Macro and Credit - Optimism bias

"The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails." -  William Arthur Ward, American writer

While looking at the numerous "sucker punches" delivered on Friday due to the "Brexit" results, we reminded ourselves for our title analogy for a subject we already touched back in January 2012, namely the "Optimism bias" which we touched in our conversation "Bayesian thoughts". Following the dismay of so many of our friends relating to the outcome and as well to both markets and bookmakers being all wrong at the same time, we reminded our friends and ourselves the following on this occasion:

"Brexit analysis simply explained: « Optimism bias »: One of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics. Many tend to overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, many underrate our chances of getting divorced, being in a car accident, or suffering from disease and overestimate probability on extreme long-shots such as winning the lottery." - source Macronomics

Last week, when it came to assessing the potential outcome for the much dreaded referendum we also indicated the following:

"For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe..." - source Macronomics, June 2016

While assisting in Paris to the "Brexit conference" set up by our friends at Saxo Bank, one of the members of the audience during the Q&A session pointed out the "accuracy" of the bookmakers for the remain to "prevail". We could not resist but intervene to rebuke that statement by using as an illustration how bookmakers got it so wrong when offering 5000/1 odds at the beginning of the season for FC Leicester to clinch the British football Premier League and still having the odds at 500/1 around October. The biggest liabilities for the bookmakers were accrued at around 100-1 to 500-1. To quote Mike Tyson: "Everyone has a plan 'till they get punched in the mouth". Since that "FC Leicester punch" the longest odds that can now be placed on any event will be 1,000-1 to ensure that the betting company Ladbrokes is less exposed in future to 'black swan' events. We reminded also the Saxo crowd the Nash equilibrium concept, us playing on this occasion the "Devil's advocate". In fact not a single time did the bookmakers anticipated a victory for "Brexit" yet another display of the "Optimism bias" as displayed in the below chart from the following The Telegraph article "Why the 'experts' failed yet again to call which way Britons would vote" from the 25th of June:

- source The Telegraph

Parsing through the markets various "reactions" on Friday akin to a "deer caught in the headlights" kind of moment, us being contrarians, we were ready for the "sucker punch" on our "gold miners" exposure (which we have been advocating for a while for those who follow us...). It looks like indeed our "pessimism bias" was this time around the "lucky approach". But at this juncture dear readers before we go into the "nitty gritty" of this week's conversations, we think it is is important for us to "illustrate" our core philosophy which we have nurtured in recent years by asking a simple question: Why people get lured into making inaccurate conclusions?

What affect one’s judgment in today’s world markets one might rightly ask?

We think the below four points resume our core contrarian "philosophy":

1. « Herd mentality »: People are influenced by their peers to adopt certain behaviors, follow trends, and/or purchase items. Examples of the herd mentality include stock market trends and fashion.
2. « Information cascade »: One of the topics of behavioral economics often seen in financial markets where they can feed speculation and create cumulative and excessive price moves, either for the whole market (market bubble...) or a specific asset, like a stock that becomes overly popular among investors.
3. « Dunning-Kruger effect »: a cognitive bias in which unskilled and inexperienced individuals suffer from illusory superiority, mistakenly rating their ability much higher than average. 
4. « Optimism bias »: One of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics. Many tend to overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, many underrate our chances of getting divorced, being in a car accident, or suffering from disease and overestimate probability on extreme long-shots such as winning the lottery.

Of course Friday's shock result was clearly illustrated by the last point, hence our title analogy given we have already used as title analogies most of the above points in previous musings. Therefore, challenging  the “consensus” is like betting in a race horse on the outsider – the returns, if achieved, will be significantly higher.

For instance we have told you before that Government bonds were always correlated to nominal GDP growth, regardless if one looks at it using "old GDP data" or "new GDP data". So, if indeed GDP growth continues to be weak, then one should not expect yields to rise anytime soon. As a matter of fact in January 2014 we recommended and bought very long duration exposure on US Government bonds using PIMCO ETF ZROZ when nearly all « experts » were calling for higher US yields by the end of 2014. Very few such as us, Dr Lacy Hunt and Jeff Gundlach called it differently. The ETF ZROZ finished the year 2014 as the best performing ETF in the Fixed Income space, gaining more than 44% in US dollar terms but that's another story...

While everyone is still reeling on the "Black Swan" outcome from the Brexit vote, we watched with interested US Durable-Goods Orders cratering further by 2.2% in May (vs. -0.5% expected). Not only U.S. firms are already cutting back on their capital expenditures but we would also expect going forward weaker Nonfarm payrolls, neutering in effect the "recovery" story and stopping in its tracks the hiking process of the Fed which is reinforcing even more our appetite for US long duration exposure and of course validating our gold miners exposure.

In this week's conversation we will look focus on the productivity puzzle and its impact on economic growth leading to the on-going "secular stagnation", we will as well look at additional pointers on deterioration of credit metrics and why the trend in medium term is not your friend.

Synopsis:

• Macro and Credit - Secular stagnation? It's the productivity stupid!
• Macro and Credit  - Our "pessimism bias" make us continue to prefer the safety of US High Grade
• Final chart: Global Non-Financial Corporate Debt to GDP is "off the charts"

• Macro and Credit - Secular stagnation? It's the productivity stupid!

On numerous occasions on this very blog we have pointed out our lack of "optimism  bias" towards the much vaunted "recovery story" being sold mostly by pundits due to the lack of "wage growth" as indicated in our conversation  "Perpetual Motion" from July 2014. We argued that real wage growth was indeed the "most important" piece of the puzzle the Fed has so far been struggling to "generate":

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014

But, there is more to it when it comes to the theory of "secular stagnation" and this has all to do with the lack of "productivity" it seems. On that very subject we read with interest Bank of America Merrill Lynch's take from their Global Economic Weekly note from the 3rd of June entitled "The global productivity puzzle":

"The global productivity puzzle 

• Labor productivity growth has slowed significantly across developed markets over the past half-century; it currently is at record-low levels.
• Weak total factor productivity (TFP) growth is the main reason; low capital investment or declining labor quality only account for a small portion of the slowdown on average.
• There are many potential explanations for weak productivity but much of the decline remains a puzzle, with no clear policy offset.

Pronounced, and potentially persistent 

Growth in most developed markets (DM) has been disappointingly slow, while emerging markets have seen their growth rates decelerate each of the past five years. Many observers have gradually come to the conclusion that the supply side of the global economy appears to have been damaged — perhaps permanently. The clearest evidence of this phenomenon is the sharp reduction in labor productivity — total output divided by total hours of labor input — in most developed markets (and many emerging markets) over the past several years. In fact, DM labor productivity has converged to historically low, sub-1% growth rates (see Chart 1 and Chart 2 for G10 country data). More significantly, the decline appears to have begun  before the global financial crisis hit.

These two observations have important implications. First, it strongly suggests that common global factors may be responsible for the worldwide decline in productivity growth. Second, the global financial crisis is unlikely to be the main, let alone the only, explanation — although persistent spill-overs or hysteresis (cyclical shortfalls that become structural) from the crisis may be playing some role in holding back the supply side globally. Indeed, one of the troubling aspects of this analysis is that the causes of the productivity slowdown remain elusive, despite a myriad of potential interpretations.
Notably, some of these are much more persistent than others, and some are more amenable to policy fixes. Together, these imply the global economy isn’t doomed to low productivity forever, but it could drag on for quite some time.

