Friday, 20 November 2015

Credit and Macro - Fluctuat nec mergitur

"The human race's prospects of survival were considerably better when we were defenceless against tigers than they are today when we have become defenceless against ourselves." - Arnold J. Toynbee, British historian.

While still reeling from the outrageous Paris attacks (one of us being a "born and bred" Parisian), and, looking at the continuous rally in risky assets, for our chosen title and in homage to the numerous victims of this senseless act, we decided that our chosen title should reflect Paris, hence our election for Paris coat of arms' motto "Fluctuat nec mergitur". It was officially established on the 23rd of November 1853 but dated back from at least 1358, a coincidental "number anagram". This motto could be translated as follows for Paris: "Paris is tossed by the waves but does not sink". 

When it comes to our analogy, Paris is like credit, resilient, it is tossed by waves but does not sink as reflected in the below graph from RBS The Revolver note from the 17th of November:
- source RBS

As we move towards the end of 2015, when it comes to credit European High Yield in the credit space has clearly outperformed US High Yield and even US Investment Grade. In this week's conversation, we would like to look at the prospects for credit for 2016 as well as pointing out some additional signs of credit cycle exhaustions as of late which, we think, warrants further monitoring.

  • LBO fatigue - yet another additional "caution" sign of the "credit cycle"
  • The US High Yield Market continues to be heading "South"
  • What to expect in 2016 - Will it be "Fluctuat nec mergitur" again for credit?
  • Final chart - Q4 US consensus profits growth is already forecast to be negative
  • LBO fatigue - yet another additional "caution" sign of the "credit cycle"
Whereas in recent weeks/months we mused around our favorite credit indicator for the lateness in the "credit cycle" being the "CCC Credit Canary" and its issuance issues, we also recently questioned ourselves in our conversation "Liebig's law of the minimum":
"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." - Macronomics, October 2015
Indeed, whereas we have seen an acceleration in large M&A transactions, the continuous struggle of the "CCC Credit Canary" and the rise in the "cost of capital" have finally taken their toll and translated into the LBO market as shown in the  recent comments below from SG US derivatives desk highlighting that once again "weak feeling" we have on US HY credit markets, following a quickly erased October rebound:
"This week surprisingly weak demand for financing of the LBO of Veritas caught banks by surprise. The consortium led by Bank of America and Morgan Stanley ended upstuck with $5.6bl of the debt as they were forced to postpone the offering, even after they offered a discount to investors and a yield as high as 11%. The consortium of banks will now have to the debt on their books and wait for a more opportune time to sell the high yield debt. Earlier this year a group of Private Equity investors led by Carlyle agreed to buy Veritas from Symantec (SYMC) in an $8bl Leveraged Buy Out, the largest LBO of 2015.
The high yield debt market has seen stress from the energy sector, where default rates have risen to 8.2% last month from <1 beginning="" in="" nbsp="" of="" span="" style="color: red; line-height: 20.8267px;" the="" year.="">The stress seems to spread to other segments of the high yield market, as demonstrated by the failure to place debt of a tech company and a overall widening of spreads of risk free rates.
We launched an High Yield Thematic basket (SGUSHY Index) last week that replicates the HYG, but holds the stocks instead of the corporate bonds of the issuers in the Markit iBoxx High Yield index. The basket therefore offers a much more attractive transaction costs (1mL – 30 financing costs vs. 90bp borrowing rates for HYG (indicative prices))." - source Société Générale
For us, it was interesting to see the difficulties of the Veritas LBO refinancing deal, far away from the struggling oil sector. Different times, different situations, but some 2007 memories came to our mind, particularly when the first signs of the credit market peak came from a few struggling LBO refinancing deals at the time.
Within the general High Yield market tone of nervousness we also noticed on the US Convertible markets in the last few day some several "massive" spread widening moves, especially on the High Y iled "renewable energy" segment:  SUNE, SCTY…
 SPX vs US HY ETF HYG - source Bloomberg:
- graph source Bloomberg.
Also, we are also wondering about the increasing number of cash M&A deals met with market skepticism (with acquirers shares selling off on the announcement: ON Semi/Fairchild and Air Liquide/Airgas yesterday, Mylan/Perrigo and Dialog/Atmel situations in the last few weeks…). Are we seeing some signs of fatigue? It certainly looks like it to us.

