Macro and Credit - The Sokal affair

"Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things." -  Isaac Newton

Looking at the recently released minutes of the Fed's latest FOMC and its dovish impact on the US dollar in conjunction with the new US administration war of words, not only validating our solitary contrarian stance so far against the US dollar bullish crowd but, as well rewarding us for our late December gold/gold miners positioning, made us reminder for our chosen title analogy the Sokal affair, 

Given our fondness in recent musings in anything relating to hoaxes, the Sokal affair, also called Sokal hoax, was a publishing hoax perpetrated by Alan Sokal, a physics professor at New York University and University College London. In 1996, he submitted an article to Social Text, an academic journal of postmodern cultural studies, to test the intellectual rigor and, specifically to investigate weather "a leading North American journal of cultural studies - whose editorial collective includes such luminaries as Fredric Jameson and Andrew Ross – [would] publish an article liberally salted with nonsense if (a) it sounded good and (b) it flattered the editors' ideological preconceptions". The article, "Transgressing the Boundaries: Towards a Transformative Hermeneutics of Quantum Gravity", was published in the Social Text spring/summer 1996 "Science Wars" issue. It proposed that quantum gravity is a social and linguistic construct. At that time, the journal did not practice academic peer review and it did not submit the article for outside expert review by a physicist.  On the day of its publication in May 1996, Sokal revealed in Lingua Franca that the article was a hoax, identifying it as "a pastiche of left-wing cant, fawning references, grandiose quotations, and outright nonsense ... structured around the silliest quotations [by postmodernist academics] he could find about mathematics and physics."

The hoax sparked a debate about the scholarly merit of "humanistic commentary" about the physical sciences; the influence of postmodern philosophy on social disciplines in general; academic ethics, including whether Sokal was wrong to deceive the editors and readers of Social Text; and whether Social Text had exercised appropriate intellectual rigor. In response to the heavy criticism received by the editors of Social Text, Sokal said that their response illustrated the problem he highlighted. Social Text, as an academic journal, published the article not because it was faithful, true, and accurate to its subject, but because an "Academic Authority" had written it and because of the appearance of the obscure writing:

"My goal isn't to defend science from the barbarian hordes of lit crit (we'll survive just fine, thank you), but to defend the Left from a trendy segment of itself. ... There are hundreds of important political and economic issues surrounding science and technology. Sociology of science, at its best, has done much to clarify these issues. But sloppy sociology, like sloppy science, is useless, or even counterproductive."

You are probably asking yourself once again, where we are going with this analogy of ours, but, it appears to us that the Fed, and other central bankers, are "making it up" as they go along. Given most of them are "Academic Authorities", so, when it comes to the Fed's FOMC latest statement we reminded ourselves of the "wise" words of former Fed supremo Alan Greenspan:

"I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant"

In similar fashion, in relation to our central bankers and their hoaxes, sloppy economics beliefs based on sloppy "science" is useless, even counterproductive to paraphrase Sokal.  On that very subject we recommend you read John Mauldin's recent article "Post-Real Economics". 

As one of our loyal readers "kertch" commented in our recent musing "The Woozle effect" on Seeking Alpha, more and more "Academic Authorities" in central banks are indeed making claims that are entirely contrary to the basic principles of economics:

"Wozzle is a much more specific and descriptive term. It was revealed recently that the entire decades-long crusade against saturated fat was based on a Wozzle and has no basis in fact. I also now see economists make claims that are entirely contrary to the basic principles of economics. When will we see scientists make claims that are entirely contrary to the laws of physics? (Actually that has already begun - don't get me started!) It seems that the principles of logic and mathematics (statistics) that apply to basic research have become irrelevant relics of another time and social paradigm. Scientific method in our culture is badly in need of a Renaissance."

By now you probably understand where we are going with our Sokal affair analogy given that the same "Academic Authorities" which are at the helm of central banks are less and less challenged in their economic assertions by the Mainstream Media (MSM). Furthermore, on our recent musing "The Ultimatum game", same reader "kertch" made some very interesting points in relation to principles of economics and scientific rigor that is badly lacking in economics nowadays:

"I think once again economists have jumped to the same mistaken cause/effect conclusions with the idea of "Aging Nations Like Low Prices Over High Incomes" as they did with the Phillips Curve. They go on to link the phenomenon to a decreased demand for durable goods and property. I have seen no evidence of this in countries with an aging population. In fact the opposite appears to be the case. First, it is premature to conclude that demographics is the culprit. It is more likely that economic development drives demographic trends and the accumulation of capital assets, as every nation that has achieved a high level of economic development develops almost the exact same trends. Perhaps when economists stop seeing the economy as some rigid machine where moving a lever causes a knob to turn, and turning the knob causes said lever to move, they will start paying attention to cause and effect, and asymmetric, non-reversable functions. As I've said before, it's a field were logical and scientific rigor is sadly lacking."

