Thursday 20 August 2015

Credit - Magical thinking

"Once to every person and nation come the moment to decide. In the conflict of truth with falsehood, for the good or evil side." - James Russell Lowell, American poet
Watching with interest the rising tremors in the markets current fault lines with the fragility in credit markets now spilling into the equities space, we reminded ourselves of the definition of Magical thinking for our chosen title analogy. In clinical psychology, magical thinking can cause a patient to experience fear of performing certain acts or having certain thoughts because of an assumed correlation between doing so and threatening calamities. Of course, magical thinking is creating fear in our "omnipotent" central bankers, who have indeed gone a little bit too far in their sorcerer's apprentice experience with their buckets of liquidity and their beliefs in real economy recovery with their numerous QE "healing rituals", but, we ramble again...

Whereas "Magical thinking" is most dominantly present in children between age 2 to 7 years old, it is interesting to see that according to developmental psychologist Jean Piaget's theory of four developmental stages, children during the stage of his Preoperational Stage of development are not able to use logical thinking. And, according to Piaget, children within this age group are often "egocentric", believing that what they feel and experience is the same as everyone else's feelings and experiences. In similar fashion our central bankers believe that what they feel and experience when it comes to the much vaunted "economic recovery" is the same as everyone else's feelings and experiences. We beg to see it differently. To paraphrase Star Wars, Jedi mind trick only works on the weak minded, same goes with central bankers talk.

In this week's conversation we would like to point out again the worrying deterioration in the overall global demand picture with the continuation of EM FX onslaught, deterioration in credit metrics with rising leverage in the US as well as outflows in credit funds in conjunction with significant widening in credit spreads, which explains why in the recent conversations we have indicated why we did put our deflation hat back on, meaning an increase in our US long duration exposure (partly via ETF ZROZ).

  • In US credit, net debt continues to rise at an unsustainable rate
  • End of the day when it comes to credit and default, what matters is "leverage"
  • The deepening "commodity rout" is a cause for concern credit wise
  • Final chart: LatAm FX weakening with commodity prices
  • In US credit, net debt continues to rise at an unsustainable rate
In this conversation, once again we have decided to focus on the credit cycle and where we stand when it comes to the "Global Credit Channel Clock", as designed by our good friend Cyril Castelli from Rcube Global Asset Management:
In early 2014 we indicated our long duration exposure, which we partly played via ETF ZROZ as an illustration of us playing and understanding the "macro" game. Given we think the US is moving firmly into the higher quadrant, we have increased our exposure once more to US long government bonds. 

Also in September 2014 we indicated the following in our conversation "Sympathy for the Devil":
"Whereas Europe sits more closely towards the lower right quadrant, it is increasingly clear that the US is showing increasing leverage in the corporate space, indicating a move towards the higher quadrant on the left of the Global Credit Channel Clock we think. What we have been seeing is indeed a flattening yield curve in the US with re-leveraging courtesy of buy-backs financed by debt issuance which is the point we made in last week Chart of the Day." - Macronomics, 9th of September 2014
We have long argued that in the US the credit channel clock has been ticking at a faster pace, as indicated in our October 2014 conversation "Actus Tragicus":
"The goldilocks period of "low rates volatility / stable carry trade environment of the last couple of years is likely coming to an end as we move in the US towards the upper quadrant of the "Global Credit Channel Clock".
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...)." - source Macronomics, October 2014
What we are seeing recently is indeed we think a clear move towards in the upper quadrant with a flatter yield curves, a widening in credit spreads and a very weak tone in the carry players space, namely Emerging Markets (EM). When it comes to the previously discussed "releveraging" taking place in the US corporate credit space, we read with interest Société Générale Global Equity Market Arithmetic note from the 17th of August entitled "Above the results din, US corporates continue to pile on the debt": 
"Despite all the excitement surrounding the Chinese currency devaluation overall global developed equity markets finished the week only 0.2% down. The real volatility however was to be seen in Asia ex Japan and more broadly Emerging Market equities and currencies. The MSCI EM Index fell 2.4% during the week and is now down over 20% from last August’s high.
It would appear then that US investors in particular are reasonably sanguine about the risks associated with a slowing China and declining commodity prices. However as we have highlighted before, counter-cyclical positioning is not confined to EM and commodities. The Global Semiconductors index, for example, has fallen in lockstep with Global Energy sector over the last three months and tellingly high yield corporate bond spreads have been markedly wider over the last couple of months – see chart below.

With the US reporting season largely complete, we have taken a quick look at what has been going on under the hood. These numbers all exclude financials. Net Income growth has fallen by just over 10% YoY largely as a function of the weakness in the energy sector , it is only slightly down once energy is excluded. However ex-energy profit momentum is weakening when you compare 12 months trailing profits growth in Q2 versus Q1.
Revenue growth is up a robust 5% ex-energy, driven by strong sales growth in the likes of Apple and Amazon. However it is also heavily affected by M&A, primarily among healthcare stocks. Meanwhile dividend growth is up a robust 12% per annum (including or excluding energy) – and while net buybacks are slowing once you include energy, they continue to rise when you don’t. More worrying though is that net debt continued to rise at around 20% pa." - source Société Générale
 A 20% rising rate for net debt is clearly "unstainable" unless you are affected by "Magical thinking". We believe the on-going widening in credit spreads warrants close monitoring.

We note as well the arguments made by Bank of America Merrill Lynch in their Relative Value Strategist note from the 20th of August entitled "Stocks, HG, HY: Unhappy in their own way" where they make the point that credit does not always portend doom for stocks:
"Unhappy in their own wayHappy families are all alike; every unhappy family is unhappy in its own way. The opening lines of Anna Karenina provide an apt metaphor for markets today. Credit has undoubtedly had a very difficult year. Within the asset though, high grade and high yield have each had to deal with their own unique issues. For the former it’s been about immense bond supply (our HG Strategists expect $1.1 trillion for 2015) meeting little demand and the upcoming rate hike cycle. For HY cash, it’s been about the sizable exposure to commodity related sectors and poor fundamentals including increasing leverage and stagnant earnings growth. Equities on the other hand have been frustratingly range-bound. Within the S&P 500, more than 80% of mega-caps delivered earnings beats for Q2, easily offsetting any bad news from smaller companies. On a related note, our Equity Derivatives team has shown how equity inter-sector correlations have been very low, thereby dampening the overall volatility of SPX.
As a matter of fact, it is this relatively low volatility in stocks that there has been much hand-wringing about, standing as it does in sharp contrast to the steady leak wider in credit spreads. And we’ve been fielding many questions on what that ultimately portends for stocks. Our contention so far has been that portfolio matters. We analyzed the seeming divergence between CDX IG and VIX, adjusted for the outliers in IG that aren’t part of SPX, and the gap didn’t look as wide as at first glance. The underperformance of HY relative to SPX seems to be largely Energy driven and HY returns appear to be in line when compared to Russell 2000.
Credit does not always portend doom for stocksThe anxiety among equity investors regarding signals from the credit market is understandable. The most recent memory of a meaningful divergence is from 2008 and that did not end well. But times are different now and we thought we’d look at relative moves between spreads and equity volatility over a longer period. Over the three months to 17-Aug-2015, our HG cash index is 31bp or about 23% wider, the HY index is 104bp wider, also 23%, while the VIX is 1pt higher. The shaded regions in Chart 1 show past periods with similar HG vs. VIX changes, specifically 3m windows over which HG spreads widened by 20% or more and VIX did not increase. 
For HY, we used a lower threshold of 15% in Chart 2 to account for recent Energy underperformance (exEnergy HY is 17% wider over 3m).
Over the last 25 years there have been a number of occasions where spreads have widened substantially without affecting equity volatility. More importantly though, these divergences did not always result in an equity sell-off; equities were up the following month more often than not (Chart 3 and Chart 4).
The S&P 500 return in the month following a HG-VIX divergence was positive 60% of the time and the median return for the index was 0.8%. In the month following a HY-VIX divergence, SPX return was positive 53% of the time and the median was 0.3%. So credit does not always portend doom for stocks. Other than 2007-08 sizable and sustained equity corrections are observed in the late-‘90s/early ‘2000s following a divergence.

