Tuesday, 8 November 2016

Macro and Credit - Pregabalin

"Optimism is the opium of the people." - Milan Kundera
Watching with interest the largest outflow ever in US High Yield ($3.9bn last week) in conjunction with the unprecedented 9 days of weakness in US equities and the concomitant rise in the VIX index, given the indecisive outcome for the US elections thanks partly to the FBI's recent change of heart, when it came to selecting this week's title analogy, we decided to steer towards a pharmaceutical one. Pregabalin is a medication used to treat epilepsy but more commonly to treat generalized anxiety disorders. Given markets predicaments and violent gyrations, one might wonder if indeed one should take some pregabalin to ease these rising anxieties. While we have been musings around a pre-revolutionary mindset setting in on the global stage, no doubt to us that the rise in flare-ups in Hong-Kong, Florence in Italy, Greece and palpable rising tensions in France as a few examples, make us believe that the US elections anguishes are not the beginning of the end but more likely akin to the end of the beginning to paraphrase Winston Churchill. Although investors have received some respite as of late with the FBI changing again its tune, we do believe that no matter how some pundits would like to spin it, the lateness in the credit cycle appears to be as evident as the recent record numbers in M&A transactions typical of a late credit cycle rally.

In this week's conversation rather than focusing on the US elections outcome, we would like to look at the situation in Europe when it comes to disintermediation and deleveraging for the European banking system as well as shipping still being a deflationary indicator.

  • Macro and Credit - Disintermediation accelerating in Europe
  • Macro and Credit: If you think about deflationary forces at play and global trade, think about shipping
  • Final chart: Asia will become the largest driving force in world trade in the coming decades

  • Macro and Credit - Disintermediation accelerating in Europe
While we have in many musings discussed the "japanification" process linked to the significant deleveraging process needed in the European banking system versus the US, we were reminded by KPMG as per Bloomberg's article on the 30th of October that European bank were still sitting on €1.2 trillion of nonperforming loans on their balance sheets:
"Eight years after Lehman Brothers’ collapse sparked the financial crisis, Europe’s banks still have 1.2 trillion euros ($1.3 trillion) of non-performing loans and will probably be stuck with them for decades to come, according to KPMG LLP.
Anemic economic growth across the region is making it harder for lenders to off-load toxic assets, hurting profitability while banks also come under pressure from tougher capital rules and fines for misconduct, London-based KPMG said in a report published Monday. Firms could take “decades rather than years” to reduce their exposures, hampering profitability.
European lenders are battling to cut soured loans as they face evaporating income from lending amid negative interest rates from the European Central Bank. Net interest margins, the difference between income from lending versus cost of funding, average about 1.2 percent in the region compared with about 3 percent in the U.S., according to KPMG.
“Reversing the profitability of European banks is not a lost cause but it will certainly be a lot of hard work,” Marcus Evans, a partner at KPMG’s ECB office, said in a statement. “It’s clear that across Europe banks are still grappling with the new world of low, or negative, interest rates and mounting capital and regulatory costs.”
The total value of toxic loans in Europe has surged since 2008 from about 1.5 percent of lending to more than 5 percent since 2013, according to the report. This has a negative impact on profitability from unpaid interest, raising provisions against impaired assets and realizing losses when disposing bad debts, according to KPMG." - source Bloomberg
When it comes to dealing with this burden, we have been pretty vocal in the past of what needed to be done back in July when we re-iterated our stance in relation to what the ECB should do in order to restore the credit transmission mechanism to Southern Europe in our conversation "Confusion":
"The only way, we think is for the ECB to monetize NPLs to restore the credit transmission mechanism, because without growth, there is no reduction in both NPLs and budget deficits, that simple.
We also made a more in depth analysis of the Italian NPLs problem back in April in our conversation "Shrugging Atlas":
"Either you remove the NPLs from the bloated Italian Banks' balance sheets and the ECB monetizes the lot, or they don't. Anything in between is an exercise of dubious intellectual utility." - source Macronomics, April 2016
We also re-iterated our call on ailing Southern European banks back in August in our conversation "The Law of the Maximum":
"Either "Le Chiffre" aka Mario Draghi put up, meaning monetizing the lot, or he should shut up because in our book, no matter how charming the bluff he has pulled in the past with his July 2012 "whatever it takes" moment and his OMT, when it comes to ailing Southern Europe banks, it is decision time. The members of "The Cult of the Supreme Beings" might be numerous, but, saving Southern Europe banks requires more than an act of faith we think and haven't even mentioned German banks with some of their struggle with shipping loans such as HSH Nordbank, do not get us started...." - source Macronomics, August 2016
What is of course of interest when it comes to deleveraging, disintermediation and "japanification" is that corporate bond funding in Europe has been on the rise thanks to record issuance levels in the bond market. The financial repression from the ECB in conjunction with its latest corporate bonds asset purchases has moved hand in hand with the primary market for bonds. On the subject of disintermediation, we read with interest Société Générale quarterly note entitled "In the mood for loans" published on the 7th of November:
- source Société Générale

