Wednesday 30 September 2015

Credit - A couple of charts summarizing recent credit markets violent moves

"The more violent the storm, the quicker it passes." - Paulo Coelho
Interesting entry points in cash bonds, if one believes in continuous Central Banks liquidity support and no recession. 

CDS Indices are finally starting to widen as well this week, but still massively lagging cash bonds recent moves (basis widening). For those with "liability visibility", basis trades are a safer way to play a “corporate bonds European QE” with less risk than o/r cash bonds longs.

Please see below a couple of charts summarizing recent credit markets violent moves via Bank of America Merrill Lynch, global cash bonds charts below (US / EUR / EM - IG &HY): 
- source Bank of America Merrill Lynch

US Investment Grade Index, Cash vs CDS basis :
- source Bank of America Merrill Lynch
As we posited in our last conversation the US "releveraging" has been fast and furious  which is not yet the case in European credit (far less "leverage" and "buybacks").

Therefore on European Investment Grade Credit as well as European High Yield, we have reached some interesting "entry" points when it comes to "cash credit". This could be an enticing play for investors "gutsy" enough to "front-run" a buying spree from the ECB on a much greater spectrum of corporate bonds than just a few issuers (which so far have been included in their buying program). 

Should the ECB decide to "ramp up" its balance sheet and include additional issuers in the corporate world, this would no doubt trigger a bull case for spreads. Of course, a potential rally in European credit would depend on additional "generosity" from our European central bankers, otherwise, the market will continue to struggle.

"I believe that truth has only one face: that of a violent contradiction." - Georges Bataille, French writer

Stay tuned!

Wednesday 23 September 2015

Macro and Credit - The overconfidence effect

"Well, I think we tried very hard not to be overconfident, because when you get overconfident, that's when something snaps up and bites you." - Neil Armstrong, American astronaut
Watching with interest the increasing pressure on Emerging Markets and various asset markets alike with Brazil getting Pink Floyded as "all in all it was just a BRIC in the wall", and with VW being taken to the proverbial woodshed with its market cap decimated thanks to another "Bayesian" movement on both its stock and CDS prices, and us as well, like many pundits, being wrong footed on our Fed 25 bps hike call, we reminded ourselves for this week's title analogy of a well-established bias namely the "Overconfidence effect". 

With this "bias" a person or market pundit's confidence in his judgement is reliably greater than the objective accuracy of those judgements, especially when confidence is relatively high.

Overconfidence effect is indeed a good illustration of "miscalibrating" subjective probabilities (hence a Bayesian outcome in many asset prices as of late...). Truly, last week, our confidence in the Fed exceeded clearly our "accuracy" meaning we were more "sure" than "correct" to say the least.

When it comes to "overconfidence" distinctions, and in relation to the Fed and other "generous gamblers" aka central bankers, one specific "overconfidence" distinction comes to our mind, namely the "illusion of control" which describe the tendency for central bankers to behave as if they might have some control when it fact they have none. 

"Overconfidence" has also been called the most “pervasive and potentially catastrophic” of all the cognitive biases to which human beings fall victim. It has been blamed for lawsuits, strikes, wars, and stock market bubbles and crashes but, guess we are rambling again...

In this week's conversation we are going to revisit once more how the credit clock has been ticking faster this time around courtesy of the Fed, meaning we are indeed very late in the credit cycle with a Fed losing credibility facing weaker global growth and lacking ammunitions apart from launching another round of QE.

  • Default risk is rising, spreads are widening and the price action is becoming "Bayesian" in some High Yield names
  • US corporate leverage is in full gear while US corporate earnings are weakening - not a good recipe
  • Emerging Markets have also been plagued by the "overconfidence effect"
  • Final chart - Annual change in US 12 month forward S&P500 EPS expectations points towards recession
  • Default risk is rising, spreads are widening and the price action is becoming "Bayesian" in some High Yield names
Back in July 2015 in our conversation "A Cadmean victory", we already indicated that the credit channel clock was ticking faster and not only for High Yield:
"Over the course of the summer we expect credit spreads to widen, particularly in the High Yield space. We keep repeating this but in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger."
This of course was not a case of "overconfidence effect" but, from our point of view understanding the "overmedication" in the credit markets.

We also indicated at the time:
"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 as per our previous conversation when it comes to High Yield."
Of course when it comes to High Yield, perception of default risk matters and when it comes to the Energy sector currently in the eye of the storm given the significant fall in energy prices with European coal slumping below $50 and having declined 26 percent so far in 2015, default risk no doubt is rising as indicated by Fitch on the 21st of September in the summary of their latest report:
"Energy TTM Default Rate Approaches 5%; Highest Level Since 1999

•Fitch Ratings’ trailing 12-month (TTM) U.S. high yield par-weighted default rate climbed to 2.8% in August from 2.5% in July.

Default volume exceeded $4 billion for the second consecutive month, an event not seen since June 2009.

•90% of third-quarter default volume is in the energy and metals/mining sectors following the September distressed debt exchange for Halcon Resources and chapter 11 filing for Samson Resources.

•September TTM energy and exploration/production rates will approach 5% and 8.5%, respectively, assuming no additional defaults this month.

Second-quarter leverage (debt/EBITDA) rose to 5.4x from 5.1x in the first quarter, while coverage (EBITDA/interest expense) dropped to 3.3x from 3.5x.

•Leverage and coverage remained essentially unchanged from the prior period, removing the 87 energy and metals/mining companies from the sample." - source Fitch
 As a reminder from our conversation "Blue Monday":
What is of course of interest is that looking at the current default rate doesn't tell you much about the direction of High Yield, as aptly explained by our good friends at Rcube Global Asset Management, entitled "Long-Term Corporate Credit Returns"  in their very interesting previous note:
"Credit investors have a very weak predictive power on future default rates. Benjamin Graham’s famous allegory of a “Mr. Market” who alternates between periods of depression and euphoria applies especially well to corporate credit investors. In addition to having a bipolar disorder, corporate credit investors are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates. " - source Rcube
So all in all, looking at default rates on their own is akin to looking at the rear view mirror for too long while driving on the narrow credit road.

When it comes to convexity and price movement, in our August conversation "The Battle of Berezina", we indicated that we were following with interest the situation of Abengoa SA (ABGSM) the Spanish company involved in the Renewable Energy sector which is particularly exposed to Brazil and that S&P had a recovery value of just 30%. As indicated on the 21st of September by Bloomberg, bonds due March 2021 tumble to 27.7 cents on the euro and the CDS now signals 93 percent probability of default within five years in their article "Abengoa Bonds Fall to Records After Report HSBC Withdrew Support":
"Abengoa SA’s bonds fell to records after a report that HSBC Holdings Plc withdrew support for the company’s planned capital increase.
The Spanish renewable energy company’s 500 million euros ($564 million) of 6 percent notes due March 2021 fell 12.6 cents on the euro to 27.7 cents, pushing the yield to 38.5 percent, according to data compiled by Bloomberg. Credit-default swaps insuring Abengoa’s debt signal a 93 percent probability of default within five years, CMA prices show.
HSBC retracted an agreement to back 120 million euros of the Seville-based company’s 650 million-euro share sale last week, Spanish news website El Confidencial reported today without saying where it got the information. HSBC, Banco Santander SA and Credit Agricole SA had agreed to be standby underwriters of the increase last month, according to people familiar with the matter." - source Bloomberg
A good illustration of the price action can be seen in the below chart from S&P Capital IQ displaying Abengoa SA 8.875% 2017 bond price moves:
- source S&P Capital IQ
Getting closer to "recovery" value...30% that is.

This clearly illustrates our thoughts from August 2013 in our conversation "Alive and Kicking" where 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.
Of course when it comes to the "overconfidence effect", "overmedication"  and credit market in terms of issuance on "steroids" courtesy of the Fed, it can be ascertained from the below chart from Bank of America Merrill Lynch's European Credit Strategist note from the 17th of September entitled "Fed for thought":
"Goodbye to ZIRP…
We think the end of zero rates in the US means the end of credit market “excesses” in the US. During the post-Lehman era, the Fed’s zero interest rate policy was a boon for US corporations. Many took advantage of low rates to releverage balance sheets, fund share buybacks and reward shareholders. The behaviour was reflected in the rapid growth of the US credit market."
 - source Bank of America Merrill Lynch

This is particularly of interest given the potential "outflows" risk and "overconfidence" in market participants in avoiding a disorderly "exit" from their investors given there has been a rising share of funds holding the bulk of corporate bonds over the years as illustrated by Bank of America Merrill Lynch Credit Strategist note from the 18th of September  entitled "Long for longer":
"Forensic flow analysis for 2Q 2015
According to the Federal Reserve Flow of Funds data released today foreigners ($172bn) and mutual funds ($116bn) remained the biggest purchasers of corporate bonds in 2Q 2015, followed by life insurance companies ($14bn) and pension funds ($9bn). Notably purchases by foreigners rose significantly from $80bn in 1Q. Households – a residual category that also includes hedge funds and non-profits - sold $122bn of corporate bonds in 2Q compared to selling a more modest $24bn in 1Q (Figure 16). 

