Credit - Livin' On The Edge

"There's somethin' wrong with the world today
I don't know what it is
Something's wrong with our eyes

We're seeing things in a different way
And God knows it ain't His
It sure ain't no surprise

We're livin' on the edge" - Aerosmith 1993, Livin On The Edge

While we contended this week about the complacency in US stocks, when looking at the "great rotation" between institutional investors and private clients for the last five consecutive weeks as reported by Bank of America Merrill Lynch, we thought this week we would use a musical reference for a change, namely 1993 hit song by Aerosmith, which reflected at the time the sorry state of the world.

In this week's conversation, while everyone is enjoying a summer break and some much needed normalization in credit spreads, which has seen cash credit tightened overall by 5 bps this week in the European market on the Iboxx Euro Corporate index, we would like to focus our attention on the growing disconnect between asset prices and the sorry state of the real economy.

Indeed we would have to agree with our chosen title when looking how the US stock market has been defying gravity compared to the sorry state of the US labor market. There has been a growing disconnect between Wall Street and Main Street. On that note we agree with Bank of America Merrill Lynch's report from the 1st of August entitled "When Worlds Collide":

"From their 2009 lows the US economy has grown by $1.3 trillion while the US stock market has grown by $12.0 trillion (in July the S&P 500 set a new intraday high). Policy, positioning and profits (in that order) best explain the seeming disconnect between Wall Street and Main Street. Wall Street and capitalists have enjoyed a boom, as the price of equities and bonds (and more recently real estate) have soared, while Main Street and the labor market have struggled" 

- source Bank of America Merrill Lynch

Yes recently we did indicate, "we're livin on the edge", when  not only looking at the rise of the S&P index (blue) versus NYSE Margin debt (red) but also at the S&P EBITDA growth (yellow) and as well as the S&P buyback  index (green) since 2009 - graph source Bloomberg:

No doubt to us that the current bull market which has started in March 2009 has been artificially "boosted" by "de-equitization", namely the reduction of the number of shares courtesy of buybacks. A drop in stock outstanding accounted for 25% of 2012 earnings-per-share growth in the S&P 500. Buybacks are a global phenomenon.

Capital, courtesy of ZIRP, is not only mis-allocated but also destroyed with the "de-equitization" process in order to boost even more the "infamous" wealth effect induced rally by Mr Ben Bernanke. As far as profits are concerned, companies as sitting on record amount of cash and have generated record corporate profits as indicated by Bank of America Merrill Lynch's graph below:

"Profits: corporate austerity since the Great Financial Crisis has induced record corporate profits ($1.6 trillion – Chart 3) and record levels of corporate cash ($1.2 trillion), an asset-positive, growth-negative combo." - source Bank of America Merrill Lynch

While the latest ISM / PMI releases point to some much hoped economic recovery, the latest disappointing read of the Nonfarm payroll coming at 162 K shows how much the recovery has been tepid so far whereas equities have continued their surge undisturbed.

US PMI versus Europe PMI from 2008 onwards. Graph - source Bloomberg:

But if short term wise economic data shows some sign of stabilization, the volatility in the fixed income space is very much present as displayed by Merrill Lynch's MOVE index jumping from early May from 48 bps and surging back towards the 100 bps level - graph source Bloomberg:

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

What we have been tracking with interest is the ratio between the ML MOVE index and the VIX which remains elevated from an historical point of view if we look back since October 2000 - graph source Bloomberg:

This latest surge in fixed income volatility has put some renewed pressure on Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD and High Yield, as displayed by the lost liquid ETF HYG - source Bloomberg:

If the fixed income space, the goldilocks period of “low rates volatility / stable carry trade environment” of these last couple of years seems to have been seriously tested, yet there remain a big disconnect between equities and fixed income. As we posited in our conversation on the 13th of June "The end of the goldilocks period of low rates volatility / stable carry trade environment?":

"The huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space."

For now volatility indicators in both Europe (V2X) and the US (VIX) have been fairly muted. Graph source Bloomberg:

So the big question is indeed are we indeed "Livin' On The Edge"? Here is what Bank of America Merrill Lynch posited in their 1st of August note on this subject:

"United we fall, divided we rise

Secular bears of financial assets will argue, with some justification that the worlds of Wall Street & Main Street cannot diverge indefinitely. This may well be so. But in the past 5 years this view has repeatedly missed the point that a divided world of High Liquidity & Low Growth has been the foundation of a ferocious bull market in financial assets.

