Wednesday 17 June 2015

Credit - The Third Punic War

"The worst pain a man can suffer: to have insight into much and power over nothing." - Herodotus, Greek historian
While coming close to "Grexithaustion" thanks to the never ending Greek tragedy, which seems to be a manifestation of Henri Poincaré's "recurrence theorem" we discussed in our last conversation "Eternal Return", we decided to use this week a reference to Rome's Third Punic War as this week's title analogy. In similar fashion to Carthage, Greece has been asked increasing unrealistic demands from their "debt masters" leading at the time to Carthaginians defecting the negotiations in true John Forbes Nash fashion, which led to the Third Punic War and the eventual destruction of Carthage:
"In 149 BC, Rome declared war against Carthage. The Carthaginians made a series of attempts to appease Rome, and received a promise that if three hundred children of well-born Carthaginians were sent as hostages to Rome the Carthaginians would keep the rights to their land and self-government. Even after this was done the allied Punic city of Utica defected to Rome, and a Roman army of 80,000 men gathered there. The consuls then demanded that Carthage hand over all weapons and armour. After those had been handed over, Rome additionally demanded that the Carthaginians move at least sixteen kilometers inland, while the city itself was to be burned. When the Carthaginians learned of this they abandoned negotiations and the city was immediately besieged, beginning the Third Punic War." - source Wikipedia
Being history buffs ourselves we find it amusing from a "light" historical comparison, that while Greece is being increasingly punished, by the defacto leaders of Europe namely Germany, its closest neighbor France is already slipping the structural reforms trail, passing "cosmetic" laws such as the Macron law in order to avoid the wrath of the European Commission and powerful neighbors using in the process article 49.3 to bypass parliamentary vote. 
In similar fashion, while Rome was letting Numibia continue abusing its Carthaginians neighbors, it was busy imposing more and more harsher treatments on its rival Carthage.

As we stated on numerous occasions, France is the new barometer of risk, as it seems the country seems impossible to reform. As stated in our March "China syndrome" conversation:
"Given France has now postponed any chance of meaningful structural reforms until 2017 with the complicity of the Europe Commission, (again a complete sign of lack of credibility while imposing harsh austerity measures on others), and that the government will face an electoral onslaught in the upcoming local elections which will see yet another significant progress of the French National Front, we are convinced the"Current European equation" will breed more instability and not the safer road longer term."
Whereas "The Third Punic War", this time being is being waged on Greece, while captivating numerous pundits, for us it is a side show as many more risks are indeed brewing, when it comes to "instability" given once more, the Fed has failed to act early. and as we posited in a previous conversation (Singin' in the Rain), we might get another "dollar" crisis on our hands:
"Back in November 2011, we shared our concerns relating to a particular type of rogue wave three sisters that sank the Big Fitz - SS Edmund Fitzgerald, an analogy used by Grant Williams in one of John Mauldin's Outside the Box letter:"In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely: 

  • Wave number 1 - Financial crisis 
  • Wave number 2 - Sovereign crisis 
  • Wave number 3 - Currency crisis
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?"
If The Fed normalizes, get ready for a big US dollar Margin call, carry traders and leverage players beware...We touched on the issue of the rise of the US dollar in our September conversation "The Tourist Trap" where we argued:
"All the investors that piled in "high beta trade", namely our "tourist trap", in the form of Asian High Yield, Emerging Debt Bonds and Equities as well as Emerging Currencies are being hit hard. They thought they were "smart investors", playing "alpha", when it was a pure beta play courtesy of repressed volatility thanks to central bank meddling due to negative real US interest rates." - Macronomics, September 2013
Therefore in this week's conversation, rather than focusing on the Greek tragedy, we would rather focus our attention to some macro and micro aspects that warrants, we think a closer attention.

  • Bear markets for US equities generally coincide with a tick up in core inflation
  • France from a "corporate monitoring health" is deteriorating "slowly" but "surely"
  • Beware of the Repo drought
  • US Interest Rates and the US Corporate pensions gap
  • Final chart: In High Grade Credit, liquidity is coming fast at a premium

What we find of interest is that "Bear markets for US equities have usually coincided with high global core inflation". The recent acceleration in wage upside pressure as well as in rent pressure could indeed surprise to the upside, particularly due to the rebound in oil prices since March (+40%). This should translate into the headline CPI where rental prices represent 25% in the calculations and overall housing 42%:
"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008" - Macronomics, 5th of June 2014
- source

Given the strong correlation between FX carry trades and equities in recent years, the observation that recent equity bear markets have coincided with higher core inflation makes us more and more cautious on the sustainability of the US equities rally. So we will eagerly watch that space in the coming weeks and months.

  • France from a "corporate monitoring health" is deteriorating "slowly" but "surely"
In our conversation "The European crisis: The Greatest Show on Earth", we indicated:
"When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys."
One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers.
In our end of May conversation "Optimal Bluffing", we advised our readers to start following these debilitating micro trends to assess the health of the French corporate sector. 

The latest survey published on the 12th of June points to a continued deterioration in the Terms of Payments, which indicates that the improving trend since mid-2012 has turned decisively negative:
The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in receiving payments from your clients tend to fall, remain stable or rise?

Delays in "Terms of Payment" as indicated in their June survey have reported an increase by corporate treasurers. Overall +18% of corporate treasurers reported an increase compared to the previous month (+19.8% revised), bringing it back to the level reached at the end of 2013. The record in 2008 was 40%.

Overall, according to the same monthly survey from the AFTE, large French corporate treasurers indicated that they are still facing an increase in delays in getting paid by their clients. It is therefore not a surprise to see that the overall cash position of French Corporate Treasurers which had been on an improving trend since 2011 is now turning and more negative overall according to the survey:
The monthly question asked to French Corporate Treasurers is as follows:
"Is your overall cash position compared to last month falling, remains stable or rising?"
Whereas the balance for positive opinions was 17.9% in November 2014 and still at 6.3% in January 2015, February saw it dip to -5.2% and March's came at -13%, April at -0.5% and May was revised from -9.5% to -6.1% with June coming at -3.7%

We will restate what we mentioned back in our March 2015 conversation "Zugzwang":
"The French government policy is based on "hope" and their strategy is based on "wishful thinking". No matter what, we do not see unemployment falling with these deteriorating conditions."
Like any behavioral therapist would do we focus on the process, rather than the content. Hence our dubious faith in the much vaunted "cosmetic" structural reform coming from the Macron law, given that now French President Hollande is effectively on the campaign trail.

As we indicated in our conversation as well is that there was a large contingent of public servants supporting François Hollande representing 22% of the working population compared to 11% in Germany. To validate our prognosis, we find it amusing that Public Service Minister Marylise Lebranchu has announced on the 16th of June 2015 that public servants would see their salary increases as of 2017 without any mention of course of the budgetary impact it would have! Also, she mentioned that while salaries have been currently frozen thanks the stability of the index used for deciding on salary increases which depends on the economic situation, it is a possibility that in spring 2016, there could be an increase prior to the 2017 presidential elections....
The impact of a 1% increase would cost an additional €1.8 billion euros according to the Court of Auditors.
"The Court of Auditors (in French Cour des comptes) is a quasi-judicial body of the French government charged with conducting financial and legislative audits of most public institutions and some private institutions, including the central Government, national public corporations, social security agencies (since 1950), and public services (since 1976).)" - source Wikipedia
Meanwhile the French Government has announced that in order to reduce French unemployment, it would create another additional 100,000 "subsidized" jobs. Most of these jobs are for low qualified persons at a cost of €3 billion for the 346,083 benefiting from it according to the 2015 budget equating to 27% of the budget of the Minister of Labor. These additional 100,000 will cost €300 million to the budget in 2015 and €700 million in 2017 according to the Minister of Labor. It would have been much better to use these spendings in training such as what Germany does with its very successful "apprenticeship" programs which explain Germany's very low unemployment youth. So you have 100,000 low skilled public jobs created out of 5.99 million of unemployed people in France as per April 2015 data. According to DARES, which is the department in charge of analyzing the labor market in terms of statistics at the Minister of Labor, only one third of these "subsidized" job lead to full employment 6 months later. 

Whereas the Third Punic War is coming to a close, we still believe that France warrants close monitoring given its impossibility to reform. Whereas Rome was having none of it with Carthage like Germany with Greece, the current indulgence displayed with French's lack of progress is reminiscent of Rome's attitude towards Numibia we think.

