Macro and Credit - The Vasa ship

"In the ocean of baseness, the deeper we get, the easier the sinking." - James Russell Lowell, American poet.

When in Paris on the 5th of January to present our winning Saxo Bank community from their latest Outrageous Predictions for 2016 to their French clients, we had a very interesting meeting with Steen Jakobsen, their chief economist, who at the time, suggested we look into the Vasa ship as an interesting analogy for a post title. This time around curiosity did not kill the cat, and we waited, we must confess, for the right time to use this very interesting analogy in our musings. Given the on-going onslaught in risk asset classes (except for our comforting long US bonds, long gold miners and other positions) and also because, as always, credit leads equities (this means to lower levels that is), we decided it was the right time to use Steen's suggestion in this Macro and Credit related musing of ours.

So why the Vasa ship for our chosen title?

The Vasa ship was a Swedish warship built between 1626 and 1628 on the orders of the King of Sweden Gustavus Adolphus as part of the military expansion he initiated in a war with Poland-Lithuania (1621–1629). The ship is famous for having foundered and sank after sailing only about 1,300 m (1,400 yd) into her maiden voyage on 10 August 1628. Richly decorated as a symbol of the king's ambitions for Sweden and himself, upon completion the Vasa ship was one of the most powerfully armed vessels in the world (like the Bank of Japan). However, it had a massive design flaw. Vasa was dangerously unstable and top-heavy with too much weight in the upper structure of the hull (total amount of debt in the world). Despite this lack of stability she was ordered to sea and foundered only a few minutes after encountering a wind stronger than a breeze. In similar fashion, Bank of Japan's attempt in playing the Negative Interest Rate Policy game (NIRP) card sounds to us eerily familiar with the tragic fate of the Vasa ship. Kuroda's attempt foundered straight from inception with the Japanese Yen rising to 114 and the Nikkei rout continuing seeing the Nikkei lose another 2.31% on the 10th of February to 15,713.39.

The fatal order to sail was the result of a combination of factors. One being the king's impatience in seeing the Vasa ship becomes its flagship of the reserve squadron at Älvsnabben in the Stockholm Archipelago. The other was the king's subordinates lack of political courage to openly discuss the ship's structural problems or to have the maiden voyage postponed. Although an inquiry was organized by the Swedish Privy Council to find those responsible for the disaster, but in the end no one was punished for the fiasco. In similar fashion we think the central bankers at the Bank of Japan, the Fed, the SNB, the ECB responsible for the mess we are in will not be punished for the upcoming fiasco but we ramble again...

In this week's conversation we will look again at the dangerous evolution we are seeing from idiosyncratic "sucker punches" towards "systemic" risk. We will also look at why in similar fashion to the Vasa ship, new monetary policies such as NIRP will fail because of dangerously unstable markets and their top-heavy load (global world debt).

Synopsis:

• Central bankers' tricks are losing their "magic"
• Credit - The tide has turned and we are moving from "idiosyncratic" risk to "systemic risk"
• Final chart - Don't catch falling knives

• Central bankers' tricks are losing their "magic"

As we pointed out recently in our conversation "Under pressure", our Generous Gamblers aka our central bankers are losing their magic we think:

"Additional easing monetary policies, but as shown recently in the various iterations of QE in the US, the Fed is getting "less bang for the buck". Basically the "magic" of our "Generous gamblers" is losing its power on driving asset prices to new heights. "Overmedication" could in fact lead in the end to "overdoses", we think." - source Macronomics, January 2016

 We also added:

"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing.
The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016

It was bound to happen as per the Vasa ship (positive correlations leading to instability). From the inception of "unorthodox" monetary policies, the biggest issue which has yet to be addressed as brilliantly pointed out by William R. White, the chairman of the Economic and Development Review Committee (EDRC) at the OECD in Paris in a Bloomberg interview in similar fashion to the Vasa ship which was dangerously unstable because of too much weight in the upper structure of the hull, is the total amount of debt in the world.

In the light of Mr. William White's great interview we would like to rehash the quotes we have used in our March 2012 conversation "Shipping is a leading deflationary indicator"particularly in the lights of the very concerning comments made by AP Moller-Maersk's CEO on the current state of affairs of his company, seeing a situation worse than 2008:

"He who rejects change is the architect of decay. The only human institution which rejects progress is the cemetery."
Harold Wilson
"He who rejects restructuring is the architect of default." - Macronomics.

This is why Mr White's comments are so to the point. The longer you delay the restructuring, the lower will be the recovery value.

But, when it comes to central bankers losing their magic, the latest "results" in the markets from the Bank of Japan's implementation of NIRP speak for themselves. This is does not come as a surprise whatsoever. It was bound to happen and it is clearly pointed out by Bank of America Merrill Lynch in their FX Vol Trader note from the 10th of February entitled "Central Banks puts expire":

"Key takeaways

• As confidence in central bank puts erode, market participants are adjusting by paying for their own protection.
• Hedge demand has pushed vols indiscriminately higher. We view this as excessive and prefer to fade the move.

Markets adjusting to less stimulus

The painful adjustments taking place across global financial markets can partially be attributed to the re-pricing of central bank expectations. With Fed QE quickly becoming a distant memory and both the ECB and BOJ failing to deliver expansion packages, the market has been forced to learn to stand on its own two feet. As implicit central bank puts expire, the market must now pay for protection out of pocket, reflected in the structural shift in long-dated EURUSD and USDJPY risk reversals, which have both turned for USD puts (Chart 1). 

Like most forms of insurance, by the time the accident is being assessed, further coverage will be expensive. The demand for options has pushed FX vols towards the highs of the past couple of years. In our view, the indiscriminate demand for vol across all currencies and tenors is excessive and we prefer to fade the move." - 

Markets anxious, buying vol indiscriminately

Concerns about the health of the US economy and the European banking sector wreaked havoc on global markets this week. The broad anxiety is reflected in the indiscriminate vol purchases across currencies and tenors (Page 5, Table 3).

Gamma in general is performing, but our core view has been that barring some sort of crisis, it will be difficult to sustain volatility without a core divergence story." - source Bank of America Merrill Lynch

Also, as we posited in back in November 2014 in our conversation "Chekhov's gun", the changes in the communication of monetary policy have indeed taken a turn for the worse. This was clearly demonstrated by the SNB in 2015 and the surprise NIRP implementation by the Bank of Japan:

"What we find of interest is that both the Fed and the Bank of Japan have been trigger "QE " happy, As we have argued in our last conversation, investors' belief in central bankers' omnipotence and deity status enabling them to sustain over extended asset price levels is being threatened we think by the changes in the communication of the conduct of monetary policy as indicated by Richard Koo, chief economist at the Nomura Research Institute in his latest note:

"The problem is that treating monetary policy like currency intervention also has side effects. Over the last decade it has become standard practice around the world to conduct monetary policy with a minimum of surprises based on careful dialogue with market participants.Until the mid-1980s, monetary policy decisions tended to be made in closed rooms, something then-Fed chairman Paul Volcker was very good at. In Japan, it was even considered “acceptable” for authorities to openly lie in the lead-up to decisions on the official discount rate (or the timing of snap elections).Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members.

