Wednesday 28 October 2015

Macro and Credit - Le Chiffre

"If you spend a week at a casino you will very easily see that people have a certain way of behaving in a casino." - Mads Mikkelsen, Danish actor (who played Le Chiffre in the recent Casino Royale).
While observing the rapid, yet severe pain inflicted to the "short crowd" so far in October thanks to the "relief rally" in risky assets "High Yield" and equities included, supported as of late by the PBOC double rate cuts and the return to the front stage of our "Generous Gambler"  aka Mario Draghi, we decided this week given our eagerly anticipation of the release of the 24th opus of James Bond's adventure Spectre to steer towards a "Bond" related analogy when it comes to choosing this week's title for our musing. While we could have simply elected to go for "Casino Royale", the character Le Chiffre appears to us more interesting from a central banking "gambling" perspective given the latest actions of the PBOC and promises made by Mario Draghi. Le Chiffre after all was the main villain of the official 2006 James Bond film "Casino Royale". In order to win the money back lost during the summer, one could argue that Le Chiffre aka our main European central banker has indeed set up and entered a new high-stakes Texas hold 'em tournament in similar fashion he did at the Casino Royale in Montenegro in the movie. In the movie Casino Royale Bond eventually beats Le Chiffre in the game of poker by catching his bluff. In the start of the movie Bond tells Vesper: "in poker you never play your play the man across from you". 

While in the movie Le Chiffre pretty much made a game out of it with nothing on his cards in the first game, in similar fashion Mario Draghi made a game out of it with his "OMT" and "Whatever it takes" July 2012 moment. In the movie it made Bond surmise that Le Chiffre was in desperation to get the money and resorted to bluffing (It was exactly our thought at the time). Le Chiffre and Mario Draghi share the same trait, both are poker prodigies hence our title analogy.

Whereas in the last couple of weeks, we have mused around the deterioration of credit metrics particularly in High Yield land,  with renewed M&A marking what we think signs of exhaustion in the "credit cycle", in this week's conversation, we would like to highlight the weakening effects of the various iterations of QEs have had on risky assets, showing in essence that Le Chiffre is probably "overplaying" it particularly when one looks at the poor effects on "credit growth" in Europe and "inflation expectations".

  • QEs and the law of diminishing returns
  • Europe's "Japanification" process is still supportive of European credit
  • Final chart - Bonds have been the only game in town when it comes to "over-allocation"
  • QEs and the law of diminishing returns
In last week's conversation we used Liebig's law of the minimum concept as an analogy for our title given it was originally applied to plant or crop growth, where it was found that increasing the amount of plentiful nutrients (liquidity via QEs) did not increase plant growth (Economic growth). Last week we read with interest that the ECB indicated Credit Standards improved as QE Program supported lending as reported by Bloomberg:
"Credit standards on loans to companies eased for the sixth consecutive quarter, the ECB’s Bank Lending Survey showed on Tuesday. Terms for mortgages tightened, with banks citing national regulation as the primary cause. A small majority of lenders reported an increase in profitability over the past six months as a result of the central bank’s quantitative-easing program, though a deterioration is seen over the next two quarters." - source Bloomberg
Obviously what we find of interest from Le Chiffre's team at the ECB is that, once more the reality of the data counters their wishful thinking as indicated by Reuters in their article from the 27th of October entitled "Euro zone bank lending sluggish despite tsunami of QE and cheap cash":

"Growth in loans to the private sector slipped to 0.6 percent in September on a year ago, lower than August’s 1 percent rate and nowhere close to the near double-digit numbers clocked before the global financial crisis.  Loans to non-financial corporations grew just 0.1 percent in September from 0.4 percent the month before, the first monthly slowdown since June 2014.That data also are at odds with ECB’s Bank Lending Survey findings released last week, which showed banks reported increasing demand for business loans." - source Reuters
QE on its own is not leading to credit growth, because as we have repeatedly pointed out in our musings, a lot of European banks, particularly in Southern Europe are capital constrained and have bloated balance sheet due to impaired assets.

We would have to agree with Reuters, namely that  no matter how charming Le Chiffre's bluff is, we are not falling for it and you should not. From the same Reuters article:
"ECB President Mario Draghi last week signaled more easing is coming in December, and that has already become the consensus among economists. 
But more than six months of QE – 60 billion euros of bond purchases in each – and years of cheap long-term cash auctioned by the ECB has so far yielded lacklustre results despite the extraordinary amount of stimulus along with interest rates at or below zero.
More stimulus will not necessarily give banks the incentive to start lending to businesses.

Instead, European banks are lending a lot for house purchases, which does not suggest there will be a spurt broader consumer prices, which the ECB targets.
Consensus forecasts for euro zone inflation at the end of 2015, 2016 and 2017 have either stayed constant or been downgraded in each Reuters poll since May, even as it slipped back below zero last month." - source Reuters
We will repeat ourselves again: QEs have no impact on the "real economy". This a subject we already discussed at length in our November 2014 "Chekhov's gun":
"If domestic demand is indeed a flow variable, 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.QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.
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." - source Macronomics, November 2014
When it comes to the change in "credit growth", we agree with Kit Juckes from Société Générale in his recent takes on the impact of QE on lending growth in his View From The Hill from the 27th of October:
"QE doesn’t boost bank lending: I have two problems and one question. The first problem is economic: I can’t see how further ECB ‘QE’ can really help boost economic activity and specifically, how it can help boost loan growth. The second problem is a market one: I have no idea how to judge how far German Bund yields can fall as growth loses momentum and investors project zero (or negative) rates further onto the future and settle for less and less yield in their portfolios. The question, which I shall attempt to answer, is what that means for the Euro. Whatever else it means, of course, it isn’t good news.
The chart shows (In my opinion) the key part of the ECB’s monthly money supply release: the growth of loans, adjusted for securitisations. This slowed to an annual rate of just 0.4% in September, from 0.8% and from a recent peak of 1.4% in July. That’s a severe loss of momentum. I plotted it against the annual rate of change in the ECB’s balance sheet, although I could have plotted it against almost any other measure of QE and got the same answer – QE does not appear to be doing anything to boost loan growth in Europe.
We don’t know (what would have happened to bank lending or economic activity if the ECB hadn’t embarked on its bond-buying programme but ‘QE’ has supported peripheral bond markets, narrowing spreads and preventing a crisis of confidence, and it seems have supported equity and increasingly, property markets across Europe. But it hasn’t supported lending. QE + the shift to negative interest rates meanwhile, have as a combination weakened the Euro, which has hopefully helped exports (though a 9% year-to-date fall against the dollar is only a 5 ½% fall on a trade weighted basis).
The issue at stake is the different path taken between the Fed and the ECB when dealing with the impaired balance sheet of their respective banking sector. After all, the "Growth divergence between US and Europe? It's the credit conditions stupid...", it is all about Stocks versus Flows as we pointed out in May 2012:
"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."
What is depreciating at a very slow pace are the impaired liabilities on banks' bloated balance sheet hence the on-going support of the financial sector via LTROs first and then QEs, but in no way finding its way "meaningfuly" into the "real economy".