Thus the corporate bond market continued to grow largely based on demand from just two types of investors, both of which to some extent are not long term investors - foreign investors and mutual funds/ETFs. As result mutual funds/ETFs now hold 26.5% of the IG+HY corporate bond market (Figure 17).
 - source Bank of America Merrill Lynch.
As per our previous musings, rising defaults could lead to "availability heuristic" which would entail "overconfidence" failure and disorderly exit and significant outflows in the asset class.

It was therefore not a surprise to read in Bloomberg on the 22nd of September that Mutual funds are facing new rules for preventing investor runs as reported by David Michaels:
  • "SEC commissioners vote 5-0 to propose liquidity protections
  •   Regulation allows bond funds to penalize investors who exit
A hallmark of the $18 trillion mutual-fund industry is that it promises easy entry and exit for investors. U.S. regulators now want new protections to ensure that pledge can be met due to concerns that firms have loaded up on hard-to-sell assets.
The five-member Securities and Exchange Commission voted unanimously to pass a measure Tuesday that addresses criticisms that its rules haven’t kept pace with the evolution of the fund industry. The SEC’s proposal follows warnings from the Federal Reserve and International Monetary Fund that some funds could struggle to meet investor redemptions during a market rout.
Under the proposal, funds would have to maintain a minimum cushion of cash or cash-like investments that can be sold within three days. Funds also could charge investors who pull their money on days of elevated withdrawals.

Protecting Investors

“Changes in the modern asset management industry call on us to now look anew at liquidity management in funds and propose reforms that will better protect investors and maintain market integrity,” SEC Chair Mary Jo White said.
Mutual funds, which are held by 53 percent of all U.S. households, already face a legal requirement to return cash to investors within seven days. In search of higher returns, many fixed-income funds have migrated into riskier debt that doesn’t trade often and could be difficult to sell at fair value during a period of market stress.
A key concern is that any problems will be exacerbated when the Fed raises interest rates, causing bond prices to plunge and prompting fund investors to run for the exits.
The SEC’s plan would force funds, including exchange traded funds, to adopt liquidity-management plans and classify how long it would take to convert positions to cash. Funds would have to hold a minimum amount of cash or cash equivalents, meaning the assets could be sold within three days. A fund’s board of directors would decide what percentage of a portfolio must be easily liquidated." - source Bloomberg.
Welcome to Hotel California Bond funds:
"you can check out anytime you like, but you can never leave"
Of course this is the result of our "sorcerer's apprentices" aka central bankers and their taste for markets meddling on a "grand scale" leading to rising positive correlations (hence the on-going volatility) as well as instability as indicated by "Bayesian" price movements.

The issue this time around is that the US "releveraging" (not yet the case in European credit!) has been on "steroids" and the earnings picture is slowly but surely deteriorating. This leads to our second point about "overconfidence" in leverage and a weakening earnings picture. Caveat creditor...

  • US corporate leverage is in full gear while US corporate earnings are weakening - not a good recipe
On the subject of rising corporate leverage which we previously discussed during this summer, we read with interest UBS take on the subject from their 22nd of September Global Credit Comment entitled "Late Cycle Re-Leveraging: No End in Sight?":
"Late Cycle Re-Leveraging: No End in Sight?
The corporate leverage cycle continues to kick into full gear as late cycle dynamics become more evident. Friday’s data release from the Federal Reserve’s Flow of Funds estimated total Q2 ’15 US Non-Financial Corporate Liabilities at $7.94tn, an 8% Y/Y increase. This increase is starting to close in on growth rates seen in the latter stages of prior credit cycles (10-11% Y/Y in late 90s, 11-12% Y/Y in 2007). This level of debt growth has historically been dangerous, but it wouldn’t necessarily be so if corporate earnings were sufficient to match it. However, US non-financial corporate earnings aren’t just lagging, they are actually contracting, albeit marginally, at -0.16% Y/Y. (Figure 1) 
Weak global growth is a major driver; US non-financial profits earned from abroad (which nearly total 25% of total profits) are now falling at a 5% Y/Y pace. Profits earned domestically also are muted, but they still remain in positive territory, growing 1% Y/Y (Figure 2). 

Further headwinds from a stronger dollar and/or renewed problems out of China/EM would likely exacerbate the situation, though an improving European economy could still act as an offset.
While it may seem surprising that debt growth is accelerating when earnings growth is tepid, this is actually the norm historically. What is not surprising is the impact on credit spreads. Weakening corporate fundamentals will eventually place credit spreads under pressure and this cycle is no exception. We find a strong relationship between the excess of debt growth over earnings growth (Y/Y) and BBB credit spreads over time, including in recent months (Figure 3).
The re-leveraging cycle for now will be dictated primarily by the evolution of M&A activity, which our equity colleagues believe will remain robust. Sluggish earnings will not be enough to upset this trend, in our view; indeed this predicament may even encourage more M&A activity. As earnings struggle and margins reside tenuously at peak levels, we think firms are unlikely to aggressively raise dividends, and buying back stock at more expensive levels is becoming less attractive. With growth opportunities low, the one option left is M&A activity, and shareholders are indeed rewarding companies with higher share prices (both the acquirer and the target). Empirically, we see this as well; M&A cycles generally correspond with either falling and/or weak earnings growth, including in the present environment (Figure 4).
Also, as we wrote in Animal Spirits: M&A Feasting on US Credit, S.Caprio, Aug 2015, we think the Fed is highly unlikely to slow the cycle. Higher interest rates have not impeded past M&A cycles; to the contrary, M&A volume has generally moved in lockstep with higher Fed Funds rates. Last Thursday’s FOMC decision also suggests to us that the Fed will be quite gradual and cautious when it does tighten monetary policy, only responding to very tangible signs of improved growth and rising asset prices, in our view. Hence, the emergence of a more hawkish than expected Fed that chills risk appetite is not probable, in our view. Increased market volatility from events abroad may take froth off the pace of M&A issuance, as they did in late August, but even here, recent large M&A announcements indicate the demand for acquisitions is still there.
All told, US corporate leverage will likely increase further in coming months as the usual dynamics of a late stage credit cycle unfold. We believe this will continue to juice non-financial IG corporate issuance and keep non-financial IG credit spreads at elevated levels for the foreseeable future." - source UBS

It is getting late in the game, when it comes to US credit! This is exactly what we concluded relating to M&A in our June conversation "Eternal Return":
"Most acquisitions are often over-valued as they are often made at the top of the cycle, when valuations are excessive and when stocks already include hefty premiums. When companies have access to plentiful and historically cheap funding there is a risk that they use it in ways that support shareholders while making their credit profiles more risky. This is the case today." - Macronomics, June 2015
Once again, the trends that are occurring in the US credit markets have historically been associated with a credit cycle that is reaching maturity.

Also in our June 2015 "Chart of the Day - S&P500 - Leverage and performance", we mused around the "spicy" cocktail of buybacks/M&A at the high of the cycle financed by debt in true "Eternal Return' fashion.

This was indeed a sign for us that the Investment Grade rally of the last few years was getting exhausted particularly in the US (as a reminder):
  • significant bond issuance
  • low spreads 
  • weakening of covenants, 
  • declining credit ratings, 
  • increase in M&A activity, 
  • less favorable use of proceeds from issuance
The continuation of this M&A wave is clearly indicating that we are moving into the final inning  of the credit cycle. The lack of investment in CAPEX means that corporate CEOs are now using M&A following multiple expansions through buybacks, which are now slowing down. M&A is indeed the last US corporate CEOs' "gameplay".

When corporate balance sheet leverage rises, default probability increases down the line, period.