Kuroda abandons forward guidance

It was because of this approach that the Fed has been able to conduct policy now known as forward guidance based on expectations of its future actions, something that had not been possible in the past. It was precisely because the Fed avoided surprises that market participants trusted it when it said it would keep interest rates at exceptionally low levels for a considerable amount of time.Policymaking evolved in this direction because of a growing awareness that monetary policy has a major impact on the economy and is fundamentally different from intervention on the currency market, which basically involves only a handful of participants.But with the 31 October easing announcement Mr. Kuroda deliberately chose to shock the markets. By doing so, he effectively removed forward guidance from the BOJ’s toolkit.When the head of the central bank enjoys surprising the market, market participants will no longer take anything he says at face value. Mr. Kuroda claimed in his Upper House testimony just three days before the announcement that the economy was making “steady progress” towards achieving the 2% price stability target even as he was secretly moving ahead with preparations for the surprise easing.

Ending QE will now be far harder for BOJ than for Fed

The BOJ governor’s decision to utilize the element of surprise could lead to major problems when it comes time to bring quantitative easing to an end. Careful dialogue with the market—including forward guidance—is essential when winding down such a policy, as the IMF has repeatedly warned.There is, of course, no guarantee that the exit from QE will proceed smoothly simply because the central bank maintains a close dialogue with the markets. Even Mr. Bernanke, with his reputation for being a good communicator, caused a great deal of turmoil in both the developed and the emerging economies when his remarks on 22 May 2013 concerning the possibility of tapering sent US long-term interest rates sharplyhigher.The Fed’s intensive forward guidance under both Mr. Bernanke and his successor, Janet Yellen, succeeded in calming markets by persuading them the Fed had no intention of raising rates in the near future. It remains to be seen how Mr. Kuroda will respond when he finds himself in the same situation.In summary, the BOJ’s shock announcement could make it far more difficult for the Japanese central bank to end quantitative easing than it has been for the Fed." - source Richard Koo, Nomura Research Institute

To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but, when it comes to winding down QE, the exit from the program will not proceed that smoothly, rest assured." - source Macronomics, November 2014

Exactly! The Bank of Japan has painted itself in a corner (and soon the Fed will as well). The shock announcement of NIRP has led to an unexpected outcome and more "sucker punches" delivered in the form of falling Japanese equities and a sudden "risk reversal" on the Japanese yen. Remember, we told you in December in our conversation "Charles law" significant "risk reversal" opportunities would happen in 2016:

"We don't see conditions improving either in 2016 and last Monday was once again an illustration of "Blue Monday" in the works we think. With liquidity deteriorating and hydrogen having been used by our "generous gamblers" as a lifting agent in  "asset balloons", there is indeed no surprises in seeing a significant rise in idiosyncratic risk leading to significant price movements. 2015 saw an increase in the number of "sucker punches" inflicted to the "cross-asset" crowd. By no means 2016 is going to be different." - source Macronomics, 15th of December 2015

When it comes to the latest "sucker punch" delivered to the Japanese yen courtesy of Kuroda's NIRP, we read with interest Richard Koo, chief economist at the Nomura Research Institute in his latest note from the 2nd of February:

"Negative interest rates an act of desperation driven by failure of past accommodation

In my view, however, the adoption of negative interest rates is an act of desperation born out of despair over the inability of quantitative easing and inflation targeting to produce the desired results. That monetary policy has come this far is a clear indication that both ECB President Mario Draghi and BOJ Governor Haruhiko Kuroda have fundamentally misunderstood the ongoing recession.
To begin with, despite the all-out efforts of central banks in Japan, the US, the UK and Europe, neither quantitative easing nor inflation targeting were able to achieve their initial objectives.
The BOJ has now pushed back the date when it expects to achieve its inflation target from “around the second half of fiscal 2016” to “around the first half of fiscal 2017,” which would be fully four years into the Kuroda/Iwata era.

Failure of monetary easing symbolizes crisis in macroeconomics

This failure clearly demonstrates that the Japanese economy envisioned by Mr. Kuroda and Mr. Iwata at the time of their appointments when they pledged to step down if they failed to achieve 2% inflation in two years was very different from the reality. In short, their models were wrong.
The same mistake has been made repeatedly in the US, the UK and Europe. In each case the monetary authorities undertook extreme quantitative easing measures in an attempt to achieve inflation targets, yet price growth continues to run far below the target levels.

In view of the fact that some of the most talented, well-educated economists in these countries are working for these central banks, it is hard not to conclude that this global policy failure is less a reflection on the abilities of Mr. Kuroda and Mr. Draghi than a signal of a crisis in the discipline of macroeconomics itself.

Conditions in today’s real economy do not conform to macroeconomic assumptions

The definitive difference between the economics that they (and we) studied as university students and the actual economic experience of the US and Europe since 2008 and Japan since 1990 is that traditional economics assumes the private sector is everywhere and always trying to maximize profit. But today the private sector is trying to clean up its balance sheet by minimizing debt.
In terms of financial markets, traditional economics means there will always be borrowers as long as interest rates are lowered far enough. In today’s world, there are no borrowers no matter how low interest rates are taken.
Traditional economic theory and econometric models assume the private sector is always forward-looking and is always seeking to maximize profit. As such, there will always be someone willing to borrow money to invest as long as real interest rates are low enough. Given that assumption, the focus of economic policy is naturally going to be on the central bank’s monetary policy.
And if we assume that the private sector is always trying to maximize profit, fiscal policy (under which the government borrows money to spend) wastes precious private-sector savings and raises the risk that the private sector—which can use funds more effectively than the government—will not receive all the money it needs. That is the primary reason why fiscal deficits are so unpopular.

Traditional economics never envisioned a debt-minimizing private sector

The private sector will always seek to minimize debt after the collapse of a debt-financed bubble. Yet traditional economics not only did not foresee this kind of situation, but does not even have a term to describe it.
Traditional economics did not envision the sort of world we have been living in since 2008 because such conditions were never observed in western economies between the 1940s, when the discipline of macroeconomics as born, and 2008.
Until 2008, in other words, there were always willing private-sector borrowers in the US and Europe who responded to changes in interest rates. In such a world, monetary policy is effective and fiscal stimulus generally frowned upon since it has the potential to crowd out private investment.

Interest rates no longer relevant once people start minimizing debt

But after a debt-financed bubble collapses, the debt remains while asset prices fall, leaving many borrowers technically insolvent or at least struggling.
This is a frightening situation for a company to be in, inasmuch as its banks can shut it down at any moment. After all, banks are not allowed to roll-over loans to bankrupt borrowers, and all financing, including trade credits could disappear once the creditors and suppliers realize the true state of the borrower’s balance sheet. For a household, too, it is a dangerous state of affairs in which assets that had been set aside for emergencies or retirement suddenly disappear. The overriding priority for these businesses and households, therefore, is getting out of this situation as quickly as possible.
Emerging from this debt overhang requires businesses and households alike to focus on saving more and paying down debt. Whether interest rates are zero or even negative, people will continue minimizing debt until they have dug themselves out of the hole. The probability of their behavior changing because of a shift in interest rates is negligible.
When this state happens throughout the private sector, not only do private-sector borrowers disappear, but the private sector in aggregate may begin saving instead of borrowing.