Lower everywhere you look 

The simplest and most direct measure of productivity is output divided by hours worked. The more output that can be produced with a given amount of labor input, the more productive each hour of labor is. Conversely, if hours are growing faster than output, labor productivity must be slowing down. Such slowing has been a common occurrence over the past few decades among developed economies (and more recently among emerging markets). Chart 1 plots a smoothed measure of labor productivity growth (estimated by locally weighted regressions) for each of the G4 economies since 1951. All are appreciably lower during the last 5 to 10 years than at any time in the prior 55 to 60 years. Chart 2 is a similar plot for several other European economies. 
In the US, productivity growth slowed notably in the 1973-1995 period, then accelerated for about a decade before slowing down more significantly from around 2004 until today. Japan and Germany had notably higher labor productivity growth in the aftermath of the Second World War but recently have converged toward US levels. Britain started slower but its labor productivity surpassed the US pace from the late 1960s until around 2000, before diving below zero recently. Chart 2 shows a similar pattern for other DM economies, with labor productivity growth generally peaking at some point in the 1960s and declining ever since; Sweden and Switzerland experienced some stability in the 1990s and early 2000s before declining further. Like the UK, Italy’s measured labor productivity has turned negative on average recently.

Accounting for the growth slowdown 

A capital concern 

To understand the factors that have slowed productivity growth, economists often engage in “growth accounting.” One way to increase labor productivity is to give workers more or better capital (tools, equipment, computers, etc.) to work with — so called “capital deepening.” As investment spending has been weak in the post-crisis period, that seems like an obvious place to look for an explanation for the slowdown in labor productivity. Chart 3 illustrates how much a decline in capital deepening has impacted labor productivity growth across the eleven G10 DM economies. Note that due to data limitations, we analyze annual data from 1994 to 2014.

All eleven economies experienced a decline in productivity growth in the 2005-2014 period relative to the prior decade, by nearly 1.1pp on average. And, in most of them, the contribution from capital deepening (the sum of the orange and green bars) declined as well — but only by less than 0.3pp on average. Japan experienced the largest decline (60% of the fall in labor productivity growth can be attributed to less capital deepening), followed by the UK and the US (although only about 40% of the productivity slowdown); in Canada capital deepening actually grew slightly. All told, only a relatively small proportion — about 25% — of the slowdown across DM in labor productivity growth over the past two decades is due to slower growth in the amount of capital per worker.

A related hypothesis is that investment in information and communication technology (ICT) capital boosted labor productivity in the late 1990s and early 2000s, but that impact has since faded. Chart 3 also separates capital deepening into ICT (green) and non-ICT (orange) components. Some countries experienced measurable slowdowns in ICT capital deepening — most notably France, the Netherlands and the UK — while several others — Germany, Canada, Sweden and Belgium — actually saw a rise. Thus there is no systematic relationship between ICT investment and the decline in labor productivity among the G10 economies since the mid-1990s.

We don’t need no education? 

A second underlying factor that could change labor productivity would be changes in the quality of the labor force. A more skilled or educated labor force is likely to be more productive, all else equal. Chart 3 additionally contains estimates of “labor quality” from the Conference Board. Some analysts have speculated that more skilled workers are hired early in a recovery, and as it progresses the average skill level of newly hired workers goes down. That dynamic might help account for lower labor productivity recently versus a few years ago, but cannot readily explain the decadal differences in Chart 3. That said, with the exception of the UK, the decline over time has only shaved 0.1 to 0.2pp from labor productivity growth. Hence, changes in the composition of the labor force are not a significant factor for lower trend productivity." - source Bank of America Merrill Lynch.

What we find of interest on the above statement relating to "education" is clearly that the "student debt growing bubble" has not translated we think in an increase in the quality of the labor force. This can be seen on a monthly basis through the BLS data relating to employment components and education as per our below updated chart:

- source Macronomics / BLS - June 2016 update

So, you will excuse our "pessimism bias" because when it comes to "student loans debt", it's "much ado about nothing" in our book hence our lack of belief in education translating in "productivity labor growth". It hasn't happen and will not happen.

When it comes to explaining the "productivity" conundrum, in their note Bank of America Merrill Lynch try to put forward several possible explanations on the subject:

"Residual issues 

The part of labor productivity growth that cannot be explained by factor inputs (as above) is called “total factor productivity” (TFP). Conceptually, TFP can take a variety of forms, including technical innovations, gains in efficiency of operations, management style changes, etc. Practically, TFP is also known as the “Solow residual,” named after the prominent macroeconomist Robert Solow, the father of growth accounting. As the name implies, TFP is what is “left over” after other observable supply-side factors are accounted for. Significantly, the decline in measured TFP accounts for most of the decline in labor productivity for the DM countries in Chart 3. More generally, variation in TFP tends to account for most of the variation in labor productivity both over time and across countries. What has led to a decline in TFP is the key question.
There are a few big theories about why TFP growth has slowed over time across DM, listed in order from the most persistent — ie, the most likely to result in long-run low
TFP growth — to the least: 

• No more “low-hanging fruit.” The big economic innovations have happened already according to this argument, and inventions today are simply not as significant as (say) electrification or penicillin or the internal combustion engine.
This is a structural story that has an “end of history” flavor to it: the internet is just a fancy telegraph; nothing transformative here. Growth will stay low in this view; better get used to it. 

• Consumption over production. In this argument, innovation has shifted from supporting more efficient production to more intense consumption. Mobile phones, ubiquitous cellular service — these are used for casual gaming and sharing cat videos, rather than pushing out the production possibilities frontier. That doesn’t necessarily preclude a more productive use down the road. But to the extent this too is a structural shift, it likely means TFP growth remains lower for longer.

• Diffusion dynamics. Important technological development is still happening; it just takes time for its effects to show up on the shop floor and in the data. Firms are still learning how to most effectively utilize mobile, cloud, sharing, etc, to raise TFP. Robotics, genetic engineering, the “internet of things” — these innovations will raise productivity (and with it trend growth) at some point in the future.  

• Mismeasurement. Productivity growth  already is high, for all the reasons mentioned above — it just isn’t measured correctly. Output excludes many free services because they aren’t priced; significant quality improvements aren’t fully captured. In this view, the statistics will eventually catch up to reality. Meanwhile, in this view real output is higher and inflation lower than commonly reported. The future’s so bright, you’ve got to wear shades.

The first two more persistent slow growth stories may have some ring of truth, but history is littered with prior assertions that productivity growth had ended — only to be proven unduly pessimistic. However, if TFP is embedded in the capital stock and investment remains low, a self-reinforcing adverse feedback loop could arise: weak productivity creates few incentives to invest which perpetuates weak productivity. Indeed, there is a risk that such a feedback loop is already in place. The third explanation does have recent history on its side: the US (as well as some other DM economies) experienced a significant slowdown in TFP growth in the 1980s as the personal computer age began, but then saw more rapid growth from the mid-1990s until the mid-2000s as the returns to ICT investment were realized. Economic historians have found related evidence that the introduction of the steam engine into manufacturing did not materially improve productivity until the production processes were altered to better take advantage of this new invention. This diffusion process took several decades in that case. Something similar may be occurring with today’s latest technological innovations, such as mobile and cloud computing.
The mismeasurement story, on the other hand, has some optimistic appeal but is hard to reconcile with the data. A recent in-depth study finds evidence of mismeasurement of technological innovation, but this has not changed over the past few decades while,the share of such products in domestic production has declined thanks to offshoring. As a result, mismeasurement actually exacerbates the productivity slowdown rather than explains it. Meanwhile, the combination of low wage and price inflation suggests that weak demand is as much at play as weak supply. Strong productivity growth historically has produced strong real wage growth, yet real wages are generally depressed in DM." - source Bank of America Merrill Lynch

What we have seen with "the rise of the robots" and the very aggressive "cost cutting exercise since the Great Financial Crisis undertaken by many large corporations is that the productivity slowdown has indeed been exacerbated leading to non existing wage growth and depressed "real wages" à la Japan as discussed in our previous Macro and Credit conversation.

