Macro and Credit - The fourth wall

"It is only with the heart that one can see rightly; what is essential is invisible to the eye." - Antoine de Saint-Exupery, French pilot and writer

While enjoying the festive season in Paris, we watched with interest a couple of interesting credit and market events that made us think about a theatrical reference which we decided to use as our title analogy. The fourth wall is the imaginary "wall" at the front of the stage in a traditional three-walled box set in a proscenium theatre, through which the audience sees the action in the world of the play (or markets). Speaking directly to, otherwise acknowledging or doing something to the audience through this imaginary wall – or, in film and television, through a camera – is known as "breaking the fourth wall" (think Ferris Bueller's day off...). The fourth wall being an established convention and given our disregard for conventions (us being contrarian), we will, therefore, in this first of the year conversation "break the fourth wall". The acceptance of the transparency of the fourth wall is part of the suspension of disbelief (or delusion) between the "fictional" recovery we have commented on numerous occasions and you, the audience.

Before we dive more into our first conversation of the year, which will relate once more to the state of affairs in the credit and macro space, we would like to make a quick parenthesis on two subjects of interest of ours, namely idiosyncratic risks in credit markets and the state of shipping (given for us it is not only a deflationary indicator, but a credit indicator as per our past conversations).

A good illustration of the idiosyncratic risk in the credit space was once more illustrated on the 29th of December by the price action relating to the "sucker punch" delivered to the senior bond holders of Novo Banco, the supposedly "good part" of former Portuguese bank Banco Espirito Santo - graph source Bloomberg:

- graph source Bloomberg

So what happened on the 29th of December that spooked the "innocent" senior financial bond holders you might rightly ask dear audience? Well, Bank of America Merrill Lynch in their note on Novo Banco from the 4th of January tells it all:

"The Bank of Portugal announced that, as part of the resolution of BES, it was transferring five bonds from Novo, back to the ‘bad bank’, BES. We believe that the resolution of BES could be viewed as a process and not a discrete series of events, since Novo is still a ‘bridge’ institution (the intention is that the resolution of Novo is complete when it is sold, although the deadline for the sale now appears to be indefinite). In our view, recovery on these securities should be viewed as uncertain as BES’s total assets were only €197m at end-2014 compared to a negative net asset position of €2.7bn, before the transfer of a further €2bn of senior bonds. It is our understanding that the senior bonds’ Governing Law is Portuguese. We note that in the original resolution of BES, the Bank of Portugal, as resolution authority, has reserved the right to move assets and liabilities between ‘bad’ bank and ‘bridge’ bank. In addition, the BoP appears to have chosen large denomination seniors, to avoid imposing losses on retail bondholders. In any case, with the transferred securities trading at ~€11, and BES now to be liquidated. 

Further losses could lie ahead 

Novo has in effect been given a further €2bn in capital post-transfer which, according to the company, means that its CET1 ratio has now increased to 13%. However, Negocios, at the end of 2015, reported that a further €2bn of ‘irregular’ loans linked to the ancien regime of the bank had been discovered (the newspaper adduces these irregular loans as the reason for the senior bail-in). The newspaper reports that the provisions relating to these exposures may be taken in 4Q15 (and beyond) leading to a significant deterioration in the accounts of the bank. Note Novo Bank did not comment on the press reports. The June report already detailed a loss of €252m. We would expect this to deepen through year end as provisioning likely catches up with the asset quality decline we saw at the bank in 2015. 

Cheap but we await clarity 

In our view the 5% bonds are quite cheap, with yields of nearly 10%. However, many erstwhile bondholders of Novo are now nursing substantial losses from their senior exposures – we assume this could lead to a degree of reluctance to take exposure on the name, at least for a while, which could mean poor technicals for the bonds. We understand that Novo is now better capitalised. However, this capital could come under pressure in the coming quarters if more losses are recognised. Events of the past few weeks have highlighted Novo’s problems and the fact that the deadline for its sale is no longer subject to public disclosure suggests a drawn-out sales process, especially as Santander has just bought Banif, so arguably does not necessarily need to add to its Portuguese assets." - source Bank of America Merrill Lynch

No, these bonds are not "cheap" and should be avoided. 

In addition to senior bond holders nurturing their losses, as of the 1st of January, depositors are now "pari passu" with senior creditors and are indeed next in the line of fire should additional "hidden losses" materialize (they will). When it comes to recovery assumption, we read with interest CMA (now part of Capital IQ)'s take on the estimated recovery value. They estimate it to be at 1%. You read that correctly. So much for an assumed recovery value of 40% for senior CDS. 

We might be sounding yet again in 2016 as a broken record but, we told you before dear readers, in the next downturn in credit, recovery values, rest assured, will be much lower. That's a given.

Moving on to the second part of our parenthesis namely "shipping", and "cheap credit", we read with interest the FT's recent article on the subject from the 3rd of January entitled "Cash burning up for shipowners as finance runs dry":

"The challenges facing DryShips are among the most acute of those facing nearly all dry bulk shipping companies after a slump in earnings drove most owners’ revenues well below their operating costs. Owners are haemorrhaging cash. Owners of Capesize ships — the largest kind — currently bring in around $3,000 a day less than the $8,000 they cost to operate. The losses for the many owners who have to service debts secured against vessels are far higher.
Basil Karatzas, a New York-based corporate finance adviser, points out that in an industry that has already been making steady losses for 18 months, such substantial losses quickly mount up.
“If you have 10 ships and you’re losing $3,000 to $4,000 per day per ship, that’s, let’s say, $40,000 per day, times 30 in a month, times 12 in a year,” he says. “You are losing some very serious money.”
The question is how long dry bulk owners — and the private equity firms which have invested heavily in the companies — can survive the miserable market conditions.
Michael Bodouroglou, chief executive of Paragon Shipping, another New York-listed dry bulk shipowner, says that owners are looking to negotiate partial repayments, standstills and payment moratoriums with their banks.
“They’re trying to batten down the hatches, reduce costs as much as they can,” he says.
Yet the brief arrest — seizure over unpaid debts — in November in Singapore of the Sparta, a Capesize dry bulk carrier controlled by private equity firms, illustrates why shipowners are especially pessimistic about this slump. The vessel’s arrest, at the request of Deutsche Bank, has been widely interpreted as a sign that banks’ readiness to keep amending loan terms to allow owners to ride out the slump might be coming to an end." - source Financial Times

We chuckled because although some pundits have the memory span of a goldfish, we don't and we clearly remembered the warnings we gave back in December 2013 on the billions poured by Private Equity players in the shipping industry in our conversation "All that glitters ain't gold":

"There is a wave of private equity money flowing into shipping, which for us is yet another manifestation of "mis-allocation" and "Cantillon Effects".We have long argued that "Shipping is a leading credit indicator", as well as a "leading deflationary indicator". We have also discussed at length the link between consumer spending, housing, credit and shipping back in August 2012.
The latest manifestation of the consequences of "cheap credit" and record cash is leading outside players such as private equity investors to dip into the structured finance shipping business

Whereas traditional shipowners tend to hold vessels for at least 20 years, private equity groups hope to turn a quick profit by listing companies or selling their vessels once charter rates and ship valuations recover.