Central bank cannot control inflation during a balance sheet recession

Once the private sector begins saving (and paying down debt) in aggregate, the money multiplier turns negative at the margin. The money supply—the money available for the private sector to use—not only does not increase but can actually decrease, regardless of how much base money the central bank supplies.
When the balance-sheet-constrained private sector chooses to minimize debt in spite of zero interest rates, the liquidity supplied by the central bank cannot come out of financial institutions and enter into the real economy due to lack of borrowers. I have dubbed this state of affairs a balance sheet recession, a term that is now heard quite frequently. Unfortunately, the vast majority of people—including Mr. Kuroda and Mr. Iwata—remain unaware of this economic malaise.
Those who do not recognize that balance sheet problems are keeping potential borrowers from borrowing believe the recession is attributable to insufficient monetary easing by the central bank. That leads them to espouse policies such as quantitative easing and negative interest rates. But no matter how far these policies are pursued, there is no reason why the economy should recover until the private sector overcomes its balance sheet problems and turns forward-looking again.
Professor Paul Krugman, who was the first to recommend that this state of affairs be addressed with inflation targeting and quantitative easing, has proposed that a 4% target should be adopted if a 2% target does not work. But the current situation is not one that can be addressed with such trivial adjustments. Interestingly, even Professor Krugman has come to admit that non-conventional monetary easing adopted up to now were “not a game changing tool.” (“Krugman: ‘Meh’ is grade Fed gets on QE,” published on Nov 9, 2015 on Market Watch.)

The theory that inflation is a monetary phenomenon that can be controlled by the central bank, since the central bank controls the supply of money, is valid in a world in which there is an ample supply of private-sector borrowers. But it is mere nonsense in the post-bubble-collapse world of a balance sheet recession, where this condition is not satisfied.
Gulf between real world and economy as envisioned by economists continues to widen
In that sense, the economies of Japan, the US, the UK and Europe now fall completely outside the realm of traditional economics, yet the vast majority of policymakers and economic agents continue to operate as though this were not the case, and the textbook world envisioned by economists still existed. This misunderstanding has complicated the situation greatly.
In other words, the equity and forex markets have responded directly to central banks’ negative interest rates and quantitative easing, but businesses and households in these countries refused until quite recently to borrow any money at all. The implication is that the exchange rates and share prices set by these markets are on very shaky ground.
As noted in the last issue of this report, forex traders over the past seven years have orchestrated heavy sell-offs of the currencies of countries announcing quantitative easing programs based on the assumption that the money supply in those countries would increase far more than the money supply of non-QE nations. But in reality, the money supply in all countries has been essentially stagnant as businesses and households continue to pay down debt.
In the same way, stock prices have appreciated each time further monetary easing measures have been announced, based on the assumption that those measures would increase the money supply and lift the economy. But the money supply has not grown meaningfully in any of these countries.
Although the forex and equity markets responded sharply to the BOJ’s negative interest rate announcement, the changes in the real economy that would justify such moves and nowhere to be seen. At some point, therefore, I would not be surprised to see a reaction in the forex and equity markets that helped to fill the gap between expectations and the real economy" - source Richard Koo, Nomura Research Institute

In similar fashion to the ill-fated design of the Vasa ship, the Bank of Japan has induced much more volatility in an already fragile situation. The best illustration of an economy "rebooting" after a total collapse of its financial sector remains Iceland we think. The pill was hard to swallow but in the end both inflation (2.10% as of January) and unemployment have been tamed (from 9.20% in May of 2010 to a low of 2.30% in December 2015):
.

- source TradingEconomics.com

The major issue that seems to lack the attention of our "Generous Gamblers", is that you have to choose your battle wisely. They cannot ignite inflation and reduce unemployment at the same time without an increase in wages and this would mean that corporate earnings would have to revert to the mean. Unfortunately CEOs seems to care these days more about their own bottom line rather through buybacks in order to trigger their alluring stock options. As we posited in the "Pigou effect" last year real wage growth is the Fed's greatest headache. We quoted Sir Jimmy Goldsmith at the time from the lengthy but great thoughtful reply called "The Response" (link provided) to the critics of his great his book "The Trap" which was eerily prescient:

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " - Sir Jimmy Goldsmith

And lowering the standard of living of one's own nation has indeed been the results of the repeated foolhardiness of the Fed and its zealous "put".

Real wage growth is the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"Unless there is some acceleration in real wage growth which would counter the debt dynamics and make the marginal-utility-of-debt go positive again (so that the private sector can produce more than its interest payments), we cannot yet conclude that the US economy has indeed reached the escape velocity level." - source Macronomics, 22nd of July 2014

Of course, as underlined by William White in his stunning interview, another solution to make the marginal-utility-of-debt going positive would be to restructure private debts (Iceland) so that the ailing US households (14.24% of the population receiving Food Stamps) could indeed save more, invest and consume again, which is in essence the purpose of good allocation of debt to the real economy. Not into inane speculative endeavors which have been extensively encouraged by the various iterations of QEs and their inefficient "Wealth Effect" to the "real economy".


When it comes to understanding credit and the buildup in a liquidity crisis (which we reminded you a couple of days back that it always leads to a financial crisis) we would like to use again a previous extract from our conversation "Pigou effect"from Sir Jimmy Goldsmith in his work "The Response":

"The idea that accounts must balance, and that inflows must ultimately match outflows, is an accountant's idea.

But there is a fundamental misunderstanding here. If you make a loss, perhaps because you own a business that is trading unprofitably or because you have made a bad investment, you will not get rid of the loss by borrowing the amount needed to pay for it. You will have avoided or postponed a personal liquidity crisis, but you will still be poorer by the amount of the loss. You will also have to pay interest on the loan.
Alternatively, you might sell your house and rent somewhere else to live. You will have used the proceeds of the sale to pay your debts, but you will remain poorer by the value of the house. And in future, you will have to pay rent." - Sir Jimmy Goldsmith - "The Response"

Since 2008, the losses have not gone away, as we reminded you as well, European banks even with LTROs and QEs Nonperforming Loans (NPLs) have not gone away and there is still around €1 trillion of NPLs sitting on their balance sheets....

If you think NPLs are going to go away when we have mounting signs of headwinds for European growth with December Industrial Production coming at -1.6%  (+0.2% expected) for France, Italy -0.7% (+0.3% expected) and even the UK -1.1% (-0.1% expected), then think again.

In the current environment where we are seeing financial conditions tightening rapidly across the world as pointed out recently by the BIS for Emerging Markets and by the latest Fed US Senior Loan Officer Quarterly Survey, it means lack of credit will slow growth and therefore will not help out whatsoever the reduction of these NPLs. Furthermore, the stupidity is compounded by NIRP because banks cannot be profitable with a massive reduction in Net Interest Margins (NIM). That simple. So please, spare us the "value beta play" mantra because so many are trading under book value (most of the time banks balance sheets are such a black box, that you have a hard time detecting you what's being hidden). We are not buying it.

This brings us to our second point related to credit given our "2007" feeling. Credit is always leading equities and what we have been commenting  throughout our musings as we watched the credit cycle unfold, is in effect happening and it's we think it is still a cause for concern as the contagion is in effect spreading.