So what are the implications for policymakers around the world given the continued rising of populism? Bank of America Merrill Lynch in their note give us some sobering indications:

Implications for policy 

Weak productivity growth translates into weaker long-run economic growth, which means it is harder to grow out of budgetary shortfalls or debt burdens. Coupled with slowing population growth and declining worker-to-retiree ratios, it means more stress on social safety nets. For monetary policy, slower productivity growth will tend to mean output gaps close more quickly for any given pace of recovery, which will force central banks to normalize policy sooner or risk overshooting on consumer and/or asset prices. It also means a slow, drawn out recovery cannot be remedied merely with low rates and large-scale asset purchases.
Fiscal policy may be able to help jumpstart faster productivity growth by encouraging innovation through product and/or labor market reforms, but these take time and tend to be politically divisive. Investment in public infrastructure also may be supportive. Evidence strongly supports the idea that global competition via open trade boosts productivity. Unfortunately, around the world both the volume of trade, and the political support for promoting it, appears to be waning. This, too, could be an avoidable factor that is helping to push down productivity growth across countries. But without a clear diagnosis of the reasons for the decline in productivity, it is difficult to suggest a set of feasible policies to counteract it." - source Bank of America Merrill Lynch

Furthermore, for the "Optimists" crowd, we think that the weak productivity situation should not be taken lightly. This is clearly re-iterated in the most recent BIS annual report published in June:

"Less comforting is the longer-term context – a “risky trinity” of conditions: productivity growth that is unusually low, global debt levels that are historically high, and room for policy manoeuvre that is remarkably narrow. A key sign of these discomforting conditions is the persistence of exceptionally low interest rates, which have actually fallen further since last year." - source BIS, 86th Annual Report

In our book, "secular stagnation" is not only due to the burden of high global debt levels but, as well by the evident slowdown in productivity labor growth, which is clearly impacted by the "rise of the robots". This does not bode well for the stability of the "social fabric" and with rising populism in many parts of the world.

Back in November 2014 in our conversation "Chekhov's gun" we argued the following:

"Our take on QE in Europe can 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?
When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend." - source Macronomics, November 2014

Obviously our "Hopeful equation" suffered from "Optimism bias" and as we argued at the time:

"Our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015) " - source Macronomics, November 2014

Increasingly it looks to us that we are moving towards the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). That's our take and our "pessimism bias" for now.

When it comes to "asset allocation" in the current "risk-off" environment, we continue to like long duration high quality credit such as US High Grade. It benefits from the rally in the "Greenback" (US dollar) as well as higher yields than its European peers. More on this in our next bullet point.

• Macro and Credit  - Our "pessimism bias" make us continue to prefer the safety of US High Grade

While we have long advocated going for "quality" and indicated that US Investment Grade credit was the only "game in town" particularly for Japanese investors, the current "risk-off" environment is favoring the safety of the US Dollar Index given today as we write our latest musing, we have seen the largest 2-day increase since 1992, a "cool" 5-sigma event. This is what you get with central banks meddling with asset prices for too long: rising positive correlations leading to significantly large standard deviation moves. This was highlighted in our "lenghty" but nonetheless must read February post on risk and VaR (Value at Risk) conversation "The disappearance of MS München".

What is currently being priced in the US government bond market contrary to the Fed's recent stance is more "easing" rather than "hiking" we think hence the relative safety and comfort in US Investment Grade credit from an allocation perspective. On this subject we agree with Bank of America Merrill Lynch's take from their Credit Market Strategist note from the 24th of June entitled "European divorce":

"More monetary policy easing 

Behind today's plunge in global yields lies - in addition to lower global growth – the expectation that Brexit will prompt more monetary policy easing from global central banks. Included in this is that we now expect the Bank of England (BOE) to lower rates and start engaging in QE this summer. Brexit is also expected to dampen the Fed’s rate hiking cycle – case in point right now the Fed funds futures market is pricing in equal probabilities of a rate hike and a rate cut at the next FOMC meeting in July (12%).

However, clearly since foreign countries lead the decline in economic growth the net result is incrementally more dovishness abroad than in the US.
That explain why US yields remain high relative to European yields, even though the absolute level of US yields is coming down (Figure 9), which should continue to attract European buying of US corporate bonds.

Moreover, on the Japanese side US corporate bonds are now more than ever the only game in town. Specifically Japanese corporate yields are now 0.13% and the situation is not much better in 30-year JGBs yielding 0.15%. However, the yield on a fully currency hedged basis for a Japanese investor buying a 10-year US senior bank bond is 0.80%, or 5-6 times as high (Figure 10)

Corporate yields can decline 

A defining aspect of the big sell-off in the beginning of the year was the stability of corporate yields – hence as Treasury yields plummeted spreads blew out almost in the relation of one-to-one. That happened as both domestic and foreign investors stepped to the sidelines with the simultaneous decline in US yields and yields relative to foreign fixed income (Figure 9). However, because the weakness this time around is driven more by expected European weakness, as explained above, our market is not becoming less attractive to foreign investors. This means that, even though yield sensitive domestic investors may now become very defensive we should continue to attract significant foreign demand. We think that the Brexit surprise means that US corporate yields can now decline further – which is what we saw in today’s post-Brexit reaction – both in the USD and EUR markets. 

Credit outperforming on Brexit 

Given the low Brexit probability priced by the market by the end of Thursday the reaction on Friday was severe across most markets. In high grade credit, on the other hand, the move wider in spreads was rather underwhelming. In particular banks and some industrial spreads are actually tighter today following the actual vote for the “leave” camp than the wides reached last week in response to just the risk of Brexit.
Moreover, highlighting the strength in credit and unlike February, Friday’s widening in high grade credit spreads was less than the decline in rates, pushing corporate yields lower in both in the US and in Europe.
On Friday, following the results of the UK EU referendum, the Sterling was down 8.2% (a 15 standard deviation move for the period Jan 2010 to the present), European stocks sold off 8.6% and iTraxx Main closed 18bps wider. Naturally the shock spilled into US markets as well, pushing the yield on the 10-year Treasury down 19bps to 1.57% and stocks down 3.6% on the S&P 500, including 5.4% for the financial sector (Figure 1).

- source Bank of America Merrill Lynch

Having exposure to US High Grade Credit in this on-going "Japanification" process can indeed dampen the volatility experienced in various asset classes, while US credit still boast more favorable carry thanks to higher yield and roll-down compared to European credit which has tightened even more dramatically thanks to ECB meddling with Corporate credit as of late. Furthermore US Investment Grade credit still benefit from favorable flows unlike equities and High Yield.