Moving on to our next point, which deals once more with credit in general and repo in particular, we think it is an important point to follow when it comes to assessing the dwindling "liquidity" picture.

  • Beware of the Repo drought
When it comes to the Third Punic War and Rome's insatiable demands, the reduction in liquidity is a direct consequences of the overwhelming regulatory burden set on banks which, in retrospect is having once again "unintended" consequences particularly in the Repo market in Europe.

As a reminder:
Basel III proposals - BIS ratios to manage liquidity risk:
The Liquidity Coverage Ratio (LCR).
The LCR requires that a bank has sufficient liquidity to survive for 30 days under a stressed scenario when global financial markets are assumed to be in crisis, all wholesale funding has dried up, unsecured lines of credit provided by other financial institutions are withdrawn and banks experience partial deposit flight. To mitigate this risk, the LCR requires that banks hold a liquidity buffer of high quality, liquid, central bank repo eligible, unencumbered assets, which are at least equal to the amount of net cash outflows a bank may face over a 30-day period.

The on-going deleveraging in the European Banking space is leading to a reduction in the financial "grease" of financial markets, namely repo markets. On that subject we have read with interest Citi's not from the 8th of June entitled "Declining Financial "Grease" Hits Market Liquidity from their European Banks Insights:
"Repo Under Pressure — Repo markets are often considered the “oil that greases the financial markets”. The leverage ratio has become the binding constraint for many wholesale banks, which have pulled back from balance-sheet-intensive, low-return repo. We estimate gross repo at global wholesale and custody banks has declined by c11% over 2012-14, with European banks bearing the brunt (down 16%, Figure 1).

This broadly matches the c13% decline in total repo (Figure 3).
Velocity But No Depth — Although market ‘velocity’ (traded volume) has increased, market ‘depth’ has declined. For example, the market depth of 10yr UST is US$125m vs peak levels of US$500m in 2007, while the US Treasury market is nearly three-fold over the same period:

Increasing frequency of “flash crashes” and “air pockets” may be here to stay (see The liquidity paradox). Whilst the strongest declines in repo books have come from DBK, UBS and RBS, the likes of the major French banks, HSBC and Barclays look less efficient even if the latter has made significant progress over the past 3 years.
  • Global wholesale and custody banks have reduced their gross repo books by c11% between end-2012 and end-2014. European banks’ repo outstandings fell by 16% vs US banks’ by 6%, mirroring the shift in FICC market share in favour of US banks.
  • In USD-terms, DB has downsized most aggressively (c40% in USD or c34% EUR) and is looking to further optimise its Prime Finance business, per its recently announced Strategy 2020.
  • The French banks are the notable exceptions amongst European banks. BNPP and SOGN in particular have grown their repo books by 41% and 13%, respectively, which has not necessarily translated to higher sales & trading revenue market share over the same period
The decline in US repo may also be driven by greater rationalisation by European banks, partly in response to stringent upcoming US FBO requirements. Repo or ’financial grease’ is likely to fall further & correspondingly, risks are likely to increase, in our view." - source Citi
This is not a surprise to see a continued deleveraging of European banks through the Repo markets. We have touched on the difference between the deleveraging between US banks and European banks extensively about the profitability in our conversation "The Pigou effect" as well as in our conversation "The Secondguesser":
"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:
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." - source Macronomics, April 2015
"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."
Given the amount of deleveraging that still needs to occur in the European banking space, this divergence between the profitability of US banks versus European banks will continue to grow and it will be reflected into the Repo markets rest assured.

As indicated previously, in the US QE was more effective for a simple reason: stocks vs flows:
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.

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 problems facing Europe and Japan are driven by a demographic not financial cycle. European banks will continue to destroy value given the amount of deleveraging that still needs to take place and do not appear to us, at least in the equities space as an enticing investment proposal when it comes to long term returns and stability.

As further reasoning behind our assertion and as highlighted in Citi's report, Banks' market revenues are well correlated to "Repo":
Banks’ trading market share appears to be reasonably well correlated with repo, as highlighted in the above charts.
European banks have already lost market share in Sales & Trading, particularly in FICC but also in Equities. Although we do not discount the effects of re-pricing and optimisation, as banks continue to increase balance sheet efficiency, further reductions in repo (as well as in other products) may drive further consolidation." - Source Citi
Lower repo, lower Net Interest Margins, lower profitability and Return On Equity (ROE). That simple.

On top of that we read that Fitch Ratings has released a report, “Corporate Bonds and Fire Sale Risk: Repo Collateral Pools Highlight Liquidity Issues ” that examines the composition of corporate bonds that are pledged as collateral in the tri-party repo market and the potential for forced sales of securities during periods of market stress and here is a summary of the findings:
"•A significant maturity mismatch exists between the short-term repos, over 70% of which mature in 5 days or less, and the long-term corporate bonds being financed. This could create risks as a withdrawal of repo funding can lead to the forced selling of collateral.

Dealers post a significant amount of bank and other financial institution notes and bonds as collateral, exposing them to wrong way risk. About 29% of the corporate collateral that Fitch studied was from banks and other financial institutions.

•Liquidity is low in some of the bonds posted as collateral, as determined by trading frequency. Almost 30% of the bonds in the Fitch study traded on less than half of trading days in 2014." - source Fitch
It will interesting to see how the LCR included in the BASEL III proposals is going to "operate" given the dwindling Repo markets and the consequences on more friction and less grease in the financial markets during the next financial crisis. 

Given the balance sheet intensive nature of fixed income trading and the elimination of the favorable risk-based capital treatment of repo and banks' holdings of Treasuries and agencies under the risk-based capital rules in the US, we do not think the United States will be spared, though less exposed than Europe.

The bond market repo activity is facing an increasing number of failures (fails to deliver are on the rise exponentially) due to the large FED holding, which has ripple effect on the overall bond market activity, hence increased volatility.

A smoothly functioning repo market is vital to the health of markets. Remember financial crisis are always triggered by liquidity crisis.

  • US Interest Rates and the US Corporate pensions gap
Or why the Fed has painted itself into a corner...and has to raise interest rates.

In our November 2014 conversation "The Golden Mean" we argued the following:
"What our "wealth effect" planners at the Fed should take into account is that rising stock prices may do relatively little to bolster the finances of corporate pension funds. Bonds matter because increases in projected distributions put even more pressure on yield hunting leading to an increase in duration risk exposure and high yield exposure. Volatility in funds’ asset value and relatively low interest rates have made managing pensions increasingly difficult for corporate managers, one of the solution they have found is shifting into bonds and away from stocks. Of course if the "magicians" at the Fed had respected the "Golden Mean" and prevented past and present excesses, funding gaps and overall pension pressures would have been avoided in the first place, but we are ranting again..." - source Macronomics
As a reminder from our conversation "Goodhart's law" in June 2013:
As indicated by CreditSights in their 29th of May 2013 Asset Allocation Trends - 2012 Pension Review:
"Key among the prevailing market realities in the post-financial crisis environment has been the extended period Quantitative Easing and the continuation of the Fed's prevailing zero interest rate policy and in the latest year's plan asset allocation data there was evidence of the effect this was having. As noted above, historically low interest rates have not only inflated the calculated liabilities of pension plans via the downward pressure on interest rates, they have also deflated assumed plan asset return rates as fixed income has increased as a percentage of plan assets." - source CreditSights.
We remember as well the observations from our good credit friend in 2013 from our conversation "Simpson's paradox" in July 2013 following the "Taper Tantrum as the Fed tries to re-establish somewhat the "Golden Mean":
"Economic growth in a society based on consumption requires credit. In order for credit to grow, or in other words banks to lend, collateral must be available. Since the 2007-2008 financial crisis, high quality collateral has slowly but surely become less available. If Central Banks continue to buy various government bonds (and US Treasuries are among those bonds), the available collateral will trend lower and the economy will stall, or worst spiral down as a credit crunch will occur at some point. So the FED has no other choice than to slow and even stop its QE if it wants the game to go on."
Hence the importance of maintaining "grease" or repo in the financial system!