Whereas the above picture shows the overall picture, it is far more interesting to look at it on country to country basis given the significant differences between core countries and peripheral countries, where the impact of nonperforming loans has not been trivial when it comes to providing new loans regardless of the compression in interest rates for new loans as put forward as a success by the ECB:

- source Société Générale

What we find most interesting from Société Générale's report from a "credit impulse" perspective is the situation in Europe compared to the US, which we pointed out in the past has led to different growth outcome in recent years:
- source Société Générale

Obviously the pressure NIRP is putting on Europeans Banks Net Interest Margins (NIM) is accelerating the disintermediation process while in no way leading to some massive improvement for peripheral countries in credit impulse leading to better growth prospects, Italy being a good example of the failings of the ECB, not to mention the unresolved large pending issues of growing nonperforming loans which has yet to be addressed meaningfully. The impact of the European Banking Association core tier one capital rule which lead to a credit crunch in Southern Europe as some banks decided to drastically reduce their loan book to attain the core tier one ratio threshold can be seen in the below chart from Société Générale's extensive loan report:
"YTD figures show a big contrast between the two corporate lending markets. Bonds are obviously more resilient then loan funding, which could fall more than 30% short compared to 2015.
Part of this shift is attributable to the strong impact of the ECB’s CSPP buying programme. The impact of this programme (between €8-9bn of purchases per month) has strongly narrowed bond spreads and has very likely diverted supply towards bonds." - source Société Générale
As we pointed out in numerous conversations is that, liquidity doesn't resolve solvency but, more importantly, the longer time you take to deal with nonperforming loans, the weaker the credit impulse and your economic recovery and ultimately economic growth. But for now, the ECB and disintermediation, in similar fashion to what happened in Japan in the past, makes investment grade credit still an appealing proposal, particularly in the US thanks to the continuous appetite from the Japanese crowd in general and lifers in particular as pointed out by Nomura in their FX Insights note from the 28th of October entitled "JPY: Lifers still prefer foreign bonds":

"Japanese lifers’ investment plans show strong demand for foreign bonds, even after the introduction of yield curve control by the BOJ. Slight steepening in the JGB yield curve since early July is viewed as not enough for them to consider aggressive JGB investment. Their views on hedging suggest unhedged foreign bond investment is likely when JPY appreciates. The current USD/JPY spot is already slightly higher than their end-March forecast, but dip-buying demand from lifers is likely, especially if US political uncertainty disappears." - source Nomura

So while US High Yield as of late have seen significant outflows particularly in the feeble retail ETF space, we continue to favor quality (Investment Grade) over quantity (low rated US High Yield such as CCCs). Though some expect the convexity game to bite with additional rate hikes from the Fed starting in December which could impact dearly the long dated / low coupon investment grade crowd. At least for now, in terms of flows, the Japanese investor crowd still has your back.

Moving on to the never ending argument between inflation or deflation, while we chose the middle grown in our previous conversation discussing "biflation" over "stagflation", we continue to assess the deflationary forces at play thanks to the shipping industry as per our next bullet point.
  • Macro and Credit: If you think about deflationary forces at play and global trade, think about shipping

As we pointed out in the past, when it comes to deflationary pressures, disintermediation and "japanification" process, we have long been looking at shipping loans as a good indication of deterioration in global trade and credit. We have regularly pointed out German banking woes when it comes to their outsized exposure to the sector which has been impacted in recent years by slumping freight rates illustrative of weaker global trade. This has been leaving shipping companies struggling to pay their creditors which meant that some German banks decided that they would even themselves run some ships to avoid recognizing their losses. For instance, back in 2013, German Commerzbank given their nonperforming shipping loans had resorted to running themselves the ships rather than recognizing the losses.