While we have been in recent months describing the slow deterioration in the credit cycle, "Brexit" or not being the catalyst for the recent bout of "sell-off", it was our belief in the US economy being weaker than expected that has enticed us again this year to play à la 2014 the long US duration play (partly once more via ETF ZROZ). We keep telling you that we are indeed in the last inning of the credit game and as per our last conversation we'd rather focus on the big picture being tighter financial conditions and deterioration in macro data rather than on the "political fallout" stemming from "Brexit". Once again like any behavioral psychologist, we tend to focus on the process rather than on the content. When it comes to advising you to reach for quality in 2016 credit wise, we also agree with Bank of America Merrill Lynch's High Yield team when it comes to assessing the credit picture. For instance, we read with interest their High Yield Wire note from the 20th of June entitled "Bifurcate or break: the investment conundrum of a rolling blackout":

"Laelaps and the Teumessian fox 

In Greek mythology the Teumessian fox’s great power was to always be able to escape its hunter. Laelaps the dog, on the other hand, charged with catching the fox, had an equally great power: to always catch its prey. And with such simplicity a great paradox was created: how can one who catches everything catch something that can never be caught? The answer? It can’t. In the case of Laelaps and the Teumessian fox, Zeus turned both into stone. We find great meaning in the story … what happens to an economy that can’t grow or generate inflation when it is met with a central bank that, although has made mistakes in the past, seems to always right the economy eventually? Like Zeus, who turned our main characters to stone, do the modern day fox and dog effectively become paralyzed in their current states of low growth and accommodation? And if so, what does this mean for markets?
We believe the credit cycle is currently in its latter innings as the growth process has arguably stalled if not begun to slip backwards. Although Draghi, Kuroda and Yellen are doing their best, monetary policy can only be as useful as fiscal policy allows. And although our belief is that eventually deteriorating corporate earnings will lead to layoffs, a collapse in consumer confidence and spending and ultimately a recession, we also believe that an increasingly compelling case can be made that in between bouts of volatility our rolling blackout scenario may become the norm for much longer than any of us can anticipate. Under such circumstances the most levered companies with the poorest earning potential, those disrupted by technological innovation, and issuers relying on constantly open capital markets would trade at distressed-type levels. Meanwhile, those companies with consistent capital market access, strong management structures and who are financially nimble effectively would trade at some liquidity premium and very little credit risk premium, likely becoming targets for IG M&A. Effectively, valuations in high yield could become even more binary than they are today: trading at distressed levels or like an investment grade credit with a bit of extra liquidity premium.
Under such a universe, we think the case can be made that bigger is not better. In fact, we would argue that smaller high yield, high quality corporates that are attractive M&A candidates for IG companies would be compelling vs. a large BB and high quality single B credit that has a massive balance sheet and is susceptible to shocks. For those who must play high yield, believe in our barbell strategy, and are looking for index-level yields and returns, own small-cap BBs (along with a cash position in treasuries) with smaller CCC risk in issuers that have “already realized” their event.

The bigger the tree the harder the fall 

With our view that bigger companies are susceptible to risks and shocks, and that default risk has the potential to be a constant presence — even if a subdued one — for a long period of time, we are often told that the market is safer today because it’s more a “real” market relative to pre-crisis. “Real”, often defined as a bigger universe of names, larger issuers, more recognizable brands and higher EBITDA is a term we would hesitate to use. And although there is no doubt that the high yield market today is not only larger than it has ever been (it has grown in size by 90% since 2008), we would challenge the assertion that the high yield market is any safer because of growth. We prefer to judge markets more on their “maturity” and would focus more on the increase in the base of investors, breadth of industries, as well as the degree of price transparency and liquidity than on size. Clearly the ability for capital markets to structure deals in difficult times is also crucial to defining credit market maturity and having investors up and down the capital structure is also important. When considering this definition, we find that today’s market is not significantly more “real” than it has been in the past. Although we do benefit from increased price transparency because of the documentation of TRACE activity, the high yield market today still shows a relatively small investor base and high concentration among the top 3 industries (table 2):

Mutual fund ownership peaked in 1998 and — absent a brief increase in 2012 — has been on a consistent decline ever since, allowing institutional funds to gain greater market share and concentrate ownership into the hands of a few large investors (Chart 2).

The same story holds true as it relates to sectors, where in today’s market Energy, Healthcare, and Telecom make up 37% of US HY by face value. This is not all that different from Telecom, Media, and Materials’ 42% representation in 2000 and suggests the lack of industry breadth present in today’s market. We do not deny that the development of TRACE in 2005 has led to significantly greater price transparency and was the harbinger of future technological developments, including our own Instinct® Loans e-platform that was recently launched. However, these financial innovations have been coupled with increased regulatory burdens and more balance sheet restrictions, and we have actually seen lower trading volumes (Chart 3) and little change in bid/ask spreads since 2008. In fact, some would argue TRACE has hurt liquidity, as the transparency into small transactions makes it difficult to execute larger transactions discreetly.

Additionally, we believe the ghosts of markets past coupled with indebtedness never before seen will likely cause financial burdens that are not fully appreciated. Our view is that central banks have effectively obfuscated the true health of the global corporate markets and absent a significant increase in growth — something we question accommodative policy’s ability to spark – this cycle is unlikely to look meaningfully different than past cycles when the business cycle ultimately turns. In fact, when coupled with the growth in commodity issuance in the post-crisis years, the lingering impact of 2006 and 2007’s LBOs and the lack of earnings power outside of just a few sectors, we argue that in real terms, the US high yield market today looks remarkably similar to how it looked like during the Clinton and Bush years.
This is in contrast to the view that more mature capital markets and larger companies will cushion the next cycle. In fact, we think we could make just the opposite case — that large serial issuers, fueled by cheap debt and poor organic earnings prospects will likely prove a problem when the cycle turns, as history suggests size is not a good determinant for defining credit or default risk. Additionally, the biggest high yield issuers are unlikely to spur any targeted M&A, sponsor or strategic deals just given their size and bloated balance sheets. To this end, high yield is no more a “real” market than it has ever been. Have some aspects matured? Yes. Do traditional size-based measures indicate a healthier investing landscape? No." - source Bank of America Merrill Lynch

While some might infer with their "Optimism bias" that eventually things will turn out alright, we beg to disagree, in this long credit cycle fueled boy over-zealous central bankers, we believe that when the cycle will turn in earnest with US slowly grinding towards recession, the default rate will be much larger and recoveries will of course be much lower. That's a given.

What makes us having this "Pessimism bias" you might rightly ask? How about our final chart below?

• Final chart: Global Non-Financial Corporate Debt to GDP is "off the charts"

Our "Pessimism bias" stems from the very high leverage of the non-financial sector on a global scale and as pointed out before, a lot of Emerging Markets corporate debt has been issued is US dollar denominated, we believe this is a recipe for disaster as previously highlighted by the BIS as well as by our friends from Rcube. Our final chart comes from Deutsche Bank's Credit Bites note from the 8th of June entitled "A no excess cycle? Not true in corporates":

"Figure 1 looks at global non-financial corporate debt/GDP based on the BIS dataset and definitions. Whilst it’s not always easy to categorise debt into various buckets and whilst we have some issues with slightly different results across different data providers it’s fair to say that the BIS data is the best way of looking at the global debt picture. 

So non-financial debt has increased significantly in this cycle. On this measure the increase is of the magnitude of around $15 trillion since the lows after the financial crisis." - source Deutsche Bank

So in a world plagued by low productivity labor growth and high level of debt we wonder how some pundits can continue with their "Optimism bias". We'd rather stick to our "Pessimism bias and play the "minimax principle":

"A principle for decision-making by which, when presented with two various and conflicting strategies, one should, by the use of logic, determine and use the strategy that will minimize the maximum losses that could occur. This financial and business strategy strives to attain results that will cause the least amount of regret, should the strategy fail." - source businessdictionary.com

It is isn't a game of capital appreciation but it certainly becoming one of capital preservation we think...

"A pessimist is a man who tells the truth prematurely." -  Cyrano de Bergerac

Stay tuned!