In our conversation "Supervaluationism" we indicated a CITI report showing that outflows from Equities to Fixed Income have been lessened by the proposed update in mortality tables:
"What could curtail outflows from pension funds from Equities to Fixed Income could come from Updated Mortality Tables according to another CITI report from the 10th of April:
"The Society of Actuaries released drafts of proposed new mortality tables (RP- 2014) and mortality improvement scales (MP-2014) that provide the basis for determining pension liabilities. These are significant updates.-The new tables and schedules increase life expectancy at age 65 by 2.0 years for males (from 84.6 years to 86.6 years) and by 2.4 years for females (from 86.4 years to 88.8 years).-The previous set of mortality tables was published in 2000 (RP-2000), and the most widely used mortality improvement scale (Scale AA) dates back to 1995.We have estimates that longer life expectancies resulting from the updated mortality tables will increase the value of pension liabilities by 3% to 10% depending on the nature of the plan and prior assumptions.-If we take Aon Hewitt's estimate of a 7% increase in plan liabilities, that would reduce funded status by approximately 6%, or about half of the improvement experienced in 2013.-Plan durations should extend, but we do not have good estimates of how much.With lower funded statuses using the updated tables, it is likely that de-risking flows from equities to fixed income will be lower than they otherwise would have been under the previous mortality regime." - source CITI" - Macronomics, February 2015
The Society of Actuaries updated the mortality tables end of October 2014. These tables are used by pension plans to project the life expectancy of plan participants and beneficiaries to reflect that people are living longer. For example, average life expectancy for a 45-year-old has increased from 83 to 87. When fully implemented over the next few years, the new tables are expected to increase pension plan liabilities by an average of 6-9%. The issue of course is that these pension plans remain underfunded.

On this specific matter we read with interest CITI Equity Strategy note from the 11th of June entitled "Pension Comprehension in 2014":
  • "Despite the S&P 500’s 11.4% gain in 2014, low interest rates and higher longevity tables pressured corporate pension and Other Post-Employment Benefits (OPEB) funding status in 2014. Notwithstanding the S&P 500 tripling off of its 2009 lows, corporate pension funds remain underfunded with a $389 billion underfunded status in 2014, still fairly close to 2012’s peak of $452 billion. Surprisingly, pension funding dropped to 81% of obligations at the end of 2014, down from 88% in 2013, but it was up from 77% in 2012.
  • Funding status comparisons are not apples-to-apples in 2014. The Society of Actuaries’ update to private pension plan mortality tables (Retirement Plan-2014 “RP-2014”) led to a one-time significant increase in pension liabilities. While adoption of RP-2014 is at the discretion of the plan sponsor, US GAAP requires a “best estimate” for assumptions and the current tables were well accepted. Accordingly, this “one-time” hit to funded status aligned liabilities with the actuarial organization’s best estimates.
  • Robust free cash flow, earnings and cash holdings alleviate some of the unease surrounding pension funding. Investors have been concerned about pension funding levels since 2007-08, but corporate cash flows provide comfort as companies have the ability to make large contributions to pension funds.
  • After edging higher in 2013, the discount rate fell back to 3.92% in 2014, causing pension obligations to swell. The present value of corporate pension obligations is heavily influenced by interest rates and thus lower yields typically cause deterioration in funding status. While forecasts for higher yields in the future should lead to decreased concerns over the underfunded status of US pensions, OPEB accounts remain significantly underfunded as corporations attempt to shift these costs on to individuals. The value of OPEB underfunding at the end of 2014 grew to $196 billion vs. $181 billion in 2013.
  • All ten S&P 500 sectors remain underfunded, with Energy continuing to be the least funded sector. Health Care and Industrials saw the largest drop in funding status amongst the sectors. As the overall S&P 500 pension funding status has declined, it is worth noting that only 21 companies within the S&P 500 were fully funded at year-end 2014, with nearly half of the overfunded companies coming from the Financials sector. Notably, the number of fully funded companies was down sharply from 51 companies in 2013.
  • S&P 500 pension plans’ allocation to equities slid down to 44.5% in 2014 from 46.9% in 2013. The equity allocation increased most within the Consumer Discretionary and Utilities sectors in 2014, while Consumer Staples, Health Care, and Telecom Services saw a sharp pullback along with Industrials and Energy.
The drop to 81% of obligations at the end of 2014, could be link, we think to the amendments in Mortality Tables which is in fact increasing liabilities of the pensions over the long term by an average 6 to 9% as stated above.
"Pension under-funding continues to be a major issue for S&P 500 constituents even after some of the intense investor scrutiny back in 2008 and 2009 softened to some extent in 2011 as markets improved. Nonetheless, very respectable equity market gains over the last six years have not substantially alleviated pension pressures.
The S&P 500 was up more than 201% at the end of 2014 since the low in 2009 but the aggregate underfunded status of $389 billion in December 2014 is now 26% higher than the $308 billion under-funding peak seen in December 2008 (see Figure 1).

While the funding status in 2013 improved by more than $225 billion versus 2012 alongside strengthening equity market performance and a higher discount rate, this trend reversed in 2014. Specifically, revised longevity tables and lower interest rates contributed to the reduction in 2014’s pension funding status." - source CITI
So we are wondering where is indeed that famous "wealth effect" thanks to QE and ZIRP for US future retirees. Definitely not in US pension plans.

The reason? The lack of conviction from Pension funds in believing in the much vaunted "Great rotation" story as discussed by CITI in their report:
"Pension funds have been unwilling to allocate assets towards stocks after two major equity pullbacks in the past 15 years clobbered pension programs leaving allocators and consultants relatively risk averse with liability driven investing taking over the mindset. Moreover, current ERISA requirements call for companies to keep enough short-term cash and equivalents available to pay out current pension liabilities. Fortunately, corporate cash flow, free-cash flow, earnings and cash holdings are at or near record highs making required cash contributions to pension funds a much more manageable expense for S&P 500 constituents. Note that the funding status at 81.2% declined from the 87.9% level seen in 2013, which was the best reading in six years, but remained markedly better than 2012’s 77.3%, which was the weakest point since 1991." source CITI
Cash is king it seems...

But moving back to the Fed's "pensions plan" conundrum lies in the nefarious effects of ZIRP as clearly indicated by CITI's report:
"Meanwhile, persistently low interest rates on long-term bonds translate into lower discount rates for determining pension obligations, making the actuarial assumptions for the present value of these obligations appear larger than if discount rates were more in-line with the long-term average." - source CITI
Exactly, with updated mortality tables and continued ZIRP, US corporate pension plans are struggling in achieving their targeted rates.

They also added:
"S&P 500 constituents’ pension plan allocations to equities edged down to 44.5% in 2014 from 46.9% in 2013, yet remain better than 2008’s 43.7% (see Figure 8) and far below 2007 levels of 61.3%. 
However, much of the gains from 2008 would have been attributable to the increased value of equity assets within corporate pension portfolios relative to overall holdings rather than new equity-oriented allocations. Interestingly, flows returned to bond mutual funds, as released by ICI, which saw more than $43 billion flow into bond funds last year (and inflows of roughly $40 billion so far this year), US pension funds followed suit with fixed income allocation increasing by more than 3% (see Figure 9).
Moreover, defined benefit plan managers were net buyers of bonds in the last three quarters in 2014 but they have not started to buy equities just yet (see Figure 10). 

The shift to equities increased most notably within the Consumer Discretionary and Utilities sectors in 2014, while Consumer Staples, Health Care, and Telecom Services saw a steep decline in allocation along with Industrials and Energy over the past year. Fascinatingly, the funded status deteriorated for every sector in 2014, with Health Care and Industrials highlighting the weakest sectors but once again, the actuarial adjustments may be playing a role here as well. The 2014 data compares unfavorably to 2013 data, where the funded status for all ten sectors improved. However, the key difference may have been the effect of the near 30% return for the S&P 500 in 2013 versus the more modest 11.4% gain experienced last year.
As Figure 11 shows, the greatest under-funding can be found in the Energy sector followed by Telecom Services and Materials as well as old-line Industrial/manufacturing equities that have accrued large pension obligations due to long-term operations. However, in order to fund pension obligations, these companies must begin to get pension expenses under control lest their products lose competitiveness versus international peers due to higher prices.
The expected pension return rate for S&P 500 constituents continued to decrease in 2014 (see Figure 12), sustaining the trend which has been in place since 2001.
We are not that surprised by the continued decrease in pension return rate expectations in 2014 given low yields from “safe” Treasury instruments which are looking riskier now." - source CITI
The law of diminishing returns it seems...Note as well the impact the Great Financial Crisis (GFC) has had on the funding status for Telecom Services. One word: brutal.

Of course our "wealth effect planners" at the Fed are indeed in a bind given the asset side of the pension story as clearly illustrated by CITI in their most interesting report:
"Bear in mind that the stock market is crucial to the asset side of the pension story (see Figure 18).