As a reminder, our take on QE in Europe from our "Chekhov's guncan be summarized as follows:
"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). 
Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?" - source Macronomics, November 2014
We also quoted at the time Nomura's Richard Koo on the subject of lending growth, QE and liquidity:
"Central bank-supplied liquidity has nowhere to go without real economy borrowingAs I have repeatedly pointed out, the central bank can supply as much base money (liquidity) as it wants simply by purchasing assets held by private-sector banks.But a private-sector bank cannot give away that liquidity, it must lend it to someone in the real economy for that liquidity to leave the banking sector." - Nomura, Richard Koo
If Le Chiffre is again promising more "generosity" it is because, contrary to some beliefs in its effectiveness in triggering "real economic" growth via the lending channel, all is not well in the European banking world.  We noticed that on the 12th of October, 3 small Italian banks Banca Marche, Banca Popolare dell'Etruria and Cassa di Risparmio di Ferrara (Carife) had to be bailed out by the Italian Central Bank due to a "small hole" of €2.2 billion euros. There are 650 small and medium banks in Italy, you  can therefore expect more consolidation and more "support" from the ECB.

Of course, when it comes as well to Le Chiffre and "inflation expectations", QE has been as well a failure as displayed in the below Bloomberg graph - H/T Holger Zschäpitz
- source Bloomberg / Holger Zschäpitz on Twitter

While Le Chiffre has been a prodigious  Poker player when it comes to "bluffing" his way out out of the "bond vigilantes" in Europe setting their sights on weaker European government bonds, when it comes to both "credit growth" and "inflation expectations", we think Le Chiffre has indeed been "overplaying" it.

In similar fashion to Liebig's law of the minimum, the law of diminishing return means that at some point, adding increasingly more fertilizer (liquidity via QE) improves the yield by less per unit of fertilizer (QE), and excessive quantities can even reduce the yield (check out 2 year Italian and Spanish government yields...). 

Back in December 2014  in our conversation "The QE MacGuffin" we quoted Société Générale in relation to the law of diminishing return from QE:
"Life below zero. At the ZLB, central banks do what they know: they print money. But such policy seems to follow a law of diminishing marginal returns. It has worked well for the US, because the Fed had a first-mover advantage, and the support from pro-growth fiscal policy and a swift clean-up of the household and bank balance sheet. The BoJ and ECB aren’t as lucky. Let’s consider three transmission channels: 1) The portfolio channel. By pushing yields lower, central banks force investors into riskier assets, boosting their prices. But trees don’t grow to the sky. And the wealth effect on spending is constrained by high private and public debt. 2) The latter also gravely impairs the lending channel. And with yields already so low, it’s questionable what sovereign QE can now achieve. 3) The FX channel. This is where the currency war starts, as central banks try to weaken their currency to boost exports and import inflation. It however is a zero-sum game that won’t boost world growth.-The battle to win market shares highlights a fierce competitive environment, which tends to depress global inflation. Adding insult to injury, oversupply in commodities, especially oil and agriculture, currently add to the deflationary pressure. That leads central banks to get ever bolder, when instead they’d need to be more creative (e.g. a bolder ABS plan from the ECB would be far more effective than covered and government bond purchases) and get proper support from governments (fiscal policy, structural reforms)." - source Société Générale, December 2014 - Macronomics
Indeed, in December we expect Le Chiffre to get even bolder.

When it comes to Le Chiffre and QE, we would have to agree with Société Générale's Forex Weekly note from the 22nd of October, "QE is losing is Mojo" and so is Le Chiffre:
"Dubious QE impactThere’s a belief in the foreign exchange market that ‘QE’ - bond-buying by central banks - can continue to weaken currencies and boost asset prices, pretty much ad infinitum. This argument feels more and more dubious to me. In particular, I am doubtful that increased conventional QE (bond-buying) by the ECB or the BOJ will weaken the yen or the euro significantly further from their recent lows. Indeed, I’m not sure how much of the weakness in either currency to date can really be attributed to QE in the first place. I think we have learnt enough from the experiment in glowing central banks’ balance sheets to understand more about how this works in practise. The Fed went first and, by buying bonds, forced a portfolio switch on US investors, out of Treasuries and into more exotic assets, first into mortgages, then corporate bonds and then on into domestic equities and foreign assets. Up went the S&P500 and down went the dollar as outflows to EM grew. US QE was turbocharged by intervention to limit the rise of the ruble, real and perhaps most of all the renminbi
(Chart 1). 