Macro and Credit - Ubasute

"Death by starvation is slow." - Mary Hunter Austin, American writer

Watching with interest the further "japanification" process unfolding with the mighty German 10 year government bond aka the bund, falling under the zero yield boundary and the continuation compression of the Japanese government bonds aka the "widowmaker" JGB, we reminded ourselves of the Ubasute practice for our chosen title analogy. It refers to the custom allegedly performed in Japan in the distant past, whereby an infirm or elderly relative was carried to a mountain, or some other remote, desolate place, and left there to die, either by dehydration, starvation (lack of yield), or exposure, as a form of euthanasia. Of course, "Ubasute" for us is a clear reference to the "euthanasia" of the rentier close to John Maynard Keynes which we touched on in March this year in our conversation "The Reverse Tobin tax" where we discussed the dire consequences of Negative Interest Rate Policy (NIRP):

"For us, NIRP is a "reverse Tobin tax" leading in the end to the "euthanasia of the rentier" as more and more government bonds fall into negative yield territory, hence our chosen title. If indeed James Tobin tax was supposed to lead to lower volatility in the FX markets, the reverse Tobin tax aka NIRP is leading to the reverse, that's a given but we are rambling again..." - source Macronomics, March 2016

Indeed the recent gyrations in the market comes to no surprise to us as we have indicated in recent notes the cheap levels reached by volatility and the need to rethink about hedging strategies. 

As well as a reference to the "euthanasia of the rentier", "Ubasute" is a veiled reference for movie buffs like us to 1983 Japanese masterpiece by director Shōhei Imamura "The Ballad of Narayama". The movie earned the coveted Palme d'Or at the 1983 Cannes Film Festival. Our chosen analogy "Ubasute" is as well linked to the characters of Christopher Buckley's 2007 novel Boomsday, a political satire about the rivalry between squandering Baby Boomers and younger generations of Americans who do not want to pay high taxes for their elders' retirement. In his novel, the author uses the concept of 'Ubasute' as a political ploy to stave of the insolvency of social security as more and more of the aging US population reaches retirement age, angering the Religious Right and Baby Boomers, but we ramble again...

Whereas everyone and their dog are focusing as of late on "Brexit", to paraphrase Confucius, we would rather point you towards the Moon, namely the deterioration of the credit cycle and in particular towards some areas of the credit markets such as the retail sector exposed CMBS, rather than doing like the "idiots", looking at the finger only, namely "Brexit". 

For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe... 

We apologies for the long wait for our latest musing, but we were collecting our thoughts and trying to find an appropriate analogy to reflect them.

In this once more long conversation we will focus once more our attention to Japanese woes and deteriorating credit conditions. 

Synopsis:

• Macro and Credit - Yen depreciation and financial repression? It's only starting
• Macro and Credit  - Credit tightening is already starting to bite a leveraged world
• Final chart: Bank stocks on the "Road to Nowhere"

• Macro and Credit - Yen depreciation and financial repression? It's only starting

While we have been short yen since November 2012 when the Japanese yen was trading around 80 as described in our conversation "Cold Turkey" (partly via ETF YCS) guessing that the Bank of Japan had a lot of catch-up to do when it came to QEs and expanding its balance sheet, since the beginning of the year we have been on the "receiving end" of the strengthening of the Japanese yen as of late in our portfolio. We must confide that we do not warrant much attention to the recent gyrations in our position, given it is a long term position as we are firm believers in the long term massive depreciation of the Japanese currency. While all the recent action recently seems to be in "bondzilla" (the bond monster) getting much larger by the day with global bond yields plunging further into the void à la Swiss yield curve, when it comes to "Ubasute" and the Japanese currency, we believe it will be a slow death for sure, as "yields hogs" get slaughtered in the process. Given the multiplication of conversations surrounding the adoption of “helicopter money” policies, which could in effect lead to greater leeway for fiscal spending, we read with interest Nomura's take on the subject from their Japan macroeconomic insight from the 15th of June entitled "Fiscal policy unease and financial repression":

"Overview of postwar deposit blockade 

The postwar deposit blockade can in our view be seen as an exit from the monetary easing policies before and during the war in the shape of the BOJ's government bond underwriting. This method allowed the government to recover currency supply that had become bloated during the war while simultaneously defaulting on government debt that had become virtually unpayable with the end of the war. The deposit blockade was a scheme to write off wartime compensation at one go and eliminate financial institutions' bad debts by imposing temporary limits on some withdrawals of deposits and rescinding claim rights on some of the blockaded deposits. 

Is a deposit blockade possible today? 

It should not be overlooked that when the Japanese government allowed the policy-driven erosion of people's assets by sacrificing some deposits through the deposit blockade, it did so under the former Constitution of the Empire of Japan and before the adoption of the current Constitution of Japan, which stipulates that any deposit blockade must protect the property rights of the people. If the Japanese government were to adopt and implement such a scheme to write off debt, that could be ruled unconstitutional, making such a move very dubious from a legal perspective. We think helicopter money policies involving, for instance, the conversion by the BOJ of the JGBs it has purchased into perpetual bonds would risk similar legal problems because they would in effect institutionalize the degradation of JGB redemption terms. From this standpoint, we think helicopter money policies are unlikely to be adopted." - source Nomura

What we find is of interest to us is that Japan seems to be the central bank "laboratory" where most of the experiences have taken place and more recently with Bank of Japan implementing NIRP, replicating what others had done. As we wrote back in our January conversation "The Ninth Wave" one should therefore not have been surprised of the actions of the Bank of Japan in implementing NIRP which has already been implemented in various European countries and enforced as well by the ECB. As a reminder from last year conversation, this is the definition of "Information cascade":

"An information (or informational) cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts. A cascade develops, then, when people “abandon their own information in favor of inferences based on earlier people’s actions”." - source Wikipedia

The Bank of Japan has merely engaged in the same acts as others. "Information cascade" is a trait of behavioral economics. We behave like behavioral psychologist when analyzing market trends and central banks "behavior", we focus on the process, rather than on the content. What we tend to also focus on is what we call our "Mark Twain approach", we do, like others refer to history as it tends to "rhyme" rather than "repeat" itself, therefore we read with interest Nomura's take on what happened to Japan before WWII, during WWII and after when it comes to its "monetization" of Japanese Government Bonds (JGBs):

"Growing helicopter money debate and BOJ underwriting of JGBs before and during the Pacific War  

The helicopter money policy debate has been heating up. Although there are various definitions of helicopter money, the basic concept involves the direct financing of fiscal spending by the central bank (and its issuance of currency). Specific forms this might take include the central bank directly and without limit underwriting the increased issuance of government bonds to pay for large-scale increases in government spending and the central bank, through quantitative easing, converting the government debt it already holds into perpetual bonds or other bonds with very long maturities or else getting rid of redemption altogether.  

Recently, it has become well known that the BOJ directly underwrote government bonds before and during the Pacific War (Figure 1).

Perceptions that this triggered the outbreak of war by supporting unlimited growth in military spending and was an underlying cause of hyperinflation following the war are seen as lying behind the provision in the current Fiscal Act (Article 5) prohibiting the BOJ from directly underwriting government bonds. 

Considering this historical background, we think there is little prospect of the government and the BOJ cooperating in the adoption of a helicopter money-type measure. However, not only is it now the mainstream view that the current quantitative and qualitative monetary easing (QQE) policy with its negative interest rate policy (NIRP) is unlikely to achieve the BOJ's inflation target (or the assumption behind its attainment of pushing up inflation expectations by giving a boost to the real economy) but also there has been growing criticism that NIRP will actually have a greater adverse impact by depressing earnings at financial institutions, impeding financial intermediary functions, raising uncertainty in the household and corporate sectors, and reducing those sectors’ willingness to spend. 