And of course not all asset prices have reflated as nonchalantly and aggressively as US corporate stocks and credit. Commodity markets and the performance of global cyclicals versus defensives continue to point to a very, very subdued global growth environment. A breakdown in the Continuous Commodity Index (CCI –Chart 4) below 500 in coming weeks would discourage global growth upgrades (and stymie the recent rebound in Emerging Markets). 

It is very rare to see such outperformance of defensive stocks (up 26% over the past two years) versus cyclical stocks (down 4%) in a non-recessionary world (Chart 5).

- source Bank of America Merrill Lynch

As we argued back in April this year in our conversation "Equities, playing defense - Consumer staples, an embedded free "partial crash" put option", the downward protection from Consumer Staples can be illustrated from the following Bloomberg graph highlighting the performance of Consumer Staples versus Consumer Discretionary and Financials since October 2007 until October 2012:

Another "great anomaly" has been that low volatility stocks have provided the best long-term returns.

So yes indeed in, we do live, in an ambiguous world where low volatility provides the best returns, and with a great disconnect between equities and the real economy, with fixed income and equities. We think we are "Livin' On The Edge" and as indicated by Bank of America Merrill Lynch, but, we are not too far from "The Moment of Truth":

"Perhaps the best example of this bi-polar world is the fact that the US equity market now represents almost 50% of the world’s market cap. Despite limited support from the US dollar, US equities relative to EAFE are close to relative levels not seen since the 1960s (Chart 6), as investor positioning reflects belief in ongoing US market and macro leadership.

So moment of truth for the economy will arrive in the second half of this year. If ever the US were finally to achieve “escape velocity” it must be now. Significant monetary stimulus, the end of fiscal austerity, a booming housing market, a cheap dollar, and record corporate cash balances mean the US economy should meaningfully accelerate in coming quarters. Our own Ethan Harris looks for 2.0% GDP growth in Q3, 2.5% in Q4 and 2.7% in 2014.

Our investment strategy remains predicated on that outcome. In coming quarters we expect PMI’s to accelerate, job growth and bank lending to improve, higher interest rates to coincide with higher bank stock prices, and US dollar appreciation. We favor assets (such as financial stocks) and markets (such as Europe) that have lagged in the “High Liquidity-Low Growth” world of recent years." - source Bank of America Merrill Lynch

Unfortunately we do not share Bank of America Merrill Lynch's optimism on the acceleration of USD GDP growth in the coming quarters. For us, it is still muddle-through with significant risk on the downside.

US labor growth remains very weak as indicated in the below Thomson Reuters Datastream / Fathom Consulting graph:

QE and the law of diminishing returns - US QE in practice - Payrolls and Manufacturing ISM, graph source Thomson Reuters Datastream / Fathom Consulting:

In addition to this the regular economic activity and deflationary indicator we have been tracking has been Air Cargo. It is according to Nomura a leading indicator of chemical volume growth and economic activity:

"Our air cargo indicator of industrial activity came in at -3.8% (y-o-y) in June, following -4.8% in May and -7.4% in April. As a readily-available barometer of global chemicals activity, air cargo volume growth is a useful indicator for chemicals volume growth.

Over the past 13 years’ monthly data, there has been an 83% correlation between air cargo volume growth and global industrial production (IP) growth, with an air cargo lead of one to two months (Fig. 2). In turn, this has translated into a clear relationship between air cargo and chemical industry volume growth (Fig. 1).

- source Nomura

On a final note, if you think that stocks are "Livin' On The Edge" and that a QE tapering is around the corner, then maybe you ought to think about US Treasuries again, for a very simple reason, government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". In fact the case for treasuries is also indicated in Bloomberg's recent Chart of the Day:

Investors should buy Treasuries if they anticipate the Federal Reserve will reduce its purchases, based on the last two times that the biggest buyer of bonds stepped back from the market.

The CHART OF THE DAY shows the benchmark 10-year yield dropped and gains in the Standard & Poor’s 500 Index slowed after the Fed ended each of the prior two rounds of quantitative easing in the past four years. The yield declined 1.26 percentage points between the end of the first round of Fed purchases in March 2010 and the beginning of the second round in November that year. The U.S. stock gauge rose 2.4 percent, compared with a 36 percent advance during QE1.

The yield slid 1.3 percentage points between the end of the second round in June 2011 and the beginning of Operation Twist in September the same year. The S&P 500 fell 12 percent after gaining 10 percent during QE2.