Since we envision only modest mid-single digit gains from current levels through mid-2015, it will not close the gap entirely. The most significant impact on pensions will come when interest rates move higher, thus reducing the present value of future pension obligations, which will accelerate the timeline of fully funded status. With roughly $755.1 billion of pension assets in stocks currently (assuming the year-end 2014 figure appreciated by roughly 1% thus far in 2015 using the S&P 500 Index as a benchmark), there would need to be a more than 50% upward move in equity markets to close the $390 billion funding gap without an increase in discount rates to decrease the pension obligation. Thus, it will be more of a gradual move even as significant progress has been made in spite of investor anxiety over the pension issue from time to time." - source CITI
So go ahead dear Fed, damn if you do raise interest rates, damn if you don't. When it comes to US pension plans and their large exposure to credit and given the lack of liquidity and the dwindling repo market, it seems there are indeed larger issue at stake, no offense to our Greek readers, than the closure of the Third Punic War in Europe it seems.

  • Final chart: In High Grade, liquidity is coming fast at a premium
With Repo levels falling and liquidity concerns in conjunction with oversupply in the primary markets, US Investment Grade Credit as we posited in our last conversation "Eternal return" is fast becoming a "crowded" trade we think and we are not the only one given's Bank of America Merrill Lynch's take from their Situation Room note from the 15th of June entitled "Bonds 0 - CDS 1":
"Liquidity at a premium
With Fed liftoff fast approaching and increasing long term interest rates, liquidity conditions in the high grade corporate market are worsening. Our view remains that the unintended consequence of the intended consequence of financial regulation (the decline in dealer balance sheets, Figure 10) is that liquidity conditions in the market deteriorate. 
However, so far this effect has been masked by inflows – hence the change as this year the credit market makes the transition from inflows to outflows. We are about to feel the true extent of the unintended consequence of financial regulation – namely the collapse in liquidity." - source Bank of America Merrill Lynch
In this context, and as per our last conversation "Eternal return", we expect volatility in the Fixed Income space to continue to rise. In our May conversation "Cushing's syndrome" we asked ourselves:
"On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured.
 In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out." - Macronomics, May 2015
In these jittery markets, no wonder giant fund manager BlackRock has therefore been forced to "recalibrate" its VaR models as described in Bloomberg by Eshe Nelson in her article from the 15th of June entitled "Bond Swings so Extreme Even BlackRock rewrites Risk Measures":
"BlackRock is testing how risky its holdings are by running them through new worst-case scenarios that assume more volatility and varying correlation among asset classes. And strategists at JPMorgan Chase & Co., the world’s biggest debt underwriter, now see the need to calculate a “liquidity premium” for top-rated, longer-maturity government bonds in Europe, a new wrinkle for benchmark securities that are considered the safest assets available because of their deep markets.
The selloff is “questioning what is the right price given the current illiquidity in these asset classes,” said Nandini Srivastava, a global market strategist at JPMorgan in London. The difficulty in assessing the amount of risk “exacerbates the problem as you have investors on the sidelines thinking ‘Are these really the right prices and yield levels?’”
Volatility Surge
Yield volatility on 10-year bunds has climbed to nine-times its average during the past 15 years, giving traders a taste of the turbulence European Central Bank President Mario Draghi said June 3 they should get used to as the byproduct of record monetary stimulus.
A measure of 30-day volatility on bunds surged to 300 percent in May. It hadn’t gone above 100 before this year, in data compiled by Bloomberg going back to the middle of 2005. The market’s gyrations are being magnified by record-low yields: In the week of Draghi’s remarks, yields soared 0.36 percentage point, the biggest jump since 1998. The yield was at 0.82 percent on Monday at 1:30 p.m. in New York, up from a record of 0.049 percent on April 17.
“Investors should be pricing in more risk,” said Grant Peterkin, a money manager at Lombard Odier Investment Managers, which oversees 161 billion Swiss francs ($172 billion). “Given bonds steadily rallied for a long period of time, the low volatility suggested they were low risk, which potentially forced investors to buy more of them.”The danger is that this kind of instability may seep into other assets, he said. This could pressure companies as well as governments with rising borrowing costs. Yields on junk bonds around the world have collapsed to about 6.6 percent, versus their average of 9.7 percent since the end of 1997, according to Bank of America Merrill Lynch index data.
Risk Measure
Citigroup strategists are recommending investors measure their vulnerability by placing more emphasis on duration -- a gauge of a bond’s sensitivity to interest-rate changes -- and the amount a country has borrowed, in addition to volatility, according to Alessandro Tentori, head of international rates strategy.
BlackRock is testing how its holdings would perform in scenarios like the dislocation in peripheral debt in 2011 and 2013’s taper tantrum. It’s also looking at how they’d react to sharp moves in the Standard & Poor’s 500 Index.
“It’s challenging, particularly when the correlations change, that’s the most difficult thing,” Thiel said." - Source Bloomberg
Credit bubbles generated by ZIRP will not preserve equity, nor US pension plans rest assured as per the conclusion of  our November 2014 "The Golden Mean" conversation and Poincaré's recurrence theorem...

"The only good is knowledge, and the only evil is ignorance." - Herodotus, Greek historian

Friday 12 June 2015

Guest Post - US Dollar Upside & Under-priced Financial risks

"Only those who will risk going too far can possibly find out how far one can go." - T. S. Eliot, American poet
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 US Dollar Upside risks and under-priced financial risks:
(Notes to Readers Source for all charts: Rcube, DataStream, Bloomberg, Fred, BIS)
Has the second upleg in the US dollar already started? Is the FED, reassured by the recent batch of positive data, about to raise interest rates into what still looks like a slowdown. If so, how will emerging market corporate borrowers and global investors react to both a rising US dollar and rising interest rates?

Because the dollar remains the undisputed global unit of account in debt contracts, a significant rise in the US currency automatically tightens financial conditions for non‐US based borrowers. This is why the supply of dollars measured by the twin deficits is such a great leading indicator for EM assets. We believe that this mechanism is probably the most misunderstood and underestimated financial risk today.

As the dollar rises, and global financial conditions consequently tighten, global growth slows down, re‐enforcing the dollar strength. This negative feedback loop is where our scenario diverges from the consensual bullish outlook currently held by investors.

As we have repeated many times, 9 trln US dollars have been borrowed by non‐US corporates over the last decade, more than half by EM‐based companies.

Bond issuance by nonfinancial corporations outside the United States have been rising at 15% per year on average for more than 7 years in a row. This is historical.

A large part of that borrowing has been contracted by commodity or commodity related sectors.

The vicious part of the current cycle is that these companies are now facing a double hit. As the Chinese investment cycle slows down…..

commodity prices weaken.

In parallel, monetary policy divergences boost the US currency, which mechanically depresses commodities.

The impact of China’s slowdown on global growth further accentuate the dollar rise. This negativefeedback loop has been in place since 2011 (mostly centered around EM currencies) and has started to accelerate in Q3 last year. Japanese and European QEs have been obviously adding fuel on the fire.

If rates start rising, on top, all non US‐based borrowers will be facing higher borrowing costs (weaker local currencies and higher US reference rates), at a time when the redemption wall will hit borrowers. The BIS estimates that about 700bln us dollars need to be refinanced every year in the next three for EM corporations. This is already massive but imagine what might happen if suddenly global investors risk appetite deteriorates.

During the commodity boom years (China’s investment bubble 2000/2011), EM corporate credit risk improved meaningfully, allowing them to borrow massively. As a result, deposits at local banks surged, creating a domestic lending boom to borrowers that could only rely on bank loans for credit. The risk now is that as the cost of the existing stock of debt rises (higher yields, weaker currencies and deteriorating credit risk), large companies draw their deposits at local banks to pay down their maturing debt (even more so if the rollover window closes down). This mechanically tightens the local credit channel because banks’ loan to deposits ratios surge, forcing them to significantly cut lending. The tightening is already observable:

Since 2000 the average duration of emerging market corporate bonds has doubled, moving from less than 6 years to more than 12 years today. This means that investors who have poured more than 2.5 trn US dollar into these bonds are now much more sensitive to US rates than in the past.

So the main question that we have to answer is where is the US dollar heading from here?

We believe that a disorderly unwind of the 9trn carry trade is not a remote possibility any longer but a real threat.

Dollar yen has once again broken out on the upside after a 5 months consolidation.