If this situation persists, the possibility that momentum may grow for the adoption a helicopter money approach as an emergency measure cannot be ruled out.

Assessment of BOJ government bond underwriting: lessons from the past  

In considering how the risk scenario of helicopter money policy might unfold after its introduction, we think it instructive to look back to when the BOJ underwrote government bonds before and during the war and how the aftermath of hyperinflation was dealt with.
First, let us look at the position with the BOJ's underwriting of JGBs. The roots of the BOJ's government bond underwriting date back to the expansionary fiscal policy (from 1931 onward) under then Finance Minister Korekiyo Takahashi aimed at escaping the deflationary recession known as the Showa Financial Crisis, triggered by the Great Depression in 1929. The general view is that the BOJ's direct underwriting of JGBs accompanying the aggressive fiscal policies was adopted as a "temporary expedient" by the bank under heavy pressure from Finance Minister Takahashi.
As noted earlier, the direct underwriting of government bonds by the BOJ acted as a trigger for the outbreak of war by allowing military spending to grow without limit and is generally viewed as having been the underlying cause of hyperinflation in the postwar period. However, we think a closer look at the causal relationship between the BOJ's government bond underwriting, inflated fiscal spending, and hyperinflation is needed in considering the current monetary easing and the impact of helicopter money. From a broad perspective, we think the relaxation of fiscal discipline and hyperinflation cannot all be blamed on the BOJ's underwriting of government bonds.  

Was underwriting JGBs the main cause of relaxation in fiscal discipline and hyperinflation?  

First, let us consider the impact of the BOJ's underwriting on JGB yields and the relaxation of fiscal discipline. Some, for example, have criticized the current large-scale JGB purchases under QQE and the adoption of NIRP as having greatly lowered government bond yields across all maturities, saying that the exceptionally low yield they have brought about have already given rise to a relaxation in fiscal discipline even without waiting for the introduction of any helicopter money measure.
However, we think it is rash to blame the BOJ's underwriting of JGBs before and during the war for the relaxation of fiscal discipline by holding down JGB yields and for supporting military expansion and triggering the outbreak of war.
From before the war to during it, JGB yields actually declined despite deterioration in the government's fiscal balance and growth in outstanding debt (Figure 2).

We think it inappropriate to blame the BOJ's JGB underwriting for the following two reasons. First, although after the underwriting of JGBs began the BOJ did underwrite a large proportion of newly issued bonds, at almost 80%, the great majority of the JGBs underwritten by the BOJ were subsequently sold in the open market. We see the BOJ's government bond underwriting as in a sense having compensated for inadequacies in the bond underwriting capacity of private-sector financial institutions. With the decline in JGB yields in the market, meanwhile, we see this as due more to the impact of the introduction of a system in 1932 whereby JGBs could be listed at book price equivalents to standard issuance prices stipulated by MOF. Exempting financial institutions from booking their JGB holdings at current value appears to have greatly eased the selling pressure on JGBs.
How about the view that the BOJ's government bond underwriting was the cause of hyperinflation in the postwar period? Although most of the bonds underwritten by the BOJ were subsequently absorbed by the market, the large increase in fiscal spending in parallel with the BOJ underwriting did lead to a large expansion in the money supply. It is possible to see hyperinflation as the result of this not being absorbed even after the war. 

From the perspective of the real economy, however, we think there was a greater impact in opening the way for hyperinflation from the extreme diversion of production capacity to military purposes during the war, from damage caused by wartime fires, and from a rapid narrowing in the output gap as private-sector demand quickly recovered with demobilization after the war. 

Deposit blockade as an exit strategy for JGB underwriting 

With helicopter money now being actively discussed as an option for what could be seen as a move toward a more radical form of conventional QQE, we believe it is crucial to look at how the authorities finally addressed the BOJ’s JGB underwriting during World War II and the swollen currency supply and hyperinflation caused by the massive expansion in wartime spending by the government.
A deposit blockade could be viewed as an exit strategy for monetary policy after the start of JGB underwriting by the BOJ. This method allowed the government to recover the excess currency supply that had emerged during the war while simultaneously defaulting on government debt that had become virtually unpayable with the end of the war. Below we take a look at the effects of this deposit blockade, both on the monetary side in areas such as currency supply and on the fiscal side in areas such as adjusting government debt.  

Overview of deposit blockade  

Here we examine the concept of a deposit blockade and the processing of government debt that accompanies it.
During World War II, the Japanese government attempted to manage the fiscal imbalance caused by the massive increase in military spending and the drop in tax revenues from the halt of private-sector industrial activity by increasing the issuance of government bonds, the underwriting of those bonds by the BOJ, and debt guarantees known as wartime compensation given to arms companies for accounts receivable related to military procurement.
Of course, Japan's defeat and the war's damage to its domestic production capacity deprived the government of its means to repay these wartime compensation debts. This resulted in many loans turning bad at the Japanese financial institutions that had supplied credit to these arms companies with wartime compensation as effective collateral. At the same time, the money created by this supply of credit collateralized by wartime compensation, alongside the destruction of supply capacity in the real economy, was a root cause of the excess liquidity and hyperinflation that followed the war.
As a measure to simultaneously reduce both the resultant risk of default on government debt and this excess liquidity, it was proposed that withdrawals be temporarily restricted for some sorts of market deposits, allowing the government to write off its wartime compensation debt while financial institutions disposed of their bad debt, while also effectively devaluing these market deposits via the currency redenomination (shift to the new yen) also carried out during the deposit blockade period (Figure 3). 

The deposit blockade was put into effect with the emergency financial measures ordinance of 17 February 1946. In accordance with the simultaneously announced special asset audit ordinance, the government began the process of assessing the total amount of wartime compensation debt and the amount of citizens' assets subject to writeoffs. Following this, on 24 July of the same year, the cabinet officially decided to cancel all wartime compensation and the blockaded assets were categorized into type 1 blockaded assets and type 2 blockaded assets to reflect the amount of compensation to be written off. Figure 4 shows the extent of the blockaded deposits subject to withdrawal restrictions and the debt with which they were matched.

Unregulated deposits with no withdrawal restrictions accounted for 15.4% of total deposits at Japanese banks (as of August 1946, when blockaded deposits were categorized), while type 1 blockaded deposits accounted for 37.5% and type 2 blockaded deposits accounted for 21.9% (Figure 5). For individuals, withdrawals from these blockaded deposits (in new yen) were limited to ¥300 per household per month and ¥100 per household member.  

On 18 October 1946 the government enacted the Wartime Compensation Special Measures Law, which imposed a special tax for wartime compensation equal to the amount of wartime compensation debt. With this special tax, the government effectively defaulted on its wartime compensation debt. To address losses on the financial institution debt that consequently became unrecoverable, the type 2 blockaded deposits were allocated to fund debt writeoffs at private-sector financial institutions under the Financial Institution Reconstruction Law and Business Reconstruction and Adjustment Law implemented on the same date. Roughly 57.5% of the total balance of type 2 blockaded deposits as of directly after their categorization in August 1946 was eventually used for these writeoffs (Figure 6). 

Is a modern deposit blockade possible?  