The issue of course for our private equity friends that they will soon discover is that if quick profits depend on valuations, they also depend on "recovery". We think they are bound for some disappointment as overcapacity is still plaguing the industry. " - Macronomics, December 2013

Given the "evident signs" of the recovery as displayed in the latest dismal print for the Baltic Dry Index to 467, a new record low (since its creation in 1985), one might wonder if indeed the PE players will make their "quick buck" on their "shipping" ventures. We don't think so:

- source Bloomberg.

Why we don't think so? Because "cheap credit" has led to "malinvestments" with PE pundits placing bets on a business they hardly know, and they have added overcapacity to overcapacity. Simply put, there is a "shipping" glut.

One can ascertained QEs and ZIRP have been deflationary by looking at the fall in the US of M2 "velocity":

-source CLSA

In similar fashion in the shipping industry, the "velocity" of ships aka their speed has been as well falling as reported by Bloomberg in their article entitled "Slowing Boat From China Provides Clue to Health of World Trade" from the 17th of December:

"Even with fuel at its cheapest price in almost a decade, the ships that carry goods around the world have been reducing speed in line with the slowdown in China, the biggest exporter.
Shipping companies have been “slow steaming” since the global financial crisis in 2008, as a way to save costs and keep as many ships active as possible. Vessels are now operating at an average of 9.69 knots, compared with 13.06 knots seven years ago, according to data compiled by Bloomberg. 

That means Nike sneakers and Barbie dolls made in China can now take two weeks to arrive in Los Angeles and a month to reach Le Havre, France -- a week longer than if the ships were moving at full speed. And there’s scope for ships to go even slower, according to A.P. Moeller-Maersk A/S.
“This is the new norm,” said Rahul Kapoor, a Singapore-based director at Drewry Maritime Services Pvt. “The overall speed of the industry has gone down and there’s no going back.”
In the boom years before the 2008 financial crisis, shipping lines expanded fleets and ran ships as fast as they could to keep up with the surging demand for goods manufactured half a world away. As demand dropped, the lines were left with too many vessels, and customers eager to reduce inventory, who would rather pay a lower rate to receive goods than guarantee quick delivery." - source Bloomberg

The new norm has been slower M2 velocity, slower growth, slower shipping. For the PE punters who have played the "recovery" game, they will have to face the "music". End of our parenthesis.

In this week's conversation, given the on-going "bloodbath" in the oil space, we will look at some of the implications. We will also look at the debilitating state of the credit markets once more.

Synopsis:

• US Energy sector (ETF XLE) versus oil price - Much more downside to come
• Credit - The credit cycle has turned and global financial conditions are tightening
• Final chart - Correlations getting higher in a macro-driven market

• US Energy sector (ETF XLE) versus oil price - Much more downside to come

While watching the continuous downward spiral of oil prices, what really struck us is the resilience from the US energy sector in the equity space versus the price of oil. We are convinced that there is more downside to come on the equity side - graph source Bloomberg from the 6th of January:

- graph source Bloomberg.

Whereas at the end of 2008, oil and XLE where trading roughly at the same levels, today it appears to us that ETF XLE as a proxy for the oil equity sector is still at least 30% above the lows of 2009 with an oil barrel at a much lower level. More pain to come, we think...

On a side note, should a rebound of oil happen at some point in 2016, one sure way of playing it would be through Fx via the Canadian Dollar (CAD) and/or the Norwegian Krona (NOK). 

Whereas, equities present more downside risk, credit has already significantly underperformed in recent month in fact as indicated by Barclays in their Oil and Gas monthly note from the 5th of January indicates the following:

"High Yield Energy Bonds Drop 23.6% in 2015 

The Barclays high yield energy index decreased 12.2% in December, the second largest monthly decline since 1991 (worst was October 2008 at -19.2%). This month’s drop leaves high yield energy down 23.6% for the year, underperforming the overall high yield market by 19.1% in 2015. In December, high yield energy credits moved lower because of a 12% decline in front month WTI and a collapse in natural gas prices to a low of $1.75/mmBtu on warm winter weather. By rating category, BB bonds returned -11.6%, B bonds returned -13.6%, and CCCs returned -12.9%. The independent index declined 18.3% in December, reflecting sharp decreases in the unsecured bonds of California Resources, Legacy Reserves, Vanguard Natural Resources, and Memorial Production Partners. Oilfield services dropped 8.4% on decreases in Seadrill, Atwood Oceanics, and CGG. New issue activity dried up completely in December, leaving year-to-date high yield energy issuance at $33bn, down from $55bn issued in 2014. 

Leverage Sensitivities and Breakevens at $40/bbl WTI 

We recently published an E&P update on leverage sensitivities and breakevens at $40/bbl WTI (report). In the report, we show sensitivities to debt/EBITDA in 2016 assuming $40/bbl WTI and $2.25/mmbtu Henry Hub, close to where strip prices are today. Two-thirds of the peer group has leverage north of 5.0x and five companies have leverage north of 10x (SandRidge, California Resources, MEG Energy, Denbury, and EXCO). However, hedging gains account for almost half of the peer group EBITDA in 2016, leaving unhedged debt/EBITDA at an average of 20x. Under this screen, 16 of the 27 companies we model have leverage north of 10x. Lowest leveraged companies under a $40/2.25 deck include Concho Resources (2.2x), Hilcorp Energy (3.2x), Baytex Energy (3.7x), and EP Energy (3.8x). Although not our base case, we note that Moody’s recently lowered its 2016 price forecast to $40/2.25, potentially foreshadowing additional ratings downgrades. 

Hedging Protection is Limited in 2017 

In our latest hedge study (report), we found that high yield E&P companies have protected 36% of 2016 oil and gas production and only 12% of 2017 production. While some high yield producers used the rally in oil to $60/bbl in May 2015 to fortify hedges, few producers have added to hedges in 4Q15 given the decline in strip prices. Almost half the peer group remains unhedged in 2017. As of 3Q15, we estimate that the peer group had a hedge book value of $12.6bn, with Antero Resources leading the peer group at $2.8bn. Top hedgers in 2016 and 2017 include Memorial Production Partners and Antero Resources, with an average 78% and 76% of 2016/17 production hedged, respectively. Credits with no hedges in place for 2016/17 include Goodrich Petroleum, MEG Energy, Midstates Petroleum, and Swift Energy. Energy Spreads Wider in DecemberIn December, energy spreads widened 292bp, to 1,296bp, compared with 58bp of widening for the overall market. December’s move left energy spreads trading 636bp wider than the high yield market, cheap compared with the 10-year average of 38bp through. The sharpest outperformance came in the oilfield services subsector, which widened as little as 5bp versus the high yield market." 

- source Barclays

Given the lack of hedges for some as reported by Barclays, should the "oil conundrum" continues, meaning lower for longer, no doubt to us that some players are going to face the default/restructuring music in 2016. 

This brings us to the second point of our conversation relating to credit and the current state of affairs.

