Saturday 11 February 2017

Macro and Credit - The Carrington Event

"Faith may be defined briefly as an illogical belief in the occurrence of the improbable." -  H. L. Mencken, American writer

Watching with interest US stocks markets reaching new record levels, while investors are pondering what are the risks coming up in the horizon such as a potential trade war initiated by the Trump administration, China credit bubble bursting, an end of the euphoria in US High Yield, upcoming European elections in Holland, France and potential elections in Italy, we reminded ourselves for our chosen title analogy of the 1859 Carrington Event, a perfect solar superstorm and arguably the most underpriced risk in the world. At 11:18 in the morning on September 1st 1859, English astronomer Richard Carrington in his observatory saw two patches of intensely bright and white light breaking out as he wrote in his report "Description of a Singular Appearance seen in the Sun". The massive solar flare had the energy of 10 billion atomic bombs and hit our planet a couple of hours later wreaking havoc to the nascent global telegraph system. Today such natural "Electromagnetic Pulse" (EMP) disaster would inflict considerable damages to critical infrastructures around the globe. Extreme solar storms pose an existential threat to all forms of high-technology and create widespread power blackouts, disabling everything that plugs into a wall socket. According to NASA from their 23rd of July 2014 article entitled "Near Miss: The Solar Superstorm of July 2012", a similar storm to the Carrington Event of 1859 would exceed $2 trillion or 20 times greater than the costs of a Hurricane Katrina according to a study by the National Academy of Sciences. We find it interesting that the more technology and connected we are the more fragile we have become, the thesis of Nassim Taleb's "antifragile" theory. Furthermore as per our long fascination with "Rogue Waves" and risk, depicted in our February 2016 conversation "The disappearance of MS München", what apparently seemed to be an oddity in terms of probabilities, isn't in terms of frequencies as discovered by scientists studying the phenomenon to their dismay. In similar fashion, a solar superstorm appears to many people to be an extremely rare type of event with a low probability. It isn't. As per NASA's article to paraphrase Taleb, we are fooling ourselves with randomness: 
"In February 2014, physicist Pete Riley of Predictive Science Inc. published a paper in Space Weather entitled "On the probability of occurrence of extreme space weather events." In it, he analyzed the records of solar storms going back to 50+ years. By extrapolating the frequency of ordinary storms to the extreme, he calculated the odds that a Carrington-class storm would hit Earth in the next ten years. The answer is 12%. "Initially, I was quite surprised that the odds were so high, but the statistics appear to be correct", says Riley. "It's a sobering figure"." - source NASA
To paraphrase Donald Rumsfeld, while in financial markets today they are known unknowns, when it comes to solar superstorms it represent an unknown known, yet simply ignored by so many.  Such an event, if it hits Earth would cost several trillions of dollars, with a potential lasting recovery time given we are much more reliant on technology these days. Therefore we are way more vulnerable to these types of "rare" event than in the past, same goes with financial markets. Central banks meddling with assets prices have rendered the system much more "interconnected" therefore much more fragile and unstable. Globalization as well, has rendered economies much more entangled than in the past.

You might be wondering where we are going with our analogy. It seems to us that 2016, the many pundits that made the case for catastrophic events for BREXIT and Trump election got not only the outcome wrong, but also got the results wrong when it came to predict the impact on financial markets. In the case of 2016 we had "bad news" (on the back of "fake news") leading to "good news" for financial markets, we are wondering if in 2017 will not be "good news" (on the back of "real news") leading to "bad news" for financial markets.

In this week's conversation we will look at if indeed the "Trumpflation" story is not losing some steam and also what it entails in terms of allocation.