High Yield earnings are also weakening and so is the global economy outlook. On this specific subject we could not agree more with Bank of America Merrill Lynch's take from their High Yield note from the 17th of September entitled "Global growth concerns spread from us to Fed":
"A slow moving train wreck
Today’s Fed decision was the second worst outcome for risk markets, in our view. We have written on numerous occasions that if the Fed didn’t hike rates today initially markets would rally modestly before selling off. The realization that global growth concerns are not only real, but very dangerous right now should cause a risk off environment. And with no room to cut rates, we question the Fed’s ability to manage any further slowdown through what would have to be QE4. However, we can’t see how additional quantitative easing will help, as the goals of QE have already played out: the banking system has recovered, rates are low, investors have driven debt issuance and asset prices to uncomfortable levels, and the housing market has recovered enough to not be a concern.
Furthermore, lower rates don’t help high yield at this point. Whether the 10y is at 2.20% or 2.0%, does the asset class really look all that more compelling? Not in the slightest. In fact, outside of hiking while sounding very hawkish, not hiking and sounding very dovish while expressing concern about the global economy may be the worst thing that could have happened today.
We have been saying for months that the global economy is weak and the Fed’s dovish disposition today only bolsters our view. Europe is about to enter QE2 as inflation and growth remains poor. Japan and Brazil were just downgraded. Commodities remain under pressure and we think, at some point, the narrative could turn from a supply driven story to a demand driven one. Domestically it becomes harder to argue that a strong dollar and the lack of inflation can be viewed as transitory and this headwind is continuing to hurt high yield corporates. Manufacturing is uneven, consumer spending hasn’t improved in a year, and 2014 real median income was down 6.5% versus 8 years ago (and down 7.2% from the 1999 level). Although auto sales remain strong, we would expect as much given low gas prices, an aging fleet and the fact that auto loans are one of the few places in the economy where it’s easy to obtain credit.
Additionally, high yield corporate earnings remain incredibly weak, with yoy earnings growth negative for the first time since the recession (even ex: commodities EBITDA growth is only slightly positive). Leverage is at all-time highs (again, even excommodities) and the High Yield index is more globally exposed than it has ever been (35% of the market generates 45% of its revenue from outside of the United States, and that doesn’t include Energy, which is globally exposed despite not realizing significant direct sales abroad).
Not only are earnings weak, but there has been next to no capex investment, debt issuance has been massive, and buybacks and dividends have driven equity valuations as CEOs and CFOs, afraid to invest in organic growth, have chosen to buy growth instead. And as a result, recovery rates are 10-15ppt below historical norms and defaults and downgrades are creeping into the market. Although we understand many will say its just commodities, is it really? What started as coal weakness 18 months ago became coal and energy weakness. But it wasn’t really just the commodity sectors, as retail was also already weak. Now it’s the commodity sectors, retail and wireline (but definitely not all of telecom). The situation almost seems unbelievable, as everything that seems to go wrong is explained as being isolated (AMD, well, of course semiconductors are in a secular decline) and treated as a surprise (Sprint)." - source Bank of America Merrill Lynch
If that's not a case of "overconfidence" effect taking place in US High Yield credit markets thanks to the Fed's "overmedication", then we don't know what is!

When it comes to credit spreads and default risks and leverage, end of the day, earnings matter!

Back in November 2012 in our conversation "The Omnipotence Paradox" which is in effect, yet another manifestation of "overconfidence" by our central bankers, we argued the following:
"We believe the biggest risk is indeed not coming from the "Fiscal Cliff" but in fact from the "Profits Cliff". The increase productivity efforts which led to employment reduction following the financial crisis means that companies overall have reached in the US what we would call "Peak Margins". In that context they remain extremely sensitive to revised guidance and earnings outlook" - Macronomics, November 2012
US corporate leverage would be less worrying from an historical context if indeed there wasn't a picture of deteriorating operating profits in the background as illustrated in the below chart from Société Générale's Credit Strategy weekly note from the 18th of September entitled "Turning Point":
"Operating profits for the universe were flat year on year in Q2 and contract slightly in Q1, and when the impact of falling oil prices and the stronger dollar is fully felt, perhaps the numbers will be even worse.
However, here again there are reasons to be cautious. The year on year decline in operating profits in 2008-2009 were clearly much bigger than the recent falls. And weak profit data in 2011-2012 proved to be misleading, with the market soon turning around and recovering.
Our suspicion, then, is that global credit markets are discounting a lot of bad news in the Q4 earnings season which starts in mid-October, and they may be pleasantly surprised. This is one of the strong reasons why, at the start of the month, we called for spreads to peak in late September." - Société Générale
Perhaps? Place your bets accordingly.

Furthermore, when it comes to "overconfidence effect", hot money flows and Emerging Markets, they have as well been plagued by this truly toxic cognitive bias as per our third point.

  • Emerging Markets have also been plagued by the "overconfidence effect"
While we recently touched on the "stock" and "flow" approach to assess Emerging Markets vulnerability from a balance of payments point of view, the hot money flows thanks to the Fed's easing policies, not only have led to a faster increase in corporate issuance and leverage in the US, but also had some significant impact on EM external borrowings in recent years (see our prior reverse Macro osmosis theory).

We believe than even with the Fed's recent dovish stance, EM assets will continue to be under pressure for the time being.

Thanks to "overmedication" and "overconfidence" EM's vulnerability to external shocks has increased. On that note we agree with Barclays's take from their FX Themes note from the 22nd of September entitled "EM FX: Not cheap given China and Fed risks":
"EM vulnerability to external financing shocks has increased
On the flipside, EM external borrowings have increased substantially in recent years, reflecting cheap financing in DMs and weak growth outcomes/low real rates in DM versus EM. Indeed, external borrowings were crucial in boosting domestic credit across the EM space (Figure 4). 

As the Fed leads the DM out of the low rates environment and with external borrowings by EMs being primarily USD denominated (eg, 87% of external issuance is in USDs), we believe a Fed tightening represents a liquidity shock that would lead to weaker EM FX and higher EM rates.
As Figure 5 shows, the correlation of short-term EM real rates with the US is low, but it is substantially higher for long-term real rates.

Nonetheless, a Fed hike of short-term rates is likely to lead to a move lower in EM FX as real rate differentials narrow. Weaker EM FX is likely to increase the repayment of external borrowings and increase refinancing in local markets – pressuring domestic interest rates higher. A Fed delay will likely be seen as temporary as the Fed seeks to ensure a recovery, which would leave long-term real rates in EM vulnerable. Hence, we do not see either scenario as supportive of a constructive view on EM assets, especially those local-currency denominated.
…and reserves have not kept pace with increased leverage
EM reserves have been declining since peaking in 2010 (Figure 6). 

It is striking that EM reserve growth has not kept pace with the increase in total external debt and has been significantly slower than the growth in short-term debt. In both cases the decline of reserve cover has been significant as EMs have increased leverage in the domestic economy.
In EM FX/Local Markets – Assessing FX reserves adequacy in EM, 19 January 2015, we used an alternative approach to assess FX reserves adequacy in EM economies. Essentially, we conducted a stress test on the capacity of EM central banks to intervene directly in the FX market to protect their currencies should capital outflows accelerate. Our updated ranking is shown in Figure 7.
Our results suggest that the TRY, ZAR, ARS and MYR are likely most vulnerable should EM risk aversion and external financing conditions deteriorate further. It also means that central banks in these countries would likely be constrained in limiting currency weakness through direct market intervention. They would likely be forced to tolerate more currency weakness, or rely on capital control measures.
At the other end of the spectrum, Asian currencies such as the PHP, KRW, THB and the CNY have FX reserves levels high enough for central banks to intervene comfortably in FX to limit the extent of currency depreciation from capital outflows. That said, given our view of further CNY depreciation and broad USD strength going into 2016, we do not think these countries would resist currency depreciation. In fact, authorities in Korea and Thailand are relaxing overseas investment measures to encourage resident outflows to offset the pressure from their large current account surpluses." - source Barclays
When it comes to China and its CNY current stability issues, as we pointed out in our part 2 of our long conversation "Availability heuristic", something will have to give:
"Without further flexibility in its CNY currency in terms of "flows", its large "stock" of FX reserves could be viewed as a Maginot line, playing useless defense in the FX market without widening the yuan's trading band. This will further weaken Asian currencies in the process we think (hence our recent HKD short post)." - source Macronomics, 
This is as well confirmed by Barclays in their FX Themes CNY note from the 22nd of September entitled "CNY: Unsustainable stability":
"Rising cost of maintaining currency stabilityAlthough we were surprised by the way that China moved to allow its currency to weaken (we expected a widening of the daily trading band), we were not surprised by the direction of the CNY move after the policy change. In our view, China’s move on 11 August to adjust the fixing mechanism for USDCNY is likely to open the door to further CNY depreciation in the months ahead. While we do not see the policy change as a panicked move towards a devaluation strategy in order to boost growth, nor as a signal of a loss of control (as discussed in Asia Themes: China: Consequences of a New FX Regime, 14 August 2015), we think the policy change will allow for more flexible adjustments in USDCNY. While China assured the G20 that it is not pursuing competitive depreciation, this does not mean stability in USDCNY will continue indefinitely, especially given the risk of a sharper drawdown in FX reserves if the Chinese authorities continue to aggressively defend the CNY.
Success at a cost
Amid growing capital outflows and pressures on the exchange rate, Chinese authorities have been using FX reserves to hold up the CNY.
As we discussed in EM Asia Strategy: China: The heavy cost of intervention, 3 September 2015, FX intervention in recent weeks has been sizeable according to our estimates, which has had a major cost in the form of domestic liquidity tightening and a consequent need to provide liquidity to sterilize FX intervention. China reported a sharp drop of USD94bn in official FX reserves in August, or closer to USD104bn after accounting for valuation effects of exchange rate changes on the composition of FX reserves. This marks a step up in FX intervention from about USD50bn in July and an estimated USD140bn from December 2014 to March 2015, which underscores the significant pressure from capital outflows. This also suggests that the recent relative stability of spot USDCNY could be misleading and coming at a cost.
Although China’s FX reserves appear to be relatively healthy at USD3.65trn, continued FX intervention at the current rate would result in a swift drawdown in reserves. If the current pace of FX intervention continues, we estimate that the PBoC could lose up to ~14% of its FX reserves (ex-valuation adjustments) during June-December 2015. Moreover, we estimate that China’s central bank would have to reduce the reserve requirement ratio by ~40bp/month just to offset the impact of its FX operations on domestic liquidity.
Illicit outflowsAnother way to look at the sustainability of current exchange rate policy is by examining illicit capital outflows. Although China’s capital account is closed, several illicit channels of capital outflows have made the capital account rather leaky. We discuss these and their impact in China: Leaky capital account: estimating outflows and policy implications. We estimate that capital outflows from China could rise from the current 8-10% of GDP, driven by slowing growth, financial market volatility, policy uncertainty and currency overvaluation. In an adverse scenario, total outflows on the capital account could rise to a significant ~15% of GDP. Since these outflows are much larger than current account inflows of 5% of GDP, they will pressure China’s FX reserves and/or the CNY exchange rate. If China absorbs the balance of these outflows (USD1trn) completely by selling reserves and meeting hedging demand (in forward markets), this implies a drawdown of 28% of the current reserve portfolio. We believe this is a significant amount, especially if authorities are unable to slow capital outflows. We expect a weaker CNY over the medium term and significant jump risk for USDCNY as sustained intervention of such a size is unlikely given the uncertainty of success.
How much further does the CNY need to fall to stabilize capital flows?With our valuation models suggesting that the CNY is about 5-10% overvalued, and with China’s growth prospects deteriorating, we see risks of capital outflows and CNY depreciation pressure persisting. Indeed we think a 10% fall in the CNY versus the USD is needed to stabilize the REER and capital outflows. China’s challenging backdrop calls for a more flexible currency regime, and we maintain our forecast of USDCNY 6.80 by year-end. The deterioration in growth prospects have led us to downgrade our China 2015 and 2016 GDP forecasts to 6.6% and 6.0%, respectively (see China: Lowering 2015-16 growth forecasts following recent soft data, 13 September 2015). That said, we estimate that 10% CNY REER depreciation would add only between 30bp and 40bp to growth. However, we believe a much larger depreciation against the USD could pose serious risks to financial stability that government officials may prefer to avoid." - source Barclays
There you go, regardless of the "stock" of FX reserves put forward by many pundits, what matters in the case of China and the "overconfidence" effect are flows and particularly "outflows" in the form of a leaking capital account akin to "negative FCF". Remember financial crisis are always triggered by "liquidity" issues and in the case of sovereigns "over leaking" capital accounts.