In conjunction with LBOs losing their "mojo", flows have well have finally shown some signs of pause after the significant inflows we described in October. For instance, as shown in Bank of America Merrill Lynch High Yield Flow report from the 12th of November entitled "The pendulum swings for HY ETFs",  the rally experienced throughout October in terms of inflows have come to an end:
"High yield fund flows reverse trendUS high yield saw its first week of outflows (-$1.61bn) in 6 weeks with both ETFs and non-ETFs ending up in the red. HY ETFs saw a massive $3.91bn WoW swing with a- $1.37bn (-3.5%) outflow this week, while non-ETFs saw a less volatile $242mn (-0.1%) net outflow. These outflows from ETFs are not surprising given the nearly 17% AUM growth the asset class has seen over the previous 5 weeks. Additionally, as we have previously discussed, investors likely grasped at the opportunity to sell into the recent rally and lock in October’s impressive 2.73% return.Meanwhile, non-US high yield funds saw $1.08bn (+0.4%) in net inflows. Outside of high yield, high grade funds continued to grow their asset base with an $828mn (+0.1%) net inflow, their 5th consecutive weekly inflow. Loans posted yet another outflow ($347mn, - 0.4%), to bring their YTD %NAV to an even -11%. EM debt saw net outflows of -$1.2bn (-0.8%), likely suffering from the ever-increasing probability of a December rate hike. As a whole, fixed income funds saw -$3.30bn (-0.2%) in net outflows, their first weekly outflow in 6 weeks. Equities saw little change with a minor $2.41bn (+0.0%) inflow.
- source Bank of America Merrill Lynch
Whereas for US Investment Grade, we still believe in a "Fluctuat nec mergitur scenario for 2016, where a rising US dollar and "external" allocations (such as Japan's GPIF) to US credit should continue to be supportive of the asset class, we are getting more and more concerned on US High Yield with the accumulations of warning signs we are seeing. This brings us to our next bullet point.

  • The US High Yield Market continues to be heading "South"

More concerning to us as (apart from "inflows" and "outflows in High Yield) has been the flattening of the US High Yield CDS curve as shown below from CMA part of S&P Capital IQ for the CDX HY Series 25:
As of per the 19th of November 2015:

As of per the 1st of October 2015:
- source CMA part of S&P Capital IQ
This, for us is yet another clear sign of deterioration whereas Investment Grade continues so far to benefit from a steeper credit curve despite market expectations of a rate rise in December by the Fed.

We are not alone to have a "negative stance" on US High Yield, we also share the same concerns as Bank of America Merrill Lynch from their HY Wire note from the 16th of November entitled "Bonds to underperform loans again in 2016":
"Fool’s gold
Several weeks ago we mentioned that taking part in the October rally was a fool’s errand, and that the inflow of cash to primarily ETFs was responsible for the bottom fishing that occurred in the first two weeks of the month. In our view, selling into the strength, despite high cash balances was the prudent move- a position we continue to like today headed into year end.
The payrolls number from two weeks ago coupled with further weakness in fundamentals and commodities, disappointing retail sales and relatively hawkish comments from Chairwoman Yellen have created a perfect storm of worry among high yield investors, as our index has retraced almost 50% of the gain from last month (Chart 1). 

And for good reason too. Our house view is for the Fed to raise rates in December and it appears as though the divergence of the US economy from high yield fundamentals isn't changing anytime soon as Q3 earnings mark a 5th consecutive quarter of weakness. EBITDA growth for a third of the HY universe that has reported so far is still negative, and adjusted EBITDA growth is near zero (Chart 2).

And unfortunately, it’s getting increasingly harder to push the blame for dismal HY earnings on the strength of the dollar.
Furthermore, geopolitical headwinds still exist, and, liquidity (or perhaps the better word is "reality" as in the reality of the real prices in which bonds can trade) continues to present challenges. To make matters worse, we can't say we love quality here either though clearly given our disposition leaves us the least ill when thinking about positioning in a must invest world. Meanwhile triple Cs and single Bs are not the place to hide with just a few trading weeks left in the year. As such, expect next to no bid on any new deals with hair on them and for higher quality new issue to be the place to hide and put cash. Finally, despite loans holding up so well to bonds this year, we continue to like loans heading into 2016, and discuss below in detail some analysis that draws us towards that conclusion. " - Bank of America Merrill Lynch
Exactly. Going higher into the quality spectrum in US High Yield is a imperious necessity as we are witnessing a clear deteriorating trend in the "credit cycle". 