  • Macro and Credit - 2017 - From optimism bias to realism bias 
  • Final charts - European sovereign yields - waiting for Mrs Watanabe and her friends

  • Macro and Credit - 2017 - From optimism bias to realism bias 
2016 for "credit" performances was a story of "bad news" leading to "good news", with the first part of the year plagued by the widening in the energy sector thanks to oil woes and spilling over to equities. Clearly the second part of the year saw a dramatic reversal of fortunes with US High Yield and in particular the energy sector leading the way, while investors extended both their credit exposure and duration exposure. While 2017 continues to see a rally in both US equities reaching new height and credit continuing its strong pace thanks to very significant inflows. This is particular the case for fixed income which is clearly seeing no sign of the "Great Rotation" story playing out, from bonds to equities that is. In fact, what is of interest is that this "great rotation" is happening with significant inflows into High Yield, most likely out of Government bond funds. As we have commented before on numerous occasions, we believe we are moving into the last inning of the credit cycle and at this stage we do not think High Yield could easily repeat its 2016 feat.
When it comes to "reaching for yield", whereas 2016 saw an extension of both credit risk and duration risk, 2017 so far is seeing somewhat a more defensive play when it comes to duration, but in terms of credit risk, High Yield has been seeing some significant flows as reported by Bank of America Merrill Lynch in their Follow The Flow note from the 10th of February 2017 entitled "Reach Higher (yield), go Shorter (duration):
"No losers; everyone benefitting so far
Rising rates are not deterring investors from allocating more into fixed income funds. In fact last week’s inflow into the asset class was the strongest in 28 weeks. Inflows were strong mainly in the higher yielding part of the market, i.e. HY and EM debt funds, but also into high grade ones; predominantly on the short-dated part looking for a “shield” against rising rates. In other words investors are seeking high-yielding instruments and shifting into low-duration IG to protect against rising rates. Rising uncertainty is also favouring flows into commodity (particularly gold) funds.
Over the past week…
High grade funds continued on a positive trend for the third week in a row. The weekly inflow was also the highest in six weeks. High yield funds saw inflows for the tenth consecutive week, and the latest inflow was the largest since March ‘15. Looking into the domicile breakdown, the inflow last week came largely from US domiciled and globally-focused funds. Nevertheless the European-focused funds inflows improved from the previous trend.
Government bond funds had their third week of outflows despite rising rates. Money market funds weekly flows were positive after three weeks of outflows. Overall, fixed income funds recorded an even stronger week of inflows than the previous one, the highest in 28 weeks and the seventh positive in a row. The asset class is rapidly approaching the $20bn mark of inflows YTD. European equity funds flows were positive for a third week but with marginal volumes.
Global EM debt fund flows continued on the positive trend for a second week; and the latest inflow was the highest in 28 weeks. Commodities funds flow remained positive for a fourth week in a row, with the inflow pace going up again.
On the duration front, inflows continued in short-term IG funds for the eighth week in a row. Note that last week’s inflow was the highest since July ‘14. Mid-term funds’ flows flipped back to negative territory after last week’s strong inflow. On the other hand, flows into long-term funds moved back to positive after two weeks of outflows." - source Bank of America Merrill Lynch
Given such powerful flows as of late, it is hard to see what could be the catalyst that will finally derail this long in the tooth credit cycle. We are wondering what could potentially be the Carrington Event for credit. In the meantime, the rally runs unabated thanks to solid macro data and reasonable earnings for the time being. As we indicated earlier one, we wonder if 2017 will not be the reverse of 2016, namely that we will have a solid first half and probably a more difficult second half of the year. It is very difficult to assess what lies ahead with so many political events lining up for the year. In this context, we have raised our cash levels, and continue to play the gold mining theme while we are waiting for more clues from the Japanese crowd before being enticed again towards US Treasury notes. On the subject of tail events, we read with interest Bank of America Merrill Lynch Relative Value Strategist note from the 9th of February entitled "Always looking on the bright side of life":
"The anti-climax of tail events
In our view, the biggest financial misjudgments in 2016 were not about underestimating the probability of certain political events. We believe the larger error, in hindsight, was overestimating the immediate severity of the market’s reaction should they come to pass. So while we had two unexpected outcomes in Brexit and the US election results, both of which were viewed negatively in their respective run-ups, the aftermath has been quite anti-climactic in our view. The market has chosen to focus on the bright side of things, building up policy proposals that it favors like lower taxes and fiscal stimulus, while casting aside those like border adjustment taxes and renegotiating trade deals that could be detrimental to asset prices. While this may eventually prove to be the right call, our caution rests on the premise that all the good has been priced in already, with little heed to the possibility of some bad on the way.
As it stands, there seems to be widespread optimism that tax reform, deregulation and fiscal expansion this year will spur strong growth and inflation in the US. While this may eventually prove to be true, our caution rests on the premise that all the good has been priced in already, with little heed to the possibility of some bad on the way. This speaks to some complacency in our view, with not enough weight being given to medium-term policy uncertainty. 
Uncertainty is high. Stay liquid. Be hedged.
In the absence of some concrete action on the policy front over the coming months, we think the rally is likely to lose momentum. In fact it could be argued that this has already begun. We think this is a good time to switch to more liquid longs. In high yield portfolios in particular, given the liquidity issues in the cash space, we favor increasing allocation to liquid instruments and favor CDX HY over indices referring cash bonds, as the basis is unlikely to compress much further." - source Bank of America Merrill Lynch
As per our last conversation, we would side again with Bank of America Merrill Lynch in regards to favoring the liquidity of CDX HY over cash bonds particularly in the light of the compression seen so far in US High Yield since the beginning of the year (European High Yield as well has had a solid run):

