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!

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