• Credit - The credit cycle has turned and global financial conditions are tightening

While looking at the evolution of Global Fx reserves and their evolution since 2003 and in comparison with the recent periods, one being 2008 and the start of the rise in the cost of capital since mid 2014, if we use the evolution of these Global Fx reserves as a proxy for "global liquidity", one can ascertain that an expansion of these reserves indicates expansion, whereas a fall, indicates a global contraction - graph source Macronomics / Bloomberg:

One can notice from the above chart that during the financial crisis of 2008, between the 31st of July and the 31st of March 2009, Global Fx reserves tightened by 4.86% ($339 bn in 8 months, roughly $42bn per month). Since the 31st of July 2014 until the 31st of December 2015, Global Fx reserves have fallen by 6.39% ($768 bn in 17 months = roughly $45 bn per month). The on-going "liquidity" crisis, which is indeed a very big US dollar "margin call", is not only much bigger than in 2008, but, is lasting much more longer!

So even if some "pundits" tell you that at these levels High Yield is a "bargain", dear reader you should think again, although no doubt there are some interesting credit story out there (much more likely in Europe where leverage is lower), credit in the High Yield space continues to deteriorate in the US, hence our recommendation of moving higher in the rating spectrum for the last few months and favor Europe from a relative value perspective (better credit metrics).

When it comes to US High Yield we have to agree with Bank of America Merrill Lynch's take from their latest High Yield strategy chartbook from the 6th of January, "Winter is coming":

"2014 redux 

Last year was a lot like 2014, only amplified. Bigger oil slump, worsening fundamentals and gappier price movements in HY, more geopolitical turmoil, and higher EM volatility. These factors were already eroding investor sentiment within HY when the US economy also buckled, showing signs of a slowdown at the heels of an already faltering global economy. The news of liquidation of several HY funds due to mounting losses from distressed credits turned out to be the last straw, driving US HY to a return of -4.6%, its first negative annual return in a non-recessionary period. The only bright spot: mutual fund redemptions were comparatively much lesser last year (-$10bn) vs 2014 (-$21bn), which arguably gave US HY a level of support. Across asset classes, US HY was the second worst performer. Only EM equities underperformed more, while less risky securities such as Treasuries, Munis, and Mortgages were the best performers. Leveraged Loans outperformed HY returning -0.69bps despite the heavy outflows (-$25bn). 

Winter is coming 

It’s a binary world we live in: 2015 returns were heavily dragged down by commodities, outside of which the index was roughly flat (tab 1.01). Half the HY universe by market value today trades at 310bps, while the other half is at 1050bps. The distressed list has a disproportionate representation of commodities (33%). However, this dispersion doesn’t bode well for US HY, as our fears of valuations eventually catching up to fundamentals have not abated. Default and distress ratios are increasing, even outside commodities:

and while rating migrations ex-commodities have not reached 2011 levels, they are heading in the wrong direction. CCC issuance has plummeted (chart below) and the US-domiciled USD HY market has seen a net annual contraction for the first time since 2008:

We expect all of this to continue well into 2016, putting more pressure on non-commodity paper. In terms of opportunities, we think Fallen Angels will provide a unique one to HY investors in 2016 as demand for higher quality paper increases, especially in light of reduced primary market activity. We also like Leveraged Loans for many of the aforementioned reasons, and believe they will outperform bonds once again this year." - source Bank of America Merrill Lynch

2016, no doubt will be an interesting year for US High Yield particularly given the contagion risk, should market turmoils continue to run unabated as it seems to be the case so far. As displayed in Bank of America Merrill Lynch's data, not only leverage is higher than in 2008, but earnings have been falling faster in terms of EBITDA YoY changes:

Even Ex Energy earnings are falling...

We know nothing, Jon Snow 

Is it possible that the world remains in its current bifurcated state? Yes, if oil prices don’t bounce back and ex-commodity fundamentals don’t degenerate further. We can sympathize with the commodity bears given the levels of global oversupply, but corporate earnings power has been eroding for one too many quarters (charts above), and top cycle behavior has surfaced one too many times this past year for us to think that the corporate credit cycle has not turned. This is the foundation of our opinion that spreads have more room to widen from here, and a broader default cycle is looming, especially if outflows pick up. The more nuanced questions for 2016 and beyond however, include: what will be the direction of the global economy and how will that impact the business cycle back home? Will events in the HY market be enough to create another impediment for the US economy? Enough to turn the business cycle? The answers to these, we don’t know yet." - source Bank of America Merrill Lynch

So, don't push your luck dear reader, we might be breaking the fourth wall, but "overplaying" the "beta" game when the US credit cycle has turned is, we think asking for more trouble than "carry".

What we have long argued during the course of 2015 is that the more correlations were getting "positive" the higher the number of "sucker punches" aka large standard deviation moves. It is no surprise to us, that the year ended, for some bond holders of Novo Banco, with a bang as described earlier in our conversation. When it comes to 2016, given cross asset correlations have risen, we do expect even more "sucker punches" being delivered hence our mention of "risk reversal" opportunities in our last conversation of the year 2015. 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.

• Final chart - Correlations getting higher in a macro-driven market

We already discussed the rise in +/-4 standard deviations moves or more in various asset classes back in August 2015 in our conversation "Charts of the Day - Positive correlations and large Standard Deviation moves":

"Cushing's syndrome" aka central banking "overmedication" leads to a rise in "positive correlations. There is a growing systemic risk posed by rising "positive correlations. Since the GFC (Great Financial Crisis), correlations have been getting more positive which, is a cause for concern" - Macronomics, August 2015

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. This is confirmed by our chosen chart from Bank of America Merrill Lynch's Credit Derivatives Strategist note from the 6th of January entitled "When credit met technical analysis":

"Correlations getting higher in a macro-driven market 

The credit CDS index market is a macro risk gauge. Post the global financial crisis and the subsequent central bank interventions, we find that pairwise correlations among different credits are now at a different (higher) regime (chart 4). 

Macro shocks (oil, Greece, China, EM risks, Fed, ECB) dominate credit markets. We see little prospect of the current market set-up changing in view of ECB QE.

Pairwise correlations across different asset classes have also been trending higher. Chart 5 shows the cross-asset pairwise correlations for equity, credit, implied vol and FX markets both in Europe and the US. Note that recently cross-asset correlations were at the highest level in a decade."

- source Bank of America Merrill Lynch.

Sorry to be breaking again the fourth wall dear readers, but, in our book, rising cross asset correlations is not a good sign for a smooth ride, but, at least indicates, there is convexity and risk reversal opportunities out there...and volatility is therefore a buy...

"A heart well prepared for adversity in bad times hopes, and in good times fears for a change in fortune." - Horace

Stay tuned!