As central bank reserves grew across EM, which created more demand for Treasuries, magnifying the effect. And it also spilled over, through diversification, into demand for euros, Australian dollars and even sterling. I wouldn’t want to argue that Fed QE didn’t undermine the dollar. But what about BOJ and ECB action? Well, these moves weren’t turbo-charged in the same way, yet the yen and euro weakened. I put that down in large part to the other policies undertaken by these ‘excess saving’ central banks. The BOJ started with FX intervention after Mr Abe’s election and the next big phase of yen weakness came about as a result of a deliberate asset allocation switch into equities, including foreign equities by the public sector pension fund. The ECB generated euro weakness not through QE but later, when QE was compounded with negative interest rates in 2015. Driving yields down, on its own, isn’t always enough to persuade investors in savings-rich, low inflation countries to move money overseas - just look at the Swiss.
If conventional QE wasn’t what weakened the euro and yen as much as combining QE with other more potent policy adjustments, it seems to me wrong to assume that another simple round of QE by the ECB or BOJ will have much impact on the euro or yen in the coming days/weeks. Maybe there’s still an effect on peripheral bonds spreads in Europe, and perhaps on equities in both Europe and Japan. Or maybe, as in the UK, the most visible effect now will be on the property market. But in FX, perhaps not so much.
If words from the ECB and QQE from the BOJ this month fail to weaken the euro and the yen meaningfully, there’s a risk of the FX market adding two and two together and making four - concluding that QE ‘doesn’t work in FX’ and challenging the idea of a stronger dollar. EUR/USD at 1.20 and USD/JPY under 115 are not at all inconceivable outcomes this autumn. All it takes is for US Treasury yields to remain anchored." - source Société Générale
Combining QE with other more potent policy adjustments such as the ones described above in our "Hopeful equation" would have indeed a more meaningful impact on the "real economy", but, the free-ride given to European politicians by the ECB is ensuring that structural reforms are either postponed or not implemented. France for instance is a basket case for slack in implementing structural reforms.

While we have long been ranting on our strong deflationary bias, nonetheless, the "japanification" process is still supportive of European credit.

  • Europe's "Japanification" process is still supportive of European credit
In a market where recent bad news is still seen as good news (as it leads to more QE), the reality of QE’s failure will become at some point "bad news" as we once more lean towards deflation. While we have during the summer touched on the lateness in the US credit cycle and in particular through the view of our "CCC Credit Canary", European, which is still an expanding universe thanks to dis-intermediation from the banking sector and new players issuing bonds rather than loans, the on-going "Japanification" process and the increase in "Reverse Yankee" (US corporates issuing in EUR) is still supportive of the asset class, but, as we are indeed getting late in the credit cycle, there is limited upside we think.

As we indicated when quoting Nomura in April 2012, "Deleveraging - Bad for equities but good for credit assets":
"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns" - source Nomura
But, while Le Chiffre is promising some additional "unconventional" card tricks in December, the law of diminishing return means that as we are getting late in the credit game in the US, we could indeed have a spillover effect on European High Yield, should the Fed proceed with some form of normalization in December as expected by the markets following the latest FOMC statement.

When it comes to European High Yield, we would have to agree with Société Générale's take from their Credit Market Wrap up of today:
"Additionally, whatever (in)action the central bank takes today, the markets are likely to react one way or another. However, hike or no hike, we believe that the reality in Europe will remain largely the same. That means low inflation, poor economic growth, high unemployment and the need for more structural reforms and ongoing QE. In that environment, don’t expect corporates to start reckless releveraging processes any time soon, and that means, as we mentioned already this week, low to non-existent defaults and supportive credit metrics in general. The end result is a constant pressure on spreads to head tighter as credit, particularly HY, remains a more attractive alternative to other fixed income asset classes." - source Société Générale
Once more, Central Banks are indeed in the "driving seat" given the non-existing strong economic growth prospects, which makes this "Japanification" process "Goldilocks" period for "credit investors". Even more so in Europe if indeed Le Chiffre in December goes far more "unconventional and extending the already finite bond buying list of some Corporate issuers further. This would of course provide an additional "boost" to European credit. This was a well highlighted by Société Générale in their Credit Market Wrap up from the 25th of October entitled "Where did the defaults go?":
"Highlights: Credit yields are heading lower again, a trend that looks unstoppable for the coming months, even though they are much more attractive than equivalent sovereign bond yields. Still the upside of credit is again increasingly limited and the downside is growing. The good news is that spreads remain very wide by historical standards and compensate amply for the risk of defaults which are simply not happening. 
The ECB continues to prepare the ground for an increase in its QE program, most likely for the duration of it (extending it well beyond next September), but we suspect for the size and scope as well with the central bank gearing up to buy non-financial corporates next year. But even if the ECB confines its purchases to sovereign bonds, the ultra-low yield environment (not just sovereigns but corporates too) is set to remain in place for a very long time. And that means that funding conditions for both governments and corporates will remain extremely attractive for the time being. 
And we can already see some of the benefits of the favourable funding conditions. Coupons in IG of 1% are no longer rare, and only corporate hybrids offer 3%+. In HY, coupons can vary substantially depending on the rating but the average of new issues this year stands at 5.08% or 5.4% since the end of the summer. And this low funding, added to the ongoing disciplined approach to spending, means that defaults globally seem to be a negligible worry. As we can see in the chart below, it’s been around four years already with very low levels of defaults despite a very difficult recession and a very slow economic recovery.