• Credit - The tide has turned and we are moving from "idiosyncratic" risk to "systemic risk"

What we have been indicating during last summer were the many signs of the credit cycle maturing. The record wave of M&A in 2015 coincides clearly with the late stage of the cycle. This has been clearly illustrated by our friend Cyril Castelli from Rcube (he finally joined the twitter family and you can reach him there: @CyrilRcube):

"The M&A cycle leads the credit cycle. M&A mania =>weaker balance sheets =>tighter bank lending => wider credit spreads"

- source Rcube - @CyrilRcube

When it comes to the potential "overshoot" in US High Yield, our friend Cyril Castelli from Rcube illustrated as well this potential:

"Excess leverage explains the US high yield crash. High Yield always overshoot. It won't be different this time"

- source Rcube - @CyrilRcube 

We agree with our friend and given that initial spreads explain nearly half of 5yr forward returns, and that spreads themselves are a very good indicator of long-term forward returns, for both static and rolling investors, given credit investors like suffer from bipolar disorder and are afflicted by a severe case of myopia, as they focus on current default rates, rather than trying to estimate realistic future default rates, we will still tight until we see much more of an overshoot. Although, it doesn't mean that they are not "opportunistic" short term High Yield / distressed name out there but this necessitate some solid credit analysis in the first place. Relative value arbitrageurs did enjoy outsize returns ever since 2008 precisely because of the “uneconomic” distortions created in markets by central bank liquidity operations. The Barnegat fund, a New Jersey-based hedge which launched after the collapse of LTCM – the world’s most notorious relative value arbitrageur – returned 132.68 per cent in 2009, thanks to “the largest arbitrage ever” – in the US bond market, caused by the Fed’s quantitative easing. But this time around, it looks like the Fed is running low in terms of "ammunitions" particularly at the time where "idiosyncratic" risk is moving towards "systemic" risk.

This brings us to the continuous drift in credit. Not only are seeing a continuation of the flattening of the US yield curve, but credit is also affected given that according to CMA part of S&P Capital IQ, the 1 year CDX HY index is wider month to date by 81 bps and the basis (difference between the index and the single name constituents) is still very high at 79 bps apart:

- source CMA part of S&P Capital IQ

More interestingly, the continuous drift in credit is starting to point towards a more systemic risk environment as pointed out recently by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 8th of February entitled "The tide has turned":

"Connecting the dots

Does the recent weakness resemble the 2008 global financial crisis sell-off or the 2011/12 European crisis one? Are we still in an idiosyncratic risk world, or are recent developments pointing to a more systemic risk environment?
Our analysis shows that: (i) the recent sell-off in bank stocks and senior financials CDS, (ii) the continued weakness in EM/oil names and (iii) the fact that the recent sell-off is not driven by the tail anymore and it is more widespread, points to one conclusion: that the tide is turning. Risks are not idiosyncratic anymore; systemic risk is rising.

Currently the level of our selloff depth indicator - that has been steadily increasing over the past weeks - is the highest since the taper tantrum and is quickly approaching levels seen in 2008/9 and 2011/12.

In chart 1 we present the % of the iTraxx Main portfolio (125 constituents in total) that has moved more than 10bp wider over a 4-week period, while the broader market (average spread of the pool) credit spreads are also heading north.
o The higher the % of the index that contributes to a sell off the more systemic is the nature of the move wider.
o The lower the % of the index that contributes to the market weakness the more the idiosyncratic is the nature of the sell-off.

• Bank stocks are back to levels seen in 2012. The recent sell-off of bank stocks has added more pressure to financials credit spreads. Risks remain to the downside for the sector. Bail-in fears (see underperformance of Italian names over the past couple weeks), the ECB looking at NPLs (an area of focus this year), EM exposed fins still under pressure, Brexit risks looming for the UK names and weak Q4 earnings season (in particular for DB and CS), keep fins CDS better bid. With bank stocks at these levels, iTraxx Senior Fins will remain the key hedging instrument against increasing pressure in high-beta banks paper.

• US non-manufacturing econ data - even though still on expansionary levels -are deteriorating at the fast pace since 2008/9 period (chart 4).

Additionally, our rates strategy team points that their model shows that the OIS curve (adjusted for the zero-bound effect) is already inverted and therefore may already be pricing a recession

 • Oil prices are back at the $30 area; same as in 2008 (chart 5).

• Equity markets are punishing high risk (vs. low risk) stocks. The underperformance is the highest in years; only slightly away from the 2009 lows (chart 6).

 • The iTraxx Main constituents (5y CDS spreads) distribution exhibits extreme levels of skewness and kurtosis. Both these metrics measure the asymmetry of the portfolio's distribution. High level of skewness and kurtosis are typical characteristics of a fat-tailed distribution that prices high level of idiosyncratic risk.

o The higher (more positive) the skewness the thicker the tail on the wide end.

  o The higher the kurtosis, the thicker the tail and the higher the concentration around the index level, leaving not many names in between.

However, both these metrics have started to move lower over the past couple of weeks.

This clearly indicates a shift in market risks: from predominantly idiosyncratic as in 2008/9 (few wide names underperform, on balance), to more systemic risks as in 2011/12 (a broader widening). Note that financials did not feature even on the 50 widest names back in 2008. However, they dominated the widest names list in 2012.

• Weakness is now a broader issue - it is not the widest names that underperform.

We analyse the performance of single names CDS since the recent tights (early December'15). We find that the names that have underperformed (in %-move terms) are not necessarily coming from the tail. In fact we see a widespread weakness in names across the credit spectrum (chart 9). 

 - source Bank of America Merrill Lynch

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald

As we posited in our conversation "Le Chiffre" aka Mario Draghi and given the market's anticipation for the ECB's next moves:

"QE on its own is not leading to credit growth, because as we have repeatedly pointed out in our musings, a lot of European banks, particularly in Southern Europe are capital constrained and have bloated balance sheet due to impaired assets.

Le Chiffre is probably "overplaying" it particularly when one looks at the poor effects on "credit growth" in Europe and "inflation expectations". - source Macronomics, October 2015

It seems that at least the European credit Vasa ship's structural flaws come from deeply impaired banks balance sheet bloated by significant NPLs which have yet to be addressed. Italy in particular is a base case as illustrated by Richard Koo earlier in the failings of QE when one looks at the Aggregate retail loan books as displayed in Société Générale November 2015 European Banks note entitled "A wake-up call":

- source Société Générale.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings.

And no earnings thanks to NIRP means now, no reduction in Italian NPLs which according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 have now been bundled up into a new variety of CDOs:

"Italian banks have already started setting up bad debt securitization platforms. Italy’s third biggest bank, Monte dei Paschi di Siena (MPS), sold a €1 billion portfolio of NPLs into a securitization vehicle financed by affiliates of Deutsche Bank in December. The state will now guarantee the senior debt of such operations. It is unlikely ever to have to honour the guarantee, as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans.
The guarantee should attract a much broader array of investors to bonds issued by such vehicles, even if the banks still have to hold onto most of the riskiest tranches. However, the price could put off all but those banks with the highest funding costs.  The state’s fee for the guarantee will be based on CDS of issuers with similar ratings to the SPV tranche. To make sure the banks are not tempted to sit back and forget about the underlying loans, the price will rise over time – initially being based on three-year CDS, then five-year, then seven. As research from Milan-based Banca Akros points out, that’s hardly encouraging, given the time it takes to realise collateral in Italy." - source Euromoney

It looks to us like a nice new Vasa ship in the making...