So there you go, there are indeed evident signs of "overconfidence" effects in both  the credit and macro  pictures. When it comes to US equities and economic outlook, the annual change in US 12 month forward EPS is a harbinger for weaker earnings, therefore wider credit spreads thanks to weaker balance sheet due to cheap credit binge releveraging triggered by the Fed.

  • Final chart - Annual change in US 12 month forward S&P500 EPS expectations points towards recession
Earnings matters as we clearly indicated in our conversation when it comes to leverage, rising defaults and wider credit spreads. While the Fed has indicated its concern about global growth, there is cause for concern when it comes to the global earnings momentum.

The final chart comes from Société Générale Global Equity Arithmetic note entitled "US profits growth has never been this weak outside of a recession published on the 21st of September:
"That the US Federal Reserve is only now declaring itself worried about global economic growth is perhaps the only real surprise of last week. After all, global earnings momentum (the ratio of analyst upgrades to estimate changes) has plummeted from a respectable 47% in May this year to a recessionary 32% last week. Even once the weak Energy sector is excluded, global EPS momentum has still dropped to 35%, also from around 47% in May.
The chart below shows the annual change in 12-month forward S&P 500 EPS expectations. This series is based on forward consensus expectations and therefore excludes many of the write-downs and exceptional items that are currently pushing down actual reported profits. It is more akin to operational profits and has never been this negative outside of a recession!"
 - source Société Générale
Is the "overconfidence effect" warning out? Looking at the recent "price-action" it's certainly looks like central bankers are losing their "Chutzpah"!

"Without the compassionate understanding of the fear and trepidation that lie behind courageous speech, we are bound only to our arrogance." - David Whyte, English poet
Stay tuned!

Wednesday 16 September 2015

Macro - Availability heuristic - Part 2

"The three most dreaded words in the English language are 'negative cash flow'." - David Tang, Chinese businessman
In continuation to our previous conversation, here comes our part two of our long macro discussion where we will specifically look at Emerging Markets Corporate debt and wonder if it isn't the proverbial "elephant" in the room given the latest "Mack the Knife" gyrations (Rising US dollar+ positive real US interest rates).

  • Is the "elephant" in the room: Dollar denominated EM corporate debt?
  • The importance of  the "stocks" versus "flows" approach in assessing Balance of payments issues
  • Final chart - What matters is not a large current account deficit in a single year but the persistence of large current account deficits for a significant period of time.
  • Is the "elephant" in the room: Dollar denominated EM corporate debt?
We believe that the Fed might indeed hike on the 17th of September tightening further the noose on carry players and macro tourists alike particularly exposed to US dollar denominated corporate debt. 

In our last conversation, we indicated that there is a clear potential for a "continued rout" in Emerging Markets in true "availability heuristic" fashion. 

In relation to the proverbial "credit canary" while in the Western world, in the High Yield space the CCC bucket is indeed the "canary" in the coal mine, for us, in Emerging Markets, US denominated Emerging Market corporate debt is as well yet another "credit canary" particularly in LatAM you should focus on from a "monitoring" perspective.

We share this concern with our good friends at Rcube Global Asset Management:
"EM corporate debt is a time bomb.
We have written extensively about this matter. EM corporations’ stock of US dollar credit has exploded over the last 10 years. At approximately $5trn, it is a time bomb. Commodity producers’ cash flows are melting, cost of capital is rising sharply, capital outflows are intensifying, domestic bank lending behavior is tightening. This only means one thing: corporate defaults. EM corporate bond spreads do not currently price these risks properly. As long as it remains the case, EM assets will keep diving.

Furthermore, the BIS recently published a piece (“Investors’ redemptions and fund manager sales of emerging market bonds: how are they related”) highlighting the risks facing EM bond markets due to the shift of credit flows intermediation. Banks used to be the main protagonists for credit flows to EM corporations, but, since the great recession, they have given way to long term bond investors (Mutual funds, ETFs etc). As a result, investors’ behavior has become central to the credit channel. The impact of possible reversal of portfolio flows on the underlying economies is thus a large underestimated risk. Bond sales may result either from the sales needed to meet investors’ redemption or from discretionary sales beyond that implied by investors’ redemptions. Their finding shows that discretionary bond sales are a significant part of total bond sales by EM bond mutual funds and that discretionary sales by fund managers tend to reinforce the sales driven by redemptions by ultimate investors. The magnitudes are also found to be economically significant. Cash hoarding by fund managers will thus, in the future, have a similar economic impact than bank deleveraging.
About half of total bonds issued by emerging market corporates are held by retail investors (through bond funds). Clearly they have absolutely no clue about the risk of their investment and will sell in herd when the news flow will deteriorate (EM corporate defaults making headlines). We are very close to that moment.
In a separate working paper (Global dollar credit & carry trades: a firm‐level analysis), the BIS also reveals that emerging market corporate tend to borrow more in US dollar when they already hold large cash balances suggesting that cash needs for investment or other expenditure may not be the only motivation for bond issuance. Additionally, the timing of the dollar bond issuance by EME corporates, is more prevalent during periods when the dollar carry trade is more favorable in terms of an appreciating local currency, high interest rate differential vs. the dollar, and when exchange rate volatility is low. With regards to how the proceeds of the dollar bonds issuance are used, they find that it is more likely to end up being held in cash.
In other words, the BIS work proves that a massive carry trade has been put on by EM corporates during the good years ($2500 bln), and that retail investors are holding about half of that sum. This is a disaster of epic proportion waiting to happen." - source Rcube Global Asset Management
Furthermore, the recent downgrade of Brazil's sovereign rating to junk by S&P from BBB- to BB+ while maintaining a negative outlook will put additional pressure on corporates and financials alike. At risk is giant Petrobras which has been downgraded as well to BB with negative perspective.