It is well possible that the VIX goes up over the next 2-3 months or the S&P 500 sees a meaningful correction. We’d caution against expecting either of these as necessary simply because credit is weak. Credit has been mired in its own problems including dreadful bond liquidity, high supply volumes (HG), sizable exposure to commodities (HY) and uncertainty around what the upcoming hiking cycle means for yields and investor risk appetite. The Fed, China, USD and commodities all remain the inter-connected common catalysts affecting both assets. These factors are more likely to directly determine the fate of stocks in the near-term, than a transmission mechanism through credit." - source Bank of America Merrill Lynch.
We believe that, if indeed, the Fed is not able to use logical thinking and continues with its "Magical thinking" then indeed, regardless of the weaker tone in credit we have been indicating in recent conversations, equities will be in the receiving end and both assets will continue to reprice accordingly.

Of course, for a more severe equity sell-off to materialize you need three deteriorating factors :

  1. Corporate balance sheet leverage, 
  2. Credit availability, 
  3. Earnings revisions.

From the same Bank of America Merrill Lynch note, one can indeed see that so far this year the widening in credit spreads in both Investment Grade credit and High Yield have been significant:

The opposite risk, that of a melt-up on no hike or a hike + very dovish Fed, seems more plausible now. This house is far from constructive on credit, but given valuations and underperformance versus equities there is some chance of a snapback in Q4. CDX option flows, which have had a somewhat bullish tilt even as the indices themselves sold-off, hint that this is the risk that hedges are being set against. Indeed, option implied volatility has been remarkably subdued despite wider spreads (Chart 7 and Chart 8).

 - source Bank of America Merrill Lynch.

Of course a more "dovish" fed could indeed spell some sort of rebound but, this is not the main scenario we are buying and we expect further weakness in the coming weeks when it comes to credit spreads.

We continue to believe that we are coming towards the end of the credit cycle and credit investors have indeed played well into overtime thanks to central bankers' generosity and overmedication. 

This brings us to our second point, namely that "instability" in credit is brewing thanks to the increase in leverage hence the move in the higher quadrant of the "Global Credit Channel Clock". 

  • End of the day when it comes to credit and default, what matters is "leverage"
On this specific matter of rising leverage in the US credit markets, which has been one of recurring theme on this blog, we read with interest Bank of America Merrill Lynch's take on the subject in their Situation Room note from the 17th of August entitled "2Q HG Fundamentals":
"2Q HG fundamentals: Leverage peakingWith the 2Q earnings reporting season mostly over, our estimates show that credit fundamentals of public US high grade non-financial issuers continued to deteriorate during the quarter1. Leverage increased, including outside of the troubled Energy and Basics sectors. This was simply the result of a brisk pace of borrowing outpacing weak earnings growth. Hence net and gross leverage in 2Q increased to 2.15 and 2.62x, respectively, from 2.07 and 2.51x in 1Q-15 (Figure 1). 

After having risen since the end of 4Q-2013, we expect leverage in the high grade market to peak in 2Q or 3Q this year and then decline next year. This the result of more challenging conditions in the high grade market and strong US economic growth.
Cash balances (relative to assets) increased in 2Q while the pace of capex growth declined, suggesting that companies pulled forward borrowing to the second quarter, which likely continued during the summer given the record supply volumes. For issuers outside of Energy, Basics and Utilities YoY gross debt rose 4.0% in 2Q – the highest increase since 3Q-11 – while net debt was up just 1.6% YoY. For the same set of issuers median YoY revenue (0.0%) and EBITDA (0.2%) growth were close to flat, thus pushing leverage higher (Figure 2).

Coverage for the high grade market declined in 2Q to 9.18x from 9.34x in 1Q and 9.78x in 4Q-2014 (Figure 3). 

Liquidity metrics improved, with the cash rising to 4.05% of assets in 2Q from 3.80% in 1Q and the share of long-term debt increasing to 93.5% from 92.9% in 1Q. Revenues declined 2.4% YoY in 2Q while EBITDA rose 0.7% YoY. Gross and net debt increased 4.5 and 4.6%, respectively, over the same quarter last year.
Both net and gross leverage increased in 2Q, rising to 2.15x and 2.62x from 2.07 and 2.51x in 1Q-15. This is notably above the peak 1.98x and 2.46x net and gross leverage during credit crisis in 2009 (Figure 1). Leverage also increased for our control group that excludes Energy, Materials and Utilities. There net and gross leverage were 1.26x and 2.06x in 2Q-15, up from 1.22x and 1.94x in 1Q." - source Bank of America Merrill Lynch
Where we beg to differ with Bank of America Merrill Lynch is that we believe that the strong US economic growth story is more akin to "Magical thinking" hence our current negative stance on US credit. We continue to believe that, in the near term, US rates will outperform US credit. After all flows from the asset class seem to validate our position as indicated in another Bank of America Merrill Lynch High Yield Wire note from the 17th of August entitled "Death by a thousand cuts":
"Flows: Outflows galore
Credit funds reported outflows last week: US HY at -$1.1bn driven by ETFs (-$960mn), Loan funds at -$350mn, while IG funds also came in negative at -$1.1bn. Other fixed income asset classes also experienced outflows with EM bond funds, non-US domiciled HY funds and Municipal funds, all posting outflows. Equities experienced a small rebound reporting +$890mn and commodities also breathed a sigh of relief coming in at +$450mn after a month of consecutive outflows." - source Bank of America Merrill Lynch.
Also, the note indicates that defaults are on the rise which will continue to impact the High Yield asset class as a whole:
"The best of times are behind the market
The basis for our relatively bearish outlook for 2015 stemmed from the realization that the best of times are now behind the market and, with rising defaults and a higher premium demanded for liquidity, that high yield would struggle to maintain any significant traction following a seasonally strong first quarter. 

Headed into the fall, we maintain our view that the best of times are in the market’s rearview mirror and continue to believe that the end of this credit cycle is now upon us. Although it sounds disastrous, we think the end is likely to play out over a long time, characterized by an increase in defaults, likely dominated by commodity names at first, and a slow unwind of crowded trades.
In many ways, this could be more painful than the alternative: a steep cathartic move that cleanses the market. We think the remainder of the year likely experiences further weakness as poor energy performance leaks into the rest of the market, and lackluster global growth and a strong dollar weighs on fundamentals." - source Bank of America Merrill Lynch
As it seems they are indeed different views within Bank of America Merrill Lynch, for choice, we would side with the above given we strongly believe that the ear of "selling" "beta" as "alpha" is coming to an end. When it comes to "Magical thinking" which causes a patient to experience fear of performing certain acts, investors in this case, should rethink their "collective mindset" as aptly described in Bank of America Merrill Lynch's High Yield note:
"The era of indiscriminate beta compression is over
We have had a long-standing view that accounts have shifted their collective mindset from one where they were scared to sell bonds for fear of not being able to buy them back to one where they want to sell positions they don’t view as core long-term holdings for fear of not being able to sell them later. As such, we wrote, the bond market would struggle in 2015 to surpass 2-3% total returns and that there would be more disparity between winners and losers.
Again, we continue to like this theme going into the end of the year as we expect continued bifurcation between credits and sectors. With underwhelming fundamentals serving as a backdrop for higher leverage and increasing scrutiny on earnings (see Telecom recently), we believe those companies that manage to avoid big earning misses or being swept up in the weak global growth and strong dollar environment will fare better than those which are exposed to non-domestic forces or have questionable balance sheets and future growth prospects." - source Bank of America Merrill Lynch
In our September 2014 conversation "Sympathy for the Devil"we argued:
"The continuation in the stability in credit spreads particularly in the High Yield space depends in the continuation of low fundamental default risk. On that subject, leverage matters."
To repeat ourselves, 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...). Now in EM, our "reverse macro osmosis" theory is clearly playing out. 

Forget your "Magical thinking", the credit cycle has reached "maturity" in the US. Meanwhile the continuation of the commodity carnage is a cause for concern credit wise.