Under QQE, the BOJ has come to hold an increasing percentage of the overall JGB balance, while JGBs have come to account for an increasing percentage of the BOJ's assets. With large-scale monetization of government spending via helicopter money policies now also being debated, some now express concern that such policies could lead to conditions similar to the postwar deposit blockade.
As described above, the postwar deposit blockade was implemented under the assumption that some of depositors' deposits would be written off in order to prevent a chair reaction of bankruptcies among Japanese businesses and financial institutions caused by the government's inability to follow through on its wartime compensation. It should not be overlooked that when the Japanese government allowed the policy-driven erosion of people's assets, it did so under the former Constitution of the Empire of Japan and before the adoption of the current Constitution of Japan, which stipulates that the property rights of the people must be protected if deposits are blockaded. 
If the Japanese government were to adopt and implement such a scheme to write off government debt, it could be judged unconstitutional, making such a move very dubious from a legal perspective.
Helicopter money policies that in effect institutionalize the degradation in redemption conditions for the JGBs purchased by the BOJ could risk raising similar legal issues." - source Nomura

Where we disagree slightly with the above is that, as we have seen it before, when it comes to "legal issues", on numerous occasions we have seen that, indeed, the rule book can be rewritten and politicians and central bankers alike have shown throughout history their capacity in changing the outcome, even when it comes to voting against the Lisbon treaty for example. Where we agree with Nomura is with their take on the Japanese yen, namely that it is most likely to weaken further in the long run as per the conclusion of their note:

"The consequences of financial repression 

The consequences of financial repression policies could show most strongly in forex rates as a result of the contradiction that would arise from maintaining policies to artificially suppress JGB yields even when the rise in the inflation rate would suggest that monetary easing should be ended.
Offsetting in part or in full the negative impact of inflation on the real prices of financial assets is one of the basic effects of a rise in interest rates. However, under a policy of artificially ultra low interest rates aimed at preventing government debt defaults, we would expect a decline in domestic financial assets that could not increase in real value without a rise in interest rates and we would expect an outflow of funds into overseas assets. The resultant drop in yen forex rates could further accelerate inflation and without a rise in interest rates to counter this, we would expect further acceleration in both the outflow of assets and the devaluation of the yen. It should therefore be kept in mind that the price of avoiding government debt defaults with the minimum of political and legal friction may well be quite a rough decline in forex rates." - Source Nomura

Whereas the "widowmaker" aka the mighty JGB has proven as of late it could thrive even further thanks to the implementation of NIRP, and effectively rendering "bondzilla" even more menacing, when it comes to the recent appreciation of the Japanese yen as a "safe haven" in current uncertain markets, we firmly believe that the yen will continue to depreciate over the long term hence our core "short" position.

In a world plagued by rising debt levels and in particularly in the private sector where the corporate sector has been leveraging significantly, regardless of the rally we might see should the United Kingdom decides to remain, credit tightening is already starting to bite.

• Macro and Credit  - Credit tightening is already starting to bite a leveraged world

In our February conversation "The disappearance of MS München", we discussed about risk in general and CMBX in particular as another clear indicator of a deterioration in credit fundamentals apart from our much quoted "CCC credit issuance canary". We find of interest as of late that finally Bloomberg has been picking up on the deterioration in the Commercial Real Estate (CRE) space as of late in their article "America’s Dying Shopping Malls Have Billions in Debt Coming Due" from the 16th of June:

"Suburban Detroit’s Lakeside Mall, with mid-range stores such as Sears, Bath & Body Works and Kay Jewelers, is one of the hundreds of retail centers across the U.S. being buffeted by the rise of e-commerce. After a $144 million loan on the property came due this month, owner General Growth Properties Inc. didn’t make the payment. 

The default by the second-biggest U.S. mall owner may be a harbinger of trouble nationwide as a wave of debt from the last decade’s borrowing binge comes due for shopping centers. About $47.5 billion of loans backed by retail properties are set to mature over the next 18 months, data from Bank of America Merrill Lynch show. That’s coinciding with a tighter market for commercial-mortgage backed securities, where many such properties are financed." - source Bloomberg

If we remember correctly our February conversation, here it what we indicated at the time:

"We have told you recently we have been tracking the price action in the Credit Markets and particularly in the CMBS space. What we are seeing is not good news to say the least and is a stark reminder of what we saw unfold back in 2007.Among the more recently issued CMBX series (6-9), CMBX.6 has the highest percentage of retail exposure.Sorry to be a credit "party spoiler" but if U.S. Retail Sales are really showing a reassuring rebound in January according to some pundits with Core sales were 0.6% higher after declining 0.3% in December and the best rise since last May, according to official data from the Commerce Department, then, we wonder what's all our fuss about CMBS price action and SEARS dwindling earnings? Have we lost the plot?" -source Macronomics, February 2016

Also, in our May conversation "Through the Looking-Glass" we reiterated the importance of tracking the "price action" in the CRE space has a further indication of the deterioration in credit financial conditions and deterioration in economic fundamentals:

"As indicated in our conversation "The disappearance of MS München", we have been tracking the price action in the Credit Markets and particularly in the CMBS space. The reason behind us starting to track à la 2007 is that the CMBX price action indicates that a growing number of investors may have begun to short it since it is a liquid, levered way to voice the opinion that CRE (Commercial Real Estate) is considered to be a good proxy for the state of the economy. And, if indeed investors are pondering the likelihood that the US economic growth is slowing and that CRE valuations have gone way ahead of fundamentals, then it makes sense to track what is going on in that space for various reasons, particularly when it comes to assessing lending growth and the state of the credit cycle we think. 
As a reminder from our February conversation, CRE portfolio lenders also tighten credit standards, it stands to reason that some proportion of borrowers that would have previously been able to successfully refinance may no longer be able to do so in the future." - source Macronomics, May 2016

We also told you that by tracking the quarterly Senior Loan Officers survey published by the Fed we did notice that overall financial conditions were continuing to tighten in the United States, which will eventually lead default rates higher and high yield lower, whereas in the meantime our "CCC credit issuance canary" has stop singing as confirmed by Deutsche Bank in their US Credit Strategy note from the 16th of June 2016 entitled "Illusory Benefits of Cheap Money":

"Figure 6 shows how lending volumes in CCCs, while having thawed a bit from a completely frozen state in Jan-Feb, remain at some of the lowest levels seen in the past 15 years. Investors are not exactly going after all the 13% yield opportunities in the ex-commodity HY CCC segment, and there could only be one explanation for such a behavior in a yield-starving world.
Such a behavior also naturally translated into higher realized credit losses in the ex-commodity sectors, with our default rate calculations showing an annualized 3mo issuer-weighted rate reaching 4.6% in May. Overall HY defaults, including energy and other commodities, were trending at a 9.8% issuer-weighted rate over the past three months! Trailing 12mo rates for both market segments currently stand at 2.7% and 5.8% respectively.

So, if investors are skittish about credit risk, do extreme steps taken by central banks help in reopening the credit channel? The evidence we see provides little support to that claim. Figure 7 shows overall corporate bond issuance volumes (IG+HY) in the US and EU over the past five years, presented here as a percent of respective market sizes. 

Of a particular interest is the reaction function in EU credit, where new issue volumes have peaked in Apr 2015, or a month after that ECB engaged in the original QE last year. Since then volumes have dropped precipitously, currently sitting near their lows over the past four years.