Exactly, in similar fashion, one could argue that Thomas Piketty much vaunted book "Capital in the Twenty-First Century", lack logical and scientific rigor but we would be rambling again in that instance...

In this week's conversation, we will look again at what the rise of protectionism entails in terms of allocation and risk and why so far we think our solitary contrarian stance (short US dollar, long gold/gold miners, long volatility) and defensive stance has more to run.

Synopsis:

• Macro and Credit - Trump told you so folks
• Final charts - Deglobalize me

• Macro and Credit - Trump told you so folks

In recent musings we have delved into the "optimism bias" of the "consensus crowd" being long the US dollar, long oil, short volatility, short US Treasury notes to name a few. We have argued we were not "buying" it, hence us playing the "devil's advocate" or as some left wing pundits would argue the "Trump advocate". 

As reality settles in given "Mack the Knife" aka King Dollar + positive real US interest rates is year to date down 4% and our gold mining stance up around 16% (GDX) as we type, we think it is high time you reconsider the risk of trade war escalation and what it entails for a variety of asset classes.

On the rising risk posed by US protectionism we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 2nd of February entitled "Playing with fire - the FX implications of US trade protection":

"He told us so

What if Trump does what he has said on trade policies? The so-called Trump trades, and particularly the USD, have seen a correction this year, as President Trump’s rhetoric has shifted toward trade protection. Our baseline assumes the US will avoid such policies, but we also see risks and markets could get more concerned in any case. This is consistent with a volatile but still upward USD trend. However, it is worth discussing the possible market reaction to potential US trade protection and how to hedge. This is just a first look, as a lot would depend on policy details and the potential reaction of the rest of the world.

We recommend hedges that could do well even in our baseline scenario of no trade protection. We consider three main scenarios of de-globalization: higher US trade protection; a global trade war; and a major repatriation of flows. Our analysis suggests that JPY, USD, and NOK would benefit in most cases, particularly against AUD, CAD, MXN and KRW—USD/JPY would weaken. However, for investors who do not expect such extreme scenarios but would still like to hedge their long Trump trades, our analysis supports being long the USD against AUD and CAD in G10, and against KRW in EM.

Trade protection and the Trump trades

The so called Trump trades, and particularly the long USD trade, have seen a correction this year. This is to a large extent because President Trump has gone back to his tough pre-election rhetoric against free trade. In one of his numerous recent tweets on the subject, he warned that “car companies and others, if they want to do business in our country, have to start making things here again. WIN!” In his inaugural speech, he said "we will follow two simple rules: buy America and hire America," adding "protection will lead to great prosperity and strength." This week, Trump and members of his administration accused Germany and Japan of manipulating their currencies to keep them weak. Indeed, the market correction started after President Trump’s first press conference after the elections, on 11 January, where he used strong rhetoric against US companies that invest abroad and then export to the US. This contrasts with his speech after he won the November elections, when he focused on fiscal stimulus and other market-friendly policies.

Our view is that the market is still pricing a benign scenario, in which the new US administration delivers fiscal stimulus and deregulation, but does not go ahead with trade protection. The market remains long the USD, despite the recent adjustment. The VIX index is at historically low levels, despite its latest increase. Global equities remain at historical highs, even after its correction this week. EM FX has been somewhat volatile, but without a clear trend this year. If anything, our flows reflect some buying in EM FX.

This is consistent with our baseline as well, but we do see risks. We have been arguing that the balance between fiscal stimulus and trade protection in the first 100 days of the Trump administration will determine the outlook of the Trump trades and of the USD. We remain constructive on the USD, as we expect President Trump to deliver on fiscal policy and not turn to trade protection. However, even in this scenario, we do not expect a substantial further USD rally, as the USD is already strong and the US government would also push against an excessively strong USD. Moreover, we have been flagging high uncertainties, as we are increasingly concerned about the strong rhetoric against free trade and free FDI coming from the US. Our baseline expects a volatile USD path upward. USD bulls should be more tactical, in our view.

In this context, we discuss which of the G10 and major EM currencies could be at risk in a scenario where we are wrong and President Trump does what he has said on trade policy and increases protection. Of course, a lot would depend on the details and on how the rest of the world reacts in this case. This is a first and very basic approximation but one that can provide insights even for a scenario in which the US does not increase trade protection but markets get more concerned about such a risk.

“What-if” scenarios of trade protection

Global trade is already on a declining trend. Following an almost smooth upward trend in recent decades, the share of global trade to GDP is now below what it was 10 years ago (Chart 1). After a V-shaped move following the global crisis, it has been falling recently.