But, nonetheless, a barbell strategy of quality investment grade including short duration High Yield, could still represent an attractive investment proposal, particularly in the light of continuing widening in European Government bonds and the convexity risk for long dated investment grade securities.
"Stay liquid: long CDX HY over HY cash
In the absence of some concrete action on the policy front over the coming months, we think the rally is likely to lose momentum. In fact it could be argued that this has already begun – SPX is down 0.5% in the last two weeks, while IG is 2bp wider. We think this is a good time to switch to more liquid longs. In high yield portfolios in particular, given the liquidity issues in the cash space, we favor increasing allocation to liquid instruments and prefer CDX HY over indices referring cash bonds.

The CDS-cash basis is unlikely to go much higher
The CDS-cash basis has reverted towards its pre-2015 levels. The BAML HY index, H0A0, now trades just about 50bp wider than CDX HY (Chart 1). (Note it was 38bp wider until IHRT was removed from HY27 post default.)

As Chart 2 shows, the IBOXHY cash index has consistently outperformed its CDX counterpart for a year now. We think there is limited upside to this now i.e. the basis is unlikely to compress all the way back to 2012 levels thanks to some amount of liquidity premium embedded in high yield cash bonds after the events of the last two years.
Liquidity, liquidity, liquidity
CDX HY offers a better value, liquid long here than HY cash in our view. In the event of a macro shock, the synthetic index might initially underperform cash, but if the weakness persists, bonds will eventually catch-up. More importantly, we think the level of uncertainty regarding policy and the prospect of a flare-up following this period of extremely low volatility demands a higher allocation to liquid products.
Hedge against rate risk
This switch to CDX or a positive basis trade (long CDX, short cash spread) will also perform well as a hedge against a sharp rate rise, should one materialize.
US equities outperformed European equities while volatility continued to decline in both
markets (Table 4). Equity vol in the US currently stands at 11 vol points, near the lows
seen over the past 10 years:

