Thursday 16 April 2015

Credit - The Secondguesser

"Do not try to second-guess or master-mind our military officials. Leave this for established military analysts and experts, who are experienced enough to await the facts before drawing conclusions." - Broadcasting magazine, December 1941

While playing with interest the Hang Seng Index rally game given we have taken some exposure since the 30th of March and enjoying the ride so far, we reminded ourselves the definition of "second-guess" for our title analogy, as it can be of two folds:
1. To criticize and offer advice, with the benefit of hindsight.
2. To foresee the actions of others, before they have come to a decision themselves.
Of course when it comes to our "Asian allocation", we have indeed played number two and decided to "front-run" somewhat the appetite for Chinese investors moving from Shanghai towards Hong-Kong when it comes to their regional "appetite". As far as our title is concern and the choice of allocation, it stems from learning from the wise Charles Gave of Gavekal research for whom we have great respect: 
"if there is more money than fools then market rise, and if there are more fools than money markets fall"
In the case of the HSI, there is indeed more money than fools, whereas when one look at the European government bond markets and in particular the state of the corporate Hybrid debt market we touched on last week, there are indeed more fools than money in Europe. This ties up nicely to definition number 1 for "second-guess" and the benefit of hindsight, given that the "bond" risk in Europe doesn't justify anymore the reward we think.

A commonly used meaning of "to second-guess" is to criticize the actions of others, after the event. On this blog, we try to criticize the actions before the events. When it comes to choosing our title we also reflexionated around the meaning and the origin of the expression as defined by Gary Martin:
The umpire in a baseball game used to be called, rather unkindly, 'the guesser'. People who were continually telling the guesser, the manager or the players what they were doing wrong were known as 'secondguessers' and were so defined in the Sporting News Record Book, 1937:
"Secondguesser, one who is continually criticizing moves of players and manager."
Therefore one could unkindly define us as being "Seconguesser" when it comes to assessing the macro and credit environment and the decisions taken by our brazen central bankers, but we ramble again. Although one could indeed unkindly defined as "Secondguessers" with these few examples:
  • we have been short yen since November 2012 when the Japanese yen was trading around 80 as described in our conversation "Cold Turkey" (partly via ETF YCS) guessing that the Bank of Japan had a lot of catch-up to do when it came to QEs and expanding its balance sheet .
  • Following the BOJ move, in early 2013 we went long Nikkei but in "Euros" via a quanto ETF (currency hedged).
  • Of course our biggest 2014 call has been to go long US duration in January (partially via ETF ZROZ).
As per our January 2013 conversation, "If at first you don't succeed...", we have repeatedly broken our Magician's Oath:
"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

We have to confide, that we have continued to become clear "Seconguessers" as per definition number 2 above when it comes to "second-guessing" the "Black Magic" practices of our magicians of central bankers and their "secret illusions".

So never mind the practices of our "dark sorcerers apprentice", as in this week conversation, while we will briefly touch on the attractiveness of Asia versus Europe, we will look at the supposed end of the European banks/sovereign nexus particularly in the light of the latest Icelandic proposal, namely the Sovereign money proposal which we think is a must read.

  • Yes, for now Asia is a buy and it will continue to be so
  • A large number of European banks still destroy value
  • Many Southern European banks are still capital impaired
  • Don't count on the end of the banks/sovereign nexus in Europe
  • Final note: Flows have lagged performance in EM

  • Yes, for now Asia is a buy and it will continue to be so
As me mentioned, playing our "Secondguesser" role has meant we have gotten on the HSI exposure since the 30th of March and we do believe in the compelling valuation story in Asia, regardless of the recent parabolic rise in the equity space.

So one might wonder why there has been such a rally in the equity space. It all has to do with the collapse in China money market rates as displayed by Bank of America Merrill Lynch in their recent Liquid Insight note from the 15th of April 2015 entitled "What's driving China rates":
"More to lower rates than just policy easing
The rally in the China stock market since March has been significant and in our view at least partly related to expectations of policy stimulus, as reflected in lower rates (Chart of the Day). In particular, there has been a lot of focus on China’s money market rate – the 7-day repo – which has dropped about 200bp to 3.0%. The decline should come as no surprise as market rates were high relative to inflation, and high real rates were probably the last thing the government wanted to see given the slowdown in investment and economic growth. The market move has been consistent with our view that 7d repo should come off to 3.0-3.5% in the short term.
But a closer analysis suggests banks’ liquidity management also played an important role in the decline of repo rates, over and above the PBoC’s policy guidance. The question is how fast and to what extent can money market rates fall from the current low level, in particular after the latest weaker-than-expected financing and economic data. We argue that the 7d repo rate could fall moderately further to an average of 2.5-3.0% in the coming months, but that the sharp decline of recent months seems unlikely to repeat itself." - Bank of America Merrill Lynch.
We are not the only one thinking about the China "reflation" trade as we see maverick money manager Stanley Druckenmiller recently commenting on this very subject on April 15th in Bloomberg article from Katherine Burton and Stephanie Ruhle entitled "Druckenmiller Bets on Market Surprise With China Boom, Oil Rise":
"Chinese stocks have soared with the Shanghai Composite Index doubling in the last 12 months.
“Whenever I see a stock market explode, six to 12 months later you are in a full blown recovery,” he said.
A recovery in China, the world’s second-biggest economy, would influence securities and commodities prices around the globe, said Druckenmiller. For instance, it would send German government bond prices lower, boost European exporters and lift the price of oil, he said in a separate interview." - source Bloomberg
When it comes to valuation, while the rally in Asia has been epic, when it comes to Europe, we would rather "cash in" given current valuation levels as displayed in the latest note by Louis Capital Markets from the 13th of April entitled "Three For The Price Of One" where one can see in their bonus chart the percentage of Stoxx Europe 600 members trading above their 200-day Moving Average:

 - source Louis Capital Markets
With the liberalization of personal account rules in China and a forward PE around half of the S&P500 and a free cash flow yield or around 20% according to Asia Times, Hong-Kong appears to us a better "value proposition" in these global inflated markets if we would need to second-guess investors' appetite.

  • A large number of European banks still destroy value
When it comes to Europe and in particular many points to cheap valuation in the European banking space. As we have argued in our conversation "The Pigou effect" in February this year, we have argued around the "japanification" process of Europe:
"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe."
This "japanification process can be seen with the rapid disappearance of "positive" yields in the European Government space with German Bunds closing on the zero bound.