“The Fed will taper QE not because the economy is booming but because the program has been creating excess liquidity, boosting risk assets too much,” said Akira Takei, the head of the international fixed-income department at Mizuho Asset Management Co., which oversees $37 billion and whose U.S. affiliate is one of 21 primary dealers that underwrite U.S. debt. “Ending QE is likely to trigger a correction in risk assets, driving bond yields down.”

Fed Chairman Ben S. Bernanke said on June 19 that the U.S. central bank may slow the third round of bond-buying, valued at $85 billion a month, later this year and end it entirely in the middle of 2014 if the economy achieves sustainable growth. Half of the 54 economists surveyed by Bloomberg News said the Federal Open Market Committee will decide to start taking such steps at its September meeting.

Futures traders see an almost 60 percent chance the Fed will keep the benchmark rate at a record-low range of zero to 0.25 percent through to at least the end of 2014. The 10-year Treasury yield is likely to fall to 1 percent by the end of March and may touch 0.8 percent next year, Mizuho’s Takei forecast. It was at 2.71 percent yesterday, up from 1.72 percent when QE3 was announced on Sept. 13 last year." - source Bloomberg.

Looks to us that the S&P 500 is no doubt "Livin' On The Edge".

Oh well...

"To him that waits all things reveal themselves, provided that he has the courage not to deny, in the darkness, what he has seen in the light." - Coventry Patmore, English poet.

Stay tuned!

Inception - Bernanke's QE2 experiment

Like in the movie Inception, the Fed is trying to plant an idea into people's mind. Bernanke idea's with QE2 is to create a wealth impression which would increase consumption and economic growth, with the help of rising assets prices. We had the Greenspan put and the Bernanke put, we also now have to contend with the same bubble creation plan which was initially followed by Alan Greenspan.
We all know now the results of creating asset bubbles and the consequences.
It is a very dangerous game.

I agree with Cullen Roche from the excellent site Pragmatic Capitalist, that QE1 was not money printing and was necessary in order to alleviate the massive burden of toxic assets sitting on banks balance sheet.

http://pragcap.com/bernank-put

"Over the last 15 years the Federal Reserve has essentially become a price fixing mechanism for an economy that has long struggled with severe structural problems. When problems have arisen in the economy the U.S. central bank has intervened to lessen the blow to the economy. In theory, this was intended to reduce the volatility of the business cycle. Unfortunately, many of their policies have simply exacerbated the problems or helped to generate even greater imbalances.

This all started well before the housing bubble or the Nasdaq bubble. After the 1987 crash Alan Greenspan was quick to reassure investors that the Fed was there to bolster markets. This “Greenspan put” was mastered with the bailout of LTCM as the Fed intervened in markets to make sure that losers didn’t have to become losers. LTCM was the epitome of failed economic theory at work in markets. A group of brilliant economists believed they had discovered the path to minting money in financial markets. On paper their equations appeared flawless. In reality, they were a disaster waiting to happen. In one fell swoop this collection of geniuses proved that EMH was flawed. And not two years later the Greenspan Put helped contribute to a market bubble like the United States had never seen. In the words of David Tepper, it was a “win win” market – or so they believed."

What if we had let LTCM fail in 1998? Would we have had a Lehman demise in 2008?

In his excellent post Cullen adds: "the modern day Fed has taken its role to an entirely new level. They are no longer just the lender of last resort – they have become the bailout mechanism of the capitalist system and ultimately a plaque build-up in a system that is increasingly unhealthy"

The outrage and the condemnation stem from the moral hazard of the situation of QE1, where Main Street had to step in to bail out Wall Street.

Cullen concludes his excellent post with the following comment:

"What these men haven’t stopped to ponder is whether any of this intervention was actually healthy for the markets. Perhaps the market crashed in 1987 because an irrational 40% climb in 8 months had created instability? Perhaps the Nasdaq never should have approached 5,000? Perhaps LTCM needed to fail? Perhaps housing was never intended to be a speculative asset? Perhaps these assets needed to be allowed to decline? The result has been a slow deterioration in the foundation of the system with each and every bailout."

Should the role of the Fed and its Central bankers be extended to preventing bubbles? Clearly some Central Bankers in other part of the world, think so. At least this is what the Central Bank of Canada has been following which meant that went the crisis occurred, they were in a better situation to face the financial carnage we witnessed. The Canadian Central Bank approach is highligthed in my previous post. Mark Carney, Governor of the Bank of Canada is right : "selected use of macro-prudential measures" are needed as a third line of defense in Central Banks policies, meaning deploying counter-cyclical capital buffers to lean against excess credit creation.