 (Click to enlarge)
- source Bank of America Merrill Lynch

What is of interest to us in the case of US High Yield is the very slow deteriorating trend as shown per the Q4 Fed Senior Loan Officer Survey which has been recently released. On this subject we read with UBS latest Global Credit Strategy note from the 7th of February entitled "Has US High Yield priced too much good news?":
"Has US high-yield priced too much good news?
One of the most critical questions that portfolio managers face when investing relates to what is priced into the market. We have tackled this question before. One year ago, we highlighted to investors that it was not attractive to short US high-yield, as spreads near 850bps implied a US recession was imminent, while underlying fundamental data suggested otherwise. Fast forward one year, and we are in a very different world. US high-yield spreads sit at 400bps, only 43bps above cycle tights in July 2014. US highyield has returned a superb 21.2% over the last 12 months, one of the strongest rallies ever outside of a post-recession recovery. The key question for investors: Is there still room for US high-yield to rally?
It’s certainly possible. In our recent client meetings, we have heard the strong current of institutional pressure dragging active managers into the market to stem client outflows and reduce what has been an exceptionally difficult period of active manager underperformance vs. the broader index (Figure 1). We think this theme is dwindling as cash balances are falling, but it cannot be discounted from extending further . In addition, if developed market central banks remain dovish (i.e. only 2 Fed hikes in 2017, ECB keeps Taper talk to a minimum, BOJ keeps 0% 10yr JGB yield target), we believe that would be a positive near-term for setting the marginal price of credit.
However, it is becoming impossible to ignore downside fundamental and political risks that are more elevated than when high-yield last traded at such levels. Bank and nonbank lending standards are not easing, credit card and auto loan delinquencies are rising, bank C&I loan growth has stalled, and more protectionist sentiment is being underprized in our view as a macro risk. We believe investors should protect gains at current levels, with both high-quality (BB) and low-quality (CCC) high-yield credit at expensive prices. We suggest investors own junk credit through CDX to protect against illiquidity risk in cash bonds. Investors can also bet on a widening Cash-CDX HY basis as a downside hedge with very attractive risk-reward characteristics. Lastly, we reiterate our 2017 preference for US investment-grade credit and leveraged bank loans over US high-yield.
We believe the main conclusion that investors should take away is the following: While US high-yield has rallied to near cycle peaks, fundamental data highly correlated to US high-yield has not followed suit. Today’s release of the Q4 Fed Senior Loan Officer Survey highlighted a net 0% of banks tightening standards on small firm C&I loans, marginally worse than the -1.5% of banks easing conditions in Q3 (Figure 2). While 0% is not terrible, we need to remember that in the sweet spot of the cycle, a net -5% to -10% of banks typically ease conditions. It should be rather disappointing to bullish investors that one of the strongest high-yield rallies in history has been unable to induce banks to ease standards on CI loans.
Even more important than the headline number, we found only a net 7.4% of banks tightened spreads on C&I loans (average across large and small firms). This reduction of spreads is very modest in light of the massive spread tightening seen in the high-yield bond market. In context, this reading is worse than that experienced in Q2’98 and Q2’07. Put simply, banks are not passing on the decrease in market funding costs to their customers, at least not to the same extent as in the high-yield bond market. Given that these two lending indicators empirically lead both high-yield spreads and default rates, we keep our year-end forecasts for HY credit spreads, default rates, and total returns unchanged (YE 2017 HY spread: 570bps, 2017 HY Default Rates: 3.6%, 2017 HY total returns: 0.1%). For more details on our overall credit forecasts, please see our 2017 outlook pieces. In addition, the rather mixed performance of the lending survey was not limited to C&I loans; a net 23.8% of respondents tightened standards on CRE loans, a net 8.3% tightened on credit cards (worst post-crisis) and 7.3% tightened on auto and other consumer loans (worst post crisis) (Figure 3).