We have also long argued that regardless of QE, ZIRP and AQR, European banks would be facing continued deleveraging and that both bondholders and shareholders alike would in many instances get punished for their holdings. The reason is that European banks, in many cases still destroy value. On this subject, we read with interest Nomura's EU banks strategy note from the 10th of April entitled "Why European banks still destroy value":
"Why do half Europe's banks not make a 10% cost of equity?
Even by 2016, Bloomberg consensus implies that half of Europe’s larger banks will not make a return on tangible equity above their historical 10% cost of equity. This contrasts with US banks where almost all exceed the hurdle.
In this report, we decompose profitability to identify the main drivers. Low ROE banks are mainly a result of higher costs, and to a lesser extent higher provisions and higher taxes. Margins (mix) and leverage together account for less variation between high and low ROE banks. Nordic and Benelux banks show the highest ROEs, while German and Italian banks are lowest, with UK, France and Spain around the 10% hurdle.
How and where can banks improve their profitability?
We show that cutting costs would deliver the biggest improvements in ROE, but given the consistency of national cost/income ratios, much of the differences in costs appear to be structural. Although most banks have some form of cost reduction plan in place, few target an absolute reduction in the cost base, suggesting it will take some time for banks in the least profitable countries to converge their ROEs (hence valuations) with the best in class." - source Nomura
Truth is most European banks offer poor value in terms of returns as shown in Nomura's report:
"Even by 2016, Bloomberg consensus implies that half of Europe’s larger banks will not make a return on tangible equity above their historical 10% cost of equity. This contrasts with US banks where the average ROTE of banks in the BKX index is just over 13% and where almost all exceed the10% hurdle."
- source Nomura

As pointed out by Nomura's note we were note surprise to read that US banks higher ROE was driven by fewer lower risk mortgages on balance sheets:
"The higher ROE of US banks is driven by higher revenue margins given fewer low risk mortgages on balance sheet. This (and to a lesser extent a lower cost of risk) helps compensate for a considerably better leverage (equity/assets), as well as a slightly higher cost/income ratio and tax rate."
This is not a surprise for a "secondguesser" as we have highlighted on numerous occasions the very important concept namely the accounting principles of "stocks" versus "flows":
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."
After all, credit growth is a stock variable and domestic demand is a flow variable. We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe:
"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012.
Of course, the availability of credit is only beginning to be restored in Peripheral Europe and has been encouraged by the ECB's recent QE.

The core of our macro thought process is based upon the difference between "stocks" and "flows", which we highlighted when discussing the growing difference between Europe and US growth (see our post "Shipping is a leading deflationary indicator"). The same approach can be applied in relation to the growing divergence between US banks versus European banks we think. 

This difference can be ascertained from the difference in return on assets for EU banks versus US banks as displayed in Nomura's recent report:
- source Nomura

Given the amount of deleveraging that still needs to occur in the European banking space, this divergence will continue to grow.

Although European banks have risen 16% YTD, they are still underperforming the market and when it comes to their peers in the global space they do stand out less cheap as indicated by Nomura in their report:
"EU banks stand out less as cheap vs global peers …
With the 16% rise in European banks YTD, the market capitalization weighted SX7P banks index trades at 1.2x 2015E TBV for a consensus 2016E ROTE of 11.7%, which limits aggregate re-rating opportunities (absent a sustained fall in the cost of equity).
At a global level within the banking sector, European valuations generally appear proportionate to forward ROE expectations, with some countries already implying further profitability improvements." 
- source Nomura

When it comes to a better "value" proposal, China stands out as having much better 12m forward ROE. It is also not a surprise for a "Secondguesser" to see Chinese banks listed on the Hang Seng China entreprises index rallying hard as well as indicated by Asia Times in their article from the 15th of April entitled "Chinese bank soar on valuations":
"Industrial and Commercial Bank of China led gains on the Hang Sang China Enterprises Index overnight, up 4.86%, followed by China Construction Bank (+4.39%), Bank of Communications (+4.31%), China Minsheng Bank (+3.93%), Bank of China (+3.56%) and Agricultural Bank of China (+3.50%). Banks rallied after ICBC reported mediocre 4th quarter earnings, with a big pop in loan loss provisions and a modest decline in YOY net revenue.
Mediocre is beautiful when stocks are cheap. Chinese banks non-performing loans were a mystery wrapped in an enigma wrapped in plastic explosive, and the market bid down bank stocks because of uncertainty about future write-offs. A year ago, ICBC traded at a multiple of just 4 to earnings. Now investors are convinced that banks can earn their way out their bad loss positions over time, and bank multiples have recovered–to just one-third their pre-2008 levels.
At the peak of the 2007 China equity boom ICBC traded at 21 times earnings, or three times its present valuation. The bank stock recovery reflects greater confidence in regulatory transparency under the ongoing financial reform regime. The banks have gone from distressed valuations to merely low valuations.
As global managers pile into the China trade, moreover, bank stocks are among the few vehicles with enough market capitalization and liquidity to meet the requirements of large portfolio managers." - source Asia Times
From a "second-guesser" perspective, there is indeed better value in Asia at the moment and particularly in the banking space we think whereas European banks doesn't offer that much value particularly when one takes into account the quality of capital in Southern European banks. This brings us to our next item

  • Many Southern European banks are still capital impaired
Many Southern European banks' capital basis are made up for a large part of Deferred Tax Assets (DTAs) as reported by Nomura in their Southern European Banks report of the 7th of April entitled "Quality of Capital":
"Deferred tax assets (DTAs) under the microscope
European authorities are reported to be considering whether or not the legislation and guarantees on DTAs in southern Europe can be considered state aid (FT, 7 April 2015). This is in addition to the ECB looking for greater harmonisation of European capital ratios by attempting to correct for some of the different national definitions.
How big an issue are DTAs for southern Europe?
DTAs have increased significantly in southern Europe over the past few years (generated by the significant losses incurred by many of the banks). However, under Basel III’s definition, the bulk of the DTAs will be deducted from capital ratios (a change vs the previous regulatory environment). To minimise the impact of this regulatory treatment, many countries in southern Europe enacted legislation to limit the impact of this deduction. DTAs currently represent c42% of tangible equity in southern Europe and contribute a median of c300bp to core capital ratios.
Raise capital or improve quality over time? 
Given the extent and the size of the DTAs in southern Europe, and taking into account political considerations, we think it unlikely that the banks will be forced to raise capital specifically to address this issue. However, with the ECB increasingly looking to harmonise capital ratios, the banks could be required to continue to build and strengthen capital ratios over time. This issue could also be a hurdle to those banks looking to significantly increase dividends or payout ratios. For the moment though, the majority of dividend policies for southern European banks target moderate payout ratios of c40%- 50% (with Intesa the one major exception – targeting a payout ratio of c70% in 2015 and c82% in 2016)." - source Nomura
Hence our negative stance on European Banks and Southern European Banks in particular given the additional "real capital" that is needed to compensate for the "favorable" DTA treatment offered by the local regulators.