Before we move on to our traditional final chart, here is another one courtesy of our friend Cyril Castelli from Rcube (from his twitter page: @CyrilRcube) showing that not only is AP Moller-Maersk a leading deflationary indicator but as we discussed in our post "The Cantillon Effects", the use of fine art might is an effective means to measure "bubbles" as art is removed from the capital structure of the economy. The performance of Sotheby’s, the world’s biggest publicly traded auction house has always been a good leading indicator and has led many global market crises by three-to-six months:
"Art & Shipping stocks lead the economic cycle. Recent price action of Sotheby's & Maersk is similar to 2000 & 2008."

- source Rcube - @CyrilRcube

If you think that we are bound for a "strong economic rebound" then you might want to hold off buying AP Moller-Maersk and Sotheby's because as per our final chart shows, it is never great to catch falling knives.

• Final chart - Don't catch falling knives

Whereas we keep hearing about some tremendous values offered by some levels reached by some equities, given the points we have made on credit leading equities and credit moving from "idiosyncratic" risk to more "systemic" risk, we thought we would point out to Société Générale's take on "falling knives" in the below chart from their Global Style Counselling" note from the 9th of February entitled "We love a bargain but should you buy falling knives?":

"Performance of falling knivesWe start our analysis with a simple exercise, where we look at the relative performance of a strategy that buys companies that have seen 1) 20%, 2) 30%, 3) 40% and 4) 50% declines from their 12-month peak. As our portfolios might only include a handful of companies in some periods, we only take into account periods where we have at least 20 companies, and otherwise we assume a zero return. All portfolios are then rebalanced on a monthly basis, and our universe is based on FTSE World stocks since 1990.

As the chart below shows, despite some periods of strong outperformance (these periods are often referred to as the “dash to trash”), all portfolios eventually underperformed the market.

- source Société Générale 

Then again, you might want to check if indeed your "falling knife" doesn't boast the same structural flaws of the Vasa ship....

"Beware of little lending. A small leak will sink a great European ship." - Martin T. - Macronomics

Us thinking of Italy again...

Stay tuned!

Macro and Credit - Cinderella's golden carriage

"The very concept of objective truth is fading out of the world. Lies will pass into history." - George Orwell

Listening with amusement to "Le Chiffre" aka Mario Draghi, losing some of his "Sprezzatura" ("studied carelessness") following the ECB meeting last week, leading to some significant "sucker punches" being delivered for the "Balanced funds crowd" (long German government bonds and European equities) and Euro short punters alike, given that all market pundits have been used to the "fairy tales" from the "Generous Gambler" and "happy endings" for risky assets, we decided this week to steer towards a European folk tale as an analogy for our chosen title. The story of Rhodopis, about a Greek slave girl who marries the king of Egypt, is considered the earliest known variant of the "Cinderella" story (published 7 BCE), and many variants are known throughout the world. One of the most popular versions of the story was written in French by Charles Perrault in 1697 under the name "Cendrillon" and in his version he introduced the "pumpkin". While the fairy godmother turned a pumpkin into a golden carriage in the story depicted by Walt Disney, she did warn Cinderella to return before midnight. Central bankers with their various iterations of QE have provided "balanced fund managers" a tremendous goldilocks period for investing. While we have warned of the rising instability risk caused by positive correlations in August this year , which is leading more and more to "large standard deviation moves" (sucker punches) in various asset classes, it seems to us that investors are not taking seriously fairy godmother Janet Yellen as we are indeed approaching midnight (watch what our US CCC credit canary is doing as of late...). One of the moral of Charles Perrault's version is as follows:

"That "without doubt it is a great advantage to have intelligence, courage, good breeding, and common sense. These, and similar talents come only from heaven, and it is good to have them. However, even these may fail to bring you success, without the blessing of a godfather or a godmother"

No doubt to us that without the blessing of the "fairy godmother from the Fed" aka Janet Yellen, we think, it is going to be incredibly difficult to achieve significant "positive returns" in 2016 for the "long only" crowd, as in similar fashion to the fairy tale, Cinderella's golden carriage spell is about to be broken and return to being a simple pumpkin (hence our call for heightened volatility in 2016 and the need to put on some still "cheap hedges").

In this week's conversation, we will continue to look at 2016 prospects. We will also touch on some "macro convex trade" of interests (by the way we submitted our HKD idea from September to Saxo's 2016 "Outrageous predictions", so let's see if we make the cut...).

Synopsis:

• One "macro convex trade" to think about for 2016
• Container shipping and large surge in US inventories, a great cause for concern
• Final chart - Global equities: more de-equitisation to come in 2016

• One "macro convex trade" to think about for 2016

Our own "outrageous 2016" prediction - A HKD devaluation.

Back in September this year in our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen.

At the time we argued the following:

"A weaker CNY would trigger a fall in competitivity for the entire Asian region and would massively impact the retail sector of Hong-Kong with additional fall in the number of visitors from mainland China and even more pressure on property developers. Hong Kong property sales plunged to 17-month low in August amid increasing economic uncertainty in China." - source Macronomics

Given that the latest data from Hong Kong’s Land Registry shows sales of registered residential units in November slumped to their lowest in nearly two decades with Residential mortgage approvals falling 40 percent in October as reported by Reuters in their 3rd of December article entitled "We need to talk about Hong Kong’s property market. Again.":

"The second major factor, and arguably the more important one in the short term, is what is happening on the mainland. China’s marked slowdown has taken a toll on everything from property transactions to tourist arrivals and retail sales in Hong Kong.

Chinese tourists buying up everything from Louis Vuitton bags to milk powder in Hong Kong’s shops accounted for nearly half of the city’s retail sales last year. This is slowing sharply as the economy slows and as Chinese tourists prefer to take their shopping to Korea and Japan instead. The knock-on impact is putting rents in shopping malls at risk.

The backdrop appears anything but sanguine.

But Macquarie takes a calmer view. It estimates that there is a decade worth of pent up demand (roughly amounting to 262K households) in Hong Kong that has built up as buyers got increasingly priced out of the property market. Unless there are widespread job losses it is unlikely that this demand will disappear.

If they’re right, that suggests every dip is likely to find buyers come back in even if interest rate slowly nudge higher.

Dents in the armour are showing. But 2016 may still be too early for the start of the collapse." - source Reuters

And this is indeed is a big if à la Cinderella's golden carriage being able to return before midnight no offense to Macquarie. If we want to add more "ammunitions" to our "simple" macro convex trade we can simply point out to a few factors, one being the approximate direct contribution of China tourist revenues as a percentage of GDP in 2014 and 2015, as indicated by CITI in their very interesting Emerging Markets Macro and Strategy Outlook - Prospects for 2016" recent note. Spot the "outlier":

"Direct contribution to GDP on recipients of China outflows are very small for most except in “special” territories (Macau, HK), which are suffering from a Chinese tourist slump. While tourist arrivals are booming in Japan, the biggest beneficiary of strong mainland arrivals relative to the size of their economy appears to be Thailand.

A second important constraint is the overhang from the build-up of nonfinancial private sector leverage, in the backdrop of a maturing credit cycle.

