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!

      No comments:

      Post a Comment

      View My Stats