Credit - The Pigou effect

"Nothing is perfect. Life is messy. Relationships are complex. Outcomes are uncertain. People are irrational." - Hugh Mackay, Australian scientist

While continuously following the evolution of the Euro convolution, with the temporary relief of the outcome for a Greece and the high probability of a Grexit in the end, as well as looking at the continuous fall in one of our favorite global demand indicator namely the Baltic Dry Index falling below its 1986 level towards 513 on the 22nd of February, we reminded ourselves for our title analogy of the Pigou effect, which is the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation. For Arthur Cecil Pigou, real wealth was simply defined as the sum of the money supply and government bonds divided by the price levels. He argued that when an economy was in a liquidity trap, monetary stimulus to increase output could not be used given there is little connection between personal income and money demand. Of course what we find of interest is that if the Pigou effect had been effective, then Japan should have exited deflation much sooner. Pigou, (just like our central bankers of the world today) hypothesized that falling prices would make consumers feel richer (and increase spending, that famous "wealth" effect) but Japanese consumers tended to report that they preferred to delay purchases, expecting that prices would fall further, which of course is exactly what has been happening.
It appears that "The Pigou effect" has been highly criticized as well by Michał Kalecki because: "The adjustment required would increase catastrophically the real value of debts, and would consequently lead to wholesale bankruptcy and a confidence crisis."

But, when it comes to our title analogy and the "Pigou effect", we find it quite amusing that Pigou had been John Maynard Keynes' professor. Pigou's theory is completely flawed as it is based on the hypothesis that there cannot be a prolonged period of overproduction (China) and the artificial life support of "zombie" companies (European banks, Chinese shipping companies, etc). Arguably, the trajectory of the Baltic Dry Index is indeed putting to the test that very assumption from the University of Cambridge professor. It is interesting to note that his student, John Maynard Keynes argued that a drop in aggregate demand could lower both employment and the price level in unison, an occurrence observed in the deflationary depression, which is what we are currently seeing in Europe and what is also coined by some economists the "Keynes effect":

"The effect that changes in the price level have upon goods market spending via changes in interest rates. As prices fall, a given nominal money supply will be associated with a larger real money supply, causing interest rates to fall and in turn causing investment spending on physical capital to increase." - source Wikipedia

Of course both the teacher and the student were wrong, as the former ignored the probability of extended oversupply and the latter implied that insufficient demand in the product market cannot exist forever. The Keynes effect does not occur in a "liquidity trap" according to "Keynesians", which is the result we are seeing in Europe with lack of aggregate demand due to lack of private credit as most European banks as they are constrained by their inherent "lack of capital". It is also particularly due to ZIRP and the Zero Lower Bound Problem. The result of this "liquidity trap" is, for us, self-inflicted. We discussed the issue of "crowding out" of the private sector in our conversation "Fears for Tears":

One of main reason of the relative calm in the European government bond market has been the "crowding out" of the private sector."Although, the intention of European politicians has been to severe the link between banks and sovereigns, in fact what they have effectively done in relation to bank lending in Europe is "crowding out" the private sector. Peripheral banks have in effect become the "preferred lender" of peripheral governments. It is fairly simple, in effect while the deleveraging runs unabated for European banks, most European banks have been playing the carry trade and in effect boosting their sovereign holdings by 30% since 2011 to record"

In this week's conversation we will take another look at the long term prospect for the European banking sector, as we strongly sit in the deflationary camp. We believe that rates will stay low for longer, particularly in Europe, which is caught in a vicious "japanification" process. We will also reassess some of our earlier views (long US treasuries, long Gold, short JPY), particularly in the light of the increased volatility and the impressive rise in US yields during the month of February which we highlighted in our most conversation.

Synopsis:

• The "crowding out" effect
• Banks stocks or credit?
• Banking crisis? Sweden lead the way
• Why Pigou failed in Japan and why QE is like aspirin? It's the demography stupid!
• Reassessing some of our earlier views
• The battle against the deflationary bust looming will not be won by ZIRP and QEs
• Real wage growth is the Fed's greatest headache
• Volatility is a buy and will greatly impact negative convexity assets
• On the fallacy of "Balance accounting" as per Sir James Goldsmith

• The "crowding out" effect:

The "crowding out" effect we mentioned on numerous conversations pushes yields down further meaning bonds investors are having a field day. Weak demand and ZIRP entices speculations and buy-backs rather than investments and employment. Banks play heavily the carry trade and therefore increase their link to their respective sovereigns while the private sector (SMEs) hasn't been able to easily access credit, leading to a credit crunch in Europe in the last couple of years triggering weaker aggregate demand, surging unemployment, etc.

In similar fashion to Japan, government bonds have replaced private sector lending on European banks' balance sheet. The comparison between Japan and Europe in terms of "evergreening" bad loans (extend and pretend that is, such as "shipping loans" for instance) and impaired financial sector can be ascertained from German bank Berenberg's note entitled "Turning Japanese...we really think so" published on the 10th of February.

"Policy responses – lessons not learned: In terms of fixing the banking system (the need to recapitalise banks rapidly and early on) and monetary policy (the need for shock and awe), European policy makers appear to be aware of, but have not taken on board, the lessons from Japan or the US in the 1930s. Perhaps, like their Japanese peers before them, they believe the economy is facing cyclical not structural challenges, or maybe they are concerned about their reputations or wish to prevent panic. But to be clear: fixing the European banking system remains unresolved and will remain so until hidden loan losses are dealt with.
● Interest rates will be lower for longer than anyone is prepared for: Deflationary forces arising from the balance sheet recession will see loose monetary policy
persist for another 10-15 years. For European banks, the implications are clear.

o Balance sheet structures to transform: Private sector deleveraging, continuing fiscal deficits and tightening regulation will make balance sheets smaller, drive the loan-deposit ratio below 100%, see (sovereign) fixed income assets double their share of bank assets, and lead to ever increasing equity-to-assets ratios.
Non-performing loan (NPL) ratios may yet double as they did in Japan following the onset of deflation.
o Balance sheet profitability to decline: Flat yield curves close to the zero bound and a substitution of private sector loans with sovereign bonds will push the net interest margin lower for many years to come. Combined with elevated loan losses, returns on assets (RoAs) will remain at half the levels of the precrisis, golden age.

● Share price and valuation parallels offer no support: The parallels with Japan have also held at a share price and valuation level, and suggest that there remains considerable relative downside to come (30-40%?) for European banks." - source Berenberg

Japan and the "crowding out" effect as illustrated by Berenberg in their lengthy note:

- source Berenberg

• Banks stocks or credit?