  • The deepening "commodity rout" is a cause for concern credit wise
The continuation of the EM FX massacre thanks to commodities tanking and rising US dollar is a cause for concerned for some EM corporates which are directly exposed to these serious headwinds. The recent devaluation of the Yuan has indeed added the proverbial fuel to the fire. The credit impact on over exposed countries will be significant, particularly credit wise with the significant risk of defaults for some. The impact of the Yuan devaluation was indicated in another Bank of America Merrill Lynch note from the 18th of August entitled "Adding Fuel to the Fire":
"CNY devaluation adds fuel to the fireThe extent to which the CNY devaluation last week negatively affects the EM credit market will depend largely on the impact it has on EM currencies and commodity prices. The devaluation will negatively impact countries that have large export exposure to China through their terms of trade, and will most negatively affect commodities that China holds a dominant consumer position in (platinum, iron ore & copper).
Our commodities team expects very different outcomes for commodity prices depending on the size of the CNY devaluation. A small CNY devaluation could actually be positive for commodities (negative impact on USD commodity prices outweighed by stronger domestic demand), while a large CNY devaluation (not the base case) that comes as a result of worsening domestic demand in China, would be much more disruptive to commodity prices. Our estimates are that a 10% depreciation of the CNY could translate to as much as 6% downside to commodity prices. Breaking it down by commodity, a 10% CNY depreciation could imply 5% downside to Brent crude oil prices but as much as 12% downside to copper prices.
From a macro perspective, our EEMEA team expects commodity exporters (Russia & South Africa) to be hit hardest as does our team in LatAm, which see’s Chile and Peru as most exposed given their high level of commodity exports specifically to China. In Asia, activity cycles are highly correlated to China, and Hong Kong, Indonesia, Malaysia and Korea specifically should be the most negatively affected as the CNY devalues.
Last week’s performance showcased that the broad impact the CNY devaluation will have on EM. Chart 3 below shows performance on a country level from 8/10 (deval announcement) through 8/14 for EM FX relative (1wk % spot change, vertical axis) to EM credit (1wk % spread change, horizontal axis). 

Chart 4 below shows commodity exposure of corporate credit markets by country. The most noteworthy take-aways from Chart 3 below are the markets that stand out as highly exposed to China/Commodities, but where credit markets did not react very negatively. South Korea and Chile specifically saw FX depreciation of roughly 1.5%, while credit spreads were nearly unchanged."

 - source Bank of America Merrill Lynch
What is of interest is that not only we have the usual suspects high beta countries in the above chart, but looking at the recent devaluation wave in EM FX land with Kazakhstan recently joining the party, you can expect an additional weaker tone in FX which will lead as well for some to a continuation in spreads widening.

You should monitor the sovereign CDS space as another indicator of more trouble ahead.

Activity in some sovereign names (South Korea, Malaysia, Indonesia and China) is picking up as displayed in the below table from S&P Capital IQ:
- source S&P Capital IQ

Even Saudi Arabia is not spared with its CDS now above 102 bps up on the 20th of August by 22 bps as reported by S&P Capital IQ.

The significant moves in the Sovereign CDS space can be ascertained from the following chart from Bank of America Merrill Lynch Asia Fixed Income and FX Strategy Watch from the 20th of August entitled "Fears Higher than Taper Tantrums":

"In CDS, ASEAN is clearly widened the most (see Chart 6). In the case of Indonesia, the widening of the CDS has been the result of Malaysia CDS widening as well as some spillover from Brazil CDS and outlook downgrade. On the other hand, SBI CDS (proxy to India) has moved little. This also means that if risk off moves were to amplify and correlations start approaching 1, SBI CDS has considerable distance to cover." - source Bank of America Merrill Lynch.
In the coming weeks the Sovereign CDS market in the EM space will have to be watched more closely particularly if indeed there is a Fed hike coming due in September.

This brings us to our final chart showing the relationship between LatAm FX and commodity prices.

  • Final chart: LatAm FX weakening with commodity prices
Whereas Asian countries from a sovereign external debt perspective not in the same situation as in 1998, the vulnerability of certain LatAm countries and default probability (think Venezuela) goes hand in hand with commodity prices as displayed in Bank of America Merrill Lynch Liquid Insight note from the 20th of August entitled "LatAm currency drivers":
"LatAm currency drivers
We estimate how currency drivers have changed in recent years. Commodity prices are important drivers for BRL, COP and CLP, but not MXN. The explanatory power of US interest rates has increased for BRL and MXN. We remain bearish BRL and COP as commodity prices are still plunging. We stay neutral CLP and MXN – we believe they are undervalued based on fundamentals, but exposed to lower copper prices and higher US rates.
Changing currency factors in Latin America
We estimate the main driving factors for Latin American currencies and how they have evolved from 2012 to 2015. The explanatory power of global factors (the US dollar, the VIX index. 10y US rates and commodity prices) has increased significantly for the Brazilian real and Colombian peso. It has reduced modestly for the Mexican and Chilean pesos.
In particular, commodity prices are more important drivers for BRL and COP now than they were two years ago. Their importance for CLP has remained high and stable, while they are not a significant driver for MXN. Our analysis also shows the explanatory power of US interest rates has increased for BRL and MXN, but decreased for COP and CLP." - source Bank of America Merrill Lynch

When it comes to "Magical thinking", we hope our omnipotent central bankers will to use logical thinking as the upcoming rate hike and with our "reverse macro osmosis" theory playing out, it sures look for EM as a US dollar margin call from hell...

"Petroleum is a more likely cause of international conflict than wheat." - Simone Weil, French philosopher.
Stay tuned!

Friday 14 August 2015

Charts of the Day - Positive correlations and large Standard Deviation moves

"The least initial deviation from the truth is multiplied later a thousandfold." - Aristotle

The Charts of the Day we have chosen to display reflects our concerns relating to the relationship between rising positive correlations due to the "divine" intervention of our "generous gamblers" aka "omnipotent" central bankers and the significant rising "instability" à la Minsky it entails. This can be ascertained from the rise in +/-4 standard deviations moves or more in various asset classes. 

The significant rise in these large standard deviation moves can be seen in the chart below from Bank of America Merrill Lynch European Credit Strategist note from the 11th of August entitled "The liquidity paradox":
"Chart 1, above, refreshes our “correction counter” that we first published in May. It sums, over time, the number of instances that assets in our sample register +/- 4SD moves. The chart shows that asset classes more directly impacted by central bank policy (such as government debt and currencies) are indeed seeing a relative rise in the number of “corrections” over time. But assets where central bank policy is a less direct driver of performance (such as equities, where the growth outlook is arguably key) are seeing “corrections” increase in a more linear fashion.Why might the era of high central bank help be, perversely, resulting in more market corrections? We argued in May that the cumulative result of so much monetary policy support is that the market’s emotional gap between fear and greed has narrowed." - source Bank of America Merrill Lynch
This pattern was expected given following the Great Financial Crisis (GFC), positive correlations have been rising between different asset classes, a subject we discussed again in May this year in our conversation "Cushing's syndrome" and leads us to use once more to use the below IMF chart in the light of Bank of America Merrill Lynch standard deviations move chart above:
"Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations. There is a growing systemic risk posed by rising "positive correlations.
Since the GFC (Great Financial Crisis), as indicated by the IMF in their latest Financial Stability report, correlations have been getting more positive which, is a cause for concern:
- source IMF, April 2015
This "overmedication" thanks to central banks meddling with interest rates level is leading to what we are seeing in terms of volatility and "positive correlations", where the only "safe haven" left it seems, is cash given than in the latest market turmoils, bond prices and equities are all moving in concert.
"Positive Correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:
"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson
We could not agree more with the above. Regardless of their "overstated" godly status, central bankers are still at the mercy of macro factors and credit (hence the title of our blog). When it comes to rising risk and the threat of "positive correlations" and Cushing's syndrome we read with interest Nomura European Strategy note from the 6th of May 2015 entitled "At the mercy of macro":
  • "The correlation between macro variables (eg, bund yields, FX and oil) and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. This is the first time this has happened since 2006 and the difference between the two correlations is the largest than at any point in the post 2000 era.
  • The average pairwise correlation between stocks in Europe is close to its post Lehman low. However, we do not think that this heralds the return to some kind of stock-picking nirvana (if such a thing exists).
  • The rapid move up in bund yields and EUR-USD reversals of recent weeks has been felt in some sharp factor reversals, most notably an underperformance of Momentum both across the market and within sectors.
  • We have moved away from a world where changes in macro variables cause short-term rallies and corrections in the overall index level, to a situation where the same macro variables are the driving force for groups of stocks within the market. So understanding the macro risks is no less important. This perhaps represents a market where the main focus is on the nature of the recovery and the timing and type of earnings growth rather than macro developments prompting a continuous existential crisis as we have seen in recent years. We take this as a positive development." - source Nomura
No offense to Nomura but, we do not take it at all as a "positive development". On the contrary, we think it is representative of the excess of "alkaloids" use leading to Cushing's syndrome and rising instability as posited by the great Hyman Minsky." - source Macronomics, May 2015.
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 can be larger..."