Back in February 2013 in our conversation "The surge in the Brazilian real versus the US dollar marks the return of the "Double-Decker" funds" we indicated the following:
Brazilian companies have sold the most junk bond on record since May 2011 last Month according to Boris Korby from Bloomberg in his article - Junk Bond Frenzy Poised to Spill Into February: Brazil Credit from the 1st of February:
"Brazilian companies led by Banco do Brasil SA sold the most junk debt since May 2011 last month as unprecedented global demand for high-risk securities enabled the neediest borrowers to chop their financing costs. State-owned Banco do Brasil sold $2 billion of junior subordinated perpetual bonds rated BB by Standard &Poor’s in the nation’s second-largest high-yield sale on record, pacing $4.25 billion of speculative-grade offerings in January. Junk- bond issuance accounted for 81 percent of Brazil’s corporate debt sales, versus 34 percent globally and 18 percent in the country last year, data compiled by Bloomberg show." -source Bloomberg
Last year in our conversation "Sympathy for the Devil", we gave the reason why Brazil High Yield was at risk and US High Yield by contagion, as indicated by Fitch in their August 2013 note entitled "U.S. High Yield Sensitive to Emerging Market Defaults":
"EM dollar denominated issues total $116.5 billion, or close to 10% of U.S. high yield market volume. The EM total is up from just $65 billion at the end of 2010 with $43.3 billion issued since January 2012.
The $116.5 billion includes some large issuers that are in distress, including Brazilian oil company OGX (Issuer Default Rating CCC, Negative Outlook, $3.6 billion in bonds).
The largest country concentration in this group is Brazil ($30 billion), followed by Mexico ($16.3 billion) and China ($14.4 billion). The industry makeup of these issues befits their EM source with infrastructure-related and financial bonds representing most outstanding volume. The top sectors include energy ($27.7 billion), banking and finance ($18.0 billion), telecommunication ($11.2 billion), real estate ($11.1 billion) and building and materials ($8.5 billion). The cyclical nature of the industry mix adds to their vulnerability if growth stalls.
The par weighted average recovery rate on the EM issues has been 36.9% of par to date. With the exception of one bond, the affected issues were all unsecured. Of the $116.5 billion in EM bonds currently outstanding, an estimated $95.2 billion is unsecured." - source FITCH
Given Brazil's currency has tumbled by a third in one year and that its economy is in recession, as we correctly forecasted last year, watching LatAm was indeed a necessary exercise given we are now seeing the epic bloodbath that followed in FX as well as in the significant widening of the sovereign spread of Brazil which just announced some very strong austerity measures for 2016 in order to do some damage control and avoid additional pressure on its sovereign rating.

When it comes to our EM corporate debt fears in particular, we read with interest CITI's take on the subject from their 2nd of September EM Strategy note entitled " Is EM going into a 97 Asia crisis redux":
"2015 is not a "crisis", but it is a "problem":
Many market pundits and participants are referencing the Asia Crisis of 1997 as a template for what is going on in EM in 2015. These pundits cite dollar strength, declining commodity prices, high corporate leverage and general risk aversion coming off all-time tight spreads to DM as common elements to today’s market mindset and 1997’s. We would tend to agree with this assessment on those points, but believe they miss the key variables that would transform what we see as a “problem” into a “crisis”.
A “crisis”, in our view, is sovereign implosion and default; a “problem” is ratings downgrades and subsequent risk re-pricing. We believe the key differences between 1997 and 2015 are also the most important that will keep the “problem” from turning into a “crisis”. These differences are currency policy, term structure of government debt, and current account funding. All three are more favorable for EM credit in 2015 than they were in 1997, and this ultimately puts EM credit in a much better position to ride out the storm that may be coming.
EM corporates are a bit more of a complex story. Much has been written about the impending doom for the asset class. The general story follows that currency devaluations will destroy balance sheets and capital flight will ensue, making it impossible to roll-over debt. While the most pessimistic scenarios would likely follow this path, we see the asset class as having a high degree of idiosyncratic elements, many of them related to the commodity cycle. Our basic thesis has been that EM currencies in commodity-driven countries adjust downward, providing a bit of a cost cushion to falling commodity prices for companies that have borrowed in USD. It is the “natural hedge” thesis, and has held up reasonably well in past crises. Focus on the export sector in your most vulnerable countries, and you have a degree of protection. Only take the risk in the domestic economy for the most stable countries if lending in USD. When one examines the regional distribution of USD borrowers in key countries, it is easy to see that the market has generally followed this prescription.
The current bear market in commodities is a serious challenge to EM, no doubt. The EMFX market, in our view, has been and will continue to be the shock absorber. EM sovereign spreads are highly correlated to EMFX, which in turn should negatively impact EM corporates on an RV basis. We focus on Brent oil prices as the single most important indicator of EM spread movements."

- source CITI

No offense to CITI and in agreement with our friends from Rcube, from a "flow" but more importantly, an outflow perspective,  to paraphrase CITI "ratings downgrades and subsequent risk re-pricing" matter.

When it comes to assessing the vulnerability of EM corporates, CITI makes some important points in their note:
"How vulnerable are EM corporates?
Given that flexible fx regimes are a key shock absorber, it is natural to think that any company that borrowed in hard currency (mainly USD) and earns local currency is in a big currency mismatch situation in any risk re-rating. We agree with that thesis, and believe investors in USD property, utility, telecom, retail or consumer products credits in countries with big currency declines should be worried. The reality is, however, that the non-financial USD asset class is dominated by industrials that produce and sell products that tend to be denominated by globally tradable goods. These goods are priced in USD whether they are for export (commodities like oil, gas, iron ore, copper, soybeans, pulp) or sold locally and globally (finished goods like petrochemicals, paper, steel, auto parts, meat). Local prices will tend to follow global USD prices, less transport, as exports are always an option to the producer. Our experience suggests a 3-6 month lag in domestic prices to fx movements, with sudden maxi-movements (50% or more) being less than 3 months. Therefore, for these tradable goods producers, a currency devaluation by itself is not that bad, and actually can benefit a company by reducing its USD cost basis, as we have shown in past reports on Russian and Brazilian corporates. The following charts show the breakdown of USD corporate bond sectors in the major EM countries by sector. As can be seen, financials and raw materials industrials dominate the overall issuance.

Commodity prices are a concern, but we have already seen how commodity dependent countries have experienced declines in their flexible exchange rates (figure 31), which we believe acts as an offset by reducing unit costs in USD. This, in our mind, is the clearest example of the post-1990s EM macro model serving as a shock absorber for the export sector.
The questions remain whether this reduction in USD unit costs, as reflected by a weaker currency, can compensate for a decline in USD unit selling price. As is usual in a market paradigm shift, those credits that entered the shift in the weakest shape are the most vulnerable. Our next section examines the where and the what of these sectors.
EM corporate leverage has been rising, but
risks are idiosyncratic

EM corporates have seen an increase in leverage over the past several years, as shown by the below annual data ending in 2014.

Given the more difficult scenario in 2015, it would be reasonable to expect the trend to continue to decline. If we simplify things and just look at net leverage for the largest sectors and capital ratios for banks as a whole in the major countries, one can see rising leverage ratios and declining CARs. Yet, if we dig a bit deeper, and remember the charts in figures 23-30, we see that the rise in leverage is explained by some well-known risks in the market. Unsurprisingly, Chinese leverage is highest in the property sector, which has been struggling to sell finished homes in a saturated marketplace. In many respects, the Chinese property market is ground zero for the decline in metals prices. In Brazil, the largest issuer by far is PETBRA, which has seen its leverage rise due to an aggressive capex program and inefficiency. A weaker BRL and oil price in 2015 are likely to continue this trend.
Russian corporate leverage actually looks reasonable, belying its HY status. Again, we anticipate these numbers to deteriorate in 2015 due to lower selling prices, but a much weaker RUB will be an offset. Mexico has very reasonable leverage except for building materials. Corporate investors will immediately recognize this data set as predominantly Cemex, a multinational with a large global investor base that is well educated on the company, and experienced in dealing with its past refinancing efforts.
What about potential EM corporate refinancing

EM corporates represent 70% of the asset class in USD, with an outstanding balance of approximately $720bn. In the following chart, we lay out the amortization schedule of long-term bonds in the asset class out to 2020 using Bloomberg data. In 2017-2020, average principal payments are $78bn, and coupons are $33bn, versus an average new issuance of $213bn going back to 2007. As can be seen, a significant long-term “buyers strike” would need to be maintained in order for a true liquidity crisis to develop, and blue chip credits are unlikely to be shut out of global capital markets if they are willing to pay the price the market demand.

While we do not believe a broad EM corporate debt crisis is on the way, parts of the market may be in for a difficult time. As a cattle rancher once said, “sick dogs die when the weather turns bad”. HY credits may have a more difficult time coming to market, and credits that are most exposed to out of favor businesses (small oil, iron/steel, property/construction, sugar) may have the most difficult time. Also,certain regions may come under more scrutiny than others. In the following charts, we show the principal amount (fig 40) by region and top issuers (fig 41).