The exposure to DTAs while often overlooked when it comes to the quality of capital is not trivial as per the same report and is very significant in the Spanish banking system as indicated by Nomura in their report:
"Exposure to DTAs
As we can see from Fig. 1 banks in southern Europe have built up significant amounts of DTAs. In Spain alone total DTAs reached cEUR 77bn in 2013, although net DTAs (ie, net of tax liabilities) were cEUR 68bn. Low levels of profitability have meant that for the moment the amount of DTAs continues to increase.
Under Basel III, the treatment of DTAs is harsher vs the previous regulatory regime. However, in an effort to minimise the negative impact on capital from holding large levels of DTAs, governments in southern Europe have enacted legislation to reduce some, if not most, of this impact. In Spain, for example, the value of the DTAs is underwritten by the Spanish government. The DTAs that are not used up within 18 years are considered a credit against the Spanish government and exchangeable for Spanish public debt. Of the total amount of net DTAs in Spain, the government has guaranteed c 60% or cEUR 40bn. As we can see in Fig. 2, DTAs account for a significant part of the current capital ratios for the banks.

Our base-case scenario is that the banks do not have to raise capital to specifically address this issue. However, we do believe capital ratios could be raised to higher levels. The level of DTAs could also affect banks looking to raise payout ratios to high levels or significantly increase dividends, although most dividend policies are targeting a moderate payout ratio of c40%-50% (which we believe is achievable)." - source Nomura
When it comes to "capital", what matters therefore is the "quality" of the capital. In the case of some Spanish banks, the capital levels made up mostly by DTAs are not sufficient regardless of the AQR. Given in the case of Spain, these DTAs constitute a "credit" against the Spanish government and are exchangeable for Spanish public debt we doubt this marks the end of the banks/sovereign nexus discussed in our next bullet point.

  • Don't count on the end of the banks/sovereign nexus in Europe
As highlighted by the DTAs issue in our last bullet point, the last couple of years have seen the banks/sovereign nexus increasing thanks to the "carry trade" financed by cheap LTROs allowing Peripheral banks to gorge on the domestic debt of their country (Italy and Spain). On the subject of the banks/sovereign loop in Europe we read with interest Bank of America's take on the subject in their Euro Area Economic Viewpoint from the 13th of April entitled "Towards the end of the banks/sovereign nexus":
"Banks/sovereign loop in the EA was worse, absent QEIn the Euro area, the impact of the banks/sovereign negative feedback loop was even more acute than in the rest of the developed world, given the tardiness in addressing the structural issues of the banking sector and more fundamentally because, in the absence of QE, banks played the role of marginal lender to the government - thanks to the ECB's generous liquidity policy - at the expense of funding the private sector.
But things are improvingHowever, thanks to progress in the capital position of banks and the new "presumption of bail-in" - which in our view could only come after the most acute systemic banking risks were actually alleviated thanks to government support (e.g. in Spain) - member states' exposure to the financial sector has now fallen. This liberates more room for manoeuvre for counter-cyclical fiscal policy. The recent shift, in the Euro area, from all-out austerity to a neutral, or even slightly stimulative, fiscal stance would not be sustainable, in our view, if government faced massive contingent liabilities.
And QE will help reduce the loop even further
At the same time, to wean banks off lending to the governments at the expense of the private sector without jeopardizing the governments' funding capacity - which would be equally detrimental to economic growth - the Euro area needed to find an alternative marginal lender. This is achieved by QE. In a nutshell, QE is the necessary complement to banking union and the Single Resolution Mechanism to break the banks/sovereign nexu
s. This is another, indirect, transmission mechanism of QE to the real economy. Under cover of QE, we think that the regulatory authorities will try to incentivize banks to reduce their exposure to sovereigns. This is the message that Daniele Nouy, head of SSM, sent in a recent interview in the Handelsblatt, in which she opined that holdings of government bonds should be limited to a quarter of banks' equity." - source Bank of America Merrill Lynch
We disagree with the aforementioned progress made in the capital position of banks, particularly in the light of the DTAs for Southern European banks. While QE will certainly try to incentivize banks to reduce somewhat their exposure to sovereigns, we have a hard time seeing most of these banks part with some of their highly collateral such as German government bonds due to bond scarcity with the German budget being balanced and the reduction in their debt to GDP level.

In the US the problem were dealt swiftly and differently as highlighted by Bank of America Merrill Lynch's note:
"In the US, vigorous monetary policy action - in the form of early QE - managed to offset much of the fiscal drag. To put things simply, if fiscal support is unavailable and sensitivity to interest rates is lower, then monetary policy needs to "go an extra-mile'. In our view, QE in the US has been instrumental in making sure the economy remained on the recovery track in spite of a i) effective fiscal drag and ii) unprecedented threats of "catastrophic withdrawals" in public spending, with the various "debt ceiling" and sequester episodes. The UK is another example of a country which managed to control the impact of a major fiscal drag - after a just as major public bailout of the financial system - thanks to extraordinary monetary support.
In the Euro area, in our view, the "banks/sovereign" nexus played a more acute role than in the US and the UK, not simply because monetary policy did not offer as much support, at least until very recently, but more fundamentally because the "banking issue" had a more durable, complex and pervasive effect on the economy and policy-making.
The banks/sovereign nexus is bad everywhere, but it's even worse in Europe
The reaction of the US authorities - after the initial "bail in" temptation on Lehman Brothers - was remarkably swift. Forcing a recapitalisation and imposing management decisions on banks complemented state support on liquidity. In Europe, while support came very quickly, there was comparatively little attempt at dealing with the structural issues surrounding the national banking systems. Probably to some extent because European policy-makers considered that this was primarily an "Anglo-Saxon crisis", the onus was on dampening the contagion effects of a New York born financial meltdown, without necessarily a clear awareness of the depth of the local difficulties.
This timing difference is plain to see in banks’ capital to asset ratio across the regions (see Table 3).
For simplicity of analysis, we look here at total assets, not risk weighted assets. This measure, which we take from the IMF’s financial stability report, is therefore close to a leverage ratio. Before the Great Recession, the ratio was already much higher in the US than in Europe (roughly twice as large), but what is striking is that within only three years, it had already improved by more than 2 percentage points. The best European performer during this period (France) managed an increase of only 1.2 pp, from a very low starting point.
The irony, then, is that the Europeans ended up spending slightly more government money on their banks than the Americans (4.9% of GDP instead of 4.5% of GDP for on-balance sheet expenditure alone) while triggering a much smaller improvement in their banks' capital position. To some extent, this mechanically reflects the difference in size between the two banking systems - the same public spending in % of GDP has a much lower impact on the financial position of the much larger European banking sector - but we also consider that, at least at the onset of the crisis, European governments failed to emulate their US counterpart in making public support conditional on significant and rapid efforts from banks under their jurisdiction to deal with their underlying problems.
Europe’s tardiness in dealing with the structural issues of the banking sector proved particularly toxic given the much more central role it plays in funding the economy, relative to the US. Indeed, in the US bank loans accounted for only 20% of the total liabilities of the corporate sector before the Great Recession, roughly half the proportion found in the Euro area (see Chart 2). 
It was not only a matter of quantities but also, as suggested above, of price. As we have argued before (see EEW), the health of the demand and particularly the supply of credit are key to understand the broken transmission of monetary policy, the very limited sensitivity of lending rates to policy rates in most of the periphery for most of the post-crisis period and the increased sensitivity of lending rates to sovereign yields.
Another consequence of the belated reaction of the European public sector was, that by the time the banking sector was blatantly on the brink of collapse in number of countries, the governments there had already lost market access – or at the very least was already paying crippling interest rates – precisely on account of the market’s anticipation of the bailout costs. Spain probably is the best example of this type of behaviour. Exactly at the time public sector support became crucial, its cost was impossible to shoulder.
This gets us to the second significant difference between the US and the Euro area as far as the "banks/sovereign nexus" is concerned: the "imperfect mutualization issue". In the US, even if various bodies compete in the regulation of the banking industry, two centers of decision matter: the White House and Congress, as it is ultimately a federal issue. In the Euro area, a major difficulty arose from a discrepancy, across member states, between banks' need for funds and fiscal capabilities. Ireland is the best example of this. As it can be seen in Table 2, the total of approved support to the financial sector there - on and offbalance sheet potential liabilities - amounted to 500% of GDP, while the effective cost of support exceeded twice local GDP."
   - source Bank of America Merrill Lynch