The Q4 Senior Loan Officer Survey also asked two sets of special questions regarding the future outlook for 2017 lending standards and delinquencies. The results here again are mixed, but mixed is not good enough with prices so high. On the former, it is true that a net -16.4% of banks expected lending conditions to ease for C&I loans to small firms, assuming economic activity progresses in line with consensus forecasts. This is the most bullish reading in the SLOS survey for credit investors and if it came to fruition could indicate the credit cycle is restarting. However, at the same time, a net 10.5% of banks expected to widen spreads on small firm C&I loans over the next year. This expected level of spread widening is empirically inconsistent with the forecasted easing in lending conditions, given the strong correlation between the two (Figure 2). To put in context, 10.5% of banks widening spreads is consistent with late 1999 and 2007 levels.
Significant numbers of banks indicated continued tightening for CRE (23.6%) and consumer loans (0% credit cards, 5.1% auto loans next year) as well in 2017. The outlook for delinquencies was also rather mixed. C&I loans only saw a small improvement, with a significant fraction of banks expecting rising NPLs in credit cards and auto loans (Figure 4).

This weakness in the consumer area remains a key source of concern. Our recent Evidence Lab primary survey on the US consumer suggested that rising post-election optimism was balanced out by households stating they were more likely to default on a loan over the next 12 months. Bottom line, there is clear potential for winners and losers post-election, rather than all winners.
The divergence of spreads relative to fundamentals goes beyond bank lending. Non-bank liquidity continues to tighten, largely flying under the radar of most investors. This has continued to tighten since we wrote our initial warning piece on the credit cycle in 2015 (Figure 5).

Non-bank trade credit (i.e. the financing of working capital) in particular continues to struggle, as improvement in the CMI trade-credit index has been modest and highly focused on better-quality names. (The favorable component of this series is currently at 60.8, the highest since July 2015). More stressed firms are under pressure however, with the unfavourable component of the CMI index at 49.5 in January, in contraction territory. The divergence of high-yield spreads versus weaker trade credit is now gaping. Figure 6 highlights that high-yield spreads are tightening rapidly at a time when the usage of collection agencies to collect on unpaid debt continues to grow.

When high yield spreads were at similar levels in 2014, the prospect of collection agencies was not even a remote concern. The CMI Index highlighted that retail names in the service sector were facing the most pressure, consistent our preference for underweighting this sector in US HY.
Another hole in the rally is how high-yield spreads have decoupled from underlying bank C&I loan growth (Figure 7).