Commodity currencies are also accelerating lower.

EM currencies’ down trend is intact.

The supply of dollar is shrinking at a time when the demand for it is surging. Notice how in the past 50 years, each time the supply of dollar shrunk, the most leveraged economies peaked. Latin America in the early 80s, Japan in 1990 , Asian economies and Russia in 1997/98 and in 2007 the US housing crash. We believe EM corporates are the most likely candidate this time around.

This is bearish for EM assets

990 on the MSCI EM is a key level. We believe that if the index breaks below, 900 will be tested and broken soon after.

The risk regime we are in at the moment has been showing signs of fatigue since last summer.

Corporate credit spreads have bottomed in July last year,

so did currency and interest rates implied volatilities.

Equity market breadth is slowly deteriorating, while valuations are historically very high. As an example German mid‐caps that we consider as a global benchmark because of their exporting feat trade at 2.5 times book value. Last time they reached that level was in 2007 and 2000.

The pattern of financial intermediation has radically changed over the last 10 years. The most important protagonists for credit availability are now private investors as opposed to banks. This is why we believe that investors’ sentiment has become so important for forecasting risky assets’ expected returns.

The signs of changing risk behavior mentioned above should be taken seriously. Already, financial conditions are slowly tightening while economic momentum is decelerating.

Our VIX model has its fair value more than 100% above spot level. This is the largest mispricing in
more than 30 years.

Long Dollar remains a key investment theme, together with the conviction that risk is now severely underpriced. We are therefore buying VIX forwards (4th contract), in addition to adding a long USDJPY to our long USDNZD.

"Living at risk is jumping off the cliff and building your wings on the way down." - Ray Bradbury

Stay tuned!

Tuesday 9 June 2015

Credit - Eternal Return

"There are no eternal facts, as there are no absolute truths." - Friedrich Nietzsche
Watching with interest the renewed gyrations in the bond markets rendering balanced funds "unbalanced", with the continuing Greek tragedy in true Nash equilibrium fashion wondering if indeed the Euro prisoner will eventually defect, we reminded ourselves of the "Eternal Return" concept when choosing this week's title analogy. Eternal Return is a concept of eternal recurrence, where time is viewed as being not linear but cyclical. The concept of cyclical patterns is very prominent in various religions and philosophy throughout history. In addition to religion and philosophy, the concept of "Eternal Return" can be found in French mathematician Henri Poincaré "recurrence theorem", a harmonic oscillator being a good illustration of his theory. His theory states that a system whose dynamics are volume-preserving and which is confined to a finite spatial volume will, after a sufficiently long time, return to an arbitrarily small neighborhood of its initial state. "A sufficiently long time" could be much longer than the predicted lifetime of the observable universe or current "credit cycle" which has been prolonged by central banks' liquidity induced "overmedication" we would argue.

On a side note, we will at the end of this week delve into more details into the US dollar upside risk and underpriced financial risks courtesy of our friends at Rcube Asset Management in another post. We will as well be travelling to Hong-Kong between the 23rd of June and 30th of June and won't be posting at this time. If you would like to meet up with us in Hong-Kong, get in touch.

The current gyration and volatility in interest rates is a reminder as well of our fear linked to "Aerolastic Flutter" which we touched in our conversation "The European Flutter" back in December 2011:
"An Aerolastic Flutter is a self-feeding and potentially destructive vibration where aerodynamic forces on an object couple with a structure's natural mode of vibration to produce rapid periodic motion. Flutter can occur in any object within a strong fluid flow, under the conditions that a positive feedback occurs between the structure's natural vibration and the aerodynamic forces. That is, the vibrational movement of the object increases an aerodynamic load, which in turn drives the object to move further. If the energy input by the aerodynamic excitation in a cycle is larger than that dissipated by the damping in the system, the amplitude of vibration will increase, resulting in self-exciting oscillation. The amplitude can thus build up and is only limited when the energy dissipated by aerodynamic and mechanical damping matches the energy input, which can result in large amplitude vibration and potentially lead to rapid failure." - source Wikipedia
Also, in our previous "Hooke's law" conversation, (when it comes to oscillation analogies), we argued:
"Given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates."

In similar fashion to Poincaré's recurrence theorem, in mechanics and physics, the return to the mean in financial markets is a given as displayed in Hooke's law of elasticity:
"In mechanics and physics, Hooke's law of elasticity is an approximation that states that the extension of a spring is in direct proportion with the Load applied to it. Many materials obey this law as long as the load does not exceed the material's elastic limit. Materials for which Hooke's law is a useful approximation are known as linear-elastic or "Hookean" materials. Hooke's law in simple terms says that strain is directly proportional to stress." - source Wikipedia.
Therefore it appears to us that it validates the concept of cyclical patterns hence our title "Eternal Return" as an appropriate title for this week's chosen analogy.

In this week's conversation we will look again at what can be learned from the ongoing "japanification" process for credit markets as well as why convexity is starting to bite credit and why M&A marks the end of the "goldilocks" period for Investment Grade credit. We will also look at the ongoing "de-equitisation" process through leverage and buybacks and the instability it creates.

  • The "japanification" process and its impact on credit markets
  • Credit - When convexity is starting to bite credit
  • Investment Grade is becoming less and less attractive courtesy of M&A
  • The ongoing "de-equitisation" process through leverage and buybacks
  • Final chart: QE has been a "high beta game" in credit
  • The "japanification" process and its impact on credit markets
While we have discussed in numerous posts the "japanification" process in Europe, particularly within the financial sector, we read with interest the latest Société Générale Cross Asset note from the 2nd of June 2015 entitled "What global markets can learn from Japan". Similar to what we posited in various conversations the on-going "japanification" process has been a "goldilock" period for credit as an asset class:
"Can Europe’s credit market turn more Japanese?
Lowflation environment to remain supportive for European credit. 
Europe is still in the middle of the credit cycle: Like for Japan, investment is still low. GDP growth is likely to stay near its long-term potential rate at a low level. As a result, we don’t expect strong inflation pressure in the next 12 month, and with the help of the ECB, interest rates are thus going to remain lower for longer.

Corporate behaviour similar to Japanese firms: default rates to stay low
The recent behaviour of European companies has been similar to that of Japanese firms during the lost decades. European companies, faced with limited growth prospects, have cut capex, so leverage has declined. Cash as a percentage of assets has risen. The combination means that default probabilities have fallen, and default rates are well below long-term averages. This should continue to be a positive driver for European credit in the next 12 months, as lending conditions should remain easy (cf April 2015 bank lending survey).

Comparison with Japanese spreads: further tightening possible
European spreads to benchmark remain wider than the pre-2007 average. Japan shows how much tighter European spreads can go if this environment of low growth/low capex/low inflation/low rates persists. In the report “What turning Japanese actually means for European credit”, our credit strategists highlight that European credit could see a further decline in spreads (left chart), but also a tightening in the range of spreads (right chart).
- source Société Générale
Of course we are not surprised by this analysis given this is exactly with what Nomura discussed at the time which we agreed with in our April 6th 2012 conversation entitled "Deleveraging - Bad for equities but good for credit assets", particularly in the financial sector space:
"-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.
We even played the "high beta" game of going long on some subordinated French BPCE Tier 1 debt bonds paying a coupon of 12.5% in October 2011 as confided in April 2014 in our conversation "The Shrinking pie mentality":
"When it comes playing credit, we have to confide that, indeed we did participate and bought some junior subordinated debt from a French bank in October 2011 at a cash price of around 94.5 for a perpetual bond paying a nice 12.5% coupon seeing it rise meteorically to 138 cash price, a 46% appreciation with limited volatility, hence applying our lesson learned from the Japanese experience thanks to our continued study of central bank magic...
In the case of credit, if indeed the ECB does indeed embark on QE, another big beneficiary will no doubt be in the financial bond space " - Macronomics, April 2014
Indeed QE has provided additional support to the High Yield/High Beta space in Europe providing much more "stability" in 2015 than in the Investment Grade space, which as of late has been on the receiving end of the volatility in the European Government bond space as indicated by Société Générale in their weekly credit strategy note from the 5th of June. The latest bout of volatility has finally shown signed of fatigue in the credit space:
"Uncertainty and fears of the worst will not leave credit unscathed:
The credit markets, both cash and synthetics, have put in a very resilient performance over the past few weeks despite increasing volatility in the rates world. This week however, credit has come under slight pressure. The primary markets have been disappointing (unsurprising given the sharp swings in the swaps market) and the iTraxx indices broke through the ceiling of the recent trading range, with the X-Over rising above 300bp and cash starting to feel soft towards the end of the week. Worst of all, total returns turned negative as stability in spreads and carry earned was not enough to offset the sharp Bund yield swings. Going forward the market has little else to focus on but Greece. In our view, if the worst comes to pass, all markets will come under pressure but we suspect credit will be among the most resilient and the first to recover. After all, even a Greek exit will do little to change corporates’ ability to service their debt and we believe high beta (and high yield) will post the best performance albeit after a period of high volatility." - source Société Générale
Of course it is not yet a case of "Eternal Return" being put to the mean reversion test, but, should the volatility continue in the Government bond space, it will in the near term put upward pressure on credit spreads for both cash and synthetic indices such as the Itraxx Crossover (High Yield) 5 year CDS index taking the brunt of the widening stance we think as long as the GREXIT is "avoided".