What interesting is that investors (or "yield hogs") seems to continue in many instances to disregard "safety" for "yield "as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 13th of November entitled "Yield is king":
"More in yield, less in “safety”Investors continue to embrace yield over “safety” for a fifth week in a row. Both high-yield and equity funds continued to see more inflows last week. On the contrary, flows into high-grade slipped back into negative territory. Likewise for government bond funds.
Optimism on the back of the previous week’s high grade inflow did not last long as the latest data shows; flows dipped back to negative. Nevertheless, note that high grade ETF fund flows remained positive for a fifth week in a row.

Looking at high-grade duration, both short and long-term fund flows turned negative during the previous week, while mid-term fund flows remained positive but only marginally.
A positive trend however continues in high yield, with the third consecutive week of $1bn+ inflows; the fifth inflow in a row. Last week’s flow also brought the year to date inflow for the asset class back into positive territory.
Government bond fund flows, on the other hand, moved deeply into negative territory suffering the biggest outflow in 19 weeks. Money market funds followed a similar path, but less extreme.
The week in fixed income flows therefore finished in negative territory, marking the first outflow in five weeks. YTD flows into FI funds are now negative.
 Looking at equity fund flows, the trend remains strongly on the positive side for the sixth consecutive week. YTD flows are now at $110bn+." - source Bank of America Merrill Lynch
Whereas, 2014 was not the year of "Great Rotation" from bonds to equities, 2015 was clearly supported by flows particularly in Europe thanks to the "divine" intervention and meddling of central bankers. This is leading us to our third point, namely what to expect in 2016, will it be "Fluctuat nec mergitur" again for credit?

  • What to expect in 2016 - Will it be "Fluctuat nec mergitur" again for credit?

This is particular true in Europe which, performance wise, was clearly supported by the actions of "Le Chiffre" aka Mario Draghi as indicated in Société Générale in their note from the 12th of November entitled "Risk Premium in Pictures ":
"Digging into corporate bond valuationsAt a time when the US Fed is expected to embark on the journey of normalising its monetary policy, we analyse the relative valuation of equity, corporate credit and government bonds.
With the exception of eurozone equities, most asset classes have delivered lacklustre returns in 2015. Rich valuations, a potential Fed rate hike and a slowdown in Chinese growth has weighed on asset prices this year. However, consistent with our constructive stance on eurozone equities, 2015 has indeed proved to be a fine vintage for eurozone equities.

Be ready for lower returns going forward. 
In the left-hand chart below, we plot the total return investors should expect across asset classes. Our proprietary risk-premium model suggests that most asset classes will deliver single-digit sub-par return going forward. 
However, it is clear that equities are expected to do well relative to fixed income assets. Within equities, we expect the euro area to perform best as growth expectations improve from the current bearish level." - source Société Générale

While we continue to expect Europe to outperform High Yield wise the US from a "relative value perspective", the actions of the ECB continues overall to be supportive of credit in Europ particularly in the light of continuous "financial repression", rising amount of short term negative yields in the continuation of the "Japanification" process. 

Credit wise, we are moving from a story of convergence, to a story of divergence, some would point out this is very "2011ish" in credit, but it is the reality, as the Fed and the ECB are set up for different courses. This was clearly indicated by the latest post from DataGrapple:
"The FOMC minutes released yesterday confirmed that the Fed are still on course to raise rates in December. Specifically, it was noted that “while no decision has been made, it may well become appropriate to initiate the normalization process at the next meeting”. Based on the Fed fund future market, the probability of a hike stands at 68%, but hardly anyone doubts that will go ahead. That is in stark contrast with expectations regarding the ECB next course of action. QE expectations in Europe are as high as they have ever been and investors are bracing themselves for a salvo of new easing measures mid-December. It will be the first time in a long long while that central banks in Europe and in the US embark on radically diverging paths. These contrasting environments are being played by credit investors, and some today were buying protection on CDXHY in the US while selling protection on iTraxx Crossover. Generally speaking, relative values are being played and it is obvious for all to see on the above grapple. While CDXIG and iTraxx Main (ITXEB) were trading 1bp apart at the beginning of October (at 96bps and 95bps respectively), they were trading 7bps apart early November (at 78bps and 71bps respectively) and stand 12bps apart at the close (at 84bps and 72bps respectively)." - source DataGrapple
This divergence, we think, will continue to play out in credit, from compression and convergence to decompression and divergence. Please find below our illustration on this subject - CDX Investment Grade US versus Itraxx Main Investment Grade Europe (roll adjusted) - data source Bloomberg:

- source Bloomberg - Macronomics

In this "beta" chasing game, some pundits would point out to the attractive "valuations" level of European banks. We continue to dislike the sector as the deleveraging and low profitability of the sector makes us prefer to play it through credit instruments à la "Japan". 