In Europe there were only two defaults in September, Privatbank and Savings Bank of Ukraine, both Ukrainian banks, which is not too surprising given the situation in the country, and to a certain extent this pushes the European default rate higher than it should be under normal circumstances. Still, spreads continue to price in a higher level of defaults to come.
The iBoxx Corporates index is currently around B+157bp, better than where it ended September but still very wide compared to the current level of defaults. The iTraxx indices are a cleaner way to look at the pure credit risk which is in the end a reflection of the risk of default, given the greater liquidity in the synthetic contracts but even these continue to show a very high level of implied default rates. Currently, the iTraxx Main implies a default rate of 1.15% in a year’s time for IG which is excessive as the actual default rate remains at 0.0% and IG defaults tend to be very rare. The X-Over implied a default rate of 4.86% which also looks high versus current and forecast default levels.
Moody’s forecasts a speculative default rate of 3.2% in 12 months’ time, the highest forecast in a long time but even this is lower than what the X-Over is pricing. Furthermore, Moody’s universe is very broad and includes very vulnerable names (the two Ukrainian banks for instance), while the X-Over is made up of the 75 strongest names in the HY universe, companies that have easier access to the capital markets. Additionally, we believe funding conditions for corporates will remain very attractive throughout the life of the ECB’s QE as sovereign yields remain ultra low (and are probably falling) with spreads tightening gently in the coming months. With the economy growing even at a slow pace, it is difficult to see a wave of defaults on the way." - source Société Générale
What of course could but a "spanner" in the current "overconfidence" in Le Chiffre's ability in driving further "credit" into "overtime" for us are two factors, first one being a Fed December normalization process when liquidity will be very thin, second factor is that the EPS momentum continues to slump. As per our conclusion of last week's conversation,  companies overall remain extremely sensitive to revised guidance and earnings outlook. This was clearly illustrated in an another interesting note from Société Générale from their Global Equity Market Arithmetic series from the 26th of October entitled "While equities celebrate central bank actions, EPS momentum continues to slump":
  • Global equity markets continued their resurgence with the MSCI World up 1.4% last week, up over 10% from the recent lows. Interest rate cuts from the PBOC and dovish comments from the ECB pointed to a continuing downward trend in global interest rates.
  • The ECB's words undoubtedly had the intended effect of weakening the euro and as such, in local currency terms, it was the eurozone equity markets that were the better performers last week with the MSCI Eurozone index up 4.6% and the DAX gaining 6.8%. The DAX has rebounded strongly from the correction, having bounced back 14%, but it is still 8.0% off this year's high. With the Eurozone and Chinese central banks having made their intentions clear, all eyes will no doubt shift to Japan.
  • Away from the central banks, the US reporting is in full swing and there have been some impressive price moves, particularly in the large cap tech stocks, in response to positive earnings surprises. The message remains the same though, revenues are disappointing and despite some Herculean efforts to deliver EPS surprises, US earnings momentum is awful, with 70% of all revisions to 2016 numbers coming through as downgrades. Interestingly European and Japan EPS momentum is suffering the same fate, with the direction firmly negative. Only Emerging Markets and Pacific ex Japan are seeing a rebound from lows.
- source Société Générale

So while Société Générale is right in pointing out the "low default rate" in Europe, it is we think "oversimplistic", leverage matters more and so does earnings when it comes to High Yield. Looking at default rates is like looking at the rear view mirror. It tells you what has happened, not what is going to happen and maybe indeed looking at the iTraxx CDS credit indices is a cleaner way to look at the pure credit risk, given the greater liquidity in these synthetic contracts versus cash. We like mostly as an early indicator, the ability of our "CCC credit canary" to tap the primary market when it comes to using an early warning indicator in rising default risk and exhaustion in the credit cycle.

As we posited in our September conversation "The overconfidence effect", when it comes to credit spreads and default risks and leverage, end of the day, earnings matter!

Finally, for our final chart, we would like to point out that both the Fed and Le Chiffre have been great benefactors to bond speculators who continue to have a field day. Bonds have been the only game in town when it comes to "over-allocation".

  • Final chart - Bonds have been the only game in town when it comes to "over-allocation"
The big benefactors of the Fed and Le Chiffre's gaming style, particularly since is brilliant 2012 bluff in the European Government bond poker game have been bonds. We came across this very interesting chart from Deutsche Bank (h/t Tracy Alloway from Bloomberg on Twitter) which clearly illustrates "overconfidence" and "over-allocation" to the bonds relative to the trend which are $755bn above the normal trend. This is entirely attributable to the distortions created by QEs:

- source Deutsche Bank (h/t Tracy Alloway).

But of course there is a caveat to the Fed and Le Chiffre "overplaying" it in this monumental poker game.  On that specific matter we will simply quote again Antal Fekete from our July 2014 conversation entitled "Perpetual Motion":
"Moving back to the important notion of the difference between stocks and flows we do agree with Antal Fekete's take in May 2010 in his article "Hyperinflation or Hyperdeflation" being akin to a Black Hole and the possibility of capital being destroyed thanks to ZIRP (as it is mis-allocated towards speculative endeavors) hence the risk of pushing too far the "Perpetual Motion" experience":
"Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it the Black Hole of Zero Interest. When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction -- wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators." - Antal Fekete
While Le Chiffre is indeed in the process of trying to mesmerize us once more in December with his astute poker abilities, if bond investors continue to observe Le Chiffre, they will at some point find out his physical tell (A tell in poker is a change in a player's behavior or demeanor that is claimed by some to give clues to that player's assessment of their hand).

In the movie Casino Royale, Bond knew he could beat Le Chiffre as he was confident that he would catch his tell and get an insight into his game and strategy (bluffs included). This is what happens at the end!

Why? Because Le Chiffre used to place his left hand near his wounded eye at times during play. That was his physical tell. It ended up very badly for Le Chiffre but that's another story...
"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald
Stay tuned!

Tuesday 20 October 2015

Credit - Liebig's law of the minimum

"Capital as such is not evil; it is its wrong use that is evil. Capital in some form or other will always be needed." - Mahatma Gandhi

Looking at the acceleration in M&A activity in recent days (DELL, AB InBev, etc.), which amounts to us, as yet another indication of us being in the last inning in the credit cycle, it appears evident that while credit corporate bond markets remain wide open, the last two months have shown clear signs of some form of "exhaustion" in the cycle, particularly for High Yield. It remains to be seen which next M&A deal or LBO will fall through, but, when it comes to our chosen analogy, we decided this week to leave out the "explosive" references and steer towards a principle developed in agricultural science by Carl Sprengel (1828) and later popularized by Justus von Liebig.  The Liebig's law of the minimum states that growth is controlled not by the total amount of resources available, but by the scarcest resource (limiting factor). For us, this important factor is "capital", particularly in the light of ZIRP and repetitive QEs hence this week's title analogy. 