Should the GREXIT materialise, given the Itraxx Main Europe 5 year CDS index is the proxy for investment grade and includes 21 banks out of 125 names, it would then face "harmonic oscillations" in the process.

On a side note, the Itraxx Crossover 5 year CDS index, the "proxy" for High Yield, does includes two Greek companies, OTE and Hellenic Petroleum out of 75 entities within the Series 23 index which was implemented in March this year and rolls every 6 months. Also the US equivalent to the European CDS investment Grade index, namely the CDX, does not include banks. The Itraxx Main Europe 5 year index is therefore a good "macro" hedge instrument for investment grade exposure to a potential GREXIT scenario playing out à la Poincaré...

Moving back to the impact of QE in Europe on credit investors, in similar fashion than it did in the US it will push investors down the "quality" spectrum further as indicated in Société Générale recent Cross-asset note:
 "QE will push investors lower down the quality curve
  • Disappointing Q1 due to heavy supply: The outperformance of the sovereign benchmark vs. credit in Q1 15 reflects the huge change in the supply/demand balance of sovereign bonds that ECB QE created vs. heavy credit issuance levels.
  • The QE rebalancing effect will support higher-yielding, lower-rated credit: High-yield bonds should be boosted by QE rebalancing effect, which intensifies the search for yield. EUR BBBs have tightened the most in percentage terms this year, and our credit strategists believe high yield has strong potential to improve. In particular, demand for yield should extend to single-Bs this year and make them outperform.
  • Is the IG honeymoon over? In March 2015, over €1trn of European investment grade corporate debt was yielding less than 1%, and over €500bn yields less than 50bp. Since June 2014, IG spreads have tightened in Europe vs. the US, the UK and EM. This trend may now have run its course as some investors could start rebalancing overseas if yields diverge further. In addition, given the low level of sovereign yields, highly-rated credit could suffer from wider spreads due to the zero lower bound constraints (see “A corporate is not a custodian: how falling government yields could hurt credit”) and the return of very high levels of issuance remains a risk. Additionally, while spreads have been resilient in recent weeks, the sovereign bond sell-off has affected IG total returns which turned negative in May, while HY remained resilient." - source Société Générale.

As we pointed out in our conversation of October 2014 "Actus Tragicus", from an "interest rate buffer perspective" and  "credit risk", though the releveraging has been more advanced in the US. US Investment Grade has so far been a "better" defensive play than European Investment Grade. Dollar credit was hugely popular with European investors in January and February this year, but, with the on-going Greek tragedy playing out, fund flows have slowed significantly for both High Yield and Investment Grade as indicated by Bank of America Merrill Lynch Follow the Flow note from the 5th of June entitled "No Flow":
"More uncertainty, weaker flows
Fund flows have slowed down significantly recently. The Greek debt saga and the recent bund sell-off, mixed with challenging market liquidity, have put a strain on fund flows into risky assets. Fund flows have been relatively muted over the past week with high-yield fund flows at the lowest - in absolute value terms - in 32 weeks. A similar picture is seen for high-grade, equity and commodity funds. Only government bond funds have seen some pick up on their (outflow) pace.
Investors have taken a wait-and-see stance amid Greece. Our “flows strength” indicator below shows lethargic flows over the last few weeks. In our opinion, should the recent rates moves and risks around Greece not abate, flows will struggle to gain momentum despite the ECB QE."

High grade fared slightly better than other asset classes but flows still halved from last week to $256mn. The same went for equities, with its inflows also halving to $781mn, mimicking the behaviour at the beginning of the sell-off in April. Government bond funds registered outflows at $730mn, the largest in three weeks. Money market fund outflows also soared to a three week high. Fixed income fund flows were down by over $1bn.
On the flip side, ETF fund flows fared better, both in high-grade and high-yield credit." - source Bank of America Merrill Lynch
Another case of cyclical pattern in the current "Eternal Return" environment we think.

As we pointed out in our conversation "The camel's nose" in March this year, in the credit space, it has indeed been back to "beta" and QE will no doubt accentuate this trend (provided a GREXIT is avoided...):
"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." - Macronomics, March 2015
In terms of "Total Return", this trend has been confirmed by Société Générale from their latest cross-asset note with High Yield faring much better than Sovereigns with the on-going volatility:
- source Société Générale
The weaker macro outlook as part of the "Japanification" process has been highly supportive of credit and the continuation of lower yields and a continuation of the "High beta" game. When it comes to High Yield price behavior CCCs continue to be the canary in the credit coal mine as they were in 2014 during the second semester as we pointed out in our conversation "Wall of Voodoo", (even single Bs weren't spared). So, you should watch closely this "rating" bucket as a "risk indicator".

Given the recent "weakness" in credit as indicated above, this brings us to our second point relating to convexity and of course bond volatility

  • Credit - When convexity is starting to bite credit

  • Obviously, the mechanical resonance of bond volatility in the bond market, is indicative of the "Eternal Return" concept and mathematically of Poincaré's "recurrence theorem" in the sense that  "convexity" is becoming a sell-fulfilling prophecy issue. We discussed that very subject in our June 2013 in our post tapering" conversation "Singin' in the Rain"  relating to the sell-off in EM.

    Let's move on to the underlying issue of "convexity":

    Like a spring severely coiled, when volatility is released, the destructive energy is massive because of convexity as indicated by our friend Martin Sibileau on his Popular Macro blog which unfortunately was turned off:
  • "Technical aspects that may matter tomorrow: While the Bank of Japan seems to have failed to control market forces, the Fed appears to have won the repression battle. However, there is an aspect that may be out of their reach: Convexity. The reach for yield (i.e. greed) has been such a powerful force that the rumor is that approx. only 15% in High Yield and 50% in Investment Grade portfolios are rate hedged.
    Remember: When an investor wants to be long credit risk only, as the yield is driven by: US Treasury yield + swap rate + credit spread or Libor+ credit spread, said investor will buy the credit (i.e. bond, loan) and sell the rate, to keep only the credit spread. 
    But if only 15% and 50% of positions in HY and IG are rate hedged, if Ben triggers a sell off in credit with the insinuation of tapering, the dealers on the other side, making the bid for the investors, will be forced to do the rate hedge their investors did not do, because they must be interest rate neutral! That means selling US Tsys for an average of 85% and 50% of positions in HY and IG respectively! In other words, the potential sell-off tomorrow may trigger a surprising self-feeding convexity. How are precious metals to react in such scenario?" - Martin Sibileau, Popular Macro blog
    So all in all this is the perfect storm because market makers are running inventories at 2002 levels and they are always interest rates neutral...You buy a bond from a mutual fund, you sell treasuries, feeding even more the rising pressure on treasuries yield to rise further if there is a sell-off in credit funds...
    There is no place to hide except cash at the moment and in dollars...(or shorting treasuries for the  short term tactical braves out there...we like the ETF TBT out there as of late...)." - Macronomics, June 2013
    Of course, what we are seeing as of late is exactly what has been playing out in the rates space, hence the recent "performance" of the ETF TBT and our nose bleed on our long duration exposure (attenuated by our short JPY stance...). 

    • As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower will be larger because to avoid paying negative rates, investors have either taken more duration risk or more credit risk!

      So, should the volatility in the bond space continue in conjunction with a materialisation of a GREXIT, you could indeed face Poincaré's "recurrence theorem" and a vicious risk-reversal in illiquid secondary markets.

      As we posited in our conversation on the 13th of June 2013 "The end of the goldilocks period of low rates volatility / stable carry trade environment?":
      "The huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space."
      It looks like we could face both possibilities.