There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis.

We would like to repeat what we indicated back in January 2012 in our conversation "Bayesian thoughts" when we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices." 
Expect more violent moves going forward as a consequence. For us, there is no "Great Rotation" there are only "Great Correlations"...

"History has not dealt kindly with the aftermath of protracted periods of low risk premiums." - Alan Greenspan
Stay tuned! 

Tuesday 11 August 2015

Credit - The Battle of Berezina

"The whole art of war consists of guessing at what is on the other side of the hill." - Arthur Wellesley, 1st Duke of Wellington
While monitoring the on-going onslaught in the commodity sphere with significant credit repercussions on Emerging Markets corporates and sovereigns spreads alike, marking the return of strong deflationary forces we think (particularly with the latest PBOC move on the Yuan and yes we are long US duration again...), we remembered for our chosen title analogy the Battle of Berezina which took place from the 26th to the 29th of November 1812 between the French army of Napoleon, retreating after his invasion of Russia and crossing the Berezina, and the Russian armies. During the course of the battle, the French suffered very heavy losses but managed to cross the river and avoid being trapped and annihilated. Since the famous battle, the name "Berezina" has been used in French as a synonym for "disaster". The unfolding commodity bloodbath appears to us as a "Berezina" and if the art of war consists of guessing what is on the other side of the hill, looking at credit in particular it spells a lot of trouble and potential defaults ahead of us, hence our title.

On a side note, looking at EUR/CHF heading toward its highest close in 5 months and the significant $50 bn losses for the first half of 2015 for the SNB, when it comes to our analogy, one has to remember that the four Swiss infantry regiments acted as a rearguard to enable Napoleon troops to cross the Berezina river (of the original 8000 men only 1300 were left by the time of the retreat). The Swiss, in similar fashion to today's SNB actions, suffered terrible losses and out of the four Swiss Regiments of Oudinot's corps, only 300 survived but, nevertheless, they managed to cover the retreat of Napoléon's invasion army. The Swiss heroic stand saved most of the French troops. We wonder if the latest SNB heroic stand saved most of the Euro's retreat but we ironize again...

In continuation to our previous conversation where we indicated that EM credit spreads and oil prices were highly correlated, this week we would like to further our analysis on the ripple effects the commodity market is having on credit as well as the growing discomforting and contagion risks at hand meaning that credit investors should not stay too long on the Berezina side of the CCC bucket or they might indeed face the same fate as the Swiss mercenaries at the famous battle of 1812...

  • Rating agencies oil related price downgrades and more credit troubles ahead in EM corporates land
  • Is credit in earnest starting to see some significant headwinds?
  • The immediate consequences of a Chinese "devaluation"
  • Final chart: Divergence between US and China - How long can it last?

  • Rating agencies oil related price downgrades and more credit troubles ahead in EM corporates land
While in our last conversation we discussed around the exposure of sovereigns and quasi sovereigns to the oil sector  which meant that their credit spreads have moved in conjunction with oil prices, that is wider for spreads, and lower in prices, the updated price assumptions with a significant cut at Moody's which could be followed by S&P could indeed mean trouble down the line, not only for the High Yield sector but as well for Investment Grade credit as described by Bank of America Merrill Lynch in their European Energy note from the 8th of August entitled "Moody's oil move spells potential trouble":
"Oil price assumptions cut at Moody’s; S&P could follow
Moody’s has reduced its base case Brent price assumptions to $55, $57 and $65 in 2015, 2016 and 2017 (from $60, $65 and $75, respectively) and WTI price assumptions to $50 and $52 for 2015 and 2016. Moody’s has also lowered its stress-case scenario oil price assumptions for both WTI, at $40/bbl, and Brent, at $45/bbl. The updated price assumptions represent baseline approximations Moody’s uses to analyse credit conditions of companies in a number of industries and oil exporting countries and are used to calculate future financial metrics. Most vulnerable on the back of this move, in our view, are: (1) OMV hybrids (Baa3 Stb); (2) Origin Energy (Origin) (Baa2 RfD) senior bonds and hybrids; and (3) Repsol’s (Baa2 Neg) senior bonds; hybrids and CDS. It remains to be seen if S&P will follow. This is possible and would be a particularly negative technical for Origin and Repsol, which are both rated ‘BBB-‘ at the agency." - source Bank of America Merrill Lynch.
While indeed these "high-beta" names and bonds are first in the line of this "repricing" oil exercise from the rating agencies, there has indeed been some additional ripple effects from the commodity meltdown to other sectors in the market such as peripheral Telecoms and financials having exposure to the likes of Brazil as indicated by Laurent Beruti on the Datagrapple blog on the 6th of August:

"Yesterday, TITIM’s ( Telecom Italia Spa ) Brazilian subsidiary reported weak results, mainly due to a tough macroeconomic environment. And with mobile penetration rates now over 138% in the country, competition for subscribers will only get tougher. That put TITIM’s 5 year risk premium under a bit of pressure, and it widened by 3bps to 145.5bps. But the real casualty was PORTEL (Portugal Telecom), as retail investors, who had arguably little understanding of the structure under which PORTEL bonds trade since Oi bought the company, are finally realising that they are not Portuguese risk but in fact Brazilian risk, and have been selling them over the last few sessions. TITIM’s results appear to have been the catalyst for more aggressive selling because of the poor outlook for Brazil in general and this drove the bonds 5 to 8pts lower and the 5 risk premium CDS 3.875pts higher to 11.13%." - source Datagrapple blog.
In the CDS space Spanish banks continue to underperform on the back of the ongoing weakness in Latin America.

Brazil is no doubt at the "Battle of Berezina" when one takes into account the latest PMI read from the 7th largest world economy. Brazil's PMI for services was down from 41.0 in June to 40.8 in July, the Brazil Composite Output Index is now at its lowest mark since March 2009. At the same time, Brazil's manufacturing activity contracted for the sixth time in July although at a slightly slower pace than in June: 47.2 in July from 46.5 in June. 

A good illustration of "Berezina" credit wise comes from Brazilian Steel Companies. The tough dynamics of the basic material meltdown continues to weigh heavily on the sector as illustrated by Bank of America Merrill Lynch Emerging Market Corporates note from the 5th of August entitled "Brazilian Steel Companies: The Storm Continues":
"Tough conditions for domestic steelmakers
Brazilian steelmakers continue to face tough dynamics in 2015. YTD (Jun-May), domestic demand is down -11% (flat -13% and long -8%). We believe flat steel demand could fall -15%+ and long steel demand -10%+ in the full year Continued collapse of domestic demand, increasing imports, a higher export mix (low margin), weak pricing (discounts of 5- 10%) and the erosion of EBITDA from iron ore sales have combined to drive leverage on the path to unsustainable levels. Results are also impacted by lower fixed cost dilution and higher energy costs. We expect these forces to persist in 2016. It appears that new equity is needed across the sector to reach sustainable leverage levels, and that debt covenants are at risk at Gerdau and Usiminas. We expect downgrades of credit ratings. We assume a sustainable net leverage level of 3.0x.
Needs are most substantial at CSN and then Gerdau. We estimate that CSN needs R$15.6bn of equity (three times its current market capitalization; 8/4/15 R$4.36/share); Gerdau R$2.8bn (30.6% of current market capitalization; 8/4/15 R$6.04/share), and Usiminas R$1.7bn (25.0% of current market capitalization; 8/4/15 R$4.17/share). Equity injections would be positive for bonds, but negative for stocks. However, we believe that they would be difficult to execute, particularly under the current sector environment and given the amounts required. We also think existing shareholders would be loath to issue such substantial amounts of equity due to the impact on share value and their ownership interest.
As a result, we remain negative on all three names and expect spreads to continue to widen as investors price in weaker results in 2H15, and a continued negative demand and pricing environment in 2016. Spread widening accelerated in mid-June and escalated in mid/late July with CSN’s bonds widening up to +557bp (to spreads as wide as +1,373bp; the CSN-19s), and Gerdau’s bonds widening up to +93bp (to spreads as wide as +617bp; the Gerdau perp’s). CSN has widened most at the short end (on heightened refinancing risk), while Gerdau has widened most at the long end.