What does all this mean
We believe the headline-grabbing numbers in EM corporates regarding amortizations and currency exposures overstate the probable risks. Commodities generally hurt Latam and Russia (major exporters), while helping Asia (major importers). This is not news. Weaker currencies generally reflect this, which is an essential sign that the flexible fx regime as external shock absorber is working. To some, this is news. The export sector in a weakening currency regime is generally benefitted in its credit metrics, all else equal. We do not doubt that a rough patch is coming for EM corporates as all else is not equal, yet we believe the sector has more resilience and a core investor base than many suppose. The likely fallout of risk aversion will be in the small, HY single issue type of credit, as opposed to large, frequent issuers that are well known to the market. A primary market “buyers strike” that is impervious to price and terms is the main risk facing the asset class in terms of solvency. At this time, we remain skeptical of it developing or being in place for long. Capex budgets have been gutted, so new capital is not needed. 
We believe the asset class is trading expensive given the decline in oil prices and renewed pressure on sovereign fundamentals that has exceeded our earlier expectations. Brazil, Turkey and South Africa look most exposed for a variety of reasons. Corporates in these countries will likely feel the heat. PETBRA is the company with the most amount of debt in EM, and the company with the most coming due in the near to medium term. In our view, EM corporates will continue to trade heavy and should probably widen 20-40bps as an asset class." - source CITI
As we posited above, what above all and as seen in the "Chinese equities" meltdown (regardless of the "fundamentals") what matters are "flows" and "outflows" and your "stock" of FX reserves doesn't matter that much. As pointed out by our Rcube friends as well by the BIS recent report, it seems to us that globally EM corporate debt in similar fashion to Chinese equities are in weak hands, namely retail hands through funds. Given our last post and analogy on "availability heuristic", what matters is not the "fundamentals" per se, but the latest news "flow" such as rising defaults, which in effect could trigger a nasty disorderly "exodus" from the asset class.

When it comes to "flows" and "outflows", we read with interest Bank of America Merrill Lynch GEMs Flow Talk note from the 10th of September 2015 entitled "So long, farewell":
"Foreign holdings: Total flows declining rapidly
Net purchases by foreigners have been declining every month since March, and for the last two months foreigners have actually been net sellers (Chart 1). 

Total EM flows have been declining at an alarming trend (May +$2.2bn, June -$1.1bn, July -$1.7bn), with July’s pool mainly due to Brazil outflows. Foreign holdings in August show outflows of $1.0bn so far (only 6 of 18 reporting). Malaysia, with one of the worst performing currencies, just reported large outflows of $2.0bn in August, after losing $0.5bn in July.
On the flip side, after three weeks of large bleeding, EPFR mutual funds reported smaller outflows (total debt -0.3%). Although EPFR covers a small percentage of outstanding debt, investors persist in watching it.
Mutual funds: EM flows down 0.3% this week
EPFR Global Emerging Market (EM) aggregate debt funds had outflows in the past several weeks (Charts 6), with aggregate EM Flows at -0.3% this week (YTD: -4.3%), EXD at -0.5% (YTD: -4.9%), LDM at -0.1% (YTD: -5.8%), Blend at -0.5% (YTD: -0.6%), Corporates at -0.5% (YTD: -3.6%).

We have seen increasing demand for blended funds over strictly LDM or EXD funds. There have effectively been no net outflows YTD from blended funds compared to the -5.8% and -4.9% in LDM and EXD funds. High net worth (which includes ETFs) outflows have increased in the last few weeks, a clear turn in sentiment. Selling by small retail continues the uninterrupted bleed-out of EM mutual funds since summer 2013. LDM has not seen ETF and high net worth investor inflows in nine months (Charts 9).
 - source Bank of America Merrill Lynch
As illustrated above, when it comes to "jittery" investors, retail is much more "reactive" when it comes to flows than other type of investors, hence the heightened risk for Emerging Market Corporate debt fund mostly held by retail investors as pointed out by both the BIS and our Rcube friends. So, watch out for "availability heuristic" playing out in the coming months should indeed the Fed starts in earnest its "normalization" process.

Furthermore when it comes to the "EM corporate debt" credit canary, High Yield seems to us and particularly in Brazil and LatAm significantly at risk, particularly when ones takes into account the EM High Yield maturity wall as displayed in UBS most recent Global Credit comment entitled "Has Fed Liquidity Run its course":
"Net issuance slumped during the late stage of the last credit cycle in 2007-2008 as investors retrenched from escalating credit risk. Powerful monetary stimulus from the Fed’s QE2 & QE3 programs in 2010 and 2012 led to a significant rebound in global HY issuance due to portfolio rebalancing effects, but this has been consistently slowed since “Taper Tantrum” (though EUR HY issuance remains an exception, buoyed by ECB QE). For the US & EM HY markets, net issuance is now currently negative as the Fed’s balance sheet has stopped expanding, bringing us back to a point not seen since late 2007. Hence, while the Fed’s interest-rate decision looms large this Thursday for the short-run, we doubt it will have a major impact on net issuance going forward, particularly for US & EM HY corporates. In short, Fed stimulus was a major reason why global credit markets grew to new heights post-crisis. But as Fed liquidity fades to the background, future HY issuance will be held in check by ol’ fashioned credit risk." - source UBS
When it comes to the "carry players" and other "macro tourists", we believe that, the Fed's change in "liquidity" policy means "back to school" for these "beta" investors, which for many years have been selling their "alpha" skills in a simple indiscriminated "beta" central banks induced game. Whereas the Fed has provided "overmedication and pushed the game into extra time, we have often argued that this credit artificially boosted cycle had led to serious distortions with investors reaching out for risks and yield with "overconfidence".

Definition of Credit Market insanity:
"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

There will be a second distressed wave in the not so distant future and we shall see who has the real skills to navigate these treacherous seas and deliver "real" alpha. Meanwhile "distressed debt" experts are carving their knives rest assured. It is a done deal. On that subject we  would like to add David Goldman's comments which can be found on Reorient Group's website from his note from the 13th of September entitled "We expect the Fed to hike on Sep 17 ... and deeply regret it":
"“Quantitative easing and near-zero interest rates in the United States have supported levered carry trades at home and abroad, in the form of equity buybacks that fostered the illusion of profit growth on US equity markets and capital flows to high-interest markets in the developing world. The threat alone of an end to the seven fat years of cheap leverage has already shifted the structure of interest rates drastically, with real (inflation-indexed) bond yields trading close to a three year high and breakeven inflation at a post-crisis low. This represents an enormous net shift in credit terms against debtors, whose interest costs are rising as their earning capacity deflates. The most vulnerable, that is, the most levered sectors of the market—emerging market currencies and commodity producers—already are crashing, with the Brazilian real and the Turkish lira in free fall. The fact that Brazil, a commodity exporter, and Turkey, a commodity importer, respond more or less identically demonstrates that this is a monetary phenomenon rather than a shift in terms of trade.
The Fed has bungled its way through this mess. It is like a man in a virtual-reality helmet traversing a minefield. What the Fed sees is the output of the one-period, closed economy Keynesian model taught at major universities. Rather than “if you build it, they will come,” we have, “If you create demand, they will spend.” What will the Fed do next? The International Monetary Fund staff took the unusual step of recommending that no central bank raise interest rates in the present environment, which refers only to the Fed, the one central bank that is considering a rise in interest rates.
The IMF is right: The collapse in commodity prices tracks the fed funds futures 12 months ahead more closely than any other economic variable. Deflation comes out of Constitution Avenue rather than “real” factors, whatever those might be.
By any measure inflation is flashing a warning signal: CPI is flat y-o-y, and at just 1.7% excluding food and energy (which should not be excluded in this case, because energy prices are driven by monetary policy). Breakeven inflation expectations are at post-2008 lows." - source Reorient Group
Deflation is indeed a self-inflicted wound, and the direct consequences of QE and ZIRP. The EM "hot flows" of recent years were induced by the Fed's monetary policy. Now the Fed is about to pull the proverbial rug under EM's feet.

When it comes to assessing Emerging Markets' vulnerability, we think that the "stocks" versus "flows" approach is of particular importance when it comes to "hot money" issues and Balance of payments crisis à la 1997. This brings us to our second point in our already long conversation.

  • The importance of  the "stocks" versus "flows" approach in assessing Balance of payments issues
Our core thought process relating to credit and economic growth is solely based around a very important concept namely the accounting principles of "stocks" versus "flows". We have used this core principle in the past when assessing the issues plaguing Europe versus the United States as per our September 2012 conversation "Zemblanity":
"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."
Before we delve more into the nitty-gritty of our second point, it is important, we think to remind our readers of what is behind our thought process of the "stocks" versus "flows" macro approach.