      When it comes to "balanced funds", due to rising correlations, you have both core European Government bonds and equities getting punished at the same time these days.

      In addition to what we posited in our last conversation "Optimal bluffing", when it comes to liquidity and US treasuries, there is a case of "Eternal Return" aka "mean reversion in US Treasury liquidity ratio which is creating this mechanical resonance of bond volatility in the bond market. This is also ascertained in Socété Générale cross-asset note:
      "Liquidity decline: a factor of volatility in global bond markets
      • A structural decline in liquidity… Since 2008, liquidity conditions deteriorated markedly in sovereign markets. This results in part from the changes in the structure of financial markets, including the impact of tougher regulations for banks and institutional investors, and the growing share of mutual funds. One measure of liquidity, the “liquidity ratio”, declined sharply in major bond markets, including the US. For instance, the liquidity ratio of US Treasuries (measured as the annual volume traded by US primary dealers, divided by total outstanding amounts of US Treasuries) declined sharply (see chart below from our Quant analysts).

      Moreover, liquidity in bond futures has also declined.
      • ...reinforced by unconventional monetary policy: As a result of central bank asset purchases, the liquidity of these markets has been further impaired (via a reduction in net supply and the implementation of one-way trades). For example, a study from the BoJ shows that liquidity in the JGB market has been declining since autumn 2014 (when the BoJ stepped up its QQE).
      • Lack of liquidity to amplify future volatility spikes: Shallow market depth could cause sharper volatility spikes in the future, echoing the Japanese bond crash in 2013 and the flash crash on USTs last autumn." - source Société Générale
       - source Société Générale
      Indeed a clear case of "overmedication" courtesy of central banks meddling with liquidity, in conjunction with much tighter regulations and their "unintended consequences".

      This overmedication has come hand in hand with a case of "indigestion" as of late when it comes to new issuance activity. The "indigestion" has been indicated in Société Générale's Credit Market wrap-up from the 26th of May in their note entitled "The risks to the credit markets":
      "We’ve written before about how €48bn in a month is an extremely high figure for the euro IG markets and has only been seen before in January 2009, the best month on record so far. But at the time, coupons were around 6%+, while now they are generally around the 1% mark, and volumes have been very high in recent years. As the chart below shows, a high level of net issuance has not been an obstacle for spreads until now.

      As we mentioned last Friday, even with IG issuance currently €45bn+ ahead of last year, we do not expect a very large widening on account of very high levels of issuance. These strong volumes may come as US corporates continue to flood the euro markets (today it was Eli Lilly’s turn – see below) and other non-eurozone corporates also come to raise funds. But we suspect that levels of issuance would have to be extremely high for a long time to trigger a sustainable and substantial widening trend.
      Further down the line, there are more risks such as higher M&A activity, especially from US corporates targeting euro corporates. There is the risk of rising releveraging as the economy strengthens, and there is the prospect of the lower limit problem, although that has faded.
      There is the risk of an EM sell-off, and there is still the unresolved situation between Russia and the Ukraine as well as an economy that remains fragile with very low levels of inflation and high unemployment. But these are risks to be explored another day." - source Société Générale
      In our recent "Chart of the Day - S&P500 - Leverage and performance", we mused around the "spicy" cocktail of buybacks/M&A at the high of the cycle financed by debt in true "Eternal Return' fashion.
      This is indeed a sign for us that the Investment Grade rally of the last few years is getting exhausted we think. We will look at this in our next bullet point.

      • Investment Grade is becoming less and less attractive courtesy of M&A
      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:
      Looking back on how our Rcube friends' "Global Credit Channel Clock" operates, it does seem indeed that the US has been moving faster towards the upper left quadrant of the clock, namely re-leveraging and weakening balance sheets overall. While buybacks are great at driving multiple expansions as we have argued, the overall objective and courtesy of the "wealth effect" thanks to central bankers' generosity, is of course to enable CEOs to reach for incentive-based pay structures, it is human nature after all. And what has happened in the last few years courtesy of Central banks generosity has been the multiplication of carry trades in various segments of the market. The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years is coming to an end.
      Leveraged players and Carry traders do love low risk-free interest rates, but they do love even more low interest rate volatility. This is  the chief reason why over the past couple of years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks, driving risk premiums to absurd low levels (as per the levels touched in the European government bond space...). With rising interest rate volatility, you can expect leveraged players, carry traders and tourists alike to start feeling rather nervous.

      Another "great anomaly" that investors should take into account is that low volatility stocks have provided the best long-term returns such as "Consumer Staples".

      The releveraging of US corporates means it is getting more and more late in the credit game, M&A being the last manifestation that we are indeed entering the last inning of the play we think as indicated by Société Générale in their June 2015 M&A update entitled "A powerful M&A wave":
      "One of the main surprises for investors is that M&A generally happens when valuations are high. Unfortunately, when valuations are very attractive, companies, investors and banks are not comfortable enough to face M&A risks despite the attractive prices. M&A tends to happen close to the peak of the cycle, when confidence is high among investors and companies are struggling to organically deliver the solid EPS growth expected by the market." - source Société Générale
      Eternal Return at play and usual "cyclical" behavior we would argue.

      When it comes to "releveraging" and has per the "Global Credit Channel Clock" of our friends, US companies are moving firmly into the upper left quadrant meaning to US that one can expect US M&A activity to pick-up following the "exhaustion" of multiple expansions through buybacks financed by cheap credit. This is also Société Générale's take from their latest bespoke M&A June 2015 report:
      "US companies look set to be particularly active.
      As described later in this report, we believe US profits have probably peaked and EPS will fall this year. Earnings pressure is intensifying on the back of rising wages and slower top-line growth. In 2014, companies mainly resorted to share buybacks to continue to generate EPS growth. But there is a limit to how much of that they can do, since the buybacks are financed via debt, as SG’s Global Head of Quant Research Andy Lapthorne has demonstrated. Companies are now seeking out transformational deals and also are keen to use their sky-high valuations to efficiently finance deals. We think this should prompt more US acquisitions, including acquisitions in Europe. In our view, the time is ripe for M&A activity in light of where we are in the profit cycle, as US companies have an opportunity to benefit from the recovery in European profits, starting from weak levels. According to Moody’s, US companies have over $1.7trn in cash, $1.1bn of which of which is sitting in Europe and cannot be brought back to the US as it would be taxed upon repatriation. These assets offer a very low yield in cash and any acquisition should improve their returns.
      The main factors that could potentially reduce the strength of this M&A wave are, in order
      • A stock market downturn, particularly in the US, where the market looks at risk because of stretched valuations.
      • A slowdown in the major economies.
      • A sharp rise in interest rates, making financing more difficult and the deals less attractive."
       - source Société Générale
      Of course, most acquisitions are often over-valued as they are often made at the top of the cycle, when valuations are excessive and when stocks already include hefty premiums. When companies have access to plentiful and historically cheap funding there is a risk that they use it in ways that support shareholders while making their credit profiles more risky. This is the case today.

      You cannot escape the cyclicality of the "Eternal Return":
      There are trends occurring in the US credit markets that have historically been associated with a credit cycle that is reaching maturity:

      • significant bond issuance
      • low spreads 
      • weakening of covenants, 
      • declining credit ratings, 
      • increase in M&A activity, 
      • less favorable use of proceeds from issuance