We omit Usiminas’ bonds from our discussion as they are limited in size and liquidity. Our recent meetings with over 50 investors in the UK and Europe indicated that bearish sentiment is high and increasing.
Leverage and financial debt covenants
We currently forecast CSN to end 2015 with net leverage of 6.94x, and 7.36x at spot (versus forecast) iron ore prices. We forecast CSN’s net leverage to rise to 7.10x in 2016. We forecast Gerdau’s net leverage to be near flat at 3.61x in 2015 as the company generates cash (3.70x in 2016), and Usiminas’ net leverage to rise to 3.99x (4.45x in 2016). The companies have LTM1Q15 net leverage of: CSN 4.76x/5.51, Gerdau 3.69x and Usiminas 2.89x. While CSN has no leverage covenants, Gerdau has a net leverage covenant of 4.0x that applies to 22% of its debt. Usiminas has a net leverage covenant of 3.5x that applies to 80% of its debt (potentially in danger of breach as soon as 2Q15)." - source Bank of America Merrill Lynch
CSN has no leverage covenant, meaning, there is no limit to it and no warning sign either for the "macro tourist" carry players, who, we think should think about crossing rapidly the "Berezina" bridge or face "annihilation" à la Swiss mercenaries...

When it comes to CSN, the weakest player in the Brazilian Steel Company illustrations, we read with interest Bank of America Merrill Lynch's take, which, we think is illustrative of the "Private Equity" mentality of "maximizing" dividends regardless of the outcome for bondholders à la TXU Corp, a subject we touched in our January 2013 conversation "The return of LBOs - For whom the Dell tolls":
"The paroxysm of the mega-buyout deals of the period was Energy Future, formerly known as TXU Corp which was taken private by KKR and Co. for a cool 43 billion USD in 2007. The deal did not evolve favorably for bond holders given Energy Future is now seeking an extension of maturity for the portion of Texas Competitive's revolving loan that matures in 2013 (2.1 billion million USD of revolving credit facility used in total).  Energy Future Holdings is loaded with 37.4 billion USD worth of obligations whereas Texas Competitive is saddled with 32.2 billion USD in debt, 700 million USD of which is due in 2013, and with 2.7 billion USD in interest payment due in 2014 according to Bloomberg. 
KKR and Co., TPG Capital and Goldman Sachs Capital partners paid themselves 528.3 million USD in fees while TXU Corp is moving towards bankruptcy and restructuring." - source Macronomics, January 2013.
In their note, Bank of America Merrill Lynch clearly illustrate the similar mentality that prevails in the Brazilian Steel Industry:
"In addition, to deteriorating results, companies also have controlling shareholder demands that require dividends and share buybacks. Whereas, in the typical stress situation we would expect a company to eliminate dividends and share buybacks to conserve cash flow and control leverage, we expect these items to be a continued drain, especially at CSN, and to a lesser degree at Gerdau and Usiminas. (See BofAML’s equity report: Brazilian Steels: Controlling shareholders (and companies) need cash. What now? 27 July 2015.)
CSN: SH demands for dividends and share buybacks, cash and weaker results CSN’s controlling shareholder Benjamin Steinbruch (and family) indirectly owns 54.62% of CSN through holding companies. Holdco debt totals nearly R$3.0bn and is serviced primarily with cash flows (dividends) from CSN. Estimated interest expense on holdco debt is approximately R$400mn a year. As a result, holdco debt service pressures CSN to distribute approximately R$720mn in dividends to shareholders each year. We note that CSN paid R$1.67bn of dividends in 2013, R$425mn in 2014, and R$550mn in 1Q15, while results deteriorated and leverage increased. Dividend payouts by CSN have averaged over 70% of net income in the last 10 years.
A substantial portion of holdco debt has been collateralized with holdco-owned shares in CSN. As the value of CSN shares has diminished, lenders have required additional share collateral. This situation has compelled CSN to continue to use cash to execute share buybacks (thereby supporting CSN or collateral share value). Share buybacks totaled R$909mn in 2014 and R$9mn in 1Q15. Management has declined to give share buyback guidance for 2015.
Further the amount of cash reported by CSN in its press release, and which the company calculates net leverage includes cash at Namisa (its iron partnership with Japanese and Korean steel companies). The cash amount used by CSN in calculating net debt and net leverage is R$12.251bn. However, CSN’s balance sheet reports just R$9.071bn of cash, indicating CSN’s proportional share of R$3.180bn of cash at Namisa. CSN calculates net leverage of 4.76x (including the cash at Namisa). Using balance sheet cash, net leverage is 5.51x. The Namisa iron ore assets are planned to be merged with CSN’s iron ore assets by year-end. However, there is risk that substantial cash could be dividended out before the assets are merged. We note Steinbruch’s needs for dividends and share buybacks, as well as the potential that the Namisa partners may also want to withdraw some their proportionate cash.
In 2Q15, we forecast CSN’s EBITDA at R$836mn, up 7.6% QoQ (on better iron ore volumes and slightly better realized iron ore prices), but down -35.8% YoY. We expect FY EBITDA to fall -31.4% to R$3.245bn, and net leverage to increase from 4.48x in 2014 to 6.94x in 2015. Compare forecast 2015 EBITDA to LTM1Q15 interest expense of R$3.046bn and our expected capex of R$1.3bn. On top of these demands, we expect dividends and share buybacks.
Asset sales are also a potential source of cash (and debt pay down) for CSN. We estimate that CSN could realize R$5-7bn from potential asset sales: (1) its 17.5% interest in Usiminas (R$1.0bn), (2) SWT (a 1.1mn ton long steel plant located in Germany) (R$1.0-1.5bn), (3) its 1/3 interest in MRS Logistica (R$1.5-2.0bn), (4) Tecon (a container port terminal located in Santos, Brazil) (R$400-700mn), (5) Metail and Prada (metal packaging and distribution assets (R$250-500mn), and (6) non-core real estate (R$1.0bn). Asset sales could comprise 1/3 or more of potential equity needs in order to reduce leverage to sustainable levels but are not sufficient by themselves. Compare CSN’s equity requirements of R$15.6bn. We caution that CSN could be loath to sell assets at current valuations. Local sentiment in Brazil is that CSN is reluctant to sell assets and may favor a different strategy.
We note that CSN’s debt does not have any financial covenants. Management could pursue a strategy to maintain high cash liquidity and obtain sufficient credit facilities to repay or refinance debt maturities due in the next few to several years. It could secure those facilities (to the detriment of unsecured bondholders) to obtain lower interest rates and longer maturities. We think that this is likely an interest with federal or state banks. If CSN could successfully execute this strategy, leverage (and were bonds trade) could be more or less irrelevant to management in the next couple years." - source Bank of America Merrill Lynch

Can you spell default/restructuring for CSN? Because we can. This is going to be a "Berezina".

This is clearly illustrative of maximizing the dividends payout through leverage (without due covenants) à la TXU and will end up in tears in similar fashion. It is all about "greed" in the end using buyback and poor dividends strategies to maximize the payout for shareholders which in the end will be detrimental to bondholders.