Liebig's law of the minimum concept was originally applied to plant or crop growth, where it was found that increasing the amount of plentiful nutrients (liquidity via QEs) did not increase plant growth (Economic growth). Only by increasing the amount of the limiting nutrient (the one most scarce in relation to "need") was the growth of a plant or crop improved (preventing mis-allocation of "capital"). This principle can be summed up in the aphorism, "The availability of the most abundant nutrient in the soil is only as good as the availability of the least abundant nutrient in the soil." Or, to put it more plainly, "A chain is only as strong as its weakest link."

In similar fashion, if we take biotechnology itself being totally dependent on external sources of natural capital, capitalism and CAPEX expenditures also depend on efficient market allocation of "capital". Obviously QEs and ZIRP, to that extent do not help whatsoever the process, on the contrary the distortions have been immense hence our Liebig's law of minimum analogy.

Also when it comes to our analogy and the "law of a minimum", we think investors should more and more focus on the return of "capital" as a "minimum" rather than focusing on the return of "capital" as a "maximum". Yes, there has been a strong rebound in inflows in recent weeks particularly in High Yield ETFs, but, looking at our much discussed "CCC credit canary" bucket and the dip in new issuance for the latter, it is a harbinger of trouble ahead we think, hence our recent call for moving higher in the ratings spectrum. If we would like to tweak slightly the previous aphorism we would state the following: "The credit cycle is only as strong as its weakest link, namely the CCC credit canary". 

While there has been a positive momentum in credit and equities alike, leading to strong inflows, with "bad news" on the macro side with weaker China GDP growth, leading to somewhat "good news", at least on the credit side, we think that financial system vulnerabilities have risen, thanks to the commodity down cycle in conjunction with the sharp depreciation of currencies in Emerging Markets (EM), particularly for commodity exporters such as Brazil. These developments have clear implications for foreign-denominated debt particularly for the corporate ones as discussed recently. There is a heightened risk for EM and DM banking systems alike for significant loan defaults and banking system losses in 2016.

In this week's conversation, we will look again at the consequences positive correlations have had on idiosyncratic risks and why in the current tightening mood, you should this time around avoid getting "carried away", meaning stretching for yield and risk given the lateness in the credit cycle.


  • Positive correlations means idiosyncratic risks are rising
  • More on the credit cycle turning - don't get "carried away"
  • Final charts - In a zero-inflation and borderline deflationary environment, the quality of the carried asset ultimately is more important than the cost of carry 

  • Positive correlations means idiosyncratic risks are rising
While in August we voiced our growing concerns on the rise in positive correlations and the instability it was generating in our short conversation "Positive correlations and large Standard Deviation moves", the recent significant price movements we have witnessed on numerous occasions, indicates clearly to us that this instability is leading to sudden bursts of volatility and large standard deviations move. We would not call that a "new normal" environment but, we think it is akin to the "law of minimum" in a ZIRP central banks induced world. 

This rise in idiosyncratic risks has been confirmed by Bank of America Merrill Lynch in their latest Credit Derivatives Strategist note from the 14th of October entitled "Refocusing on the big picture":
"The rise of idiosyncratic risksThe EM driven volatility is here to stay. Names with significant sales exposure to EM have borne the brunt during the recent sell-off. Additionally the consequent commodity price sell-off has triggered an increasing pressure on metals and miners. But on top of the global growth headwinds, we have also seen a significant rise of pure idiosyncratic risk recently both in high-grade and high-yield market. Multiple single name stories have been popping around. The VW story is casting a shadow on the autos and auto parts sector. Abengoa has also been on the fore over the past couple of months. Matalan recently saw their bonds down ~10pts.
Our Plunging bonds index is reflecting exactly that; the rise of idiosyncratic risks. Note that the number of bonds that dropped more than 10pts in a month spiked to the highest level in September.
However, the performance in the month of September was not that catastrophic across the board. After all not many European companies are either exposed to EM or have been affected by the VW story.
A way to illustrate the diverging performance across high-grade cash sectors is by tracking the standard deviation of their excess returns. In chart 3 we present the standard deviation of monthly excess returns for a number of non-financial sectors over time.

We find that the level of dispersion in September has been the highest since the 2008/09 global financial crisis, and far worse than the one experienced during the European sovereign crisis in H2-2011.

Note that while autos and industrials were the ones that dropped by c.4%, the rest of the market was down by ~1% on average (chart 4). These two sectors represent only ~10% of the entire high-grade market.

Record low financing costs…default risks should be contained…Default rates have historically been highly correlated to companies’ financing costs. We find that the loan interest rate cost is a good leading indicator of default rates (in the following 12 months, chart 5). 

With the ECB likely to expand/extend QE beyond September 2016, financing costs are likely to remain low for longer. Should this trend continue the currently low financing costs should support low default rates suppressing systematic default risks. 
The recent EM-driven weakness has driven spreads significantly wider, decoupling from lower loan rate costs for European companies (chart 6).

This provides more attractive levels to selectively add risk in credit instruments that have a cushion to first losses. 
Fundamentals improving…no re-leveraging despite enticing financing rates
Inflation and financing costs have been ticking down over the past couple of years. Corporate fundamentals are clearly improving. Over the past six quarters, leverage has fallen due to an improvement not only in earnings, but also thanks to lower debt overhang. Chart 7 shows that European corporates have not embraced more leverage (more in our dedicated HY fundamentals note), despite enticing record low financing costs."
- source Bank of America Merrill Lynch
We agree with Bank of America's take when it comes to European valuation being relatively more attractive compared to the US thanks to lower overall "leverage". This what we argued in our conversation "The overconfidence effect", US "releveraging" has been fast and furious which is not yet the case in European credit (far less "leverage" and "buybacks").

But, we cannot agree with Bank America Merrill Lynch's use of loan interest rate cost as a good leading indicator of default rates. This is misleading we think in this credit cycle. This time, it's different!

Why so?