      As pointed out by JP Morgan in our conversation of October 2014 "Actus Tragicus":
      "-In US High Grade markets the credit cycle is the most advanced, with increasing cash going to shareholders, rising leverage and increasing M&A.-In US High Yield credit metrics are eroding modestly alongside new-issue quality, but robust corporate liquidity supports continued low default rates.
      -In European HG leverage remains near historical highs, as the economic recovery has struggled to gain momentum. Companies are being conservative with dividends and M&A.
      -In European HY markets companies are reducing debt but revenue is declining at about a similar rate, such that credit metrics are struggling to improve.-In EM HG the rise in leverage has been driven by quasi-sovereigns where government policy remains a variable, but non-quasis have been stable.
      -In EM HY credit fundamentals have weakened with slow GDP growth. There is still some pressure from commodity sectors, but maturities are light near-term.
      -In Japan credit metrics are improving sharply with the pickup in growth and weak Yen. Companies are using the improved cash flow to pay down debt." - source JP Morgan
      Also as indicated in our May conversation "Cushing's syndrome", we believe that the Investment Grade market, particularly in the US, with the start of this M&A wave is moving clearly into the final inning given the lack of investment in CAPEX means that corporate CEOs are using M&A following multiple expansions through buybacks as indicated by Bank of America Merrill Lynch's recent HY Wire note from the 6th of May entitled "Collateral Damage Part I":
      "Perhaps a better place to see the true health of the US economy, and further see the psychological impact of the Great Recession, is by looking at the behavior of corporate CEOs. We wrote last March our expectation for CAPEX to remain deflated for the foreseeable future. Why spend on the potential for growth when you can acquire proven growth? Why increase costs when you can realize cost efficiencies through a merger? In our view the thought process behind this behavior is one of the reasons we have not had a pickup in wages and investment in the future. It also could be one of the key reasons that recovery rates are lower this cycle than during any other period in history- there is little investment in tangible assets. Furthermore, not only are CEOs not investing in growth, but by returning capital to shareholders in order to boost stock returns, they’re inherently diminishing their own recovery values should the business experience trouble. As Chart 9 below shows, as a percentage of operating cash flow, S&P 500 companies today are spending at historically low levels on CAPEX while are near historical highs for dividends and buy backs." - source Bank of America Merrill Lynch
      We concluded at the time:
      "No matter how you want to spin it but given the lack of investment in tangible assets, in the next downturn, recovery rates will be much lower. It is a given."
      Given Investment Grade bonds generally assume a 40% recovery rate for Senior Unsecured bonds when valuing CDS trades, you can probably conclude that CDS levels are somewhat "mispriced", but we ramble again...

      M&A is indeed the last US corporate CEOs' "gameplay". US buy-backs have been financed by cheap credit and large debt issuance as displayed by Société Générale in their M&A report:
      "At this stage companies have used their cash flows for capex and dividends. And their buybacks have been financed by debt.
      This is not sustainable, as it leads to rising indebtedness.
      But we believe we are reaching the limits of this process as companies do not want to endanger their credit ratings and interest rates are starting to rise. Companies are now turning to M&A to boost their EPS. Given today’s interest rates and high valuation levels, to issue more equity companies are traversing a period when M&A has become pretty fashionable.
      This is especially true when the target is a European company, as a US predator benefits from:

      • Top of the cycle valuation levels to issue shares
      • Solid earnings recovery prospects in Europe
      • A strong US dollar
      • Significant cash positions. US companies have rising debt levels but also large cash positions (estimated at $1.7trn). The top 50 cash positions account for around 2/3 of this amount. This largely comes from the technology sectors with the top 5 cash positions (Apple, Microsoft, Google, Pfizer and Cisco) accounting for 25% of the total. These cash positions currently offer very low yields versus what could possibly be obtained from an acquisition.

      The acquisition of truck and logistics company Norbert Dentressangle is an interesting case in point. Norbert Dentressangle and its acquirer, XPO, started discussions very recently as the stronger dollar and weaker US economic prospects prompted XPO to explore a potential acquisition, one that was negotiated in a record time. The surprise is that Norbert Dentressangle is twice as big as XPO and more profitable (XPO incurred a $64m loss in 2014), but currency swings and a-synchronised business cycles created an opportunity." - source Société Générale.
      For those who still believe in a US recovery without significant CAPEX, regardless of the latest Nonfarm payroll number of 280 K, we still believe the recovery in the US is tepid yet, the wage "pressure" from the last unemployment report warrants monitoring. Until it materialises significantly we remain "unconvinced" in the recovery story much vaunted by so many pundits.
       "Why spend on the potential for growth when you can acquire proven growth? Why increase costs when you can realize cost efficiencies through a merger?" - Bank of America Merrill Lynch
      Indeed, the significant increase to expect in M&A in the US will continue to even more weaken US corporate balance sheets as indicated in the upper left quadrant of the "Global Credit Channel Clock" of our friends. This brings us to a phenomenon we have already discussed briefly, namely the "de-equitisation" process and the instability it entails as we will see in our next bullet point.

      • The ongoing "de-equitisation" process through leverage and buybacks
      The "de-equitisation" process is a cause for concern as it creates increasing instability in the financial system. It will as well reduce significantly the recovery value in the next credit downturn with rising defaults we think.

      The issue of corporate balance sheet leverage was discussed in February 2015 in a guest post from good friends at Rcube Asset Management in their post entitled "Equity volatility - Going Higher":
      "Corporate balance sheet leverage
      When corporate balance sheet leverage rises, default probability increases down the line.
      The FED only looks at the difference between internal funds and capital spending. We prefer adding to that equation the net amount of equity issuance (positive when issuance > shares buyback and negative when it is the opposite). The logic is straightforward. Shares buybacks drain liquidity away from balance sheets while share issuance replenishes coffers. When, like in 2007 or today, debt issuance is used to buy back shares, the impact on leverage is very substantial." - source Rcube Asset Management
      Of course we agree with the above debilitating effect on corporate balance sheets. Back in October 2013 in our conversation "Credit versus Equities - a farming analogy" we indicated the following:
      "The increasing recourse towards bond issuing by companies will be increasing "difficulties" at the end of the on-going credit cycle, when entering a recession or depression.
      What has made the resounding success of the US economy throughout many decades was its capitalistic approach and recourse to equities issuance for financing purposes rather than bonds.
      We believe the global declines in listings is indicative of growing instability in the financial system and increasing risk as a whole" - Macronomics, October 2013.

      What is concerning is that ZIRP has accentuated the "de-equitisation process fuelled by "cheap credit". This has also been indicated as well by CITI in their Globaliser Chartpack from the 25th of May 2015:
      "Global equities: more de-equitisation?
      The cost of equity remains high relative to the cost of debt, so it makes sense for companies to de-equitise – use cheap financing to buy back their own shares; our Global Buyback screen features names like L’Oreal, IBM, Apple, Allstate, Boeing, FedEx, Viacom, Aon, and Yahoo!
      ‘De-equitisation is one of the key global investment themes for the next 12-18 months’, avows Global Strategist Robert Buckland, ‘for the cost of equity remains high relative to the cost of debt, so it makes sense for companies to de-equitise – use cheap financing to buy back their own shares. Since 2011, global non-financial corporates have bought back over $2.2trn of their own shares, equivalent to 9% of average market cap over the period. Companies doing buybacks have tended to be strong performers. Our global buyback screen has returned ~14% p.a. since 2000 and is up 3.7% YTD (vs. the MSCI World High Dividend Yield Index (+5.6%) and the MSCI AC World Index (+7.3%). The most represented sector in the screen is Consumer Discretionary (14 out of 50), followed by Industrials (9) and Financials (7). Names like L’Oreal, IBM, Apple, Allstate, Boeing, FedEx, Viacom, Aon, and Yahoo! currently feature’."
      - source CITI
       When it comes to this week analogy and Poincaré's theorem, we concluded our 2013 conversation as follows:
      "We can therefore make this over-simplistic yet provocative conclusion that:
      Equities = Freedom
      Debt = Road to serfdom
      And as we argued before, "there is life (and value) after default!", there is freedom as well.
      So we will eagerly wait for "the mother of all equities bull market" after some much needed "debt" defaults..." - Macronomics, October 2013.
      If there is indeed a GREXIT, no doubt in our mind that after a painful currency adjustment, the Greek equity index will prove to be a return to an arbitrarily small neighborhood of its initial state à la Poincaré, and that hopefully equities will be the road to freedom in a debt liberated economy like Greece, but that is another story.  
      • Final chart: QE has been a "high beta game" in credit
      The "Japanification" process has been highly supportive of credit and "High beta" game in the credit space has indicated by Bank of America Merrill Lynch' annualized total return graph from their Glow Show note from the 4th of June entitled "The Flow Tantrum":
      "Summer Bear Case: growth stall or higher inflation expectations cause markets to rebel against CBs...reversal of performance in HY, high DY, high PE assets causes flash crashes; credit returns have weakened most since taper tantrum - negative (Chart 6); 

      and huge investor fear of illiquidity...the biggest gains in era of excess liquidity have been made in very illiquid assets (Chart 8)"
       - source Bank of America Merrill Lynch

      We believe the US Investment Grade credit game is entering its final inning, as the leveraged players and carry traders are starting to be hurt by the rising volatility in the rates space. It marks the beginning of the end of the "goldilocks" period for credit. Caveat creditor...
      "The glory that goes with wealth is fleeting and fragile; virtue is a possession glorious and eternal." - Sallust, Roman historian
      Stay tuned!

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