While we don’t expect any disorderly deleveraging/credit crunch given stronger balance of payment/less FX mismatch risks for most (though Indonesia corporates have some issues), with room for some to pursue counter-cyclical monetary easing in contrast to the Fed rate hiking cycle, there are a few FX-managed regimes with very open capital accounts– HK and Singapore – that inevitably will see rates rise alongside the US and will need some monitoring, especially given its knock-on impact on property markets and household balance sheets. Moreover, persistent capital outflows could tighten domestic financial conditions, especially for those without offsetting current account buffers and/or had been significant recipient of those volatile types of capital flows– e.g. Indonesia and Malaysia look vulnerable here. Even if central banks keep monetary conditions accommodative through interest rate and liquidity tools, we note that many countries in Asia -- notably China, HK and ASEAN countries – have seen a notable rise in “credit intensity” of output in the post-GFC years. We think this is a sign of credit being increasingly allocated to less productive sectors that, over time, manifests itself in weakening cash flows relative to debt service payments. This dynamic will lead to two things: first, greater demand for balance sheet repair among indebted entities, which will drag aggregate demand, or second, if balance sheet is irreparable, rising default rates and loan losses in the banking system, which will then feed into tightening of credit standards and higher costs to credit. Our bank analysts see the biggest NPL risks arising in China, Indonesia, Thailand and eventually Malaysia. Thus, a more mature phase of the credit cycle will mean that even the effectiveness of monetary policy as a counter-cyclical policy easing will weaken." - source CITI

Very open capital accounts means that as CNY/Yuan downward pressure continues to intensify, the pressure upwards on HKD will intensify leading to more and more intervention from the HKMA to defend the peg. Defending a peg, as clearly shown by the Swiss National Bank (SNB) in 2015 works, until it doesn't.

If indeed Hong-Kong is highly dependent on Chinese tourism, then particularly the study of the "Luxury" sector and the CNY/Yuan impact is paramount. When it comes to the "Luxury" sector and Hong-Kong, we read with interest Bank of America Merrill Lynch's Luxury Goods note from the 7th of December entitled "2016 years ahead: Luxury sector embedded with earnings & valuation risk":

"2016 likely to be another weak year for Hong Kong, don't count on the weak base to support growth 

The weakness in Hong Kong is driven by lower traffic. Total visitation is flat in 2015 ytd, but down about 7% in the last 3 months. The quality of the tourist is also lower, which is leading to lower conversion rates & basket sizes. Most European luxury companies have reported Hong Kong revenues down 15-25% in the most recent quarter. Based on conversation with Hong Kong based luxury companies weak trends have continued into October despite an easy comparison base, which included the impact of Occupy Central last year. The outlook for 2016 remains subdued.

We track Watches & Jewellery retail sales to gauge luxury market demand in Hong Kong. In 2015 ytd HK Watches & Jewellery retail sales are down -13.1%, with September down 23% despite an easier comparison base. September volumes decreased 16.7% and average selling price was down by 6.2% in the month. This is shown in the charts below.

We believe monthly retail turnover for Harbour City & Times Square luxury malls in Hong Kong also provide a guide to market growth. Revenue is down around 9-10% in 2015 ytd, with the biggest declines since in the most recent quarters. This is shown in the charts below.

- source Bank of America Merrill Lynch

Now if tourism growth is close to zero and direct contributions from Mainland China tourists amounts to more than 12% of  Hong-Kong to GDP, we hope "Cinderella" investors have not forgotten that indeed the "golden carriage" can turn into a "pumpkin".

Indeed has shown in Bank of America Merrill Lynch's note, it seems the Hong Kong "golden carriage" is losing some of its appeal. We do like to track "traffic" as great macro "growth" indicators, such as Air Cargo, Container traffic and many more. What is indeed of great interest is that no new seats are being added to China-Hong-Kong flight routes for 2016 YTD:

"Hong Kong continues to lose its appealChinese consumers no longer see Hong Kong as an attractive luxury shopping destination. We think this stems from a lack of newness, increased social tension, occupy central and a strong HKD.

Total visitation is flat in 2015 ytd, but down 7% in the last 3 months, which reflects the decline in Chinese inbound tourism. However this still under-states the decline being felt by luxury companies in HK given the quality of the tourist is also lower, which is leading to lower conversion rates & basket sizes. Chart 76 shows no new seats are being added to China-Hong Kong flight route for 2016 YTD, suggesting the underlying weakness in traffic is expected to continue.

- source Bank of America Merrill Lynch

And of course the winner of the "currency war" when it comes to the "Shrinking pie mentality" we discussed in April 2014:

"When the economic pie is frozen or even shrinking, in this competitive devaluation world of ours, it is arguably understandable that a "Winner-take-all" mentality sets in." - source Macronomics, April 2014.

No wonder Japan is "winning it all" when it comes to tourists and "competitive devaluation" as indicated by Bank of America Merrill Lynch:

"Japan has grown 100% in 2015, strong growth likely to continue as appeal picks up
The number of China outbound tourist to Japan has increased by more than 100% in 9m 2015. This has led to 35% growth in luxury consumption in Japan. We expect Japan to continue to take share from Hong Kong, which is still 7x the size in terms of inbound tourist from China. As a result we expect ongoing solid luxury goods revenues in Japan (+25% cFX), despite a very tough comparison base. 

Chart 78 15-20% more seats are being added to China-Japan route for 2016 YTD, suggesting the increased in traffic is expected to materialise.

- source Bank of America Merrill Lynch

So, from an "allocation" perspective, if you want to play the "luxury" and "tourism" theme, then "overweight" the "golden carriage" in Japan, as Hong-Kong is more likely to turn into a "pumpkin"....but we ramble again.

Also with continuous pressure on China's FX reserves  which have fallen by $87.2 billion to $3.44 trillion at the end of November, from $3.53 trillion a month earlier, and in conjunction with China 's bad exports/imports data (-6%/-8%) this will further accentuate the pressure on the HKD in the coming year. The latest CNY/Yuan picture, graph source Bloomberg:

- source Bloomberg.

On that matter we read with interest Société Générale's take on the subject:

"China's FX reserve data, released yesterday morning European time, had an impact on Asian markets today. The USD 87.2bn fall was a good bit bigger than expected, even if about half off the fall is due to FX valuations. Throw is some more weak trade data this morning (surplus USD 54.1bn as exports fall 6.8% y/y, imports fall 8.7%) and the stage is set for more CNH weakness. As USD/CNY edges higher again, to 6.42, the currency's stealth-like depreciation since the start of November is looking less stealthy. Once USD/CNY breaks 6.45 or USD/CNH breaks 6.50, this is likely to be a major source of concern to markets globally, let alone in Asia." - source Société Générale

If Asia is one the receiving end of further "Chinese" devaluation, then, for us, Hong-Kong is indeed in a "very weak position" to maintain both its peg and its competitivity. Something is going to give we think.

Furthermore, as we mused in our November 2014 conversation "Chekhov's gun":

"Interesting thing happens during currency wars, currency pegs like cartels do not last eternally." - source Macronomics - November 2014.

 We would also like to point out that, in similar fashion AAA ratings are a "dying breed" and "golden carriages" often return to "pumpkin" state, currency pegs are not eternal as we reminder ourselves in our long September 2015 conversation "Availability heuristic - Part 2":

"There is indeed a clear trend in "de-pegging" currencies in the Emerging Market world, but in Developed Markets (DM) as well, the CHF event of this year has shown that pegging a currency in the current monetary system is bound to fail at some point. The sovereign crisis in Europe has also shown the inadequacy of the Euro for various European countries with different economic and fiscal policies as well as different composition (hence our negative stance on the whole European project...).