Despite the well-publicized increase in consumer confidence and business optimism post the US election, bank C&I loan growth has stalled. We think this is not normal for an economy that is expected to hit mid 2% to 3% growth rates in 2017. In fact, the current growth rate of bank C&I loans is more consistent with levels seen just before recessions. Historically, high-yield spreads lead loan growth, as banks take time to restructure old loans and new firms wait to see evidence of consumer spending before borrowing anew. But this is typically an argument made after a recession. It is difficult to reconcile why bank loan growth has slowed already, since it is now generally established that the prior increase in credit spreads and funding costs did not impact US real GDP broadly to a meaningful extent. Could non-bank financing be crowding out bank financing to skew these numbers lower? This may matter somewhat, but many small US businesses with no access to capital markets must rely on bank financing if they wish to expand their businesses. Bottom line, we need to see loan growth picking up again.
Lastly, we believe there is significantly more political risk than many investors are appropriately pricing. We see the prospect of future protectionist policies from the new administration has the potential to be a key headwind, and our conversations with clients suggest this is not being taken seriously enough. A September 2016 paper by now Commerce Secretary Wilbur Ross and National Head of Trade Council Peter Navarro indicates a desire to reduce the US trade deficit meaningfully. The authors wrote in this report that “Those who suggest that Trump trade policies will ignite a trade war ignore the fact that we are already engaged in a trade war.” On the concept of tariffs, Mr Ross and Navarro wrote that “tariffs will be used not as an end game… Trump will impose appropriate defensive tariffs to level the playing field.” The authors believe that deregulation, lower taxes, lower energy costs, and a strong US bargaining position would offset any price increases and retaliation from increased protectionism, leading to a boom in US growth. However, we view any aggressive move to reduce the US trade deficit near-term via perceived protectionist measures would likely create considerable volatility in financial markets." - source UBS
You probably understand by now why our bullet point is entitled "From optimism bias to realism bias". It is important at this stage of the credit cycle to keep a heavy dose of realism. As we mentioned as well in numerous conversations we are tracking closely US Commercial Real Estate (CRE) particularly in the light of significant tightening financial conditions as depicted in the most recent Senior Loan Officer Survey. In recent musings we pointed out that tightening financial conditions were already showing up in the US in Commercial Real Estate (CRE). This is a segment we will be particularly monitoring in conjunction with its synthetic CMBS proxy the CDS CMBX index and in particular series 6 which comprises the highest retail exposure with 37%. As a reminder in our February 2016 conversation "The disappearance of MS München", we discussed the significant headwinds for the retail sector and in particular series 6 for the CMBX index due to its larger retail exposure. We recently read with interest from an article from Matt Scully in Bloomberg from the 9th of February entitled "Deutsche Bank Says Next Big Short Is on CMBS as Malls Suffer":
"Analysts at Deutsche Bank AG, one of the biggest underwriters of bonds tied to U.S. commercial mortgages, say now it’s time to bet against the securities.
The bonds are vulnerable because they are supported in part by leases from retailers, a lagging part of the economy, wrote Ed Reardon and Simon Mui in a note this week. A combination of bankruptcies and closures could lead to faster-than-expected mortgage defaults for stores and malls, as long-term pressure from internet competitors wears many companies down, the analysts wrote.
Deutsche Bank recommends that investors bet against two series of indexes of commercial mortgage bonds: one from 2012, and another from 2013, a trade that amounts to shorting the underlying securities. Those indexes have larger exposure to malls than their more recent counterparts.
The lender famously recommended betting against real estate before. Before the financial crisis, traders led by Greg Lippmann shorted residential mortgage bonds, which helped the lender weather the global banking meltdown. His efforts were portrayed in the book and movie “The Big Short.”
Falling Index
In this week’s note, Deutsche Bank advised buying credit default protection on the parts of CMBX indexes that are a single step above junk, known as the BBB- tranches. Morgan Stanley recommended betting against portions of those indexes last week. The BBB- rated portion of the 2012 Markit CMBX price index, known as the series 6, has been falling since the end of January.
That index traded at 90 cents on the dollar on Wednesday, compared with 95.2 cents on the dollar on Jan. 27, according to data compiled by Bloomberg. The price has dropped as wagers on the index have climbed in recent weeks, reaching $2.3 billion at the end of last week, according to Depository Trust & Clearing Corp. data.
Deutsche Bank was the biggest underwriter of commercial mortgage bonds in 2012 and 2013, selling about a fifth of the deals, according to trade publication Commercial Mortgage Alert. Buying default protection on the CMBX indexes from those years amounts to betting against many of the bonds the bank sold during that period.
Commercial mortgage bonds that the bank underwrote have performed worse than those of many rivals, said Don McConnell, a senior portfolio manager at Bank of Montreal’s BMO Global Asset Management in Chicago, who helps manage $15 billion of taxable bonds. Of property securities that are delinquent, 40 percent were underwritten by Deutsche Bank, the highest of any lender, even though it is the second-biggest underwriter, he said. JPMorgan Chase & Co., the biggest underwriter, accounts for 10 percent of delinquencies.
Failing Malls
More losses may be coming. The Hudson Valley Mall went into foreclosure last year after Macy’s Inc. and J.C. Penney Co. left the mall. The mall liquidated last month at a $42 million loss to investors -- by far the largest realized loss since the CMBS market restarted in 2010, according to Morningstar Credit Ratings. Sears Holdings Corp.’s credit rating was recently cut further into junk territory after sales in stores open at least a year fell 12 to 13 percent during the holidays.
“Big mall loans have outsize losses for investors,” said Morningstar analyst Edward Dittmer. “We expect the stores like Sears, Macy’s and Penney to close more stores later this year and next year, and as they close, there will be knock-on effects that lead to other mall tenants leaving. This can start the cycle of blight.”- source Bloomberg

