Sunday, 29 November 2015

Macro and Credit - Assumption of risk

"Between calculated risk and reckless decision-making lies the dividing line between profit and loss." -  Charles Duhigg, American journalist
While watching with interest some additional "sucker punches" being inflicted, such as the one delivered as of late to equities and credit investors alike in Spanish company Abengoa and their  "credit" situation (which we already touched back in August in our conversation "The Battle of Berezina"), given it will be a mess to "restructure" thanks to the web of companies with 24,000 employees and close to €9bn of gross debt, we decided for this week's title analogy to steer towards a "legal" one, being the "Assumption of risk" in the US legal system.

The "Assumption of risk" is a defense in the law of torts (in common law jurisdictions, a civil wrong), which bars or reduces a plaintiff's right to "recovery" against a negligent tortfeasor if the defendant can demonstrate that the plaintiff voluntarily and knowingly assumed the risks at issue inherent to the dangerous activity in which he was participating at the time of his or her injury

While it was clear to us and some other pundits since August that the Abengoa "credit situation" entailed significant "downside risk", we wonder if indeed the "Assumption of risk" could not be justified for the "defendant" given there were many "red flags" for Abengoa equity and credit investors alike that they should have noticed at the time, but, yet continued "to believe" in a "happy ending" situation in the "credit" related story. At the time we argued:
"As a reminder on how "convexity" can impact the price movement in credit, we followed with interest the situation of Abengoa SA (ABGSM) the Spanish company involved in the Renewable Energy sector which is particularly exposed to Brazil. S&P Capital IQ has an assumed recovery rate of only 30%. As we told you before, we expect recovery rates in the next downturn to be much lower making the 40% overall recovery rate assumption for senior CDS dubious at best. The price action in the bonds are indeed illustrative of how price movement lower can be larger in our days and ages." - Macronomics - 11th of August 2015.
At the time, we also mused:
"No offense taken on Abengoa liquidity situation given we have heard similar denials before in other circumstances:
"Our liquidity is fine. As a matter of fact, it's better than fine. It's strong." Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.
We also made some additional comments following Abengoa's  3rd of August "out of the blue" rights issue of €650mn, or 30% of market value prior to the announcement (market cap on the 4th of August €1,335mn):
"What is of course of interest for us "credit players" versus "equities players" is once again the disconnect between the two markets, particularly given that as indicated by the team behind the Datagrapple blog, when ABGSM announced it had won a €600 million contract for a biomass power station in the UK, the stock surged by a cool 20%, meanwhile the CDS was unmoved and the price closed on the 10th of August at a nice 60% upfront +5% running spread over 5 year.
You can probably decide who is right when it comes to "pricing the risk" but we ramble again as it seems credit players are more wary of a potential "Berezina" for the bondholders while "equities players" seems oblivious to the market signals reflected in the 5 year CDS prices and the fast deteriorating macro picture in the 7th largest economy of the world. "
Given that on the 25th of November, Abengoa's both bonds and equities (B shares down by 70%) were "decimated",  thanks to the company seeking "credit protection", one could argue that indeed it is a case of "Assumption of risk" for the investor "plaintiffs" voluntarily and knowingly assuming the risks. And when it comes to "recovery assumptions", while S&P Capital IQ assumed a recovery value in the region of 30% back in August, today the other part of S&P Capital IQ, CMA, only has an assumed recovery rate of 5%, when the CDS is trading at current levels of around 15%. Here is below the price action in the 2016 bond for Abengoa as displayed by CMA part of S&P Capital IQ:
- source CMA part of S&P Capital IQ

As a reminder, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger. With Abengoa, we have yet another demonstration of "instability" and large standard deviation moves thanks to "positive correlations" induced by central banks and their markets' meddling.

In this week's conversation, we will look again at some additional prospects for 2016 and also why European growth is still anemic thanks to very slow loan growth. and on-going deleveraging of the European banking sector à la Japan. Last week we touched on our preference for European banking credit rather than equities.

  • US versus Europe - both clocks have not been ticking at the same pace thanks to "credit availability"
  • Our "top-down" views for 2016
  • Final chart - In 2016, which is going to bite first Emerging Markets or "illiquidity" in credit

  • US versus Europe - both clocks have not been ticking at the same pace thanks to credit availability

In this conversation, once again we have decided to focus on the "credit cycle" in order to assess where we stand as we move towards 2016. To do so we will look again at the "Global Credit Channel Clock", as designed by our good friend Cyril Castelli from Rcube Global Asset Management:
Whereas we believe the US will be in the upper left quadrant in 2016, we believe Europe is still in the lower right quadrant. Before we look at the allocation "implications" for 2016 we would like to explain why the difference  in growth between the US and Europe comes from the availability of credit and why the "change in credit" growth matters to trigger higher Aggregate Demand (AD) as per textbook macroeconomics literature.