In the case of QE2, fear is justified, Bernanke has crossed the Rubicon.
When the Fed is starting to lend money to the US government, meaning no sterilization of the purchase of US treasuries, it is in fact money printing, let's be very clear about that. QE2 was not necessary and is very dangerous.

Paul Mortimer-Lee of BNP Paribas, in an article called "The night they killed Santa", commented in this article following Bernanke's television appearance that
"Until Tuesday, I believed QE2 was a monetary policy play designed to facilitate lower yields and avoid the threat of disinflation. Now it looks like the nice man with the white beard was just there to fund a fiscal expansion."

This is the greatest of moral hazard, when the central bank starts lending money to the US government. Is that what QE2 is all about?

Mortimer-Lee adds:
"Belief in the US as a pillar of stability has gone. We have written before about how the Fed's ultra-lax monetary policy is threatening the US dollar's role in the international monetary system. This week we saw any pretence of fiscal probity dumped."

He concluded his note with the following comment:
"Tuesday night was when I stopped believing in Ben Bernanke. I feel a bit foolish for having been gullible for so long, but a bit sad too."

"The night they killed Santa"

"One myth that's out there is that what we're doing is printing money. We're not printing money. The amount of currency in circulation is not changing." Federal Reserve chairman Ben Bernanke, December 5, 2010.

In relation to Ben Bernanke's public intervention, the excellent Doug Noland commented in Asia Times in his weekly Credit Market Bulletin following Ben's intervention on television in December:

Bernanke was pilloried last week for his "we're not printing" comment from Sunday evening's 60 Minutes interview. I'll pile on, but from a different angle. It seems strange to me - perhaps disingenuous - for our Fed chairman to suddenly take such a narrow view of "money".

At US$917 billion, outstanding currency comprises just over 10% of the "M2" monetary aggregate (savings deposits are the largest component at $5.343 trillion). And I have argued over the years that "M2" is a much too narrow definition of "money" to provide a useful barometer of overall credit and liquidity conditions. Certainly, the expansion of paper currency has been inconsequential to the grand scheme of Washington stimulus.

In the "old days", the banking system dominated system credit creation. Bank lending was integral to credit growth, with new bank deposits created through the process of expanding bank loans. "M2" provided a good indication of bank lending - that was a decent indicator of overall credit conditions. As such, the Fed reigned supreme over the credit mechanism through its careful regulation of bank reserves. Rather mechanically, our central bank would add reserves - the fodder for new bank loans - when it sought a boost in lending. It would extract reserves when it preferred to lean against the wind. Bank deposits were the critical component of "money" supply, and our central bank judiciously monitored their expansion.

The financial world - certainly including monetary management - was turned upside down with the unleashing of (unconstrained) non-bank credit instruments. No longer did the banks dominate system credit creation. In a process that gained fateful momentum throughout the 1990s, the bank loan was relegated to second-class citizen in the age of the booming Wall Street securitization marketplace. Meanwhile, the Fed's entire process of manipulating bank reserves became moot. Fed policy immediately gravitated toward manipulating the securities markets, and Bernanke's predecessor at the Fed, Alan Greenspan - "The Maestro" - absolutely relished his new "activist" role.

I have defined contemporary "money" as the most precious of credit instruments. "Money" is as "money" does. The great Austrian economist Ludwig von Mises recognized the crucial monetary role played by "fiduciary media" that had the economic functionality of a more narrowly defined stock of money. Especially with the advent of non-bank credit, the definition of what might operate as "money" in the markets and real economy had to be broadened significantly. The greater the boom in marketable debt instruments the more paramount the role of market perceptions in determining the stability of our financial markets and real economy.

Over the years, I have explored the concept of the "moneyness of credit." Moneyness is driven by the marketplace's perception of safety and liquidity. Generally speaking, "money" is a debt instrument perceived as a highly liquid store of nominal value. Money has always enjoyed a special role and, hence, unique demand characteristics: folks simply can't get enough of it, which nurtures a propensity to create it in overabundance. Money operates with its own problematic supply and demand dynamics, and never has moneyness enjoyed such capacity to wreak global havoc as it does today. With all their good intentions, central bankers are nonetheless at the root of the problem.