What some pundits fail to grasp when assessing world trade is that containerized traffic is dominated by the shipment of consumer products hence our stance regarding the weak recovery we are seeing. Any change in consumer spending trends depends on a more pronounced housing market revival and will directly impact container traffic. Weaker demand means weaker traffic, that simple.

When it comes to German banks exposure, there is much more deleveraging to come in relation to their shipping loan portfolios and woes as per Société Générale's report:
"Already evidenced in the 3Q15 data, German, Greek and UK banks shrunk their balance sheets in the sector in 2015 by -20% to -34%.
On the other hand, French, Benelux and Scandinavian banks all increased their balance sheets by 8% to 9%, while NL banks did so by+22%."
  • "Within the container segment, mid-sized panamax vessels are being particularly hit by the situation. The Hanjin bankruptcy has been exacerbated by the re-opening of the widened Panama Canal, which means the Panama vessels are now undersized and outdated.
  • In the offshore business, drilling business remains very weak. Many drilling rigs and jackups are struggling to find profitable redeployment at the end of existing contracts, and the idle fleet is therefore increasing, which will put pressure on cash flow in due course.
  • New financing activity is low, and there has been a flight to quality among lenders, who are increasingly selective on new business while they closely manage existing portfolios. Liquidity remains strong for the top credits, and funding can be very aggressive despite the weak underlying markets. This is particularly true in Asia, where local banks (Malaysian, Taiwanese, Indian, etc) can price very aggressively to support their local clients, while Chinese lessors are being aggressive on a global scale to build market share.
  • In addition to this difficult environment, the uncertainties regarding the Basel IV regulatory capital study are further constraining banks’ appetite for new lending. The new framework, as initially drafted, is based on more standardisation and higher capital requirements for shipping lending activities, the result of which would potentially further reduce bank liquidity for this business as well as increase the cost of borrowing for shipping clients. This might in time narrow the pricing gap between traditional bank lending and alternative sources of funding in the capital markets, particularly non investment grade. Banks will need to be more agile in managing portfolios, and without anticipating the final implementation of the Basel IV rules, banks will have to be more innovative in their distribution, extending their OTD model.
  • During the summer, the industry acknowledged the bankruptcy filing of South Korea’s third largest shipping company, Hanjin Shipping. This is by far the largest bankruptcy in the sector and will have important consequences. The two other large Korean shipping companies, STX and HMM, have also been through significant restructuring in the past. HMM has announced that it is among a list of five potential bidders for some Hanjin ships.
  • A number of significant strategic operations took place this year and could bring some discipline to the container sector in the future. Examples are Marseilles-based CGM-CGA’s acquisition of Singapore’s NOL; Hamburg-based Hapag-Lloyd’s merger with Qatar/Saudi Arabian-backed UASC; and, hot off the press, the likely merger of the container operations of the three largest Japanese shipping companies – NYK, MOL and K-Line.
  • Overall, the outlook remains challenging, which is no doubt a source of stress to ship-owners and banks alike. This will require more innovation as banks evolve towards Basel IV, possibly accelerating their OTD business models to manage capital more smartly. Investor appetite for IG shipping debt is proven, with the likes of pension funds active in this market.
  • The difficulty will stand with non-IG lending (i.e. the majority of the shipping sector) where alternative investors such as hedge funds and infrastructure funds have very different approaches to pricing. Whereas banks value the underlying collateral over which they have security and this currently drives the advantageous capital treatment and lower margin, typically hedge funds don’t value this component and price on an unsecured high yield basis." - source Société Générale
On top of the weakness in global trades, which has been plaguing the shipping industry and their banking creditors, the only solace they have seen as of late has been coming from weaker bunker fuel prices. As a reminder bunker fuel constitutes the bulk of voyage expenses for shipping companies. Higher bunker fuel prices would adversely affect already ailing earnings for the industry as a whole. Bunker fuel prices, the largest cost of running a ship, correlate with crude oil prices.  For the week ended October 28, 2016, the average bunker fuel price was $321–$325 per ton. Bunker fuel prices are 13% higher than they were in the same period in 2015, when they were $321–$324 per ton. A continuation in the rise of bunker fuel would of course put additional strain on already difficult earnings for the industry as a whole. On top of that new types of bunker fuel need to be developed to meet demand for low sulfur marine fuel following the decision of the International Maritime Organization to impose a global 0.5% sulfur cap on marine fuel in 2020, according to bunker industry organization IBIA. This will as well put additional pressure on the cost structure for existing shipping companies, meaning more pain to come thanks to increase regulation and more provisions to make for the likes of Commerzbank. This means probably more "pregabalin" intake for shipping companies and creditors alike we think but we ramble again...