In the US QE was more effective for a simple reason: stocks vs flows as highlighted earlier. The problems facing Europe and Japan are driven by a demographic not financial cycle. 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 shown above in our post in Nomura's chart,  the difference in return on assets for EU banks versus US banks improved much faster in the US thanks to the swift approach by the US in dealing with the crisis as well as their existing resolution framework absent in Europe at the time.

The main reason we had recession and credit crunch in Europe was the ill-fated decision of the EBA to impose banks to reach a core tier one level of 9% by June 2012.

Of course the 2011 debacle was avoided by LTRO 1 and 2 but what the "geniuses" at the EBA did not understand was that European banks were "capital" constrained hence the speed of the deleveraging and the epic credit crunch (Italy/Spain) that followed which led to a fall in "Aggregate Demand" a point which we agree with Bank of America Merrill Lynch:
"The political balance within the central bank - compounded by, until recently, the absence of clear deflationary pressure at the aggregate regional level - made it impossible to break this negative feedback loop via direct purchases of government bonds, which at the very least would have isolated sovereign funding costs from the consequences of the banking crisis.
Instead, the ECB approach - understandable from an emergency management point of view - added another layer to the banks/sovereign nexus by turning the banks into the lender of last resort of their local sovereign. Indeed, the ECB, by allowing access to long term cheap liquidity, through the LTROs, allowed banks to engage in safe carry-trade, parking liquidity into government bonds at a time when non-residents were leaving the periphery in droves.
Banks always tend to skew their asset allocation towards government bonds in bad cyclical times, as the demand for credit from the private sector diminishes while the quality of the banks' loan books deteriorates. Still, the ECB's generous approach to liquidity clearly was a facilitator. Italy in our view managed to avoid a recourse to the EFSF/ESM only because banks, which in 2009 held only 14% of the stock of public debt, ended up absorbing 75% of the increase in public debt between 2009 and 2014.

This was probably an acceptable "second best" to QE in terms of maintaining some funding capacity for embattled governments, as well as keeping the banking sector alive in the absence of clear progress on recapitalisation and balance sheet clean-up, but such approach presented the major risk of keeping the real economy into a recessive regime. Indeed, in this configuration, peripheral banks could make a more than decent living purely on the carry-trade, with little incentives for them to try to re-start lending to the private sector." - Bank of America Merrill Lynch
And of course the above approach, for any reasonable "Secondguesser" led the real economy into recessive regime thanks to the "crowding-out" effect mentioned in numerous conversations.

Where we slightly disagree with Bank of America Merrill Lynch is that while QE seems to be a necessary condition to alleviate the distortion created on Peripheral banks' balance sheet when it comes to their overall exposure to their sovereign, it is creating yet another distortion in "valuations" triggering in effect financial instability on a grand scale:
"Beyond institutional progress on banking union, QE is the necessary condition for breaking the banks/sovereign nexus
The two key institutional elements allowing the Euro area to deal with the banks/sovereign nexus are i) the Single Resolution Fund, funded by the banks and ii) the possibility, finally adopted on 8 December 2014, for the ESM to recapitalize banks directly, i.e. without leaving the financial cost, ultimately, on the balance sheet of the sovereign in the concerned banks' jurisdiction. These two instruments' capability is limited (1% of insured deposits for the first one and EUR 60bn for the second) but this is a first, important step towards a mutualization of the banking risk across the Euro area, which is in our view made possible by the federalization of banking supervision under the SSM framework.
In both cases, however, in principle mutualized support can be triggered only after a bail-in of the private creditors. This leaves the "financial stability" issue unanswered. Indeed, if the Euro area was faced with a major banking incident in which "burning" private shareholders and bondholders would trigger an unstoppable, generalized crisis, it remains unclear how a collective response would be organized." - source Bank of America Merrill Lynch
QE on its owned as we have argued recently is not enough to put Europe on the right track as we pointed out in our conversation "Chekhov's gun":
"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).
Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?" - source Macronomics, November 2014 
QE without private demand for funds only generates bubbles. The liquidity it supplies will not enter the real economy as long as there are no private sector borrowers. From our take, as "secondguessers" the Icelandic proposal of Sovereign money would break this toxic nexus between banks and sovereigns. To explain further why the Icelandic proposal is very appealing we would like to re-quote Dr Jochen Felsenheimer from asset management XIAI we used in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!" in September 2011:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy." - Dr Jochen Felsenheimer
Looking at the current stalemate surrounding Greece in particular and Europe in general nothing has really changed from our "secondguesser" perspective.

  • Final note: Flows have lagged performance in EM
While some EM markets have continued to post on stellar performances, there is indeed a disconnect between EM equity flows and EM equity performance as displayed in Bank of America Merrill Lynch's recent Flow Show note from the 9th of April entitled "EM Disconnect":
"Europe hogs the spotlight: $3.9bn inflows this week, extending inflow streak to 13…
…meanwhile EM can’t catch a bid: flows have lagged performance (Chart 3); 8 straight weeks of outflows from China equity funds (despite her being the best performing global market past 12 months) and LatAm equity funds only see a tiny $37mn after 9 straight weeks of outflows" - source Bank of America Merrill Lynch
As "secondguessers", we would expect flows to resume in the coming weeks/months.

"Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcome after-effects. Their precise nature is anyone's guess, though one likely consequence is an onslaught of inflation." - Warren Buffett
Stay tuned!