As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe. This can also be ascertained by the comparison in terms of returns for banks between Japan and Europe as highlighted by Berenberg in their great note:

"Given the continuing poor disclosure of loan quality by the European banks, we cannot say for certain what the capital deficit really is. However, history consistently shows that at the end of a 60-70 year debt cycle when an extended balance sheet recession takes hold, there are substantial hidden loan losses. But at some point, in the face of continuing weak nominal economic growth, banks must move from forbearance to foreclosure within their loan books and thus crystallise the loan losses." - source Berenberg

This support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

The extend and pretend game of hidden losses has been of course been supported by both LTROs and by now the much anticipated ECB QE.  So, forget about "dead cat bounces" in European banks share prices, as Japanese history has shown, pain is here to stay for shareholders as illustrated as well clearly by Berenberg:

"In Figure 29 we compare the relative performance of banks against the market in Europe and the US with that of Japan (with the Europe/US data rebased by 11 years to map the timescale of Japan). The good news is that the material relative underperformance of Eurozone, UK and US banks matches that of Japan both in terms of scale and duration. The bad news, however, is that the worst is not over. Japanese banks staged a three-year rally on the back of the restructuring of the banking system driven by the 2002 Takenaka plan (which forced the recognition of NPLs and the recapitalisation of banks). However, the underperformance resumed over the last eight years and Japanese banks are now at close to their 40-year+ relative lows. With Europe yet to achieve closure on balance sheet uncertainty (ie achieve a successful restructuring of the banking system) and with flat yield curves at the zero bound squeezing net interest margins, European banks are likely to continue to grind lower relative to the market. Further, as we show in Figure 30, banks do not like QE. In Japan and the US, banks underperformed during episodes of QE (QE flattens yield curves thus squeezing net interest margins and also signals an environment of low nominal growth which is negative for asset quality)."

- source Berenberg

• Banking crisis? Sweden lead the way

When it comes to the outperformance of "Nordics" share prices versus Japanese banks as displayed above it can be very simply explained. Sweden decided to tackle head on the issues of its ailing banking sector on numerous occasions. Sweden has a good firsthand experience of financial crisis unlike Europeans. 

Sweden suffered through a banking crisis in the early 1990s and then again in 2008 and 2009. It chose to inject capital into struggling banks only in return for equity to avoid raising deficits and burdening taxpayers. The government in 2008 set up a financial stability fund by charging banks an annual fee and enacted various crisis-management measures including a bank guarantee program to help support lending.

The fund will grow to 2.5 percent of gross domestic product by 2023 and stood at 35 billion kronor ($5.2 billion) at the end of 2010, including shares in Nordea Bank AB, according to the Swedish National Debt Office. 

As far as European banks are concerned, regardless of the European Banking Union, AQR and other shenanigans, we agree with Berenberg's take on the triviality of the AQR adjustments:

"The triviality of the AQR adjustments was the most damning in our view. It is simply not credible that at the end of a 60-70 year debt cycle and after seven years of near nonexistent economic growth that the adjustment to Non-Performing Exposures equalled just 62bp of total assets. Charitably, this could be blamed on IFRS and its requirement to only identify losses on an “incurred” basis rather than expected one (indeed, rephrasing the critique given IFRS only allows provisioning on an incurred basis and given the adjustments were so trivial, it must imply that the ECB acquiesced in covering up the scale of hidden losses in banks’ balance sheets). Indeed, as Hoshi and Kashyap wrote presciently in October 2013, the European authorities “appear to be hesitant to admit to the size of the problems facing the banks” perhaps out of fear of triggering a panic.

In short, until there is true clarity in the value of European banks’ assets, then the value of the equity is highly uncertain, making European banks uninvestable. In our view, what Europe needs to do, and what happened in Japan, is to force banks to dispose of a material proportion of their non-performing loans. As shown in Figure 36, NPLs were over-valued for in excess of a decade.

Such forced disposals should help achieve price discovery around the true value of bank assets. And in turn, this should pave the way to achieving confidence around the capital bases of the European banks." - source Berenberg

• Why Pigou failed in Japan and why QE is like aspirin? It's the demography stupid!

In relation to our title the "Pigou effect" and central banks' intervention leading to a "liquidity trap therefore neutralizing the "Keynes effect" , Japan is clear illustration of the failure of the "wealth effect" of Pigou's proposal as pointed out by Berenberg:

"In Japan, where the burden was shifted early on from monetary to fiscal policy, a Catch-22 is emerging. The Japanese government cannot afford to allow rates to rise, yet keeping rates low risks increasing distortions in the economy through the mispricing of risk. It has been estimated that a 2ppt increase in average bond yields would require almost all tax revenues to be used to service the government’s debt. Thus QE and the monetisation of the national debt must continue in size (apparently the Bank of Japan purchases the majority of all new debt traded) until the Bank of Japan owns most of the government’s debt. But if the quantity of something is increased and demand is constant then the price must fall, ie the yen must weaken further (and Japan exports deflation).

As noted in the previous section, abundant liquidity and low interest rates squeezed net interest income for Japanese banks (two-thirds of the revenues for a typical bank). This arose through two effects. Ample liquidity and a lack of private sector demand for credit meant that the Japanese banks materially increased their holdings of government bonds (with typically lower yields than private sector loans). Secondly, low interest rates and QE flattened the yield curve, reducing the benefit of the maturity transformation.

Markets are rejoicing that the ECB is finally following the Bank of Japan and other central banks in embracing QE. But what if, as Kiyohiko Nishimura observed (the former deputy governor of the Bank of Japan), the problems facing Europe and Japan are driven by a demographic not financial cycle. He has noted that in Europe and Japan, as well as the UK and US, crises have almost always coincided with a decrease in the ratio of the working-age population to the non-working age population":

- source Berenberg

 You probably better understand now much better our long standing deflationary stance and lack of "appetite" for European banks stocks (we are more credit guys anyway...). It's the demography stupid! Beside's that we have pointed out in our conversation "Stimulant psychosis:

"Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment."

Both the master Pigou and the student Keynes have inadvertently grant unprecedented capital gains to rentiers in the form of exorbitant bond price! Exorbitant bond prices? How about Portuguese 10 year bonds at 2.13% trading briefly below US 10 year bonds?

• Reassessing some of our earlier views

Duration - party on Wayne! party on Garth!

While we endured the proverbial battering on our long duration exposure during February (offset somewhat by our short JPY stance), as discussed in our last conversation, the latest raft of weaker than expected US data such as US home resales falling to their lowest level in nine months last month at an annualized rate of 4.82-million units, as well as Industrial companies indicating they would only raise capacity by 1.8 percent in 2015, which is  the smallest increase since 2011, after boosting it 3.1 percent in 2014 according to  the Fed said in its Feb. 18 release on production, reinforce our view that we have probably seen the top of widening move in US yields for the time being. The current levels make it interesting to think about increasing slightly more our own long duration exposure.

Gold - everything that glitters...

In terms of flows, it seems precious metals saw their first outflows of $0.3bn in 5 weeks according to Bank of America Merrill Lynch "The Flow Show" from the 19th of February entitled "Out with the Safe, In with the Risk":

"YTD asset returns: stocks +3.1%, bonds -1.0%, commodities +1.4%, US dollar +4.4%; vol, gold & long duration bonds were the clear Jan “winners”; but risk assets have rallied big in Feb and quietly Treasury yields have jumped sharply (30-year up 50bps in Feb)" - source Bank of America Merrill Lynch

Our gold and duration calls from our conversation of the 6th of January entitled the "Fright of the Bumblebee" performed well in January and got punished in February:

"In terms of "allocation", we think we are looking more towards the upper left part of the Credit Channel Clock which means:
-a continuation of flattening yield curves,
-being long volatility as we enter a higher volatility regime
-a continued exposure to US long government bonds. Long dated US government bonds from a carry and roll-down perspective continue to be enticing at current levels compared to the "unattractiveness" of the mighty German 10 year bund indicating a clear "japanification" process in Europe.
-adding again some gold exposure in early 2015. We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it is going to be working again nicely in the first part of 2015"

The latest US raft of economic data has given some support of the $1200 level. We still remain positive for gold prices, given the lack of clear resolution of the Greek situation in conjunction with geostrategic tensions flaring with interventions looming in the Middle-East and with Ukraine 's economy in complete meltdown.