In September 2014 in our short note "US High Yield issuance and debt outstanding" we indicated the following:
"In Europe, the situation is different, where the explosion in growth in the High Yield market comes from substitution from corporate loans to bond issuance due to the disintermediation on the back of bank deleveraging (which by the way is way behind the US). Existing loans in Europe are getting refinanced therefore via new High Yield issuance in the bond market, which implies that there is no significant releveraging as seen in the US so far.
Credit wised, the Loan-to-bond refinancing, or disintermediation, is another growth driver in European High Yield markets as European banks tighten lending conditions. According to Bloomberg, analysis shows 50% of funding in Europe from loans vs 40% in U.S. so while banks are in retrenching mode, companies are switching to the bond market rather that asking banks for loans with the stringent covenants normally attached to bank loans"

- source Macronomics, September 2014, graph Morgan Stanley, March 2013.
Europe is an on-going story of "deleveraging" when it comes to its banking sector. Banks are not making that many new loans, particularly in peripheral countries because weaker banks are still capital constrained! If you think banks have completed their deleveraging, then watch German banks and in particular Deutsche Bank. More pain to come, more assets to be offloaded, more jobs to be cut.

Using again our Liebig's law of the minimum analogy, the limiting nutrient (the one most scarce in relation to "need") for European banks is "capital". 

As a reminder credit growth is a stock variable and domestic demand is a flow variable. Central-bank induced liquidity is pointless without the real economy borrowing and the issue at the heart of the problem is that most Southern European banks are in fact "capital constrained" and plagued by NPLs (Nonperforming loans) and their "core capital " has been artificially boosted by Deferred Tax Assets (DTAs). DTAs are like "Aspartame", an artificial, non-saccharide sweetener used as a sugar substitute in some foods and beverages but, when it comes to European banks by no means it can be considered true "capital". DTAs currently represent c42% of tangible equity in southern Europe and contribute a median of c300bp to core capital ratios. This is significant!

With loans you have covenants as an alert system, even less so in the US with the return of Cov-Lite loans,  and with bonds, not that much covenants, hence the significant increase in "idiosyncratic risk".

Furthermore, we agree with our Rcube friends recent take on "bonds" being now a more serious indicators than "loans":
"We have been highlighting for months now that the combination of redemption and rising cash levels would be equal to a serious tightening of bank’s lending standards. This is because the share of corporate financing now achieved through capital markets has massively increased over the last 10 years. Bond funds have taken over loan officers as the main credit providers to corporations around the world. Only watching banks’ lending standards to evaluate the health of credit flows is a serious mistake in this cycle. In the US alone, the ratio of bond issuance vs. loans is 5 to 1. For risky assets to drop, negative sentiment is a prerequisite condition. It is now the case." - source Rcube

While we might be sounding like a broken record but, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger, even for European Issuers, regardless of their EM exposure, or not.

This brings us to our second point namely that in a context of deteriorating "credit metrics" for High Yield issuers (and no it isn't only bound to the "Energy" sector...), we think that investors should focus on return of "capital" rather than return on "capital" because  increasing amount of plentiful nutrients (liquidity via QEs) did not increase plant growth (Economic growth) so far, although we keep hearing from the "snake-oil" pundits that's the "recovery" is just around the corner:

US Labor force: For the first time since May 1990 the Ratio Not in Labor Force / Civilian Labor Force has topped 60%:
- source Macronomics

  • More on the credit cycle turning - don't get "carried away"
Whereas cheap credit has enabled some "extend" and "pretend" game, one of the major consequences has been to allow the extension of the "Maturity wall" to a later stage as illustrated by Bank of America Merrill Lynch in the below graph displaying the maturity profile for US High Yield bonds and Leveraged Loans:
- source Bank of America Merrill Lynch

In similar fashion, for some distress issuers in Europe, the game has been extended to "overtime" but in no way has altered the necessity for some form of "restructuring" as illustrated recently by the situation of Norske Skogindustrier ASA, a Norwegian pulp and paper company based in Oslo as reported by DataGrapple on the 16th of October:

"So NSINO (Norske Skogindustrier ASA) eventually paid their 2015 bonds. The company has apparently decided to buy some time in order to find a suitable solution to manage their considerable debt pile. Their next maturity falls in May 2016, but once these junior bonds will have been paid, there will be very little cash to redeem other maturities. It is therefore no surprise that holders of longer dated bonds are mulling restructuring plans. A group of investors holding NSINO’s 290mln euros of senior bonds due 2019 allegedly met with the company to discuss a possible debt for equity swap. Holders of junior bonds due 2017 approached management with an alternative plan that included extending their claims until after 2019. The company is conveniently in blackout period ahead of its results on October 22nd. They should expect a grilling then regarding their intentions. But in the meantime, as their willingness to kick the can down the road was evidenced by the payment made yesterday, investors have steepened the risk premium curve of NSINO on the short end. The 1 year CDS closed today at 29pts upfront, 10pts lower than 2 days ago." - source DataGrapple
Of course, in similar fashion, the "lunatics" running the "central bank" asylums have also played the "buying some time" game to say the least. They seem to be oblivious to Liebig's law of the minimum but we are ranting again.

We think it is high time investors start thinking about "playing" defense", this means going higher into the "ratings" spectrum. As goes our second point, do not get "carried" away, meaning stop "selling "beta" for "alpha" (though we do know that the first source of "alpha" are fees to quote one of our Hedge Fund manager friend...) because the cycle is running out of steam. 