Wednesday 8 April 2015

Guest Post - US Corporate Profits Under Threat

"Human behavior flows from three main sources: desire, emotion, and knowledge."- Plato
Please find below a great guest post from our good friends at Rcube Global Asset Management. In this post our friends go through the numerous factors pointing towards corporate profits in the United States surprising on the downside in coming quarters:

Michal Kalecki was a Polish neo‐Marxist economist who, during the mid‐30s, undertook the difficult task of explaining why, contrary to Marx’ predictions, corporate profit rates in capitalist societies were not converging towards zero.

The starting point of his argument lies in the fact that an economy can only save (i.e. increase its aggregate wealth) by investing. Kalecki’s profit equation therefore begins with the following equation:

Saving = Investment

If we divide saving into Business Saving (= Profits after taxes and dividends) and Non‐business saving (Personal saving + Foreign saving + Government saving), the equation becomes:

Profit after taxes and dividends = Investment ‐ (Household + Foreign +
Government) savings

=> Profit after taxes = Investment + Dividends ‐ (Household + Foreign + Government) savings

The Kalecki profit equation is not a mere macroeconomic model. It is an accounting identity that remains true at all times. One can always verify its validity by checking the following items in the National Income and Product account.

Interestingly, the Kalecki equation implies the following paradox: although the business sector often advocates for balancing governments’ budgets, the Kalecki equation undeniably shows that a large part of corporate profits actually derives from budget deficits. It has certainly been true over the last 70 years.

Following Kalecki’s equation, the fiscal cycle can be used as a lead indicator for corporate profits and the business cycle.

In a recently published piece, John Hussmann explains that because in the US, investment,dividends and foreign savings usually cancel each other, the Kalecki equation can be reduced to:

Corporate profits = ‐ (government + household savings).

In recent years, this has however not been the case. Investment rose while the current account improved (imports‐ exports= foreign savings). Therefore, as the chart from Hussman’s blog shows, the relationship broke down over the last 5 years.

- source Hussman funds

This explains why, despite reduced savings from the combined government and household sectors, profits have held up quite well. Part of the answer comes from quantitative easing. Debt issuance to repurchase shares has artificially lifted profits. Additionally, the last few years also correspond to the shale oil revolution. It is therefore possible that with a lower energy bill, the US was able to “self‐finance” investments without the usual help of imported foreign savings. The question is, can that last now that QE is over and with the FED about to lift interest rates? Given the strength of the dollar and the weakness of the global economy, the most likely scenarios are that investment weakens and/or that the current account improvement goes into reverse. Already, capital goods’ spending is weakening, and the oil crash has increased the odds that it will weaken substantially more.

Furthermore, over the last 3 years, consumers have tapped into their savings. The saving rate went from a high of 8.5% in 2012 to 4.5% today. It is unlikely that the saving rate will drop further given 1/ the close memory of 2008 2/ demographics 3/ current households behavior (consumer are using their strong cash flows to pay down debt).

At more than 600% of GDP, the US government + unfunded off balance sheet debt leaves no options on the fiscal side of the Kalecki equation when the cycle turns.

As a result the boost to private consumption from consumers is unlikely to be repeated. And since government dissaving has more than offset consumer spending it is likely that profits will surprise on the downside in coming quarters. Even more so, if investment weakens on top.

We can also observe a strong link (with a lead) on both corporate credit spreads….

and thus equity volatility.

As we have shown recently, the strength of the US currency is another threat to corporate profits and forward earnings estimates. When the supply of dollars globally shrinks (budget and current account improve together) overseas earnings tend to crash, hence the relationship below.

Current consensus believes that extremely low yields and energy prices will more than offset these threats.

With US equity volatility as mispriced as it was back in 2007 according to our model, now is not the time to be overly complacent.

Finally we would like to also add an important point made by David Goldman which can be found on Reorient Group's website from his note from 31st of March entitled "US Corporate Profits Inflated by Undersestimated Depreciation":
"If the United States wants to attract Chinese investors, it had better improve accounting standards. That sounds like the beginning of a joke, but it’s not. There have been isolated cases of accounting fraud in Chinese companies listed on US exchanges, but there appears to be systematic distortion of US corporate profits across the board. The issue is depreciation of plant and equipment. This is another reason we don’t like US stocks at present valuations.
Before-tax earnings of US companies in the GDP accounts are reported two ways: with Inventory Valuation Adjustment (IVA) and Capital Consumption Allowance, and without. The two measures have diverged by about 25%, or US$500 bn, since 2012. That’s a big divergence. The stricter measure (based on the Commerce Department’s depreciation model) shows that Q4 corporate profits in 2015 were lower than in Q4 2011; the looser measure shows substantial growth. Note that the S&P 500’s earnings per share track the higher, not the lower number."
- source Reorient Group

"When growth is slower-than-expected, stocks go down. When inflation is higher-than-expected, bonds go down. When inflation is lower-than-expected, bonds go up." - Ray Dalio

Stay tuned!

Saturday 4 April 2015

Credit - The Honey Pot

"Man is the only kind of varmint sets his own trap, baits it, then steps in it." - John Steinbeck, American author
Looking at the abandonment with which investors are piling into Corporate Hybrid debt such as Bayer AG 2%⅜ coupon, maturing in 2075 with a spread of 241 bps over Bunds to its first call date in 2022, we reminded ourselves for this week's chosen title analogy of the movie 'The Honey Pot", a 1967 crime comedy-drama film written for the screen and directed by Joseph L. Mankiewicz which was inspired by 1605 English play called Volpone (Italian for "sly fox"), a merciless satire of greed and lust just like today's markets we think. Movie buffs like ourselves will note that Joseph L. Mankiewicz was the brother of Herman J. Mankiewicz, famous for winning an Oscar for co-writing Citizen Kane in 1941 but we ramble again... 
But, moving back to our chosen analogy, as there is always another layer to it, it is also a computer terminology for a trap which is set up to detect, deflect or use as a bait to entice computer hackers. In our credit case, corporate subordinated debt such as hybrid have been effectively used by "sly fox" issuers to lure unsatiated yield hungry investors to dip outside their comfort "risk" zone as aptly described by our friend and former colleague Anthony Peters, strategist at SwissInvest and regularly featured in IFR in his recent column:
"Subordinated corporate debt is all the rage in a world in need of yield and issuers are not being shy in coming forward in order to oblige. Investors, on the other hand, have been hoovering the stuff up and, not surprisingly, the premium they are being paid in order to take the extra and until recently quite innovative risk has melted away.

Subordinated corporate risk satisfies a string of needs but if fixed income and credit investors think that they are getting the best of the upside, they are sorely mistaken. Corporate sub debt is the ultimate ratings arbitrage. I had, given my background in structured credit , always assumed that the CLO (Collateralised Loan Obligations) was the pinnacle in terms of making a silk purse out of a sow's ear but I am beginning to see corporate hybrid debt as a much more straightforward example of the dark art.