• The battle against the deflationary bust looming will not be won by ZIRP and QEs:

Looking at the global economy as a whole, we think the globalization of ZIRP is not reducing the deflationary forces at play but in fact reinforcing them, pushing us towards additional currency war which is reminiscent of the build up towards the crash of 1929 and the Great Depression that ensued. On that specific matter we share Dr Lacy Hunt's views and concerns. He is the Executive Vice President of Hoisington Investment Management and gave a month ago a long interview with Gordon T Long on the current economic situation. While gathering our thoughts since our previous conversation, we also took into interest in the wise but gloomy comments from Hedge Fund manager Crispin Odey given in an interview with Nils Pratley in the UK newspaper The Guardian on the 20th of February:

“1994 is when we were all slathering about the idea of a world economy, and what it is going to do as we open up,” says Odey.
“And Goldsmith basically says: ‘Hey, be careful about this because it is fine to have trade between peoples who have the same lifestyles and cost structures and everything else. But, actually, if you encourage companies to relocate and put their factories in the cheapest place and sell to the most expensive, you in the end destroy the communities that you come from. And there will come a point where the productivity gains from the cheapest also decline, at which point you have a real problem on your hands’ – And we are kind of there.” - source The Guardian

This struck a chord with us as it indeed reminded us of Sir Jimmy Goldsmith's great 1994 interview following the publication of his book "The Trap" which was eerily prescient. He violently criticizes the GATT and the curse of globalization as denounced as well by the great French economist (and scientist) Maurice Allais.

In response to the critics, Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response" (link provided):

"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

• Real wage growth is the Fed's greatest headache

In similar fashion the slack in US real wage growth is the real problem to clearly validate the much vaunted US recovery  according to a University of Wharton article entitled "The Economy Is Coming Back — Why Wages Are Stuck in a Rut" and published on the 23rd of February:

"Despite that one bright moment in the late 1990s, U.S. real average hourly wages haven’t budged much for decades. The U.S. average hourly wage of $20.80 in January 2015 is about the same as that in January 1973, adjusted for inflation, according to the Bureau of Labor Statistics." - source Wharton University

This is exactly the issue for the US economy as we stated back in July 2014 in our conversation "Perpetual Motion":

"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, 22nd of July 2014

Real wage growth, we think is the most important indicator to follow we think from a Fed tightening perspective.

We also indicated at the time:

"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

• Volatility is a buy and will greatly impact negative convexity assets

From a market perspective, we recommended in our first conversation of 2015 that investors needed being long volatility as we enter a higher volatility regime, this is confirmed by the rise in the CVIX index (CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs) as displayed by Bank of America Merrill Lynch in their Liquid Insight note from the 23rd of February entitled "Letting the data speak again on G10 FX":

"This is just the beginning
We expect that the year so far is a preview of what will follow. Our year-ahead had argued FX volatility would increase as data dependence replaces forward guidance in monetary policy, ECB and BoJ QE would not be enough to replace Fed QE as boosters of global risk appetite, and oil prices would be lower and more volatile. In the global monetary union with the US we pointed out that loose Fed policy and forward guidance in G10 central banks had killed market volatility and FX correlations with data and fundamentals, and argued volatility and such correlations would come back as Fed QE ends, G10 monetary policies diverge and USD strengthens.
We believe these forces remain valid. We recently argued FX volatility has become the prime driver of global volatility, as central banks react differently to the common oil price shock and some are behaving as if they are in a currency war. The latest FOMC minutes also suggest the Fed is unlikely to continue ignoring the drop in inflation expectations, suggesting the upward USD." - source Bank of America Merrill Lynch

As a reminder and going forward, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger!

•  On the fallacy of Balance accounting as per Sir James Goldsmith

"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.
When the Asian countries, as mentioned by the European Commission, invest their 'excess cash' abroad, normally they do so by buying into businesses or by lending money. The latter normally takes the form either of buying government debt or of deposits, say in sterling or dollars, in the banking system. Now consider the position of the nations which, unlike the Asian countries, import more than they export and which, as a result, have a deficit as opposed to an excess of cash.
To finance their deficit, businesses or other assets are sold and debt is issued. This puts them in exactly the same position as an individual who sells his house or borrows money to cover his debts. Such a haemorrhage can last only a limited time before ending in bankruptcy." - Sir Jimmy Goldsmith

Hence the need for central banks to issue more debt to sustain the global financial system...until it doesn't work but that's another story...

Thanks to Global ZIRP and our central bankers we are indeed living on the Planet of the Apes...oh well.

"If you pay peanuts, you get monkeys."- Sir James Goldsmith

Stay tuned!

Credit - While My Guitar Gently Weeps

"It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." - Mark Twain

Looking with interest at the latest surge in the US 10 year yield to 1.94% in conjunction with the "improved" employment picture in the US as well as the fall to record low level of 1986 for the Baltic Dry index to 559, we remembered one of our favorite song from the Beatles "While My Guitar Gently Weeps" recorded in 1968 for our title analogy. "While My Guitar Gently Weeps" was ranked no. 136 on Rolling Stone '​s list of "The 500 Greatest Songs of All Time", no. 7 on their list of the 100 Greatest Guitar Songs of All Time, and no. 10 on their list of The Beatles 100 Greatest Songs.

As far as the above Mark Twain quote goes, it's indeed what we know for sure when it comes to global economic growth which is of concern to us, regardless of the supposedly "deflation escape velocity" reached by the US economy and its latest Nonfarm Payroll figures. We still sit tightly in the deflationary camp for the time being and remain extremely cautious about the risk posed by the velocity in the rise of the US dollar.

The Baltic Dry Index indicative that all is not good in global economic growth - graph source Bloomberg:

"Baltic Dry Index down to levels not seen since 1986" - source Bloomberg

You might therefore be wondering why we have used such a title as an analogy. Georges Harrison's musical masterpiece had an initial incantation, which we think, resonates well with the current investment environment and global central banks meddling in asset prices:

"I look at the trouble and see that it's raging,
While my guitar gently weeps.
As I'm sitting here, doing nothing but ageing,
Still, my guitar gently weeps."

There was as well an unused line in the very beginning of his initial writing which was eventually omitted:

"The problems you sow, are the troubles you're reaping,
Still, my guitar gently weeps."

And when it comes to QE and Central Banks, an early acoustic guitar and organ demo of the famous song had a slightly different third verse which we find interesting for the sake of our analogy with our central banks "money" games:

"I look from the wings at the play you are staging,
While my guitar gently weeps.
As I'm sitting here, doing nothing but ageing,
Still, my guitar gently weeps."