On that note, we could not agree more with Bank of America Merrill Lynch's High Yield Wire note  from the 19th of October entitled "Fool me once, shame on you, fool me twice…":
"All credit cycles come to an end. This one’s no different.We’ve said for a while now that the benefits of low rates have long been sapped from the market, and we are in no rush to change our tune on the back of a two week rally. As we look at the fundamentals of the market, our strategic view on high yield remains crystal clear: the market is in its 7th or 8th inning and still needs to cheapen substantially before valuations become attractive. With the risk for 100s of billions of investment grade downgrades, our view that defaults will soon be increasing, and that Fed stimulus is no longer a tailwind to the market, our expectations are for wider spreads in 2016. This is not to say we expect a massive default wave next year, but do wonder whether the lack of liquidity and general direction of the market creates an attractive entry point anytime soon. 
Spread compensation not enough for what matters: ReturnsAs we have been traveling across the US and Europe the last 6 weeks we have heard two arguments why investors may find value in high yield. First, there is a lack of alternatives. Second, with the recent widening, spread compensates you for the default expectations priced into the market. We don’t agree with either. Investors need to demand return, not yield. A 7% coupon does not yield a 7% return and with the potential for low average returns for some time, we think alternatives do in fact exist. Additionally, traditional measures of spread compensation are flawed in our view, and need to be seen in the context of alternatives and default risk over the life of a portfolio." - source Bank of America Merrill Lynch

When it comes to Liebig's law of the minimum and "return" of capital, we also agree with Bank of America Merrill Lynch's take on the need for looking for "quality" rather than yield:
" All credit cycles come to an end. This one’s no different.
Over the last couple of years, the market has frequently been fooled by assuming a new old world where bad news is bad news and good news is good news, only to be whipsawed by risk on sentiment where fundamentals matter less than easy monetary policy. At the risk of being fooled again, we say the tide has turned, and low rates and pushed out hike expectations matter less in a world where sentiment has shifted, fundamentals are poor, and investors are not being compensated for default and
liquidity risk.
It is interesting how so few disagree with us that fundamental metrics in HY are quite poor and unlikely to take a turn for the better any time soon and yet so few agree with our thesis that this is highly problematic. The effectiveness of central bank policy in boosting asset prices over the last few years has created a blind spot when it comes to fundamentals. This is apparent when the only counter to our argument is “where else will the money go?”
The steadfast belief that low rates and the central bank put will continue to mean a reach for yield, never mind it’s quality, seems absurd and contrary to evidence. It’s been six years since the recession; we’ve had numerous rate cuts and quantitative easing programs the world over, we’ve seen all-time high stock prices and we’ve witnessed all-time low bond yields, and yet neither the market, nor it seems the economy is allowing the Fed to hike rates. As Thanos wrote recently, we should have known something was wrong when bad news was greeted more cheerfully than good news.
Ok, so what has changed now you say; if central banks continue to remain so accommodative, why not more of the same? Because the last six years have also borne witness to the fastest growth in corporate debt that we’ve ever seen and re-leveraging to a scale comparable to the worst moments in HY’s history.  
This has occurred in conjunction with mediocre revenue growth, disappointing capex spending and earnings burnished by buybacks and acquisitions. And just as credit quality started a turn for the worse, risk aversion has set in quite firmly within the market. The flight from Energy and the reluctance to step back in even at today’s highly distressed levels amongst investors has been stark, as they anticipate many HY E&Ps to raise priority debt ahead of existing bondholders and potentially file for bankruptcy. Even the erstwhile “safer” places to hide may not make the cut going forward. We have already seen some unraveling in the traditionally defensive pharma market with stock and bond prices of drug makers taking sizable hits on the prospects of drug price caps. Lately, the risk aversion has spread to mainstream hospitals too- case in point HCA equity down 23% since August 4th.
In the same vein BBs, which have outperformed Bs and CCCs all year (BBs -0.93%, Bs -2.67%, CCC -7.14% YTD), face headwinds from falling angels once rating agencies begin downgrades ahead of the default cycle. In the past two migration cycles, an average of 10% of the starting IG universe was downgraded to HY over the course of the cycle (Chart 3). 
This translates to as much as $300bn worth of par value in cumulative downgrades over the next 3 years if the rating agencies begin to shift their expectations in 2016. Should history repeat itself, these downgrades will expand the current BB universe by a whopping 63% and the overall size of the high yield index by nearly 25%.
Of course, existing BBs today will also suffer attrition by way of downgrades to Bs, and Bs to CCCs, but the overall indigestion to the market could prove massive. We hear so much about the potential for outflows, but very little about the potential for new paper through downgrades. The latter dwarfs the former.
Finally, the re-pricing in the primary market as issuers bow to investor demands is just another reminder of waning risk appetite. Never before has access for CCC issuers, even non-commodity ones, been so poor post crisis. The proportion of low quality issuers accessing the market on an annual basis has now dipped below 20%, a far cry from the 50% at the top of the cycle. It doesn’t take much to see what this means for the survivability of low quality issuers going forward. In fact the previous times we were at these levels and heading in the wrong direction was in 1989, 1999, and 2008, right at the heels of default waves (Chart 5). 

Of particular interest is that once CCC issuance (as a percentage of all existing triple C issuers) falls below 20%, the default rate tends to spike north of 10% within a year and a half on average. In the late 1980s/early 1990s, the time to double digit defaults was 20 months, in the late 1990s/early 2000s it was 22 months and in 2008 and 2009, it was just 14 months. Assuming a similar pattern today, one would expect the current risk aversion to lead to a significant pickup in defaults sometime in mid-late 2017, consistent with our previously published estimates. 
The idea that once again bad news is good news and good news is bad news has no merit in our view, especially in the context of all the late stage indicators we are seeing. We’ve said for a while now that the benefits of low rates have long been sapped from the market, and are in no rush to change our tune on the back of a two week rally. In fact, we would argue that we have witnessed nothing but a dead-cat-bounce in HY, and a price action which has little if anything to do with the expectation for rates or improved fundamentals, and everything to do with ETF buying and short covering. The $2bn+ that flowed into ETFs in the week ended Oct 9th was the highest on record for HY ETFs (Chart 6). 