Why, one needs to ask one's self, would a company issue subordinated debt? It didn’t have the capital and reserve restraints which affect banks so who is the winner and why? Look no further than the boardroom. Older readers - that's the over 45s - will recall the world's leading corporate names all being in the triple-A, double-A or occasionally in the rather sad and ignominious single-A ratings space. Management was proud of the high quality of its company's debt. Then, beginning in the mid-1990s, everything became a matter of "shareholder value". Balance sheets were geared up to the ying-yangs and cash returned to shareholders. It was an age of stock-price above all else. At times, the entire stock looked like a board-approved pump-and-dump circus.

The fashion was for "making the balance sheet more efficient". Had executive remuneration not been so closely tied to the stock price, a lot of this might not have occurred. Executives couldn't buy themselves a yacht or a ski chalet from higher debt ratings but they could from a higher stock-price. Ultimately, obviously, there were limits to how far you could reasonably leverage a balance sheet until someone dreamt up the hybrid corporate bond.

The hybrid bond fulfils two principal functions. Firstly, it lets companies borrow without adding further pressure to the senior bond ratings which is good although, of course, the balance sheet is not relieved of debt, thus offering something rather akin to invisible leverage. Secondly, it gives the borrower cheap equity without diluting the share capital and hence negatively influencing the wealth of those who's remuneration is linked to share price performance and is expressed by way of stock awards. It is, in many respects, a victimless crime. There is nothing altruistic in corporates issuing subordinated debt.

And yet, investors are tripping over themselves in pursuit of such paper. Early and enthusiastic investors in hybrids made out like bandits but the juice has gone. Furthermore, as in the case of Additional Tier One (AT1) notes, the sub-class has not yet been tested in a prolonged and properly stressed market which renders the pricing process for such paper a bit of a game of pinning the tail on the donkey. The price of a bond needs to take account of the expected recovery rate in the event of default. I'm not sure anyone has come up with a usable and credible model for this one. Does one insert zero recovery? If so, how should that risk be correctly priced? 241 bps certainly doesn't seem to cover the bases. And that, incidentally, does not even include any meaningful pricing adjustment for the higher liquidity risk of junior sub debt in a stressed market where bids for institutional size will surely once again be scarcer than pink and blue striped unicorns.

The principal risk which should be worrying us is not, when push comes to shove, the one covering default and recovery but the one of mark to market volatility. The higher convexity which the currently low coupons impose on bonds brings with it higher price volatility and hence much higher risk to investment portfolios. What effect this might have on such matters as the solvency of insurance companies has not, in my opinion been taken on board. In their race to slaughter market liquidity on the altar of transparency, the regulators are doing just what we feared they were, namely they are preparing to re-fight the last war. "- Anthony Peters, strategist at SwissInvest   

Exactly! We agree with our friends when it comes to convexity risk. Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:
"In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."
So Corporate Hybrids investors beware, because, the reward doesn't justify anymore the risk and the lack of liquidity will one day come back to haunt you when you will be seeking "price discovery" for your holdings rest assured.

At this juncture, we think it is very important to look back on how the "Global Credit Channel Clock" operates, as designed by our good friend Cyril Castelli from Rcube Global Asset Management which we introduced in our conversation "The Night of the Yield Hunter":

In this week's conversation, as we move into the second quarter of 2015, we will look at the current business cycle from a credit perspective and ponder were we stand when it comes to allocation in "nth" inning game.

  • Although "leverage" is rising, it is still "goldilocks" for credit in particular for US Investment Grade Credit
  • In this late credit cycle game, we recommend playing "quality"
  • Global QE is not only leading to the "Honey Pot" but as well extending the game into "overtime"
  • What to do in Q2?
  • Final note: the only "Great Rotation" has been from retail investors to institutional investors

  • Although "leverage" is rising, it is still "goldilocks" for credit in particular for US Investment Grade Credit
As we pointed out in our previous conversation, there is indeed greater enthusiasm for US dollar credit. 

US Investment Grade Credit in terms of returns have been so far more appealing as clearly displayed by Morgan Stanley's Leveraged Finance Chartbook from the 30th of March:
- source Morgan Stanley
But, as indicated by CITI in their March 2015 note entitled "Is the credit cycle headed to extra innings?", leverage in the Investment Grade credit space has been rising, confirming we are indeed in the higher left quadrant of the "Global Credit Channel Clock":
- source CITI

We have long argued that in the "japanification" process, particularly in Europe, credit could outperform equities: 
"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
This outperformance has played out until 2015 which saw the launch of the ECB's QE and a switch in the "regional macro" perspective as we pointed out last week:
"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." - Macronomics, "The camel's nose", March 2015
The current "deflationary" environment is indeed a golden age for credit, and given the "macro regional switch" one should indeed favor a stronger allocation to US Investment Grade in the US while European High Yield remains more enticing than European Investment Grade credit due to the disappearance of the interest rate buffer we discussed last week as well as convexity issues (lower and lower coupons and increased duration). 
In Europe, 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. When one looks at the Asset Class Total Returns in 2015 in the Fixed Income space as displayed in Morgan Stanley's Leveraged Finance Chartbook from the 30th of March, one can see that our positive stance on US Investment Grade Credit which we discussed again in August 2014 in our conversation  "Thermocline - What lies beneath" has been validated by returns:
"For those that need to seek comfort in a safe haven, we believe Investment Grade credit while tight from an historical point of view, still benefits from positive exposure thanks to the Japanification process. In that sense, we expect the Fed to keep a dovish tone in this muddling through economic situation in the US meaning that the releveraging process taking place in the US is still positive for credit." - Macronomics, 19th of August 2014.

- source Morgan Stanley
 In our conversation "Sympathy for the Devil" back in September 2014 we argued:
"The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters." - Macronomics, September 2014
Yes indeed, when it comes to the High Yield space, default perception risk matters and is ultimately linked to leverage. What could significantly impact High Yield spreads would be a sudden rise in defaults rise, particularly coming from the "Energy" sector which has been in the limelight courtesy of the sudden fall in oil prices. 
In Morgan Stanley's Leveraged Finance Chartbook from the 30th of March one can take notice of the "pessimistic" Moody's Forecast versus their much lower baseline scenario:

- source Morgan Stanley
But, as pointed out by our Rcube Global Asset Management friends, from their March 2013 guest post "Long-Term Corporate Credit Returns", credit investors have a very weak predictive power on future default rates:
"Current spreads have virtually no correlation with actual future default losses. They are therefore driven by something else (risk aversion, greed/fear cycle). Corporate credit investors actually seem to care a lot about one thing: current (i.e. trailing 12-month) default rates.
We interpret this as evidence that credit investors are collectively subject to an extrapolation bias.
When default rates are high, credit investors behave as if default rates were going to stay high for the next 5-10 years. They liquidate their portfolios in panic (or because they are forced to do so). This snowball effect leads to spread levels that have no economic rationale. At the height of the latest credit crunch, corporate high-yield spreads were pricing a 33% annualized implied default probability over the following five years (20% / ( 1 – 0.40 )), which is around four times the maximum five year annualized default probability during the Great Depression!