This is a concern, as empirical evidence suggests international trade and economic growth reinforce each other. A move toward trade protection in the US could lead to a further decline in global trade, making everyone worse off.

Focusing on US trade policies, trade protection would hurt Mexico and Canada the most. China and the Eurozone export more to the US (Chart 2).

However, as a share of their GDP, Mexico and Canada stand out (Chart 3).

We believe MXN already reflects Trump policy risks, but we have been arguing that CAD underestimates such risks.

If we consider a very adverse scenario, in which protectionist trade policies in the US potentially trigger a global trade war, KRW, MXN and CAD could be affected the most.
• Looking at openness to trade as defined by the share of total exports and imports to GDP, the countries most vulnerable to a potential pull-back of global trade include Hungary, Czech Republic, Switzerland, Korea, Poland, Sweden and the Euro zone (Chart 4).

However, most of the European trade is intra-regional and it is safe to assume that protection within Europe will not increase—the region could still suffer if global supply chains get significantly disrupted. Excluding Europe, Mexico and Canada also stand out.
• Looking at the FDI net inflows as a share to GDP, the countries that will be affected the most by a pull-back include Switzerland, the Euro zone, Hungary, Brazil, Australia, Canada and the Czech Republic (Chart 5).

• Combining these two measures, this analysis will suggest negative risks for CAD, MXN and KRW, particularly against USD and JPY (Chart 6).

HUF, CZK, CHF, PLN, and EUR could also be at risk if global protectionism affects European exporters—our CEE baseline is bullish, as these currencies are undervalued and will benefit from a hiking cycle.

Considering an even worse scenario, in which trade protection triggers a repatriation of flows, Norway, Switzerland and Japan would receive most of it as a share of their GDP (Chart 7).

These are the economies with the largest net international investment positions relative to GDP by far. We would therefore expect NOK, CHF and JPY to appreciate in such a scenario, particularly against NZD, AUD, MXN and TRY.

Bottom line

Putting everything together, our analysis suggests investors who would like to hedge a tail risk scenario of a move away from globalization and toward trade protection should be long JPY, USD, and NOK against AUD, CAD, MXN and KRW. USD/JPY would also weaken in this case.

As the scenarios we have considered are extreme and mostly tail risks, we would prefer to focus on hedges that can do well even if these risks do not materialize and the USD rally continues. In this context, we would be long the USD against AUD and CAD in G10 and against KRW in EM. We remain constructive in CEE and we would avoid shorting MXN, as it could do well in a free-trade scenario." - source Bank of America Merrill Lynch

Obviously our contrarian stance sits opposite to Bank of America Merrill Lynch's baseline scenario and the "optimism bias" of the long US dollar "herd mentality". In prolongation to what we posited in our last missive, we would tend to agree with their tail risk scenario, in the sense that the dislocation in volatility between EURJPY versus USDJPY has been at the cheapest levels relatively in past decade as indicated by Bank of America Merrill Lynch previously quoted FX Vol trader note entitled "USD vols are relatively overvalued". Regardless of the Fed's monthly FOMC "Sokal" hoax, we tend to focus on what is "cheap" from a "relative basis" perspective to what is "crowded" such as long US dollar from a positioning perspective. As we pointed out last week:

"If indeed the current account balance in the US deteriorates, then the US dollar should weaken as it generally happens in the late stage of a 10 year credit cycle, hence our contrarian stance versus the bullish US dollar crowd. The credit cycle is therefore deterministic we think" - source Macronomics, January 2017.

While at this juncture, FX wise we have recommended going against the dollar bullish consensus, in relation to the "Big Short" aka the short US Treasury speculative short positioning, we have yet to fall meaningfully enticed to the other side for the time being, at least until we see the Japanese GPIF, Lifers and others coming back to play in size, but obviously this is depending on some adjustment in the currency basis.

Moving on to "credit", as we pointed out in last week's final chart, it seems to us that currently High Yield is indeed "priced for perfection". As we indicated, we will be tracking very closely what credit spreads will do in the coming weeks. Yet, flows remain supportive for now and so does the shape of the CDX High Yield CDS index, a proxy for High Yield in the derivatives space. As pointed out by Bank of America Merrill Lynch in their Follow The Flow note from the 3rd of January entitled "So far so good...inflows across the board", investors have continued playing the "beta" game:

"YTD flows – inflows across the board

So far this year, amid a rising rates environment, investors have favoured higher yielding pockets of the fixed income world. Both EM debt and HY funds recorded strong inflows YTD. However, the ECB QE backdrop remains positive for IG and government bond funds; at least for now. Equities have started on the positive territory, but the pace is still slow (Chart 1).