We encountered previously through our readings an essential post dealing with our core concept of "stocks versus "flows" from Mr Michael Biggs and Mr Thomas Mayer on entitled - How central banks contributed to the financial crisis which explains precisely why both Friedman, Keynes and the central banks have been behind the curve in preventing the previous financial crisis and potentially the next one: 
"We have argued at some length in the past that because credit growth is a stock variable and domestic demand is a flow variable, the conventional approach of comparing credit growth with demand growth is flawed (see for example Biggs et al. 2010a, 2010b).To see this, assume that all spending is credit financed. Then total spending in a year would be equal to total new borrowing. Debt in any year changes by the amount of new borrowing, which means that spending is equal to the change in debt. And if spending is equal to the change in debt, then the change in spending is equal to the change in the change in debt (i.e. the second derivative of the development of debt). Spending growth, in other words, should be related not to credit growth, but rather the change in credit growth. 
We have called the change in debt (or the change in credit growth) the 'credit impulse'. The credit impulse is effectively the private sector equivalent of the fiscal impulse, and the analogy might make the reasoning clearer. The measure of fiscal policy used to estimate the impact on spending growth is not new borrowing (the budget deficit), but rather the change in new borrowing (the fiscal impulse). We argue that this is equally true for private sector credit." - Mr Michael Biggs and Mr Thomas Mayer on
We have always wondered in relation to the global rounds of quantitative easings the following:
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"
Credit dynamic is based on Growth. No growth or weak growth can lead to defaults and asset deflation. The change in credit growth is a flow variable and so is domestic and global demand!

The big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.

As we have argued before QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.

As a reminder from our November 2014 conversation "Chekhov's gun":

"In textbook macroeconomics, an increase in AD can be triggered by increased consumption. In the mind of our "Generous Gamblers" (aka central bankers) an increase in consumer wealth (higher house prices, higher value of shares, the famous "wealth effect") should lead to a rise in AD.
Alternatively an increase in AD can be triggered by increased investment, given lower interest rates have made borrowing for investment cheaper, but this has not led to increase capacity or CAPEX investments which would increase economic growth thanks to increasing demand. On the contrary, lower interest rates have led to buybacks financed by cheap debt and speculation on a grand scale.
In relation to Europe, the decrease in imports and lower GDP means consumer have indeed less money to spend. We cannot see how QE in Europe on its own can offset the deflationary forces at play.
In the case of Europe, deflationary forces can be ascertained by slowing global trade in the shipping industry." - source Macronomics, November 2014
"Stocks" versus "flows" for assessing Balances of payments "situations" are an essential core concept to the understanding of both the sovereign crisis in the Eurozone as well as the on-going volatility in EM assets.

From CITI's take on the subject  of Balance of payments crisis from their 2nd of September EM Strategy note entitled " Is EM going into a 97 Asia crisis redux", we would like to point out their comment:
"The end result of the Asian crisis reinforced the lessons of Mexico’s crisis for many EM countries. Policymakers abandoned their hard currency pegs, and developed internal long-term capital markets. Initial economic dislocation was severe as GDP fell, but eventually the combination of subdued import demand and competitive exchange rates moved current accounts from deficit to surplus, which allowed reserves to be rebuilt, thus restoring investor confidence and ultimately growth. Banking systems needed to be rebuilt, which kept credit in the system low, discouraging consumption. As economies recovered, the private sector began to expand again and ultimately entered global capital markets. For those countries that had experienced sharp devaluations and defaults, domestic-oriented companies tended to avoid hard currency borrowing, which has since been dominated by exporters and banks. Exporters have a natural hedge in cash flows, while banks presumably can hedge this exposure. Of these two sectors, we favor exporters, despite their commodity exposure, over banks.
The key lessons were use flexible exchange rate policy and reduce dependence on “hot money” to fund current account and fiscal deficitThe important analogy of a BOP crisis is a bank run. Investors flee all at once before the money window can close. Inevitably, the system runs out of reserves and shuts down. A flexible fx policy allows the monetary authorities to keep hard currency reserves by reducing the price of their fx as sellers exit. This keeps cash on hand, as well as addressing some of the core imbalances in the current account and terms of trade with the rest of the world. It is a shock absorber. Investors and borrowers know this is the rule, and plan their expectations accordingly. The other key lesson is to not rely on short-term debt to fund the current account, as this only exacerbates the exit risk." - source CITI
When it comes to "regional" sovereign risk we believe LatAm this time around is much more exposed than Asia, if one wonders about a 1997 "redux".

In relation to a Chinese devaluation risk and our previously mentioned "reverse osmosis" macro theory, China needs indeed to move towards a flexible FX policy to keep its hard currency reserve stash which has been dented as of late. When it comes to the importance of flows, and Chinese "outflows", we read Bank of America Merrill Lynch's China Economic note from the 16th of September entitled "The Fed rate hike - Is China prepared":
"Capital outflow: How much is the risk for China?The biggest concern for EM countries once the US Fed starts a rate hike cycle arises from capital outflow pressures, as foreign investors may repatriate their funds away from EM assets to US assets on better growth outlook and higher return of yields. Sizable capital flight could introduce greater market volatilities, trigger financial asset sell-offs and hurt financial system stability.In our view, China is in the face of bigger capital outflow pressures due to expected US Fed rate hikes, weak economic growth momentum and financial market pessimism. However, the risk of capital flight could still be manageable for China, compared with many other EM countries, which borrowed foreign debt extensively to finance their current account deficits or attracted too much FX inflows to their stock markets.
Low foreign participation in local bond/equity marketsFor China, the impact of potential portfolio outflows may have relatively limited direct impact on China’s financial assets, thanks to its still strict capital account management.
• The foreign ownership of local bonds is less than 3% in China, among the lowest for major EM countries. In comparison, it is 14% in Korea, 17% in Thailand, and 48% in Malaysia.
• Foreign investors held less than 2% of tradable A-shares in China. This is very low compared with other Asia countries, such as Taiwan (28%), Korea (30%), Thailand (38%) and Indonesia (65%).
How much hot money inflows to unwind? Nearly US$650bnBeyond the equity/bond market channels, foreign investors have sought various ways to participate in China’s financial markets, as RMB carry trade was arguably one of the most popular trades over the past few years until 2014, due to expectations of one-way RMB appreciation and wide interest rate spreads against other major currencies.
If there had been a huge hot money inflow into China since the US Fed cut its interest rates to 0 in December 2008, then China might be under big risk of capital flight if the hot money leaves China once the US Fed starts to hike rates again.
We have made a rough estimate for "portfolio and other unexplained capital flow" to capture the "hot money" nature of some cross-border flows. In a nutshell, we take the change of the FX purchase position and FX deposits as the aggregate inflow, deducting flows by trade surplus in both goods and services and net inflows of direct investment from the aggregate inflows, leaving the remainder as portfolio and unexplained capital flow. Moreover, we adjust for the impact of RMB international trade settlements. China did run an accumulated hot money inflow in the five years of 2009-13 at US$971bn, but it has then undergone a hot money outflow, at US$30bn in 2014 and at US$94bn in 1H15. Hot money outflow widened to US$97bn in July and further increased to US$100- 110bn in August. Adding up these numbers, there could still be US$640-650bn in hot money remaining in China.

Capital outflow risks should be manageableWe believe the potential capital outflow amount of nearly US$650bn should be manageable for the following reasons.
1. China’s FX reserves are still quite big, at US$3.56tn, 31% of world total FX reserves and 33% of China’s 2015 GDP. Moreover, we expect China to maintain its surplus in current account, at 3.0% in both 2015 and 2016, which would add foreign currency supplies to the PBoC. Note that, in 8M15, China’s trade surplus amounted to US$367bn.
2. China has relatively strict capital controls in place even though it started to quicken capital account liberalization in a prudent manner since 2014. The PBoC has taken various measures and will likely take further actions to improve the balance of capital flows, such as to discourage speculative capital outflows, to raise costs of USD purchase, and to relax inflow rules for long-term investors.
3. Some of the fall in FX reserves could be attributed to higher FX assets of other domestic entities as some corporations/households may wish to increase their FX deposits for hedging or to retain value of their assets amidst rising expectations of
CNY depreciation. Those could be translated into higher FX assets in the domestic
banking system, instead of cross-border capital flight.
Capital outflows: about US$110bn in August and may decline in the coming monthsIn August, Chinese banks’ FX purchase position dropped RMB724bn (US$114bn), after falling RMB249bn (US$40bn) in July. This is the biggest monthly drop in record. We estimate capital outflow at about US$100-110bn in August, up moderately from US$97bn in July (Chart 9).