Inversely, when default rates are low, credit investors believe that stability is the norm, and start piling up on leverage, inventing new instruments to do so (CLOs, CDOs, CPDOs etc.). This recklessness leads to malinvestment, and sows the seeds of the next credit crisis." - source Rcube Global Asset Management
And as per our tile "The Honey Pot", credit markets are indeed a "merciless satire of greed and lust" as concluded by our friend in their 2013 guest post. Credit investors do suffer from "bipolar disorder" and alternate from greed to fear, except that contrary to 2007/2008, during the next "fear" episode, liquidity will not be around:
"Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates." source Rcube Global Asset Management
While for some it appears to be late in "the Honey Pot" game, one thing for sure is that additional QE from the ECB has been adding extra innings into the "credit" business cycle.

  • In this late credit cycle game, we recommend playing "quality"

In this late credit cycle game, we recommend playing "quality" as clearly displayed by Morgan Stanley's Leveraged Finance Chartbook from the 30th of March, it matters:
- source Morgan Stanley
Looking at the above table, both AAA exposure and CCC, doesn't justify, from a risk exposure the risk/reward due to interest rate volatility for the latter and the expected rise in defaults risk for the former. So where is the value?

On the subject of "credit quality" and given investors interest for the BBB "credit belly", we read with interest Morgan Stanley's take in their 27th of March note entitled "The BBB Tail":
"Near-Term Softness; Longer-Term Value
Credit markets continue to have a late cycle feel. Supply comes at a record pace in spite of the 40bp widening since the tights. IG has underperformed equities over the medium term. Despite the widening, our models say that spreads are slightly rich, as weaker Q1 GDP and the recent rate rally weigh on valuations. Over the longer-term, we look through some of the GDP weakness and expect higher rates, both of which will support IG credit.
Revisiting the BBB Trap
While spreads are roughly flat YTD, Non-Financial BBBs are underperforming, wider by 6bp, whereas A-rated issuers are tighter by 5bp. Though the Energy sector is certainly a reason for BBB underperformance, there are other late cycle reasons including quality deterioration, M&A and buybacks.
The BBB Trap: This is significant, as 50% of the IG market ex Financials is comprised of BBBs (35% are A-rated). Furthermore the spread differential (about 80 bps, driven in part by Energy) makes the credit quality view an important one to get right from a carry perspective. 
Are BBBs Cheap Now?
We don’t think so. Ex-Energy and Financials, BBBs provide only 61bp of spread premium over A-rated issuers. While that premium was below 50bp during the peak of the last cycle, the average premium over the past 10 years is about 84bp.
The Trap Becomes a Tail
BBBs are a significant source of dispersion relative to A-rated issuers. The formation of this tail is happening rather quickly, and in our view, represents the fallen angel class of issuers in this cycle." - source Morgan Stanley
In their note Morgan Stanley also highlight the dispersion risk involved in the "BBB" credit bucket and how to avoid it:
"How Does One Avoid the Dispersion Risk? Outside of avoiding BBB risk, credit analysis is the obvious answer, but that assumes realizing a good batting average. Within structured credit, senior tranches are the natural choice, as they are fairly immune to credit dispersion as long as overall spreads are healthy. From the short side, we would recommend protection positions in legacy CDX IG indices which tend to experience credit-quality deterioration at this point in the cycle."
- source Morgan Stanley
Even leveraged credit can be less risky than unleveraged equities as credit is far less volatile than equities, some leverage is sensible.

  • Global QE is not only leading to the "Honey Pot" but as well extending the game into "overtime"
QE has indeed been stimulating on a grand scale flows not only into specific asset allocation but, as well to regional allocation (European equities) as we pointed out in our last conversation. A good proxy of the "over-stimulation" of the "Honey Pot" can be seen we think through the prism of year to date flows as a percentage of AUM as indicated in Bank of America Merrill Lynch's Situation Room note from the 2nd of April entitled "Selling stocks but holding on to bonds":
"Outflows from stocks funds increased to $9.15bn last week from a $4.40bn outflow in the prior week. High yield bond funds had a small $0.58bn inflow, while short-term high grade (- $0.45bn) and loans (-$0.20bn) continued to report outflows. Outside of short-term funds high grade flows were little changed from the prior week at $3.16bn. However, weekly data for high grade outside of short-term funds tend to be inflated by PIMCO-related flows, and PIMCO again reported outflows for the month of March." - source Bank of America Merrill Lynch
When it comes to the supposedly "Great Rotation" story of 2014 from bonds to equities, with YTD inflows of $31.7 bn into High grade versus $20.2 bn into equities, the only great rotation story of 2015 has been in Europe with significant inflows into equities courtesy of the ECB's QE.

The ECB QE factor has been driving equities flows in Europe. It can be ascertained from Bank of America Merrill Lynch's Flow Show chart from the 2nd of April entitled "My Herd is My Bond". The European "Honey Pot" à la Japan:
"My Herd is My Bond: another week, another week of inflows ($8.5bn) to fixed income; indeed 2015 has seen biggest first quarter of fixed income inflows ($102bn) since 2001.
Dollar driving equity flows: inflows to Europe & Japan, outflows from US & EM; overall $9.1bn weekly redemptions from equity funds.
Everyone loved QE: as noted last week ECB QE-inspired inflows to European equities now v similar as % of AUM to Japan equity inflows during launch of BoJ QE in 2013 (Chart 1)."
Cash smashed: very large $53bn outflows from Money Market funds, largest since Oct'13 US government shutdown. - source Bank of America Merrill Lynch.
As pointed out in their note as well, Europe has seen very significant inflows courtesy of our "Generous Gambler" aka Mario Draghi:
- source Bank of America Merrill Lynch.
Global QE and increasing negative yield in Europe have led to investors being led to the "Honey Pot" to smash the Piggy bank (money market outflows) and to run into overdrive towards fixed income. So much for the "Great Rotation" story...

The global easing and QE policies have effectively led to a late continuation of the the business cycle as indicated by Bank of America Merrill Lynch's US Economic Weekly note from the 2nd of April entitled "The continuing case for risk assets":
"The benefits of clean living
A popular view is that business cycles die of old age. If this were true, then the length of recoveries would tend to cluster around a certain number of years. In reality, the length of recoveries has a very flat distribution, extending from 12 to 120 months (Chart 2).