When it comes to our recent "convex" macro musing around the HKD we also note that Asian pegged or quasi peg currencies could indeed be the next shoe to drop" - Macronomics

 - source of the table - Société Générale

More closely to "home", in Europe that is, of course we continue to believe that Denmark will as well eventually be forced to "ditch" its peg to the Euro. On that take we read with interest Bloomberg's article from the 7th of  December entitled "Currency Battle-Front Reset as Danes Seek Euro Peg Normalization":

"While Denmark won its battle against currency speculators earlier this year, there’s still far to go before the central bank can consider a “normalization” of its monetary policy.
Governor Lars Rohde says Denmark’s benchmark interest rate will over time be closer to the European Central Bank’s. The Danish deposit rate is now minus 0.75 percent, and the ECB’s is minus 0.3 percent. Denmark pegs its krone to the euro in a tight band, forcing the central bank to track ECB policy closely.
“One might ask if minus 0.75 percent as a marginal rate is normal, and the answer is that it’s probably not and neither is minus 0.3 percent at the ECB,” Rohde said on Monday in an interview in Copenhagen.
How soon Denmark acts to reduce that spread “will largely depend” on the actions of the ECB. President Mario Draghi’s decision last week to deliver a smaller-than-expected stimulus package certainly provided relief to the Danish central bank. “It turned out to be very easy not to do anything,” Rohde said.
The ECB on Dec. 3 cut its deposit rate less than some traders and investors expected. It also extended, but didn’t raise, its bond-purchase program. The news sent the euro more than 3 percent higher against the dollar and took pressure off a number of central banks across Europe that had previously struggled to prevent their currencies from strengthening against the euro.
“The projected krone appreciation pressure is unlikely to intensify materially after the ECB left the big easing bazooka at home,” Danske Bank analysts said in a note on Tuesday. The Danish central bank “effectively delivered a small rate hike by not shadowing the ECB last week.”
Nykredit, Denmark’s biggest mortgage bank, says Denmark is now set to raise rates twice next year, following the “soft” package unveiled by Draghi last week."  - source Bloomberg

While indeed the Danish central bank has won a battle, it hasn't won the war and at some point we think, that in similar fashion to the SNB, it will lose the war but that's another story.

When it comes to Denmark, and in particular the "game of survival of the fittest" being played in this "shrinking pie mentality" world, we previously pointed out Danish A.P. Moller Maersk as a "survivor" in the container shipping industry in our August 2012 conversation "The link between consumer spending, housing, credit and shipping":

"If you want to pick winners in this survival of the fittest contest, you have A.P. Moeller-Maersk A/S investing in fast and fuel efficient vessels (Maersk vessels are designed to operate efficiently at both high and low speeds),  and so is Evergreen Group, owner of Asia's second biggest container line is as well adding more fuel efficient vessels to its fleet as well as Neptune Orient Lines Ltd" - source Macronomics - August 2012

What is getting us more and more worried for the  probability of the "golden carriage" to turn into a "pumpkin" is that even our identified "champion" has not been immuned to the very strong deflationary forces at play and is in fact moving towards "loss-making". This brings us to our second point of our conversation.

• Container shipping and large surge in US inventories, a great cause for concern

Containerized traffic is dominated by the shipment of consumer products. Weaker traffic means very simply weaker demand (and no we don't care about what European PMIs are supposedly saying).

Back in March 2012 in our conversation "Shipping is leading deflationary indicator", we argued that shipping was in fact an important credit and growth indicator, but most importantly a clear deflationary indicator. We also indicated that consolidation, defaults and restructuring were going to happen, no matter what in the shipping industry, and guess what, it did! Not to mention the fact that we indicated some forced exposed players such as Commerzbank with their nonperforming shipping loans had resorted to running themselves the ships rather than recognizing the losses as pointed out in our June 2013 conversation "Lucas critique":

"In similar fashion to the extend and pretend game being played by banks relating to their real estate exposure and negative equity, some German banks, which total exposure to shipping loans amount to 125 billion USD with a nonperforming ratio of 65%, have resorted to avoid recognizing the losses by acquiring some ships in a bid to salvage their bad loans as reported by Nicholas Brautlecht in Bloomberg on June 13 in his article "Commerzbank Acquires First Ships in Bid to Salvage Bad Loans":

"Commerzbank AG, the German lender whose soured shipping loans prompted a ratings downgrade by Standard & Poor’s last month, is taking the helm as it tries to salvage some of the 4.5 billion euros ($6 billion) it holds in bad debt from the crisis-hit industry.It plans to take over two feeder ships from debtors this month, holding off on a sale until values recover, said Stefan Otto, 42, the head of the shipping unit. The vessels, which can transport as many as 3,000 standard 20-foot containers, or TEU, are the first the Frankfurt-based bank will actively manage as part of a goal to reduce shipping losses and exit ship financing." - source Bloomberg" - Macronomics - June 2013

If indeed our favorite "survivor of the fittest" Danish giant A.P. Moller Maersk is turning into "loss-making", then indeed, we would caution investors to start in earnest to think about "battening down the hatches" to use a shipping analogy.

On the subject of shipping we read with great interest Nomura's Special Report on Container Shipping entitled "Counting Containers - Unprecedented action required" published on the 26th of November:

"Container shipping lines have a choice: return chartered vessels, or face the consequences

Supply-demand balance to deteriorate significantly in 2016-17E
Supply outstripping demand is nothing new in the container shipping industry, as evidenced by nominal capacity +53% during 2008-14, vs volumes +22%. What is new, however, is that slow steaming – which absorbed 26% of capacity during this period – is now reversing, adding new capacity on top of that provided by the orderbook. With nominal capacity expected to increase by 5-6% CAGR during 2016-17E, and volumes unlikely to exceed 3%, the supply-demand balance is set to deteriorate even without increased vessel speeds. If this trend continues, the industry will face an even more severe imbalance.

Freight rates can – and most likely will – decline further
With headline freight rate indices currently at historical lows, further reductions may appear unlikely. However, on a cost-adjusted basis, freight rates remain well above the trough levels seen in 2009 and 2011, periods during which the industry suffered heavy losses. With supply-demand set to deteriorate, and contract rates to be revised downwards, we believe freight rates can – and most likely will – decline further, driving the industry back into financial losses. 

Maersk Line case study provides some grounds for hope… 
With supply-demand fundamentals overwhelmingly bearish, container shipping investors could be forgiven for giving up hope. However, our analysis shows that, if other shipping lines follow Maersk Line's successful recent strategy – of maximising utilisation rates by returning chartered capacity to owners – the supply-demand imbalance can be rectified, with persistent losses averted.

…but only if the industry can act with unprecedented discipline
Our analysis shows that competitor shipping lines should narrow Maersk Line's cost advantage during 2016-17, but only if utilisation rates can be maintained. Returning chartered capacity to owners, culminating in a significant increase in idled capacity, provides the best means to facilitate this. Yet we estimate idled capacity would need to reach 14% for this to be achieved – materially ahead of the previous peak of 11-12% seen in 2010. Whether the container shipping industry has the discipline required to achieve this, only time will tell.

- source Nomura

When it comes to "hope" being a bad "strategy" such as expecting a "golden carriage" not to return to its initial "pumpkin" state, we reminded our thoughts from January 2013 from our conversation "The Fabian Strategy":

"People are trading on hope: "Please make Mario Draghi keep his word", we could posit in similar fashion to what we commented in our September 2011 conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!""So far the devil's best trick has been to persuade us that risk-free interest rates did exist. It ain't working anymore and that is a big cause of concern." - Macronomics.