While CMBX Series 6 saw it prices recover somewhat following the volatile first semester of 2016, the recent price action in conjunction with the weaker Senior Loan Officer Survey does suggest that there is indeed more pain coming for the sector and it is already playing out in this particular CMBX series. This as well documented in Bank of America Merrill Lynch's latest Securitized Products Strategy Weekly note from the 10th of February;
"Recap & relative value
With benchmark conduit spreads unchanged, no private label deals pricing and only one conduit transaction in the marketing process, the majority of this week’s conversations remained focused on the retail sector. Over the past two weeks short-risk interest in lower-rated CMBX6 tranches surged (Chart 45), fueled by a consensus among some hedge funds that retail and regional mall problems will accelerate in the coming months.
As a result, lower-rated CMBX6 tranches, which are collateralized by about 37% retail exposure, have borne the brunt of the pain (Chart 46), falling by as much as 3.5 points since the beginning of the month.
Although retail sector problems will likely continue to unfold over the coming months and years, it is important to understand what sparked the recent selloff. Over the past two weeks there has been some negative retail-related news (Wet Seal, LLC, filed for bankruptcy on Feb 2, Hudson’s Bay Co. approached Macy’s about a takeover, etc.) and the recent broader-market risk-rally stagnated as evidenced by range bound equity markets and falling 10-year Treasury yields and breakevens (Chart 47).
Ultimately, however, we think the recent move lower in the CMBX wasn’t based on new, fundamental information. Despite the selloff among lower-rated CMBX6 tranches over the past few weeks the underlying cash reference obligations have held in extremely well: there has been little client selling and cash bond spreads have barely moved. As a result, the BBB-minus and double-B cash/synthetic spread differential gapped sharply negatively (synthetics underperformed the similarly rated cash bonds) and (Chart 48) and are now testing, or through, their tightest historical ranges.

This isn’t to say that problems don’t exist. The regional mall space is likely to consolidate over the coming years, which may put pressure on some of the loans collateralized by these assets. Aside from those investors that are using lower-rated CMBX6 tranches to hedge their long-risk books (as some distressed investors do), in order for the “short CMBX6.BBB- or CMBX6.BB” trade to work successfully for an investor that is selling risk outright, the retail sector would need to experience a significant, large shock that has systemic implications to serve as a catalyst. The most commonly mentioned catalyst by many investors would be a near-term bankruptcy of a large retailer. Among retailers, Sears tends to be one that many investors focus on, given the company’s broad-based regional exposure in regional malls and the difficulties that it has experienced over the past few years.
Over the past few weeks, however, no new negative announcements have been made by the company that could have sparked renewed downward pressure on the CMBX. In fact, the company today issued a press release in which it announced it initiated a restructuring program targeted to deliver at least $1 billion in annualized cost savings in 2017. This is not to say that all is fine: although 4th quarter earnings were better than expected, total comparable store sales for the fourth quarter declined 10.3%, comprised of a decrease of 8.0% at Kmart and a decrease of 12.3% at Sears Domestic.
Ultimately, there are several independent “variables” that need to play out simultaneously for an outright short-risk CMBX6 trade to work as well as many hedge fund investors hope it will. In all likelihood, we think this is unlikely to happen. Instead, we think lower-rated CMBX6 tranches will trade in a wide range over the upcoming months and be exposed to potentially significant price fluctuations – both higher and lower – as investors react to headlines. At this point, following the magnitude of the recent move, which began at the end of January (Chart 49), we think the lower-rated CMBX6 tranches are over-sold and could rally as investors get short squeezed.