This was the same period over which the HY index staged a dramatic 70bps of spread tightening, but has since given back some gains. In contrast, actively managed retail funds saw a meagre inflow of $140mn over the same period.
Note that the market was pricing an impossibly low probability for a hike before September’s meeting and that the market sold off all summer despite treasury yields falling. In fact, after Yellen’s press conference, where she discussed the lack of inflation and weak global growth as the main reasons for keeping zero interest rate policy, the market sold-off. Yet, we are meant to believe that when the same concerns were expressed in the minutes, everyone had changed their mind that these issues were now a good thing? We don’t buy it.
As hard as it is to accept that this glorious run for credit has come to an end, in our view it is time to acknowledge that valuations do not justify the risk-reward profile in HY, and no amount of QE or easy monetary policy is likely to change the story for an extended period of time. The market is in its 7th or 8th inning and without a substantial increase in earnings- a prospect that will require fiscal policy changes more than monetary stimulus, in our opinion- we think high yield will have a difficult time sustaining rallies. And to substantiate that view, we attempt to counter the most frequent arguments we’ve heard from those who disagree. 
Spread compensation not enough for what matters: ReturnsYield does not equal returnThis may be stating the obvious. But we find it necessary to say so anyway. The most vociferous argument for HY seems to rest on the fact that it indeed provides a high yield; more importantly a higher yield than Treasuries, high grade and perhaps even expected stock returns. But what good is a high coupon if enough price loss and defaults occur to wipe away any cash inflow? We would think investors would search for return, not yield, in which case, in our view compensation is not commensurate with the alternatives.
In late December last year, the yield on our HY index was over 7%, the highest it had been in over two and a half years. Just a few weeks back it was over 8% and year-todate returns stand at -0.6%. High yield or higher yield than recently observed did not by themselves preclude an even higher yield or negative returns. Why opt for 2-3% returns in HY with its volatility, defaults and liquidity challenges when HG paper yields 3.3%, has less volatility and virtually non-existent default risk?" - source Bank of America Merrill Lynch
Given the "holding" pattern of the Fed, we believe as well, that US Investment Grade has become somewhat attractive again. On that matter of "quality", we have read with interest Bank of America Merrill Lynch's Situation Room note from the 20th of October entitled "It’s what you don’t see that hurts you":
"Cash gets no credit
High quality industrial spreads are attractive relative to their lower quality HG counterparts. This is because currently single-A and BBB-rated industrials offer similar spread levels per turn of gross leverage (ex. energy, materials, utilities) – see Figure 1. 
This means that investors give A-rated industrials little credit for their superior liquidity positions, with higher quality industrials holding about twice as much cash on their balance sheets as BBBs (Figure 2). 

In other words, current valuations assign close to zero value to the much lower net leverage of high-quality companies compared to their lower rated peers. With corporate releveraging expected to slow we think credit market valuations should become more aligned with net than gross leverage. While a significant portion of corporate cash could be overseas, it would still be available and useful to repatriate - after a tax haircut - in situations of distress. 
The trend in gross leverage for both high quality and BBB-rated industrials has been similar, with the median leverage rising since 2012 (Figure 3). 
In contrast the higher cash balances actually pushed the net leverage down for single-A rated issuers, while net leverage increased for BBBs (Figure 4). 

In fact, about 40% of single-A issuer in our credit universe (ex. energy, materials, utilities) have negative net debt as of 2Q-2015." - source Bank of America Merrill Lynch
"Quality" indeed in Investment Grade credit is once more a "compelling" argument, we think, given the lateness in the "credit cycle".

While in September we would confide we have been adding on our US long duration exposure, it seems to us that in a "deflationary" enclined world, "quality" credit Investment Grade is still good value for your money, US High Yield doesn't appear to us like it and this bring us to the main reason we have also discussed in recent weeks is the rise in the cost of capital and global tightening financial conditions (think about our CCC Credit Canary and its issuance "issues"...).

This brings us to the final "inning" of this week's credit conversation, namely that in Liebig's law of the minimum, what matters in a D for Deflationary world more and more is the return of your capital, not the return on capital.

  • Final charts - In a zero-inflation and borderline deflationary environment, the quality of the carried asset ultimately is more important than the cost of carry 
While we recently boasted on the attractiveness of "deflation floors" for US Tips as compelling in a "D" world, there has been as well as of late, some evidence of the rise in the cost of capital hence a slowdown in buybacks and US corporates starting to become more defensive of their "balance sheet". We would like to point out David Goldman's comments which can be found on Reorient Group's website from their note from the 18th of October: 
"Part of the reason for lower per-share profits is the decline in equity buybacks. Factset reports, “Companies in the S&P 500 spent US$134.4 bn on share buybacks during the second quarter. This represented a 6.9% decline in spending from the first quarter. At the sector level, six out of eight sectors saw a sequential (quarter-over-quarter) decrease in share buybacks at the end of Q2 (excluding the Telecom and Utilities sectors, which have each averaged less than US$2 b in quarterly buybacks since 2005).” 
Buybacks, in turn, have declined because the cost of financing them has risen. The spread to Treasuries paid by medium-grade corporate borrowers rated Baa/BBB has risen by a full percentage point since July 2014.

In a zero-inflation and borderline deflationary environment, 5.4% interest on term debt is real money, and corporates are getting reluctant to lever their balance sheets in order to show higher per-share earnings. During the past five years, the 100 members of the S&P 500 with the highest proportion of share buybacks (the S&P 500 Buyback Index) outperformed the rest of the index by 20%.
Source: Bloomberg
During the July-September correction, though, the S&P Buyback Index underperformed, losing 4% against 1% for the S&P as a whole.
That’s an important signal that the quality of the carried asset ultimately is more important than the cost of carry. If earnings continue to deteriorate, carry trades will start to resemble the conclusion of the Stephen King film with the homophonous name. " - source Reorient Group - David Goldman - 1§th of October
While it isn't yet "Nightmare" on "Credit Street", it looks to us that while leverage matters, earnings matter even more when it comes to "default" risk as we posited back in November 2012 in our conversation "The Omnipotence Paradox" which is in effect, yet another manifestation of "overconfidence" by our central bankers, at the time 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

One thing for sure, don't get "carried" away, preserving "capital" sure is the law of the minimum...

"Words have no power to impress the mind without the exquisite horror of their reality." - Edgar Allan Poe

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