We have long argued that the United States have been on "fast forward" versus Europe thanks to the different approach taken when it comes to dealing with their banking sector and their "balance sheet" issues. 

As a reminder from our part 2 of our long September conversation "Availability heuristic",  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."
When it comes to the United States versus Europe. Different approaches have meant different results, particularly when it comes to the European banking sector, which will continue its deleveraging process in 2016. No doubt it will be supported once more by the much anticipated next raft of decisions taken by "Le Chiffre" aka Mario Draghi at the helm of the ECB.

This "deleveraging" can clearly been seen in the below chart from Société Générale "In the mood for loans" report from the 20th of November we think. The deleveraging process has much more to go particularly as we have highlighted last week due to the significant amount of Nonperforming loans still "impairing" a lot of European banks' balance sheets as reflected in the levels in Loan-to-deposit ratios between Europe and the United States:
"European loan-to-deposit ratios structurally still on downward trend."
- source Société Générale

This explains our previous comment from our "Le Chiffre" conversation:
"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." - Macronomics
We also argued in our long September conversation "Availability heuristic" the following:
"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." - source Macronomics
This can be seen in the very slow change in "credit growth" in Europe (1.5% in H1 2014), which does explain largely the "weak growth" observed in Europe and the disintermediation taking place in the banking sector where large corporates and even smaller issuers have been tapping the bond markets instead of obtaining "new loans" from the European banking sector. This is as well clearly illustrated in the Société Générale report quoted above:

- source Société Générale.

European banks are still depending significantly on the ECB for their funding and support compared to the US. The disintermediation in Europe has been more pronounced, but in no way there has there been a significant  corporate sector "releveraging" in Europe compared to the US.  The below chart from the same Société Générale report clearly shows the difference between the European Market and the US market when it comes to sources of financing.

 - Source Société Générale.

Furthermore, because a lot of Southern European banks are still "capital impaired" and have their balance sheets bloated by nonperforming loans, there is still a significant gap in terms of terms and conditions for new loans for Small and Medium Entreprises (SME) between various European countries has shown in the below chart from Société Générale:
- source Société Générale.

The difference of "monetary policies" between the ECB and the Fed is therefore leading us to our second point namely different "allocation" implications.

  • Our "top-down" views for 2016

In terms of "allocations" and in the context of the "Global Credit Channel" clock, with a tightening of the lending standards in the US versus somewhat more favorable lending conditions in Europe we think that the growing divergence since mid-2015 of the CDS-cash Bases between Europe and the US are very illustrative of the difference of paths taken as shown by Barclays in their European Credit Strategy note from the 20th of November entitled "CDS-Cash Basis – The Atlantic Disconnect":
"When thinking about the divergence, it makes sense to understand the driver of the CDS-cash basis in each region. In the US, the primary driver of the significant widening of the basis has been the performance of cash, which widened materially from May to October. Similarly, the CDS-cash basis for Europe has dropped also – although from positive to near flat, with cash underperformance again being the key driver. Notably, in a generally widening market, CDS has outperformed cash, which is atypical – CDS usually leads the move wider, with cash trailing. This speaks to the degree of relative weakness in cash.
When it comes to the decreasing basis in Europe and the US and the growing divergence between US and European cash, both are being driven by cash underperformance. We attribute the majority of the observed differences to differing supply and demand dynamics in Europe and the US. How and why has this divergence occurred? In the US, investment grade supply has been high relative to previous years, driven partly by M&A, whereas supply has been more moderate in Europe. In the US, investment grade demand has been weaker, driven by retail outflows this year and a seemingly reduced institutional bid for bonds at low rates. In Europe, for the first half of 2015, there has been a steady ECB QE-induced bid for credit by corporate treasurers and insurance companies alike.
What, if at all, will likely change? For the US, we do not expect supply to increase relative to this year, whereas demand could stabilize if rates go higher. As such, the drivers for US cash weakness could abate. On the European front, we expect a pickup in supply (partly from “reverse Yankee” issuance – US companies issuing in Europe), and on the demand side, we expect the effect from the ECB bid to wane, driven by FRN issuance catering to treasury functions, as well as heightened concerns about idiosyncratic risk in the wake of of Volkswagen and Glencore. This would leave cash technicals in the US and Europe more closely aligned. 
The most obvious conclusion from our analysis is that selling Itraxx Main CDS index and buying its US equivalent CDX IG protection still appears attractive, with the view that Main and IG are likely to diverge even further, although optically it does not look attractive given that Main is already trading inside CDX IG.
One important consideration for this trade is the potential effect of FX moves. Our FX strategists expect the depreciation of the EUR against the USD to continue, with EURUSD trading at 0.95 by year-end 2016. For investors looking to size the trade, one way to take this into account is by selling more iTraxx Main protection than current FX rates imply." - source Barclays

