the fall in food prices as illustrated as well by Société Générale in their report:
"Asia is the EM region where the share of food in the consumer price index is the highest on average." - source Société Générale
From a "value" proposition, it seems that indeed, Asian high yield remains the most attractive asset class based on internal rates return according to Société Générale:

"Asian high yield bonds look relatively attractive from a valuation perspective, while both euro sovereign and high yield bonds look expensive. We are taking profit on our European credit position.
In our new asset allocation, we have increased the weight of Asian high yield and reduced the weight of core eurozone bonds and of European investment grade credit. Asia is taking over on Latam as the biggest EM USD-denominated corporate credit market. This is our favourite region in terms of fundamentals ahead of Fed tightening. Asian assets should also be supported by China more aggressive monetary policy easing" - source Société Générale

While the rebalancing to the East from a longer perspective continues, but, tactically, from a credit perspective, Asia appears more appealing for the time being.

"Right discipline consists, not in external compulsion, but in the habits of mind which lead spontaneously to desirable rather than undesirable activities." - Bertrand Russell, British philosopher.

Stay tuned! 

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