The Fed may not be running the currency printing press around the clock, but Fed policies have certainly been instrumental to the unending expansion of Treasury borrowings. And, clearly, any meaningful definition of contemporary "money" must include government debt instruments. Indeed, with bank (and, more generally, private-sector) credit suffering from post-housing mania stagnation, never before has government debt so dominated system "money" and credit creation.

Importantly, the Federal Reserve's zero-rate policy and massive monetization program have been instrumental in maintaining the perception of "moneyness" in the face of unprecedented Treasury debt issuance. I can't envisage a more powerful bubble dynamic: the Fed intervenes and manipulates the Treasury market - the predominant debt market underpinning fixed income and securities markets more generally. Enormous fiscal stimulus then works to stabilize system incomes, corporate cash flows, state & local tax receipts, and asset prices more generally. In the final analysis, trillions of dollars of government-created purchasing power ensure that a structurally maladjusted US economy has, at the minimum, the appearance of viability - and the stock market booms.

The Fed may not be "printing", but its operations as "backstop bid" are fundamental to the US and global government finance bubbles. In a replay of how "backstop bid" of mortgage guarantors Fannie Mae and Freddie Mac, the Fed and the US Treasury created the "moneyness of credit" for mortgages and related securitizations, the Fed's quantitative easing program distorts market perceptions of various risks (credit, interest rate, liquidity and systemic) and promotes over-issuance. From this perspective, our central bank's operations are more dangerous than the traditional printing press.

"Moneyness" was fundamental to the doubling of mortgage debt in just about six years during the mortgage finance bubble. Over time, the expanding gulf between market perceptions of moneyness and the true underlying state of mortgage credit ensured a crisis of confidence. Moreover, the trillions of additional mortgage credit had played havoc with spending and investing patterns and, increasingly over time, the underlying economic structure. These days, the attribute of "moneyness" in Treasury debt is on track to ensure the doubling of federal borrowings in the neighborhood of four years. For this round, the "expanding gulf" is much more pernicious and the consequences of a crisis of confidence potentially more devastating.

Money has throughout history demonstrated its dangerous side. Abuse money and "moneyness" at your own peril - although this fundamental lesson is invariably unlearned given enough time (and the seductiveness of monetary booms). The fiascos are always a little different, inevitably created by clever new wrinkles in the many faces of "money" and credit.

We are in the midst of another sordid episode. John Law's experimentation with paper "money" in France ended with the spectacular bursting of the Mississippi Bubble in 1720. Today's backdrop is much more complex: the Fed and global central bankers are working diligently to control an experiment in electronic "money" and credit gone terribly awry.

If it were only the printing press, it would be easier to appreciate what was developing and how to administer some restraint. Instead, the Fed has banked everything on its capacity to inflate marketplace liquidity, sustain massive government debt issuance, and maintain market perceptions of moneyness."

Where Doug makes his point is the role played by the Fed in maintaining what he calls "moneyness". The Fed acts as a backstop bid as well as maintaining perception of value. In fact, what he means I think is that the game of the Fed is to maintain perception of value by inflating assets prices through QE, moneyness being the perception of safety.

The point he makes and we all know that, the Fed is great at creating bubbles after bubble and QE is already creating the seeds for another one. It will end up in tears.

Gold will therefore continue its meteoric rise, supported by the misguided QE2 policy. Oil got my attention when it was recently trading at 75 USD in October. I am not surprised we are getting closer again to the 100 USD level. I think we will reach 100 USD in early 2011.

Oil in 2010:

Also at the current level of VIX, buying insurance for a market correction is once again cheap, and as in April, before the May sell-off, I wrote it was the right time to buy some protection. Again this time around, I think it is a good time to start buying some protection for some downside risk in early 2011.

Facts on current vols levels:
-EuroStoxx 50 is at the lowest level in the last four years. One month Implicit Vol was on the 15th of December at 17.3%, the lowest point was 6th of April 2010 at 15.5%, we know what happened in May... Implicit Vol 1 year was at 22.8% on the 15th of December.
-V2X has never drop as fast as it did between the 5th and the 15th of December since 2004. 19.7% as of the 15th of December, lowest point in 2010 was 19.8% on the 26th of March 2010. This is the lowest point since 30th of May 2008. V2X was at 31.1% on the 30th of November 2010 as a reminder.

Merry Christmas to all!

Martin T.

PS: Happy Birthday to my blog, it has been more than a year now and it is well alive and kicking. I would like to thank all my friends who have provided me with reports and some Bloomberg specific graphs which have helped me to illustrate my point of view. Please don't hesitate to comment on the posts to make this blog more interactive.