When it comes to Brazil corporates, year to date 13 EM corporates including 6 from Brazil have "paid the piper" compared to only 3 in the first seven months of 2014 according to Bank of America Merrill's EM Corporate Monthly note from the 6th of August 2015 entitled "Between a rock and a hard place":
"Tonon’s default in July takes YTD total to 13
Brazil’s Tonon Bionergia defaulted in July after going through a distressed exchange of $300mn of unsecured notes due in 2020 for new unsecured notes. However, S&P upgraded Tonon to CCC- (from D) 4 days after the closure of the exchange offer, since the refinance achieved more than 95% of bondholder’s acceptance and most of the short term debt was refinanced. S&P now sees upside potential and relieved liquidity pressures in Tonon. The trailing 12 month EM HY default rate ended July at 3.7%, unchanged from the end of June.
YTD, 13 EM corporate issuers have defaulted, which compares to only 3 defaults in the first seven months of 2014. On a trailing 12mo basis, there have been 19 EM HY defaults. Regionally, LatAm accounts for 8 defaults (6 from Brazil alone), while there have been 6 defaults in EEMEA (4 from Ukraine) and 5 defaults in Asia (4 from China). The regional LTM HY default rates as of the end of July were: LatAm HY 4.6%; EEMEA HY 3.4%; Asia HY 3%." - source Bank of America Merrill Lynch
Brazil and Colombia HY were the worst performers in July particularly in the light of heightened downgrade risk on Brazil's sovereign rating on the back of very weak macro data. Whereas 1998 was all about "Asian risk", current tensions clearly shows that the on-going "tapering tantrum" and commodity rout is putting clearly more pressure on LatAm corporates (Energy sector, Materials, Real Estate). As a side note YTD EM HY outstanding corporate debt expanded by 30% due to massive migration from Investment Grade status to High Yield in Russia and Brazil when new supply is down by -43% y/y according to Bank of America Merrill Lynch's note:
"Of the 283 bonds downgraded YTD, 100 came from Russia, 75 came from Brazil, and 29 came from China (combined, 72% of all bonds downgraded YTD came from these 3 countries). There have been 10 upgrades in Russia YTD, 8 in Brazil, and 18 in China (43% of all bonds upgraded YTD)." - source Bank of America Merrill Lynch
When the trend, is not your friend, credit wise, that is...

This brings us to our next bullet point namely the increasing pressure from credit and not only from the previously mentioned CCC bucket, the "credit canary" mentioned in numerous conversations including our previous one.

  • Is credit in earnest starting to see some significant headwinds?
We touched in July in our conversation "A Cadmean victory" on the recent underperformance of credit particularly in the Investment Grade space, with US underperforming Europe overall: 
"From a positioning perspective in an environment impacted by dwindling liquidity and rising "convexity" risk from both a duration and credit quality perspective, we believe in a defensive position in H2 on US investment Grade, meaning lower duration exposure in credit as well as higher credit quality. This brings us to our third point, namely that given the disappearance of interest rate buffers in the credit space, thanks to central banks "meddling" and "overmedication", investors have no choice but to take on more credit risk hence our credit "mousetrap" reference." - source Macronomics, July 2015.
What is interesting of course is that finally 2015 really is a story of the "Great Rotation" when it comes to the outperformance of equities relative to credit as displayed in Société Générale's Credit Strategy Weekly from the 31st of July 2015 highlighting the Total Return performance of equities versus credit:
"Total returns see mixed performance:

This is clearly the year of the European equity markets, which continue to dominate the total return performance table. This week, equities in Europe were a touch lower by Thursday and total returns were down from a week ago, although they remain well ahead of any other asset class (in local currency). US equities improved further but are well behind, and fixed income asset classes had a mixed performance, with most still struggling to get back into positive territory. The Euro IG market remains the laggard at -0.56%, although it has been outperforming its US counterpart recently." - source Société Générale.
But is there something rotten in the Kingdom of Credit one might rightly ask to paraphrase Shakespeare's Hamlet "Equities players" should pay attention to?

Flow wise, it seems that finally the "convexity" pain (namely over extended duration and credit risk investors) continues to bite as indicated by Bank of America Merrill Lynch in their Situation Room note from the 6th of August entitled "Outflows from duration and risk":
"Outflows from duration and risk. For the third week in a row mutual funds and ETFs reported outflows form risky asset classes such as stocks and high yield bonds. At the same time the flows for high grade last week were out of duration and into the frontend as the flows for long-term high grade funds turned negative while short-term funds swung to the largest inflow since November. Long-term high grade funds reported a $0.58bn outflow last week following a flat -$0.01bn reading the week before. More generally flows outside of short-term funds (which also include intermediate and total return funds) declined to +$0.37bn from +$0.92bn the week before. Short-term funds reported a $0.79bn inflow after a $0.54bn outflow in the prior week. This makes last week’s inflow the largest since the start of the fairly consistent outflows from short term funds outflows in December 2014.
The risky asset classes reporting outflows last week included stocks, high yield, loans and EM bonds. Outflows form stocks accelerated to $3.62bn from $2.64bn the week before, while outflows form high yield slowed down to $0.82bn last week from $1.31bn in the prior week. EM also funds continued to report outflows ($0.26bn last week and $0.39bn the week before), while leveraged loan funds turned to outflows (-$0.43bn) following a flat reading the week before (-$0.06bn). Muni funds remained muted with a $0.04bn inflow. The net result was a small $0.27bn outflow from the all fixed income category, which also includes government and mortgage funds. Finally, money market funds reported a $15.03bn inflow." - source Bank of America Merrill Lynch
Of course this should not come as a surprise to us, given that to avoid paying negative rates, investors have either taken more duration risk and/or more credit risk thanks to our "generous gamblers" policies aka our beloved central bankers and their omnipotent powers.

Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:
"In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..." - source Macronomics, August 2013.
As a reminder on how "convexity" can impact the price movement in credit, we followed with interest the situation of Abengoa SA (ABGSM) the Spanish company involved in the Renewable Energy sector which is particularly exposed to Brazil. S&P Capital IQ has an assumed recovery rate of only 30%. As we told you before, we expect recovery rates in the next downturn to be much lower making the 40% overall recovery rate assumption for senior CDS dubious at best. The price action in the bonds are indeed illustrative of how price movement lower can be larger in our days and ages (h/t Credit Macro PM / Bloomberg graph source):
- source Credit Macro PM - 4th of August Twit - Graph source Bloomberg.
Things have escalated quickly since Friday 31st of July poor senior management call with analysts as indicated by Laurent Beruti on his Datagrapple post on the 3rd of August:
"The call between ABGSM’s management and analysts on Friday left the latter scratching their head as the company which previously appeared committed to de-levering announced out of the blue a capex increase and reduced FCF guidance. The communication around how the €500mln bonds due in 2016 will be managed was not very convincing either. Investors pushed the 5 year risk premium 12pts higher to 48.25pts (insuring $1 of ABGSM’s bond against a default costs 48.5cts spot and 5cts per year afterwards) and the 1 year risk premium to 30pts upfront. " - source Datagrapple blog.
In this case while the price movement of the bond is lower, the price of CDS protection against potential default is significantly higher to say the least.