In 2004, Harrison was inducted posthumously into the Rock and Roll Hall of Fame as a solo artist. "While My Guitar Gently Weeps" was played in tribute by Tom Petty, Jeff Lynne, Steve Winwood, Steve Ferrone, Marc Mann, and Dhani Harrison, and concluding with arguably one of the most  memorable guitar solo by fellow inductee Prince but we ramble again.

In this conversation we will re-assess current trends and "rotations" and "look at the trouble" to see if it is indeed "raging" while our guitar gently weeps as well as musing around the impact QE has had in Europe so far.

Synopsis:

• Lower expected returns and higher expected volatility
• "Great rotation" not from bonds to equities but, from US equities to European equities in early 2015
• European equities lift-off akin to the move seen on the Nikkei  (hedged) in 2013but with less firepower!
• Rising divergence between volatility and credit spreads in Europe

• Lower expected returns and higher expected volatility

When it comes to the outlook for returns, we agree with Nomura's latest Strategic Outlook note from the 6th of February 2015, namely that we are going to see lower expected returns and higher expected volatility. We also share their concern on the US economy. We think it is more fragile than currently assumed:

"A common view is that the US economy is in good shape – effectively immobile against a stronger USD or lower energy prices or low productivity. With most of the rest of the world (ex Brazil) loosening monetary conditions (FX and rates) another view is emerging that EM growth will recover. And the ECB’s QE announcement should, it is argued, hedge downside inflation and hence growth risks in the euro area. These views rest squarely on the assumption that the US will not and never has slowed down from above trend growth without the intervention of the Fed via tight monetary policy. In contrast we see increasing evidence that the US profit cycle is in fact maturing rapidly and that profit growth is likely to disappoint through H1. If this is the case then slower capex and employment follow – regardless of the Fed. This would constitute a major surprise to global forecasts that are more clustered than they have been since 2007.

Given the starting point for inflation this scenario would generate further upside pressure on real yields across the curve. How risk aversion would respond is critical to predicting the outcomes for returns. By contrast the bullish growth scenario would, we think, lead to a rapid repricing of Fed hikes back toward June given the stage of the US cycle. Our unpalatable strategic conclusions are that growth estimates for H2 will probably need to come down, that real yields or nominal yields are going back up under most scenarios, and that risk aversion will continue to trend higher." - source Nomura

While we have taken the proverbial "beating" on our ETF ZROZ long duration exposure losing 7% since the 30th of January, we are sticking with our position, given our lower entry level in the trade (we have also exposure to a long term macro short term trade offsetting the short term pain via ETF YCS, being short JPY for disclosing purposes...). The recent widening in US Treasuries make a good entry point for those who missed out, we indeed, expect, the data in the US, from a contrarian perspective to be weaker than previously expected, regardless of the most recent NFP.

On that specific point we would like to point out to Reorient Group's latest note on a US premature rate hike from the 8th of February 2015:

"Individual components of the employment report are at odds with other data. One of the fastest-growing components of employment, for example, was construction, with total head-counts up 5.5% year-on-year as of January. Construction spending adjusted for the construction Producer Price Index was flat year-on-year. Either the spending numbers were wrong (but unlikely because construction activity is easily counted) or the employment numbers are suspect."

 - source Reorient Group

We agree with the above, that all is not what it seems and it demands a more inquisitive mind when it comes to taking the data at "face value".

• "Great rotation not from bonds to equities but, from US equities to European equities in early 2015

From an allocation point of view, what we find of great interest has been the continued inflows into the bond sphere (59 straight weeks of inflows to Investment grade bond funds with $8.7bn) as indicated by Bank of America Merrill Lynch's Follow the Flow note from the 5th of February entitled "The Bond Capitulation":

"On Flows and Markets
Bond is Back: massive inflows to bond funds ($21bn – 7th largest weekly inflow on record – Chart 1); outflows from equity funds ($7bn).

Gold is Back: largest 3-week inflows ($3.8bn) to precious metals funds since
Aug’11 (Chart 2).

Europe is Back: 4th consecutive week of equity inflows to Europe (Chart 5); contrasts with outflows from US/EM/Japan.

EM Debt is Back (at least for a week): 1st inflows in 9 weeks to EM debt funds ($0.9bn).
Risk Resilience: best explained by ECB & Sentiment (risk has rallied since BAML Bull and Bear Index flashed "buy" on Jan 7th…US HY 1.8%, SPX 3.0%, ACWI 5.4%, WTI 5.5%, SX5E 9.1% (all $-terms).
Risk Resilience: note also significant weekly inflows to bonds and/or gold in past 15 years (i.e. moments of “fear”) have unsurprisingly proved decent entry points into stocks (Chart 4).

- source Bank of America Merrill Lynch

In relation to Bank of America Merrill Lynch and its "Great Rotation" story, it seems that, courtesy of the ECB unleashing a QE of its own, the great rotation has clearly been from US equities into European equities it seems with $4.3bn of inflows for a 4 straight week, whereas the US saw $9.9bn of outflows for a 5 straight week. European assets seems to be a large beneficiary from the ECB's promises to deliver a QE of its own as indicated once more by Bank of America Merrill Lynch's Follow the Flow note from the 6th of February 2015 entitled "Income mania":

"Biggest inflows ever into European assets
Fund flows highlight the chronic shortage of yield in Europe. Last week saw the greatest ever total inflow into European assets (chart 2). 

The reach for yield was in full effect across high-grade and high-yield credit, government bonds, money market funds, equities and commodity funds, according to EPFR. In terms of notable trends:
• Money-market inflows were the 4th highest ever.
• European equity inflows were the 6th biggest ever.
• Inflows into government bond funds were the 3rd largest ever.
• Inflows into all fixed-income funds were the 2nd biggest ever.
• High-grade credit flows were the 8th largest, since data began.
All in all, aggregate risk-on flows in to European assets were huge: almost $40bn!" - source Bank of America Merrill Lynch

At the same time and on a monthly basis, the S and P 500 saw during the month of January $28bn of outflows and equating to 15% of AUM according to Morgan Stanley. In fact, the biggest monthly outflow ever:

- graph source Bloomberg / Morgan Stanley


Also, investors continue to pile into the yield trade as the search for income runs unabated.

For instance IYR (REITS) had its largest daily inflow ever on the 2nd of February ($900 mln or 12% of AUM) according to Morgan Stanley:

- graph source Bloomberg / Morgan Stanley

We believe the great rotation story in 2015 currently playing out is indeed from US equities towards European equities for the time being and we agree with the following comments from Morgan Stanley:

• "US investors are loaded up on US risk:  50% of the entire industry ETF flows since 2009 has gone into US equities ($300 bln).
• The peak in global growth might very well have come in Q1 (US printed 5% GDP in Q3 and Q4 GDP came in 2.6% below the 3% consensus forecast).  Now we have a strong dollar and we are starting to see countries implementing policy stimulus to close the gap in growth." - source Morgan Stanley

So indeed while our guitar is gently weeping, US risk is indeed much less appealing than European risk (Grexit avoided of course...).