This may sound a bit surprising to many who would expect much faster pace of capital outflow pace in August. But actually, the difference in FX purchase position change could be mainly explained by the change in FX deposits (declined by US$41bn in July but up by US$27bn in August, the difference here would be US$68bn).
Looking ahead, we believe capital outflows will continue but at a slower pace, and we shall not extrapolate such sizable drop of FX purchase position in August to the future. This is because (1) CNY deprecation expectation could be reduced, as the government has emphasized about CNY stability and the PBoC has taken various measures to stabilize the FX market; and (2) it has become much harder and costly for speculative purchase of USD and arbitrage trading activities, after the PBoC tightened scrutiny over speculative capital flows. Beyond some short-term anomalies, the direction of capital flows will depend on China’s macro fundamentals." - source Bank of America Merrill Lynch

Given it seems our "reverse osmosis" macro theory is playing out thanks to the mighty dollar and US real interest rates in positive territory, we believe that China, in order to deflate orderly its past credit "excesses" will have no choice but to adopt a more flexible exchange rate policy to accompany its deleveraging process. The current de facto US dollar peg is hindering its deleveraging effort we think. (We touched on the devaluation risk from a HKD perspective recently).

Without further flexibility in its CNY currency in terms of "flows", its large "stock" of FX reserves could be viewed as a Maginot line, playing useless defense in the FX market without widening the yuan's trading band. This will further weaken Asian currencies in the process we think (hence our recent HKD short post).

Moving on to the subject of assessing a country's vulnerability using the "stocks" versus "flows" approach, we came across a very interesting special report from Société Générale on the subject from the 7th of September entitled " Forecasting markets using balance of payments":
"Tools to monitor external imbalances: the current account and the net international investment position (net IIP)
In this report, we use both the current account (flow approach) and the net international investment position (stock approach) to monitor external accounts in 48 countries (24 developed, 24 emerging). The purpose is to bring attention to indicators that are currently overlooked, at a time when financial markets are focusing exclusively on fiscal imbalances.
Note that monitoring the fiscal health of a nation also involves a stock/flow approach (public debt is a stock and budget deficit is a flow).
Flow analysis of external accounts:
The balance of payments is a statistical statement that summarises for a specific time period the transactions of an economy with the rest of the world. Transactions between residents and non-residents consist of those involving goods, services and income (the current account balance) and those involving financial claims on, and liabilities to, the rest of the world (the financial account balance). The statement involves all institutional sectors, i.e. government, financial and non-financial corporations, and households.
Stock analysis of external accounts:
Closely related to the flow-oriented balance of payments framework is the stock-oriented international investment position (IIP). This states, at a specified date, the value and composition of an economy’s external financial assets and external financial liabilities. The difference between the two sides of the balance sheet provides the net position, which signals if a country is an international creditor (external assets larger than external liabilities, i.e. Japan) or an international debtor (i.e. the US). Source: IMF (1993), Balance of Payments manual, 5th edition.
Thresholds: alert and crisis levels
The current account and the net international investment position are indicators followed by the European Commission under the Macroeconomic Imbalance Procedure (MIP); a surveillance mechanism that relies on a warning system to identify economic imbalances. According to the European Commission, a three-year moving average current account balance below -4% of GDP and a net international investment position below -35% of GDP signal sizeable macroeconomic imbalances
Meanwhile, Catão and Milesi-Ferretti (2013) show that “the ratio of net foreign liabilities (NFL) to GDP is a significant crisis predictor, and the more so when it exceeds 50 percent in absolute terms and 20 percent of the country-specific historical mean.”(See Bibliography p.65 for sourcing details.)" - source Société Générale

- source Société Générale
As indicated previously by CITI, flexibility in the currency has become an essential monetary tool in recent years particularly to manage the "stock" of FX reserves. This is as well illustrated in Société Générale's report:
"Sharp drop in commodity exporters’ currencies
Increased currency flexibility in the EM world compared to previous decades has allowed a fast adjustment to the lower commodity prices. All the commodity exporters that we follow here have floating currencies, except Argentina (crawl-like currency regime).
- source Société Générale.

There is indeed a clear trend in "de-pegging" currencies in the Emerging Market world, but in Developed Markets (DM) as well, the CHF event of this year has shown that pegging a currency in the current monetary system is bound to fail at some point. The sovereign crisis in Europe has also shown the inadequacy of the Euro for various European countries with different economic and fiscal policies as well as different composition (hence our negative stance on the whole European project...).

When it comes to our recent "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop as illustrated as well by Société Générale (when flows and outflows matter...):
"Asian currencies, the next casualty in the currency war
The change in China’s currency regime will likely trigger a weakening of Asian currencies in a bid to preserve competitiveness.
The Chinese currency had appreciated strongly against major currencies and other BRIC currencies in recent years.
China’s decision to liberalise the exchange rate regime may not be driven just by concerns about export competitiveness, but it is likely to start a wave of depreciation in Asia, where currencies have been resilient to US dollar strength compared to other EM regions." - source Société Générale

Asia’s export growth is slowing down, although still performing better than other EM regions. China’s currency devaluation is however a risk for its Asian competitors." - source Société Générale.
Of course when it comes to "stocks" and "flows" on the micro level for High Yield as well as on the macro level for sovereigns, "cash balances" matters and FX reserves as well when it comes to outflows and negative operating cash flows as shown as well by the Société Générale report:
"Malaysia and Turkey’s reserves do not cover their short-term external debt. Turkey is even more at risk given its current account deficit. South Africa and Argentina do not have large reserves either."
 - source Société Générale
And if you think about "stocks" and the need for the Fed to "normalize", this can be ascertained by the net IIP position of the US at the end of 2014 and asset performance in 2015year-to-date  as well as its Twin deficits as displayed by Société Générale:

"The US is the most at risk with its twin imbalances, while New Zealand and Australia have only excessive private sector debt." - source Société Générale
The US seems to have no choice but to attract capital inflows through continued positive real interest rates hence the need to hike.

Private sector debt (stocks) always matter regardless of the low level of public debt (Spain). When it comes to flows, recent history has shown that, fiscal profligacy as well external imbalances such as the ones seen recently in Europe have been the root cause to the sovereign crisis, Public debt in the case of Spain have shown that it was a poor "risk" indicator to the vulnerability to "external" shocks.

Current accounts do matter hence the importance in "macro analysis" and sovereign risk to take into account a "stock" and "flow" approach. The source of the European crisis can be seen in the below graph from the same Société Générale report:
"Contrary to what is commonly acknowledged among policymakers, the roots of the eurozone crisis are not only fiscal profligacy, but also external imbalances. Hence, the eurozone crisis has many similarities with the balance-of-payments crises that emerging markets experienced in the 1990s. At that time, Asian and Latin American countries moved from fixed exchange rate regimes to floating ones to restore external competitiveness." - source Société Générale.
To restore external competitiveness, we wonder how many more "lean" years peripheral countries will have to endure thanks to the "rigidity" of the Euro currency but, we ramble again...

This brings us to our final point which is that persistence of large current account deficit matters in the long term.

  • Final chart - What matters is not a large current account deficit in a single year but the persistence of large current account deficits for a significant period of time.
The "stock-flow" approach we have used in numerous occasions to point out the various issues plaguing not only Europe from economic perspective but as well as the different approach between monetary policies such as the difference between the Fed financing "stocks" (mortgages) and the ECB financing "flows" (deficits) is we think central to a good understanding of "macro" issues.

On a final note we would like to point out a final chart from Société Générale's report displaying the cumulated flows and stocks due to valuation effect for the United States:
"Net International Investment Position (IIP) equals the cumulated current account balance with valuation adjustments
What matters is not a large current account deficit in a single year but the persistence of large current account deficits for a significant period of time. Hence, the stock approach to external imbalances is extremely relevant but until recently academics weren’t able to use this approach because of the lack of long-term time series.
Improving information gaps on international investment positions is actually one of the goals set by the Financial stability Board. In the IMF-FSB joint report to the G20 entitled “The Financial Crisis and Information Gaps” (November 2009), it was recommended to increase the number of countries that report IIP data and to promote quarterly reporting. At present, 119 countries provide annual IIP data and 48 provide quarterly IIP data to the IMF."
The figures below show the evolution of the share of foreign equity and debt liabilities in
external liabilities. They show that the external balance sheet structure of developed markets and emerging markets is quite different: the liabilities structure of industrial countries is mainly made up of debt (they are “short debt”), in particular in Japan, the US and the UK. In contrast, the international balance sheet structure of emerging markets is typically composed of equity liabilities (“short equity”), which is the counterpart of strong FDI inflows that contributed to improve emerging markets’ external profile in the last decade.

- source Société Générale
End of the day, what seems to be playing out is a reverse of these "imbalances" which were not doubt exacerbated by the Fed's QE and ZIRP policies of recent years.

"Logic takes care of itself; all we have to do is to look and see how it does it." - Ludwig Wittgenstein
Stay tuned!

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