As per last week's conversation, different monetary policies entails divergence in Investment Grade credit between Europe and the US, that simple: 
"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 Macronomics/Bloomberg 

This "divergence" is leading us to some ideas in terms of "allocation implications", for 2016:

  1. We favor US Investment Grade versus European Investment Grade
  2. We favor European High Yield versus US High Yield. 
  3. We favor European stocks over US stocks
  4. In Europe for the banking sector we continue to favor high beta credit versus equities 
  5. In the US, we believe you should continue to play a flattening of both the US rates curve as well as the High Yield credit curve (CDX HY index 1 year now up 71 bps in one month...
"Le Chiffre" (aka Mario Draghi) is pushing further into negative territory European government bond yields as well as driving the Euro lower. From a "flow" perspective this is clearly "positive" for US Investment Grade. This will lead more supply in Europe from US corporates (reverse Yankees as per Barclays remarks above as well) and more "yield starving" investors and switching their "Assumption of risk" towards US investment grade. We agree with Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 23rd of October entitled "It’s all about monetary policy":
"Draghi sends more investors our wayOne of the key drivers of our overweight stance on US high grade corporate credit is the outlook for more aggressive global monetary policy easing (see: Strategically overweight US HG credit 02 October 2015), which will have the effects of driving more global investors into the US corporate bond market as well as diverting US supply abroad.

Yesterday ECB President Draghi delivered without actually delivering anything – yet – as he opened up for the possibility of more aggressive monetary policy measures in December, including a rate cut further into negative territory and increased QE.

More negative yielding fixed income assets in Europe (Figures above) and ECB crowding out of private investors, combined with less perceived interest rate risk in the market in the US due to weakening economic data, mean that the global credit investors will find US corporate credit even more attractive." - source Bank of America Merrill Lynch
There are as well some other interesting points made by Bank of America Merrill Lynch, which we agree with from their Global Credit Strategy Year Ahead note entitled "2016 - it's complicated":
The myth of one credit cycle 
Globally our views across credit markets span a wide spectrum: from the bullish outlook for US high-grade to the bear market that is US high-yield. But we believe that divergence is the norm now in credit, precisely because the fundamental cycles are so disjoint. In US high-yield, corporate leverage is at an all-time high and we expect defaults to rise to around 4% next year. But in US high-grade, we see leverage declining in 2016 after companies releveraged this year ahead of the Fed. And in Europe, paradoxically, we see leverage heading to a record low despite the QE backdrop.
Global weakness => US high grade strength 
Global weakness benefits US credit in two ways. First yield-deprived foreign investors are driven into the US market. Second, global weakness is a drag on US economic growth and that should be considered a good thing for US high grade credit. This is because lower economic growth leads to a much gentler rate hiking cycle and resulting lower risk of destabilizing outflows. 