Therefore, when it comes to allocation to European equities it is definitely on the "menu du jour" as displayed in Louis Capital Markets Cross Asset Weekly report from the 2nd of January:

"Run Forrest!
No client meeting we have conducted has passed without a question on the relative performance of European equities compared to US equities being posed. European investors are well loaded with European equities as they suffer the classic “home bias”, well known in academic literature. US investors are similarly biased, but the letters Q and E, that recently reared their head in Europe, have broadened their investment universe and a flow of money has poured into European equities. The US ETFs that hedge the currency impact have benefited strongly from this trend as we show in the chart below.

This re-balancing has happened in a context where Wall Street has started to show some signs of weaknesses. We have recently discussed this hypothesis and it seems that US indices have lost their upward momentum (at least, in the short term).
The reversal of the profit trend could be the reason for this weakness. Or perhaps this is simply a profit taking phase, because as we all know these are a regular occurrence in equity markets.
Sarcasm aside, the fact that European equities recorded new highs in this less than favourable context is therefore heroic, because on the profit side there is absolutely nothing new. The charts below illustrate this. We can understand that the impact of the EUR/USD is positive for European companies and negative for US companies, but in the earnings forecasts of analysts there is no change. 

The 2015 EPS of the Eurostoxx50 has been revised down by 2.2% for the sole month of January. 

Although we share the consensual view that the decline of the EUR/USD will support profits of the European index later this year, this 2.2% negative revision is a reminder that on an index level the macroeconomic developments that appear obvious to many investors are not so straightforward when it matters due to its composition/structure.

By sector, the message is consistent with the “currency advantage” as consumer stocks that are quite global have done better than more domestic sectors like utilities or financials. The telecoms sector, with its very strong performance, is the exception in Europe.
However, the difference in performance between the Eurostoxx and the S&P500 since the beginning of the year is broad based and not related to a specific sector. The underperformance of US financials compared to European financials sends a key message here: this is not only a matter of exchange rates.

The herd mentality is strong on equity markets with this run against time to chase European equities that keep a potential for a catch-up if we look at prices. If we look at valuation (without discussing the impact of possible different profit cycles and different profit trend growth) the potential for a catch-up is exhausted. We have updated our table on the valuation of the MSCI EMU if we apply to it the sector composition of the US index. Here, we find a mere 2.2% discount in terms of forward PER.

Last week we started mentioning the valuation aspect of the Europe/US question. To be clear, we stress that profits have to improve significantly to think that European indices can outperform on a sustainable basis its US peers." - source Louis Capital Markets

• European equities lift-off akin to the move seen on the Nikkei  (hedged) in 2013but with less firepower!

This European lift-off in equities hedged is akin to the move seen in 2013 on the Nikkei hedged complex which provided solid performances for "wise" investors. (we admitted in 2013 that we enjoyed being long Nikkei hedged in Euro). We have repeatedly highlighted the weakness in aggregate demand in the Eurozone. We argued in the past that the growth divergence between US and Europe were due a difference in credit conditions. Unless there is a significant sustained improvement in credit conditions in Europe, we don't think Europe can deliver more stellar returns than Japan did in 2013 while our guitar gently weeps.

• Rising divergence between volatility and credit spreads in Europe

From an equity to credit perspective, one of the major impact from the ECB's QE has been the rising divergence between Eurostoxx 50 Put/Volatility versus Credit Spreads. This has been for us quite logical for Investment Grade, less so for High Yield. According to Goldman Sachs the spread between Out of the Money Put options on the Eurostoxx 50 and CDS spreads is at its highest level since 2010, and the yield that can be obtained by selling 70% put on the Eurostoxx 50 is 3 times higher than the Itraxx Main Europe CDS 5 year index (Investment Grade proxy for risk with 125 entities):

- source Goldman Sachs

Furthermore, as we indicated in our conversation relating to the growth divergence between the United States and Europe ("Growth divergence between US and Europe? It's the credit conditions stupid..."), it is all about Stocks versus Flows:

"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

This major difference can already be seen, we think from the behavior of credit versus equities as discussed by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 6th of February entitled "Catch the basis if you can":

"Central Banks liquidity primarily provides a strong back-stop against funding risks; rather than support earnings, which usually come further down the line. When the Fed announced the first QE program, credit spreads outperformed equities.

On the flip side, the ECB QE announcement has not ignited the same response. This time around credit lagged equities.

One could argue that European credit spreads are already close to the tightest levels in years, and thus should lag post an ECB QE announcement, especially when growth outlook is coming off the lows. At the end of the day the ECB QE is meant to boost growth rather than to reduce funding/default risks, and equity markets have started pricing that.

However, we expected Crossover to follow suit on the strong reaction from equity markets, being a growth proxy in the credit market. We were expecting Main to underperform Crossover in a QE event, also reflecting the same strong growth potential the equity markets are pricing.
However, XO has lagged the risk on move tighter. We think that this was not driven by the lack of yield in credit markets – as government bond yields have continued to rally – but mainly due to the rise of geopolitical risks and the resurfacing of funding risks." - source Bank of America Merrill Lynch

End of the day, it doesn't matter that European stocks have been racing ahead of fundamentals, from a "quality" and "japanification" perspective, it is still a goldilocks period for Investment Grade credit, particularly in a shift towards a new regime of higher volatility.

On a final note we leave you with Nomura's forecast of stock of assets purchased by central banks as a % of national GDP from their Economics Insights note of the 28th of January 2015 entitled "Comparing ECB QE with BOJ, Fed and BOE programmes:

"• BOJ holdings of JGBs are expected to increase from the equivalent of around 40% of Japanese GDP at the end of 2014 to around 60% of GDP by the end of this year. This compares with “only” 14% of GDP in the case of the Fed and just over 20% of GDP for the BoE.
• ECB purchases of sovereign bonds (just over €40bn a month, allocated according to the capital key) will be equivalent to around 4% of GDP by end-2015. These will have grown to about 7.5% of GDP by end-September 2016 (or around 13% of the total stock or 17% of the targeted stock; the latter referring to the maturity parameters of a remaining maturity of 2 years and a maximum remaining maturity of 30 years at the time of purchase).
• Only the Fed has engaged in macroeconomically significant (measured as a share of GDP) purchases of assets other than Treasuries, buying the equivalent of 10% of US GDP of Agency MBS. We estimate the ECB will maintain private sector asset purchases at around €10bn a month, resulting in purchases equivalent to just 1% of GDP by the end of this year and reaching 2% of GDP by the end of September 2016.
• In conclusion, if one believes in the effectiveness of QE (we don’t), then size probably matters. In this context, there are two considerations: (i) the increase in the stock of purchases is going to be gradual, which implies it is going to take some time for the cumulated size to become meaningful, and (ii) the cumulated expected size of the programme by the end of this year will still be only a third of the size of the Fed and BoE programmes, suggesting that, if you believe in the effectiveness of QE, the ECB’s programme will need to grow much more significantly before it has a macroeconomic impact." - source Nomura

 “It's not the size of the dog in the fight, it's the size of the fight in the dog.” - Mark Twain

Stay tuned!