You can lead a horse to water, but you can’t make it drink." - source Deutsche Bank

While we will note delve again into the "lack of understanding" of our "Generous gamblers" aka central bankers in our credit transmission operate (hint: not through the "wealth effect"), when it comes to CRE and credit conditions, if you think "refinancing" has been tough as of late in the energy sector and in particular the CCC rating bucket, then we would like you to take a look at the CMBS space because it will not be pretty either as indicated by Bank of America Merrill Lynch in their weekly Securitization note from the 10th of June:

"While many borrowers will be able to successfully refinance their loans, it is inevitable that some will not. To the extent that borrowers with higher quality properties have already refinanced, we think that many of the outstanding 2006 vintage loans are adversely selected. If they can’t refinance we anticipate that the 60+ day delinquency rate (Chart 46) and special servicing rate (Chart 47) for legacy loans could increase sharply over the next six months. 

The inability for some legacy borrowers to refinance will likely be exacerbated by the recent slowdown of CRE price appreciation.  

To this point, April 2016 Moody’s/RCA CPPI data were released this week and offered mixed results. Although the data indicate that the index increased 16bp month/month at the national level, the index that represents assets in major markets fell (Chart 48).

Furthermore, price change by property type was mixed as well. At the property level, prices for retail, apartment and industrial properties increased, while office prices fell. 

When we analyzed the long term commercial real estate price trends by property type, the slowdown in commercial real estate price appreciation for assets located in major markets was especially noticeable. This held true for each of the core property types." - source Bank of America Merrill Lynch

On top of this surging overall weakness trend in CRE, you will probably understand our "interest" in tracking the "Ubasute" fate of CMBX series 6 and why, we continue to think it should be "shorted" from Bank of America Merrill Lynch additional comments from their note:

"Within the mall space, quarter-to-date returns don’t look particularly attractive as only one of the eight companies our equity mall REIT analysts cover posted positive returns (Chart 53). 

Along this line, Ralph Lauren announced this week that it plans to cut 8% of its workforce and close more than 50 stores. 

Despite feeling like we read these types of announcements several times a week, store closings so far this year are not only lower than they were last year at this time, but are at levels last seen in 2013 (Chart 54). 

Bringing this back to what retail sector weakness means for the CMBS market, we think that the weakness, coupled with slowing CRE price growth, imply that loss expectations for cuspy legacy bonds may be too low. This could be particularly painful for bonds in this category that are priced at levels that don’t incorporate unexpected downside. For example, many legacy deals only have a small handful of loans left, many of which are, and have been, current. Despite this, if a tenant has (or plans to) vacate the building but is still paying rent, this might result in a loss that has been neither considered nor accounted for. When we plotted 2006 vintage AJ current subordination levels against our credit model’s expected deal losses, we found that a number of AJs were very close to taking an expected loss (Chart 55) – even without taking into the account unknown unknowns that could cause performance to deteriorate relative to one’s current expectations.

The way to interpret Chart 55 is that any “dot” above the diagonal red line indicates that expected deal losses exceed the amount of subordination for the AJ represented by the dot. While it is likely that many of these AJs already trade at discounted dollar prices given the expectation that they will incur some loss, what about bonds trading at mid-to-high $90s (or higher) that are not expected to take a loss? These bonds are represented by dots below the diagonal line. Obviously, dots closer to the line indicate that less cushion exists to absorb any unanticipated negative surprises.
Although greater market stability may lead to better refinance success, it appears that fewer loans are being recycled back into the CMBS market. To the extent that the alternate lender has tighter underwriting standards, it is possible that losses could increase relative to many investors’ current expectations. In fact, despite recent comments from regulators noting the increase in CRE exposure on bank balance sheets, many local, regional and national banks continue to increase their CRE loan
origination activity and market share. This holds true both for all commercial real estate lending (both acquisition and refinance) as well as for only loans that are refinancing. While we aren’t suggesting that losses may increase significantly from current levels, we think that it makes sense to price “cuspier” bonds to a slightly more negative scenario in order to buffer against unanticipated negative events." - source Bank of America Merrill Lynch

Of course we do not think the level of provisions on banks balance sheet is adequately set for this type of "sudden" deterioration which we think is more likely to happen given the trajectory we are seeing in the US economy hence our lower for longer stance when it comes to our long duration exposure...

This leads us to our final chart given than some pundits continue to believe in the attractiveness of bank stocks, in particular in Europe from a "valuation" perspective.

• Final chart: Bank stocks on the "Road to Nowhere"

While we have repeatedly indicated our "distaste" with Banks stocks and our preference for credit in particular when it comes to Europe, looking at Japan and "Ubasute", we think the "valuation" pundits should think again given the below chart from Société Générale from their recent Asia Investment Navigator note from the 17th of June entitled "Debt is not only a China problem" displaying the performance of Japanese banks over a 25 year period:

Long Japan banks -  The banks de-rating has been an important factor behind the lower valuation of the overall market. In particular, the sector has massively underperformed due to concerns of deepening deflation caused by rising yen. The negative interest rate policy framework has exacerbated these concerns." - source Société Générale.

No disrespect to Société Générale, but even with "contrarian" stance, taking a longer view perspective prevent us from seeing the "interest" in going "long Japan banks" or long anything "banks" apart from "credit" given the on-going support from central banks:

- source Société Générale

"Ubasute" in Japan might have reached "full-employment" but, when it comes to inflation and banks stocks, it is clear that it has been an utter failure. NIRP has in fact created a dangerous situation with now CDS spreads widening and banks stocks going lower.

In a world stifled by too much debt therefore weighting on global growth we can not envisage seeing any value in this environment in owning bank stocks as illustrated by Bank of America Merrill Lynch in their Thundering Word note from the 16th of June entitled "Barbells, Banks, Fizzy Bonds & Brexit":

"Year of the Barbell, not Year of the Banks

“Deflation assets” & “inflation assets” winning in 2016: gold & bonds; resources & defensives; Brazilian real & Japanese yen all outperforming. Tail assets stretched (e.g. HY energy most overbought in 7 years) but banks have “funded” barbell (Chart 1) and reversal of long barbell-short banks trade requires EPS & GDP upgrades. Neither visible." - source Bank of America Merrill Lynch

When it comes to advising you end of last year to go long duration via long dated US Treasuries, long gold and long gold miners (2016 total returns YTD: gold 23.6%, commodities 14.5%, bonds 8.0%, stocks 0.1%, and the US dollar -4.1%), there was a simple reason to it, we expected slower GDP growth given our deflationary bias as illustrated by one final chart, the correlation between gold and slower US GDP potential from Bank of America Merrill Lynch's Global Metals Weekly note from the 17th of June entitled "Era of uncertainty, weak growth and gold":

"Walking from crisis to crisis 

Switching tack slightly, macroeconomic uncertainty in the Eurozone and US remains elevated; the high correlation between US potential GDP growth and gold (Chart 15) highlights how important this is for the precious metal. While the underlying ills are nuanced between countries, an increasing polarization of politics and a rise in populism have been common by-products; to that point, wealth generation/wealth distribution, immigration and sovereignty have caused contentious debates. Of course, this has not helped confidence and did not make it easier for governments to implement the measures necessary for putting economies on a more sustainable footing. As a result, a host of countries has moved through a series of mini-crises in recent years. This dynamic has also tied the hands of central banks and persistently loose monetary policies have, through various transmission channels, been supportive of gold. As such, even if the UK remains part of the EU and gold corrects, we believe prices below $1,200/oz would be a buying opportunity." - source Bank of America Merrill Lynch

When it comes to gold, we believe the "trend is still our friend", regardless of the "sucker punch" we will get from a "no Brexit" vote, we have to agree with Bank of America Merrill Lynch and we will be happily "buying the dip" in that instance.

Don't hesitate to comment and reach out!

"The voice of conscience is so delicate that it is easy to stifle it; but it is also so clear that it is impossible to mistake it." - Madame de Stael, French writer

Stay tuned!