US high grade the only game in town 
Over the past four years global high grade corporate bond yields have declined about 100bps to current levels just inside 3%. Not only are global corporate yields now incredibly low, but due to global weakness/US strength and resulting divergent monetary policies over the same period of time the US high grade market has grown in relative importance to now account for 75% global corporate yield income, up from 50% in 2011That means global high grade corporate bond investors have no choice but to embrace the US market, which has led to significant foreign inflows over the past couple of years that accelerated this year. " - source Bank of America Merrill Lynch.
Of course you are going to ask us "what about volatility" given our various iterations around "sucker punches" (large standard deviation moves), rising positive correlations between equities and bonds.  As per the "Global Credit Channel Clock",  we expect "volatility" therefore in 2016 to be "more volatile" as illustrated in Bank of America Merrill Lynch Global Credit Strategy Year Ahead note:
"Vol-of-vol and market implications 
We expect gamma to be a better bid than vega, as investors gradually become more risk averse in a credit market characterised by challenging technicals, deteriorating liquidity and increasing uncertainty around global and most importantly EM growth.
In an era of monetary policy interventions by most major CBs, the vol cycle has changed. In chart 7 we present the measure of Vol-of-Vol; to gauge the volatility of the 1M realised volatility over a period of one month. 
We find that volatility shocks have been rare historically but that their occurrences were detrimental. However, nowadays shocks appear to be more frequent but less damaging." - source Bank of America Merrill Lynch
Where we disagree with their take is that we expect shocks to be not only more frequent but more damaging as illustrated from the "Abengoa" story. We had plenty of "sucker punches" in 2015. We expect more of the same in 2016, particularly given heightened geopolitical tensions, lacklustre earnings growth, rising political risks (Brexit, Portugal, to name a few) and deteriorating overall global financial conditions picture with tightening financial conditions in EM and in the US, except for good old Europe, making it more enticing from a relative value perspective.

This leads us to our final point on our recurring concerns about Emerging Markets and the lack of liquidity in credit, pointed out, as well by many pundits.

  • Final chart - In 2016, which is going to bite first Emerging Markets or "illiquidity" in credit
Illiquidity is credit can clearly be seen, at least in Europe from the "dislocation" of the CDS cash bases given CDS has outperformed cash, which is clearly atypical. CDS usually leads the way when it comes to a move wider in spreads., This time around in Europe we have cash trailing.

Our final chart comes from Société Générale Credit Weekly note from the 13th of November entitled "Not as scary as it could be":

"Global credit markets have had a good run since the third week of September, with spreads on European IG, for example, dropping by 72bp from 172bp back to 150bp. European IG has still suffered the biggest percentage widening in spreads this year (while European high yield has seen the smallest widening amongst the major markets), but the performance is better than it was.
Yet several pieces of news this week might worry credit investors in the months ahead. First, European growth is at best tepid, with both France and Germany generating GDP growth of just 0.3% in Q3, and our economists looking for a similar 0.3% number for the eurozone as a whole. Second, commodity prices continued to drop this week, with WTI spot prices reaching their lowest levels since August and LME copper cash prices slithering to $4836 - the lowest level since 2009. This spells further jitters not only for US high yield oil producers (which widened this week) but also for EM corporate bond spreads (which so far have been relatively restrained). 
But perhaps the most worrying news of all this week came from China. Shanshi Cement this week announced that it would not repay RMB2bn of domestic notes, which triggered a cross-default on the offshore bonds. The 2020 issues (which were issued at 99 in March) dropped to a cash price of 65 on the news. The bonds were sold with a letter of support from China National Building Materials, but the documentation specifies that this is not legally enforceable and designed for “comfort only,” but this will be cold comfort to the bond holders. Chinese credit conditions may be tightening, as loan growth in the month to October proved weaker than expected at RMB513.6bn figure (vs consensus of RMB800bn), although the number was depressed by local government debt swap programs.
There are plenty of reasons to worry about emerging market credit in general. In When the EM corporate pain could come, our emerging market strategists highlight the problems facing the EM hard currency corporate markets, which are now twice the size of the EM hard currency sovereign markets. The huge increase in the size of the market has coincided with a sharp increase in balance sheet leverage, which is all the more worrying since the companies in the index have become more cyclical. EM corporate bonds have not widened as much as EM currencies, even when weighting currency baskets by the weights of the EM corporate issuing countries; however redemptions next year could lead to a repricing of the market. This is why in our triannual Fixed Income Portfolio Strategy (Start buying credit but avoid EM), we remain underweight EM corporate bonds and other corporate assets.
Could an EM sell-off drive European credit markets wider? The correlation between the quarterly percentage moves in an EM currency basket and in US corporate spreads since the mid 1990s has been around 50%, so this is a reasonable fear. However, we see a scenario for next year closer to the late 1990s, when EM weakness actually led to inflows into credit.
The impact of emerging market weakness on developed market economies is likely to be one of the most important themes for 2016" - Société Générale.
We have to agree, 2016 should be very interesting as we are running late into the "credit cycle" in the US. Fore sure it ain't going to be "plain sailing", so you better be careful in 2016 dear credit and equities "plaintiffs" in terms of your "Assumption of risk".

"I think there's a difference between a gamble and a calculated risk." - Edmund H. North, American writer

Stay tuned!

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