When it comes to deflationary forces at play in global trade, we do not see a reversal in sight for the current weakening trend we have seen in recent years. This is as well clearly put forward by Deutsche Bank in their Logistics note from the 8th of November entitled "Weak environment - no trend reversal in sight":
"Over the next three to five years, global trade is likely to grow only at or around the same pace as global GDP.
This structurally weaker momentum should be reflected in slow growth in the global and regional flow of goods, as has already been the case in recent years. In its role as an open, export-oriented economy, Germany – and the German logistics sector in particular – should continue to feel the sting of this development. At a nominal average of 2% a year, turnover growth in the sector is likely to be below the long-term average in the years ahead.
Global openness – the share of trade in global GDP – increased from just over 10% in the mid-1990s to more than 30% in 2008.
In the wake of the 2008/09 global recession, global trade suffered a setback. Openness fell to around 27% in 2009. Due to the lingering weakness in global trade since 2012, global openness has yet to return to above 29% in 2015. We expect global trade to remain anemic in the years to come.
Low global trade growth goes hand in hand with weak momentum in the global flow of transportation.
The growth rate in international seaborne trade fell each year between 2012 and 2015. Growth came in at just 2% in 2015 – its slowest pace since 2009, a year plagued by recession. The situation is similar in global airfreight, where transport volume grew by an average of just 1.5% a year between 2010 and 2015. Between 1993 and 2010, airfreight transport volume expanded by more than 5% a year.
The slow expansion of trade in recent years is ultimately also reflected in domestic freight transport.
In 2015, the total volume of goods transported in Germany was only around 3% higher than it was in 2011, corresponding to an average annual growth rate of 0.7%. Between 1995 and 2011, transport volume increased by an average of 2.6% a year. The total volume of goods transported in Germany looks likely to grow by only slightly over 1% a year between 2017 and 2019.
In this climate, it is not surprising that the German logistics sector has also been mired in less than stellar growth for years now.
Nominal turnover in the sector increased by only slightly over 1% a year between 2012 and 2015. As a result, average growth was significantly lower than it was between 2003 and 2008 (4.6% a year). From 2016 to 2020, turnover growth in the German logistics sector will probably come in at just over 2% a year on average. Some segments, such as contract logistics and the provision of value-added services, fundamentally offer opportunities for higher growth." - source Deutsche Bank
So if you think that the rise of populism and discontent à la 30s is potentially coming back, then indeed, global trade could be further threatened down the line by additional pressure on "Global Openness as described above by Deutsche Bank. If global trade does remain anemic in the years to come, then indeed the deflationary floor we mentioned embedded in US TIPS we talked about recently as a low correlated asset allocation tool is still of good value we think.

If politicians start in earnest dealing with "globalization" thanks to rising discontent triggered by a rise in inequality, then again the inflationary burst we have seen will not lead we think to "stagflation" but no doubt to the "biflation" scenario we mentioned in our last conversation:
"What we are seeing we think is more akin to the development of "biflation" rather than "stagflation" in the sense that we could see the development of the simultaneous existence of inflation and deflation in an economy. This would lead to a resurgence in inflation in commodity prices with deflation in debt-based assets. Biflation can occur when a fragile economic recovery causes central banks to "overmedicate" via their monetary policies. This may results in higher prices for certain assets such as energy and precious metals with declining prices for leveraged assets such as real estates and automobiles (see our July conversation on declining prices for classic cars "Who is Afraid of the Noise of Art?"). With biflation,  the economy is tempered by increasing unemployment and decreasing purchasing power. As a result, a greater amount of money is directed toward buying essential items and directed away from buying non-essential items. Debt-based assets (mega-houses, high-end automobiles and other typically debt based assets) become less essential and increasingly fall into lower demand." - source Macronomics, 30th of October
The weaker trend in global trend has been running on since 2012 as illustrated by Deutsche Bank in their note:

"The lingering weakness in global trade since 2012 caused global openness to fall to 29% in 2015. Our analyses to date suggest that global trade is likely to continue posting anemic development in the years ahead, as the elasticity of international trade with regard to global GDP growth has probably decreased, partially due to structural factors. As a result, the link between cyclical and structural factors continues to exist.
In particular, the following aspects point to continued weak global trade going forward: slower economic growth in China and the realignment of the Chinese economy towards more domestic consumption, the probable plateau in the development of global value chains, the faltering status of multilateral trade liberalisation and the increase in the number of additional trade restrictions since 2008. Furthermore, there are no unique events on the horizon with the potential to boost trade globally or, at the very least, regionally. In the previous decade, such events included China’s admission to the WTO in late 2001 and the EU’s eastward expansion in 2004. This less positive outlook for global trade also means muted prospects for globally active logistics companies." - source Deutsche Bank
But, if you believe like ourselves in very long term trends, then indeed what we are seeing is the rebalancing towards Asia as mentioned by Angus Maddison in his outstanding book "Contours of the World Economy, 1-2030 AD, Essays in Macro-Economic History". The interesting part is relating to the share of World GDP for China, the peak was around 1820 at 32.9% according to Angus Maddison. It dropped to 17.9% in 1870 which is explained by the industrial revolution experienced by Western Europe at the same time. In 1950 and 1973, China's share of World GDP was 4.6 %. In 2003, China's share of World GDP came back close to 1870's level at around 15.1 % of World GDP.

This is where it is becoming interesting, according to Angus Maddison's projection for 2030(page 340 in his book), you can expect the following:
  • Western Europe share of GDP will drop to 13% in 2030 from 19.2% in 2003.
  • Asia (including Japan) shares of World GDP will power ahead from 40.5 % in 2003 to 53.3% in 2030.
  • In 1820 Asia's share was 59.4 % with a low point of 18.6 % in 1950.
Before you reach for your pregabalin, we encourage you to read the stunning work of Angus Maddison given our final chart.
  • Final chart: Asia will become the largest driving force in world trade in the coming decades

Asia will become the largest driving force in world trade in the coming decades and this is clearly illustrated as well in Deutsche Bank's note by our final chart taken from their note:

"Significant shift in the flow of trade away from Europe and towards AsiaBehind the aggregated global flow of trade lies a significant shift in the importance of regional trade within a continent or between continents. At 27%, the trade in goods within Europe continues to account for the lion’s share of global trade. But, from the early 1990s to today (2010-2015 average), it has grown slower than global trade overall, bringing Europe’s share down by five percentage points. Asia, by contrast, has grown significantly in importance. The share accounted for by trade within Asia increased by eight percentage points to 23% over the same period (chart 7).

China’s breathtaking rise to becoming the world’s largest trading power (WTO admission in 2001) was the main driving force behind Asia’s growing importance. China is a partner in each of the five largest bilateral trade relationships that have seen the strongest growth in their share of global trade since the early 1990s. Bilateral trade between China and the US has seen the strongest growth in importance and now places fourth with a share of almost 3% of global trade. In relative terms, trade between the US and Japan and between the US and Canada has lost the most significance. However, bilateral trade between the US and Canada remains in first place.
This shift towards Asia is likely to continue on account of the significantly higher growth rates in Asia than in Europe and progress on trade agreements, such as the Trans-Pacific Partnership (TPP), the Regional Comprehensive Economic Partnership (RCEP) and the Free Trade Area of the Asia-Pacific (FTAAP). Although the Transatlantic Trade and Investment Partnership (TTIP) negotiations between the US and Europe are still under way, critical voices have recently been gaining strength among the public and policymakers. Should the trend that has been around since the early 2000s continue, trade within Asia could outstrip trade within Europe by 2019.
A look at the flow of trade between the continents also illustrates Asia’s growing importance. The share of global trade accounted for by the flow of goods between Asia and Europe has grown by more than one percentage point since the early 1990s, reaching 13% in 2015. Although the significance of trade between America and Asia started to decline in the early 1990s, it has again risen to 12% since the mid-2000s. The importance of trade between America and Europe has fallen by almost three percentage points to 7%." - source Deutsche Bank
Sometimes the long term trend is indeed your friend...While the credit clock might be slowing thanks to central banks meddling, deflationary forces while temporarily at bay might come back thanks to the risk of renewed populism, rising discontent over inequalities and a return of protectionism, but that's another story. For the time being all eyes are on the US elections.

"Under the pressure of the cares and sorrows of our mortal condition, men have at all times, and in all countries, called in some physical aid to their moral consolations - wine, beer, opium, brandy, or tobacco.' - Edmund Burke

Stay tuned !

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