On the 3rd of August Abengoa announced an "out of the blue" rights issue of €650mn, or 30% of market value prior to the announcement (market cap on the 4th of August €1,335mn). This "market surprise" or credit "sucker punch" was reflected by CITI's take in their 4th of August note on the issuer:
"Understanding the right issue:
On 31 July after market close, Abengoa released its 1H15 results, the first set of results under the new management team (both CEO and CFO recently changed). While the underlying business performance operationally looked promising, it was a disappointing performance in terms of credibility on the most important factor for this stock – the balance sheet and in particular, liquidity levels. The company has made enormous progress over the last two years in laying out and delivering on its asset and capex-light deleveraging strategy. However, the significant reduction in FCF guidance as a result of heavily increased capex, has caused the markets (both debt and equity) to once again question the liquidity situation of the group. 
Having expressly stated on the call that the company would not need to come back to the markets (equity and credit) this year, and that liquidity was ‘comfortable’, the group then announced a material rights issue (€650mn or 30%+ of the equity value prior to the announcement) on the next trading day following its results (today, 3 August 2015). The company’s view that liquidity was comfortable was backed up by a detailed disclosure on its €1,330mn of cash and short term investments that was not linked to suppliers (total cash and STFI was €3,095mn). These cash and STFI balances, combined with the (increased) expectations for disposals, and the expected reversal in working capital, inevitably raises the question as to why the rights issue should be necessary if there is not a liquidity situation. 
Moreover, not only did the company state that it did not intend to come back to the market and that liquidity was comfortable, but the company also included a slide in its results presentation showing its assessment of what it considered to be a prudent valuation of the equity, at €8 per share. Accordingly, undertaking a material rights issue at what is likely to be an extremely large discount to that assessment of value (the shares are currently trading post today’s 30% drop at €1.42) once again calls into question those views on liquidity.
We spoke to the company today (investor relations), who stated that while they were indeed confident in their liquidity situation on Friday, they received significant feedback over the weekend from bondholders and investors that a rights issue would calm the speculation over liquidity. However, judging by the reaction of the bonds (and shares) today, it appears that the announcement of the capital increase has in fact had the opposite effect, in making it appear that there is indeed a liquidity situation, hence the need for a rights issue. The company believes that the reason for the negative reaction is that some investors feel that the capital raise may not go ahead, and others that it is not large enough. The company was adamant that the reason for the rights issue was NOT because banks had demanded it. Accordingly, the only reason (short of a genuine liquidity crunch) for the rights issue, is that the company thought that this was what markets wanted." - source CITI
No offense taken on Abengoa liquidity situation given we have heard similar denials before in other circumstances:

"Our liquidity is fine. As a matter of fact, it's better than fine. It's strong." Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002. 

In the case of ABGSM, between Q1 and Q2 has seen a significant increase in CAPEX coming from a major Brazilian T&D project representing a total amount of €2,696mn as shown in CITI's report:
"The key shift in this table is that debt has dropped materially, being replaced by an additional €761mn of equity from Abengoa, hence the significant increase in equity capex laid out at the 1H15 results, partially offset by increased disposals, which led to the significant reduction in FCF guidance." - source CITI

The rub, lies when it comes to "tightening" financing conditions due to higher inflation in Brazil thanks to deteriorating macro as well CAPEX financing difficulties facing further BRL depreciation which will no doubt negatively impact project costs in local currency.

What is of course of interest for us "credit players" versus "equities players" is once again the disconnect between the two markets, particularly given that as indicated by the team behind the Datagrapple blog, when ABGSM announced it had won a €600 million contract for a biomass power station in the UK, the stock surged by  a cool 20%, meanwhile the CDS was unmoved and the price closed on the 10th of August at a nice 60% upfront +5% running spread over 5 year.

You can probably decide who is right when it comes to "pricing the risk" but we ramble again as it seems credit players are more wary of a potential "Berezina" for the bondholders while "equities players" seems oblivious to the market signals reflected in the 5 year CDS prices and the fast deteriorating macro picture in the 7th largest economy of the world.

But, apart from the overly exposed "high beta" peripheral issuers, there is indeed some significant headwinds building up in credit, particularly in the light of the recent weakness in Media shares which saw a significant widening in CDS 5 year spread as displayed by S&P Capital IQ graph below from the 11th of August:

"Media shares fall due to downfall in Disney. Movers include Disney, Comcast, Timewarner and CBS"-  source S&P Capital IQ
The disappointment in earnings seems to have led to the selloff and the credit widening in 5 year CDS spreads. But one indeed might rightly ask if the tone in credit is weakening and not turning sour? On that point we agree with Datagrapple's take from the 7th of August:
"Have tables Started To Turn?
Since the beginning of the summer we have been used to seeing the commodity related sectors underperform consistently the rest of the market. The fall of the commodity prices severely impacted the likes of RIG ( Transocean LTD ), ABX ( Barrick Gold Corp ), or FCX ( Freeport-McMoRan Inc ) and the risk premia of these high beta names were under severe pressure. Since the beginning of the week, there is a new cohort of names which joined the ranks of battered credits: media companies. It started with DIS ( Walt Disney Co ) which reported disappointing earnings raising concerns about subscriber erosion and the long term viability of the cable model, and rapidly spread to CBS ( CBS Corporation ), TWX ( Time Warner Inc ) and today BSY ( SKY pLc ). All of a sudden, it is no longer all about the widest credits, and low beta names appear vulnerable as well." - source Datagrapple blog.
Make no mistake, with China finally joining the currency war, the deflationary forces are indeed more potent than ever making us significantly increase our long US bond exposure. From a contrarian stance, we are also looking at adding from a medium term perspective some Norwegian government bonds in local currency, the rational being that from their macro fundamental long term perspective, NOK seems oversold given Norway can balanced its budget with oil  at $40 USD versus $106 for Saudi Arabia and Russia, but that's another subject we will deal with at a later stage.

This brings us to our third bullet point, namely the immediate consequences of China's latest currency move.

  • The immediate consequences of a Chinese "devaluation"
Back in April 2014 in our Conversation  "The Shrinking pie mentality" we argued the following:
"Reading with interest the latest take on China by both Russell Napier from CLSA in his latest Solid Ground opus as well as Albert Edwards on the similar subject of a potential Chinese devaluation risk which would push the world further into outright deflation, we reminded ourselves of the "Shrinking pie mentality" in relation to our chosen title. Indeed, when the economic pie is frozen or even shrinking, in this competitive devaluation world of ours, it is arguably understandable that a "Winner-take-all" mentality sets in. Shrinking economic growth resulting from the financial crisis means that, from a demographic point of view in Europe with a shrinking working age population, low birth rates and a growing population of older people, it means to us that Europe does indeed face a critical choice: meet their unfunded pension liabilities and go bust, or cut drastically in entitlements in order to compete with emerging countries that don't have these large "legacy" costs associated with aging developed countries. 
When it comes to the benefits of "Quantitative Easing" program which went on in various countries (Japan, United States and the United Kingdom), the possible gains of this uphill battle against strong deflationary trends for a small share of a shrinking pie rarely justify the risks in the long run we think.
In relation to the aforementioned Chinese devaluation, we do agree with both Russell Napier and Albert Edwards that a Chinese devaluation is a strong possibility given that the Chinese have studied carefully Japan's demise from its economic suicide thanks the fateful decision taken to revalue the yen following the Plaza Agreement of 1985 (a subject we discussed with our good credit friend back in March 2011 in our conversation "Fool me once, shame on you; fool me twice, shame on me..."). In its most recent commentary, the US Treasury states that the Yuan is “significantly undervalued” and suggests that it must appreciate if China and the global economy are to "enjoy" stable growth. Unfortunately for the US Treasury the Chinese are not stupid as indicated by this article displaying the Chinese view on the Japanese economic tragedy written in 2003:
"Under US pressure, the Japanese government and banks "honestly" carried out the "Plaza Agreement", starting to interfere the yen exchange market on a large scale together with the US. As a result the exchange rate of yen against US dollars skyrocketed, exceeding 200:1 by the end of 1985, going beyond 150:1 at the beginning of 1987 and nearing 120:1 in early 1988. This means that the Japanese yen had doubled its value against US dollars in less than two years and a half!" - People's Daily, September 23 by Professor Jiang Riuping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing." - source Macronomics, April 2014
What we have argued at the time as well is that devaluating the RMB has much more to do with "Information cascade" rather than pure economic justification:
"The issue we have with Société Générale's EM strategists case that devaluating the RMB would have little economic justification in the current "rebalancing" act, is that increasing disinflationary pressures from outside China might indeed lead it to succumb to "Information cascade" as a cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts." - source Macronomics, April 2014
China has indeed finally decided to join the ranks of the currency wars players we think. At the time we also sided with Nomura's take on the probability of a Chinese devaluation to put our position in context:
"The problem is, however, that the headwinds of deleveraging and the property market correction are so powerful – domestic demand is at its weakest since 1997 – that the economy is unlikely to be stabilised on piecemeal easing measures. Moreover, the potency of stealth-like, piecemeal targeted easing on the real economy has weakened significantly, in our view, even for the sectors (e.g. small enterprises) that the targeted measures are supposed to support.
Should this time window for more traditional wholesale monetary policy loosening be missed, the authorities may eventually be forced to ease more aggressively when the economy is slowing more sharply and edging closer to deflation, adding volatilities to the economy." - source Nomura
This is indeed a materialization of the above mentioned "Shrinking pie mentality". Global demand is weakening and slowing hence the growing temptation in preserving at all costs one's position by using the "devaluation" tool and exporting therefore further deflationary pressure on the rest of the world and Europe in particular. On that case our recent musing on "shorting" the 3 large German automakers as described in our conversation "Ominous Decade" seems more and more relevant in the light of the recent actions from the PBOC.