Given the lack of material, significant fundamental news, this week’s move seems largely technically driven. Over the past few weeks we’ve analyzed the regional malls collateralizing the CMBX6 and last week looked at loss severities for mall loans that were liquidated last year (Regional mall rhetoric has become too negative). One additional data point that we didn’t discuss, but which we think is important, relates to the timing between when loans first show signs of stress and when they were ultimately liquidated. Although this may not matter for investors shorting CMBX6 as a trade, it is important to investors shorting the index outright, since losses would need to be crystalized in order to receive a payout. On average, for the loans liquidated in 2016 that were collateralized by regional malls, it took approximately 48 months between when loans first began to show signs of stress and when they were ultimately liquidated" - source Bank of America Merrill Lynch
So, while no doubt, when it comes to the retail sector there is blood in the water and sharks are starting to circle, it appears to us that in this particular case "someone" is effectively "talking his book". While some pundits might eagerly follow the "Optimism bias" course of action with that "short" trade idea, we would rather side with Bank of America Merrill Lynch and play the "Realism bias" given the potential for the enthusiastic punters to get "short-squeezed" in very short order on that move.

For our final chart and when it comes to being more a "realist" the recent significant widening in French yields have been explained by many pundits by the sudden rise in the political risk in French from seeing Marine Le Pen getting elected at the next presidential election in France. For us, as we have been explaining in numerous conversations, when it comes to European government yields, you seriously need to track the flows from Japan.

  • Final charts - European sovereign yields - waiting for Mrs Watanabe and her friends
In 2016, in numerous conversations we have indicated the importance of tracking Japanese flows from the Government Pension Investment Fund (GPIF), their Lifers friends and Mrs Watanabe playing it through the famous Uridashi retail funds. We believe that in 2017, following Japanese flows is paramount when it comes to assessing yield movements in European government bonds. While the political rational might be enticing for some, for us it is simply a question of flows, or lack thereof, from the voracious 2016 Japanese investors which have been on a diet as of late. Our final chart comes from Bank of America Merrill Lynch Japan Rates and FX Watch note from the 8th of February and displays the cumulative purchase of European sovereign bonds by Japanese since 2012 (JPY trn):
"FDI and portfolio outflow offset current account surplus
Today Japan's Ministry of Finance (MoF) released international balance of payment statistics for December and a preliminary portfolio investment report for January (based on reports from designated institutions). The seasonally adjusted current account surplus was ¥1,669bn, somewhat lower than in November (¥1,780bn), but still a high level. The current account surplus for CY2016 was ¥20.6trn, and direct investment deficit of ¥14.6trn cancelled out most of this. The ¥30.5trn deficit in portfolio investment is sizable, but a significant part of this portfolio investment should have been hedged. This pattern of investing surplus funds overseas and using the profits to fund the home country reflects Japan’s status as an aging developed country. Also, due to the rising number of foreign visitors to Japan, a surplus of ¥1,339.1bn was recorded in the travel account, the largest such surplus since 1996.
The Trump shock’s aftereffects and Europe’s political risk
The rise of US yields following the US presidential election appeared to settle down around the beginning of 2017, but Japanese investors continued to sell a net ¥1.62trn of foreign bonds in January. Banks were the main sellers. They were net sellers of ¥1.97trn in one month. Life insurers, who had been net sellers along with banks in the previous month, switched to a net purchase of ¥159.8bn in January. Details of flow for January have not been released yet, but we do know from December figures that the net sale of US Treasuries was ¥2.39trn that month, the largest since May 2013." - source Bank of America Merrill Lynch
So if indeed in the Land of the Rising Sun, the sun is in fact setting on their appetite for European sovereign bonds, then no doubt you might get your equivalent of a Carrington Event and solar storm in European bond land we think. It might simply be that "Bondzilla" the NIRP monster might have a serious case of "bond" indigestion after his epic fest of 2016, but we ramble again...

"The world is divided into two classes, those who believe the incredible, and those who do the improbable." -  Oscar Wilde

Stay tuned !

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