 Moreover, if anything, economic recoveries have tended to get longer over time. In the “good old days” of the gold standard the average recovery lasted only two or three years, and the economy was in recession almost as much as it was in expansion. Since World War II the average recovery has increased to 58 months. Even more telling, the last three recoveries have been among the four longest in history. By this standard, the current recovery is middle-aged, not old.
Recoveries don’t die of old age, they end due to three kinds of excesses—major asset bubbles, overexpansion of cyclical sectors and high inflation. In addition, a related excess, the shock of higher oil prices, has been an important cause of many recessions. None of these health risks are evident today:
  • Healthy diet: unlike during the housing and tech bubbles, in the current cycle easy credit has been used for balance sheet repair. While there may be minibubbles in parts of the markets, there is no sign of a bubble in major asset markets such as housing and the stock market.
  • Low cholesterol: Historically, the three cyclical sectors of the economy— consumer durable spending, housing and business equipment investment— tend to collapse during recessions and then over-expand late in the recovery. Today, all three sectors have taken back only about half of their decline as a share of GDP (Chart 3).
  • Non smoker: Inflation remains low and given strong global headwinds it is unlikely to pick up significantly any time soon.
  • Drink in moderation: Oil prices are a long way from levels that have triggered recessions in the past and are unlikely to return to their highs any time soon (Chart 4).
 - source Bank of America Merrill Lynch
Of course we disagree with Bank of America Merrill Lynch's take who is not seeing froth into any major asset class. As per our earlier rant of our current credit conversation, the European corporate credit hybrid space is a clear case of "overreaching" investors!

  • What to do in Q2?
When it comes to the "pain trade" we benefitted from the February weakness into US Treasuries to add to our long duration exposure (partly via ETF ZROZ). The 126K weaker than expected print for Nonfarm payrolls well below the "optimism bias" economists forecast of 247K, validated even more our cautious long standing "deflationary" stance.  We continue to see value in being long duration via US Treasuries. The macro data in the US continue to point out that the US economy is much weaker than it seems and we do not see the Fed hiking in June and hiking in 2015 even. The Fed has clearly stated it is data dependent.

Looking again at the upper left quadrant of the "Global Credit Channel Clock" from Rcube Global Asset Management friends, you should:
  • remain long volatility
  • remain long US Government Bonds
  • remain long gold
  • continue to play yield curves flattening

Our position is relatively similar to what has been advocated by Bank of America Merrill Lynch in their Thundering Word latest note entitled "Moment of Truth" when it comes to being long volatility:
"We remain a buyer of volatility (so at margin add to gold and cash). Without doubt the key Q2 call is can the US economy recovery its mojo (i.e. Q2 GDP pops above 3%) or not (GDP for 3rd consecutive quarter fails to break much above 2%). Big GDP...Fed hikes get priced-in. Small GDP ..."secular stagnation" back in play, investor "buyers strike" in overvalued corporate bonds and equities. In either scenario, volatility performs well. Vol remains the "buy the dip" trade of 2015.
Lower exposure to spread product. BAML house view is US GDP above 3.5% Q2. This likely to put upward pressure on bond yields as June/Sept in play for hike. In turn this is likely to widen spreads across corporate bonds, a trend that at any moment can be exacerbated by latent investor fears on market liquidity, speculative excesses in "yield" products, and levered ETF risk parity strategies." - source Bank of America Merrill Lynch.
Where we disagree strongly is with their "house view" of US GDP above 3.5% in Q2. It will not happen for the following reasons:

  • Only 34,000 jobs were added in March, according to the Household Survey. 96,000 Americans, meanwhile, left the labor force. The Labor Force Participation Rate has fallen back to post-1978 lows. The 126 K NFP print along with downward revisions of 69,000 for January and February shows that the U.S. economy is an a dead stall. The Atlanta Fed GDPNow tracking forecast shows zero growth during the first quarter.
  • New York’s ISM purchasing managers’ survey came in at 50, vs. 63.1 the previous month and a survey expectation of 62.
  • Most pundits assumed that cheaper oil would spur consumer spending. Check latest retail sales...
  • Earnings are vulnerable to big disappointments. Factset reported on the 1st of April (not April's fool day on that matter) that positive guidance is at the lowest level since 2006: 
“For Q1 2015, 85 companies in the S&P 500 have issued negative EPS guidance and 16 companies have issued positive EPS guidance. If 16 is the final number of companies issuing positive EPS guidance for the quarter, it will mark the lowest number since Q1 2006. The number of companies issuing negative EPS guidance for Q1 2015 is above the trailing five-year average (76), but slightly below the trailing one-year average (87) for a quarter.”
"That’s mostly price movements, to be sure, but the collapse of export prices in dollar terms reduces capacity to service dollar debt. Deficit = death in this kind of market."
  • The Chicago MNI Business Barometer came out at 46.3 in March, barely above the 45.8 reading in April, indicating more contraction. The consensus estimate called for a recovery to 51.7. Yet another miss by the "optimism bias" crowd of pundits. 
  • Dallas Fed Manufacturing Survey printed at -17.4, the worst since 2011.
  • Real personal consumption fell by 0.1% in February, the second-biggest drop since the 2009 crisis. It was forecast to rise by 0.2%.
  • Durable goods orders were down -1.4% in February vs. a consensus estimate of +0.2.
 So all in all we do agree with Bank of America Merrill Lynch's note title: "Moment of Truth".

We could go on with the weaker than "expected" data releases in the US, but hey, "bad news" is "good news" given markets seem increasingly dependent on super easy monetary policy to go on for longer (hence the extended duration of the credit business cycle into overtime until sudden death or penalty shoot-out maybe?).

In that context think European equities investors would be wise to take a few chips from the table given the significant rally since the beginning of the year. Take a break and lock some profits.
Same apply to the short Euro crowd, beware of strong risk reversal in Q2. While the US equities crowd, we think, will continue to face disappointment, in the form of earnings, this time around. Tread cautiously in Q2.

  • Final note: the only "Great Rotation" has been from retail investors to institutional investors
On a final note we leave you with a chart from CITI's March 2015 note entitled "Is the credit cycle headed to extra innings?" displaying that no matter how the Fed central bankers would like to spin it, there has not been wealth effect, only "cantillon effects":
"But if stocks go down, it’s even worse" - source CITI
What is of interest is that while quietly institutional investors have been cashing in such as Private Equity, retail investors have been piling in, indicative of the lateness in of the credit business cycle driven  by central bankers. In last 3weeks in Europe, a Portfolio Manager friend has seen big share blocks placed after market closure. It seems Insiders/PE guys really believe in the much vaunted recovery...The "Honey Pot" is indeed a satire of greed and lust...

« Murphy Junior’s law »: My central banker is too optimistic”.  - Macronomics
Stay tuned!

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