Equities wise, we believe the banking sector will continue to underperform "high beta financial credit", regardless of the bullish and overweight stance of Société Générale's Equities team and the below graph from their report European banks from the 13th of November entitled "A wake-up call":
"Top picks 
We are Overweight European Banks. There is value, with over half the sector (and €600bn of market cap) now trading below TBV. The earnings momentum has stalled post Q3, and banks need to wake up to the new reality of revenue stagnation. Restructuring and a focus on isolated areas of revenue growth will help. This can be supported by increasing capital strength. Our Top 5 list outlines the banks that can best benefit from these themes: Barclays, Erste Group, ING, Lloyds and UBS. We remain cautious on BBVA, CS, DBK and Nordea.

- source Société Générale - SX7P = Eurostoxx 600 Financials vs Eurostoxx 600 = SX7E

No "offense" to the equities guys but here are some facts about the banking system in Europe still being "capital impaired" as indicated by Linklaters on the 2nd of November:

  • Estimated €826bn of NPLs are currently sitting on the balance sheets of European banks that are supervised by the SSM
  • NPL volumes still remain close to levels revealed at the ECB’s comprehensive assessment in 2014
  • Significant differences between NPLs across different countries with high volumes in place across Italy, Spain, France and Greece
  • Greek, Austrian, Portuguese, Italian and Cypriot banks likely to be challenged further in future stress test

New analysis from Linklaters estimates that since the ECB’s Single Supervisory Mechanism (‘SSM’) was implemented on 4 November 2014, non-performing loan (‘NPL’) volumes across the banks it supervises remain high, reducing marginally from €841bn* to €826bn**. 
The NPL to Asset Ratio of these banks has also only slightly decreased from 4.13% (end of 2013) to 3.92% (H1 2015). 
Banks have been announcing plans to offload NPL portfolios and demand continues to be significant from investors with at least €40bn*** of distressed funds raised to buy these portfolios. But the research suggests that NPLs in certain countries are steadily increasing, causing a drag on banks’ profitabilities and market confidence. Tackling these credit risks will be a key supervisory priority for the SSM in 2016." - source Linklaters
No matter how our "equities friends" want to "spin it", we are not "buying it" and we will stick to "credit" when it comes to banking exposure in this "japanification" on-going process. There is much more "deleveraging" to go in Europe, in 2016 as well as shown in the never ending earnings revision in the sector as displayed in the same Société Générale report:
- source Société Générale.

So if you want "Fluctuat nec mergitur", when it comes to "banks" exposure in Europe, stick to credit.

In the end for credit, and markets, leverage matters, financial credit conditions matter and so does earnings for any rally to be sustained.

  • Final chart - Q4 US consensus profits growth is already forecast to be negative
Whereas during most part of the summer we have been musing around the credit cycle, leverage, defaults and indicators, more recently we have touched on the deteriorating picture and risk of "peak profitability in the US", earnings, regardless of the surge in the US dollar are facing "headwinds" and this, we think is linked to global financial conditions tightening. For our final chart, we would like to point out the fundamental problems facing equity investors given the weakening earnings picture. This is clearly illustrated by the below chart from Société Générale Global Equity Market Arithmetic report from the 16th of November entitled "US profits facing numerous headwinds":
"Equity investors face a variety of fundamental problems, including higher levels of debt, expensive valuations and weakening profits. And whilst earnings momentum has turned up recently, as it typically does during the reporting season (and from very low levels), the proportion of downgrades coming through remains elevated and is only likely to increase in preparation for Q4 reporting. Notably Q4 US consensus profits growth is already forecast to be negative even once financials and energy are excluded.

US dollar strength is clearly already a problem for US corporates and weak US import prices are taking its toll on industrial profitability. However a strong US dollar is not necessarily a given post the first interest rate rise. A quick back of the envelope calculation shows that whilst the US dollar typically appreciates in the 3 months leading up to the first rate rise, in 9 out of the last 10 interest rate cycles the US dollar was weaker in the 3 months thereafter." - source Société Générale

Remember when everyone is thinking alike, no one is really thinking...

"We cannot solve our problems with the same thinking we used when we created them." - Albert Einstein
Stay tuned!


  1. Have you come across a chart of HY EBITDA vs overall SPX EBITDA?

    1. Not yet in any specific report, but that is something we can easily look up.



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