The 3 Big  German automakers have already conceded significant price discount to revive sales and increased subsidies with affiliates. While luxury brands and their high margins might absorb more easily a drop in the Chinese currency, we think it is therefore going to be more headwinds going forward for automakers and particularly European ones.

As an immediate consequence to the Chinese "sucker punch" move with their currency, our fellow blogger "Sormiou" at Macronomics made a very interesting point when it comes to the widening of the fluctuation band from of the Yuan (CNY) and its impact for exporters to China:
"With rising doubt on future further widening of the fluctuation band for CNY, hedging strategies  for exporters to China (Carmakers, luxury brands, etc.) will have to be "reviewed". One might wonder if we are going to move from a market with zero demand for FX options (cf. CHF market prior to the removal of the peg to the Euro) to a new "real" market for CNY FX options"
CNY 3 month volatility:
 - graph source Bloomberg
An interesting "development" indeed, given that Exporters will have to more and more "mitigate" the fluctuations of the CNY in order to "smoother" their earnings and lower their volatility in the future.

When it comes to EM exposure to China and the "Shrinking pie mentality", with Korea biggest trading partner being China representing at least 25% of their exports, they are indeed in the receiving end of the latest joiner in the "currency wars". While MSCI Emerging Markets is showing some clear downward pressure, we would not be surprised to see the Korean Kospi index seeing increasing downward pressure as well in the coming weeks/months particularly after 6 months of exports contraction. This is well clearly illustrated in Bank of America Merrill Lynch note from the 22nd of July 2015 Korea in Focus entitled "Exports: looking beyond the surface":
"Cyclical export challenges for Korea
Exports, the key driver of Korea’s economic growth, remain challenging from both a cyclical and structural standpoint. The long-awaited tailwind from better external demand remains elusive, as the global economy failed to muddle through hurdles including the jittery Greece. Accordingly, nominal exports contracted 5.0% yoy in 1H15, following two semi-annual growth of around +2.3% yoy in both 1H14 and 2H14 (Chart 1). 

Meanwhile, real exports excluding service produces also plunged into negative territory (-0.9% yoy) in 1Q15, the first merchandise exports contraction since 3Q09 (-0.1% yoy).
Shifting structure of China’s production and trade
Recall that exports to China are predominantly intermediate goods. More than 80% of goods exported to China are used as inputs to produce final goods in the country, be it for Chinese domestic consumption or re-exports from China. This implies that Korea's exports to China are cyclically very sensitive to growth in China, as well as its export destinations, as the demand for intermediates is more cyclically sensitive than the demand for final goods.
Even though China remains the top destination of Korean exports, advancement in China’s domestic manufacturing and technological capabilities continue to put pressure on Korean exporters. According to a report published by Korea Institute for Industrial Economics & Trade (KIET), overall Chinese imports of intermediary goods noticeably decreased from 63.6% of the total imports in 2000 to 48.8% in 2012. This is because both domestic and foreign manufacturers that are based in China are increasingly procuring the locally-made Chinese parts and materials. Accordingly, Korean exports to China of intermediary goods dropped from 84.4% to 72.3% over the same period. In our view, exports to China will proportionally decrease in the long term as the competitiveness of China’s intermediate goods continues to rise.
Another vivid impact of the structural change in China can be found in the change in processing exports. Influenced by the Chinese government’s policy to boost ordinary trade, Chinese ordinary imports have increased from 44.8% to 56.6% over 2007-13, while Chinese processing imports have decreased from 38.6% to 26.8% (Chart 2). 

Meanwhile, over the same period, reliance of Korean exports to China on processing goods barely changed, declining from 54.1% to 51.9%. As the share of processing exports in Korean exports markedly increased, expanding from 0.1% to 7.8% over 2009-14, this slowdown in Korea’s processing exports had a much greater effect on total exports. As Chart 3 shows, decline in Chinese processing imports has translated into a negative contribution in overall exports.
Searching for the silver lining
In 2H15, we see returning growth momentum in trading partners. Our economists expect the US and the EZ growth to expand by 3.2% saar and 2.2% saar in 3Q15, respectively (up from growth of -0.2% and 1.5% in 1Q15 for the US and the EZ). Meanwhile, China growth will likely stabilize at 7.0% yoy for 2H15. In line with these expectations, Korea’s leading indicator for exports is showing a better outlook in 3Q15 (Table 1).

In our view, swift depreciation of the KRW in both bilateral and multilateral terms will likely help boost the exporters’ price competitiveness. Moreover, the recently inked free trade agreement with China should help stimulate Korea's exports and GDP growth over the long term." - source Bank of America Merrill Lynch
Unfortunately we disagree with the above and cannot see a silver lining for Korea particularly in the light of most recent US data as well as the PBOC latest currency weakening move which does spell trouble for the highly export dependent Korea.

To ascertain the return of the "deflationary forces" at play, we read with interest Bank of America Merrill Lynch Connecting Asia note from the 3rd of August entitled "The rise and fall of Asia FX Reserves":
"The final broad implication is the risk of sustained capital outflows due to a Fed tightening cycle (explored in Economic Insight). This could help to reinforce the falling trend in Asia’s FX reserves and result in falling money supply – see front page chart.

This will add to pressure for some Asian central banks to ease. In China’s case it can be achieved only at the cost of a weaker CNY as maintaining a stable CNY implies a contradictory withdrawal of liquidity (as we have argued in Connecting Asia: Contradicting China. This also helps to explain the aggressive policy intervention in the stock market to prevent the amplification of outflows." -source Bank of America Merrill Lynch
This is what we posited in our last conversation "Mack the Knife" and our "reverse osmosis theory explaining our difficult it is for EM countries to currently stem capital outflows:
"Emerging Markets including China are in an hypertonic situation, therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates)." - source Macronomics
We will have to watch closely how effective the latest PBOC actions are in stemming capital outflows but, if indeed our "reverse osmosis" theory is playing out and the Fed effectively starts raising rates in the near term, then you can expect additional capital flows pressure on EM countries, falling FX Reserves as well as weaker money supply growth, therefore weaker growth.

What is at play by China is a "Winner-take-all" strategy which can be illustrated as well by Korea's giant Samsung posting recently disappointing earnings as cheaper smartphones made by Chinese manufacturers are slowly but surely eating away at Samsung's share, like Lenovo is a well eating away Dell's pc market share.

A continuation of a weakening of the CNY will of course accelerate this long term trend which brings us to our final chart, namely the divergence between US ISM services with China PMI manufacturing.

  • Final chart: Divergence between US and China - How long can it last?
Given the weakening tone coming from the Chinese economy compared to the US, as a final note we leave you with Bank of America Merrill Lynch chart from their Liquid Insight note from the 10th of August entitled "Where do we stand?":

"The decoupling trades
The Chinese and US economies have been on diverging paths over the past few months
(Chart of the day). Against this backdrop, it is not surprising that trades designed to profit from this divergence have performed generally very well. Whether it is buying DM equities against selling EM equities, buying S&P consumer discretionary against selling industrials, or buying G3 currencies against selling commodity currencies, these so called “decoupling trades” have generated strong returns with high Sharpe ratios since May." - source Bank of America Merrill Lynch
Given our propensity to be contrarian, hence us having jumped again in the last couple of weeks on the deflationary wagon again, we wonder if we are not going to see some strong rebound at least in the precious metals space and miners alike in the near term...

"Educate men without religion and you make of them but clever devils." - Arthur Wellesley, 1st Duke of Wellington

Stay tuned!

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