We could not resist but we chuckled when we read the following comment from a credit desk:
"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."

Looking at the growing divergence between "hope" (equities) and reality (US High Yield), we wonder when "reality" will settle in. Could it be that in 2016 we will see the return of the "pumpkin"?

When it comes to the "reality" that can be assessed from Shipping, demand outlook is not favorable as pointed out by Nomura in their special report:

"Demand outlook remains tepid, at best

The world has changed. Let’s accept it and get on with it

The days of 3-4x GDP multipliers are gone – possibly forever
The 3-4x multiplier of GDP at which global container volumes used to grow is well known – for instance, with the volume CAGR of +12.5% seen during the period between China joining the WTO in December 2001 and the start of the global financial crisis (GFC) in 2008 equating to an average GDP multiplier of 3.8x.

Since this time, the high growth rates of 14.9% seen in 2010 and 7.4% in 2011 were driven by the end of destocking, which occurred towards the end of 2009, rather than underlying strength. When global inventory levels had returned to more normalised levels, the volume CAGR of 3.5% seen during 2012-14 equated to an average GDP multiplier of 1.4x.

2015 will likely be the first ‘normal’ calendar year to see a multiplier <1 b="" x="">
We often find that investors and industry commentators alike take a global container GDP multiplier in excess of unity for granted. Yet a multiplier of 1.0x was recorded for 2013, and for 2015 we expect volume growth of c+0.8%, equal to just 0.3x of the 2.9% increase in global GDP that is forecast by the OECD.

This would be the first time, on our records, that the global container volume multiplier has fallen below unity during what we consider to be a relatively ‘normal’ calendar year of economic activity.

…but this is not unprecedented on a rolling 12-month basis
On a rolling 12-month basis, the global GDP multiplier has already fallen below unity during what we classify as a ‘normal’ period without any major macroeconomic fluctuations or inventory swings – specifically, the 12-month period to 4Q13.

Although this weakness was only temporary, we do consider it to be important, given that it demonstrates that, even during a period of steady-state economic conditions, a global container GDP multiplier of less than 1.0 x is not unprecedented.

Looking ahead, ‘GDP plus a bit’ feels about rightAlthough forecasting global container volume growth will never be a precise science, we continue to believe that a growth rate of ‘GDP plus a bit’ remains an appropriate rule of thumb. We assume a multiplier of 1.1x for 2016-17, consistent with the 1.0-1.3x range that we consider to be reasonable during steady-state economic conditions. 

In reality, fluctuations during this period are inevitable, but for reasons that are difficult or impossible to forecast (eg, inventory movements, currency swings, technological changes, among others). As such, we do not attempt to incorporate such factors into our mid-term forecasts." - source Nomura

Conclusion: secular stagnation is here to stay and one can expect "rates" to stay lower for longer and demand to be weaker as well. "Mind the gap" between effective capacity and total demand as it is widening...because "demand" is not outstripping "supply". Another illustration of the "shipping glut", is that for the first 10 months of 2015, Chinese ship builders saw orders for new vessels plunge 62% from to same period last year, for a total of 20.3 million tons, according to data from the China Association of the National Shipbuilding Industry (CANS)

Apart from "weaker demand" another concern which has been highlighted justifiably so is the current US level of inventories. This worrying trend has been as well clearly highlighted in Nomura's recent Shipping special report:

"US inventories peaked in February 2015, at a level that warrants major concern

Although our analysis suggests the destocking that has prevailed in Europe during 2015 will soon moderate, the situation in the US suggests concern for import volumes in 2016. As shown in Fig. 43, the total business inventories-to-sales ratio spiked up sharply during the several months to February 2015, and showed smaller increases during the months leading into September 2015.

This upward movement bucks the downward movement in US inventories-to-sales that has prevailed over the past 20+ years, and after controlling for this trend by considering inventory-to-sales in terms of the number of standard deviations from the trend line, the recent upward spike in inventories is even more apparent. Specifically, inventories-to-sales are more than 1.5 StDev from the trend, not far off the peak of 2.0 StDev seen in January 2009, around which time US imports fell precipitously.

Irrespective of the sector, US inventories appear ominously highFigs. 45 and 46 summarise the split of US Business inventories (measured in US dollars) between the retail, manufacturing and wholesale sectors. The current share is remarkably uniform, with manufacturing the largest sector with a share of 36%, but retail and wholesale not far behind on 32%.

- source Nomura

You can expect this level of inventories to be a drag on fourth quarter GDP when the Fed is about to "hike" in a weak demand environment. It looks like the "fairy godmother from the Fed" aka Janet Yellen is about to pull the spell which has so far being "levitating" the "golden carriage".

When it comes to continuing with the "golden carriage", one thing we are certain in 2016 is that the global "de-equitisation" process will continue to run its course and generates further instability into the financial system as per our final point.

• Final chart - Global equities: more de-equitisation to come in 2016

In June 2015 in our conversation "Eternal Return" we made the following point:

"The "de-equitisation" process is a cause for concern as it creates increasing instability in the financial system. It will as well reduce significantly the recovery value in the next credit downturn with rising defaults we think." - Macronomics, June 2015.

The above debilitating effect on corporate balance sheets was already highlighted in October 2013 in our conversation "Credit versus Equities - a farming analogy" we indicated the following:

"The increasing recourse towards bond issuing by companies will be increasing "difficulties" at the end of the on-going credit cycle, when entering a recession or depression.
What has made the resounding success of the US economy throughout many decades was its capitalistic approach and recourse to equities issuance for financing purposes rather than bonds.
We believe the global declines in listings is indicative of growing instability in the financial system and increasing risk as a whole" - Macronomics, October 2013.

What is concerning is that ZIRP has accentuated the "de-equitisation process fueled by "cheap credit". This has also been again indicated by CITI in their Globaliser Chartpack from the 30th of November 2015 and is our chosen final chart:

"Global equities: more de-equitisation?De-equitisation should remain a key global investment theme for the next 12-18 months; the most represented sector in the screen is Consumer Discretionary (13 out of 50), followed by Industrials (9)‘More de-equitisation’, declares Global Strategist Robert Buckland, ‘for deequitisation should remain a key global investment theme for the next 12-18 months.The cost of equity remains high relative to the cost of debt, so it makes sense for companies to de-equitise – use cheap financing to buy back their own shares. Since 2011, global non-financial corporates have bought back over $2.2trn of their own shares (equivalent to 9% of average market cap over the period). The most represented sector in the screen is Consumer Discretionary (13 out of 50), followed by Industrials (9). Share buybacks is currently a very US-heavy theme; we also note positive momentum in Japan. Names like Ahold, Boeing, Xerox, Allstate, Adecco and Yahoo! feature’." - source CITI

In 2013 we concluded our 2013 conversation as follows:

"We can therefore make this over-simplistic yet provocative conclusion that:
Equities = Freedom
Debt = Road to serfdom"

Although the "fairy godmothers from the Fed" did put a spell on for many years, we think we are indeed coming closer to midnight and the "Cinderella" investors of the world would be well advised to "hedge accordingly" before they are left holding the "pumpkin", as it looks increasingly clear to us that 2016 will be indeed a very challenging year.

"A powerful idea communicates some of its strength to him who challenges it." - Marcel Proust, French writer

Stay tuned!