Over the past week…

High grade funds continued on a positive trend for the second week in a row. However the flows trend remains below what we have seen before tapering fears emerged. High yield funds saw inflows for the ninth consecutive week, and the asset class has accumulated more than $4bn of inflows since the start of the year. However, looking into the domicile breakdown, as Chart 13 shows, the inflow last week came only from US domiciled and globally-focused funds, while the European-focused funds inflows were very marginal.

Government bond funds had their second week of outflows amid rising rates; albeit very small. Money market funds weekly flows were negative for the third week in a row, while the outflow trend is strengthening. Overall, fixed income funds recorded a strong week of inflows, the highest in 27 weeks and the sixth positive in a row.
European equity funds flows were positive for a second week showing signs of moderate strengthening. Last week’s inflow was the highest in 11 weeks. However note that this pace is much slower than the inflows strength seen during 2015.

Global EM debt fund flows flipped back to positive territory after a brief week of outflows. Last week’s inflow was also the strongest in four weeks. Dollar weakness has been beneficial for the sector. Commodities funds flow remained positive for a third week in a row, but the inflow pace has slowed down.

On the duration front, inflows continued in short-term IG funds for the seventh week in a row. However the pace of the inflows has slowed down notably over the past weeks. Mid-term funds’ large outflow couple of weeks ago was partially reversed recording the biggest inflow in 13 weeks. On the other hand, flows into long-term funds remained downbeat recording an outflow for a second week." - source Bank of America Merrill Lynch

It is no surprise to see, credit investors playing "defense" and rotating into shorter duration funds given that last year, during the second part they had increased both credit risk and duration risk as well. As we mentioned earlier, we are very wary about Japanese flows and appetite for foreign bonds which have been dwindling as of late following a record 2016 take up. Data from Japan’s Ministry of Finance confirmed this week that Japanese investors sold around ¥1.3 trillion ($11.54 billion) in foreign bonds between Jan. 21 and Jan. 28, taking net sales for the last 12 weeks to over ¥3.7 trillion, the largest amount since April 2014 according to the Wall Street Journal. This is as well confirmed by the latest Nomura JPY Flow Monitor note from the 2nd of February 2017:

"MOF international weekly capital flow data (22 - 28 Jan)

Japanese investors were net sellers of foreign bonds again last week for the second week in a row. The net selling accelerated to JPY1359bn ($11.9bn) from the previous week (JPY538bn), recording the biggest net selling since March 2016.

Uncertainty on the US policy stance remains high, while US yields have been rising again since mid- January, which has likely discouraged Japanese investors from increasing their foreign bond investment for now. Seasonally, foreign bond investment by insurance companies tends to slow in Q1 too, as the fiscal year-end approaches. January foreign portfolio investment by investor type data are scheduled next Wednesday, which will show the major contributors to the relatively large net selling of foreign bonds last week.

Japanese investors resumed their purchases of foreign equities for the first time in two weeks. They bought JPY125bn ($1.1bn) of foreign equities last week. This suggests the underlying Japanese appetite for foreign assets remains strong, although they had been large net sellers of foreign bonds over the past two weeks.

Foreign investors continued selling Japanese equities for the second week in a row (JPY144bn or $1.3bn), although the pace slowed from the previous week (JPY376bn). Their fixed income investment was mixed, purchasing long-term Japanese bonds (JPY446bn or $3.9bn) while selling short-term bonds (JPY586bn or $5.1bn)." - source Nomura

This could have serious implications should this trend continue. It represents not only a headwind for immediate further compression on US Treasuries yield, but, as well, it is adding pressure on the US dollar and could as well generate, contrary to what is expected by many, a rebound in the Euro in short order.
Furthermore, when rates move up, while it can be even more supportive for Euro High Yield, it represents a significant headwind for already expensive European Investment Grade thanks to the convexity factor credit wise. In conjunction with rising inflation, it is in short a bad recipe. This is clearly explained by Bank of America Merrill Lynch in their Credit Derivatives Strategist note from the 1st of February entitled "When rates move up":

"Rising rates are supportive for high yield credit

Fixed income investors embrace higher yielding (with same quality/rating) instruments when rates decline. This has been the case over the past decade as flows into high grade funds were accelerating vs flows into govies. We find that there is a strong correlation between the rates trajectory vs. the flows differential between high-grade and government bond funds. We also find that flows tend to exhibit a “barbelling” trend, when rates advance, and vice-versa. Amid a rising rates backdrop, we see that the balance of flows in the fixed income market will likely favour high yield and govies more than flows into high grade funds.
High yield credit tends to beta-outperform its high grade counterpart in a rising rates environment. We prefer to be long European high yield via synthetics more than via cash bonds, post the recent underperformance of Crossover.

Rising peripheral risks are under-priced in credit

European credit spreads have always been well correlated to peripheral risks (chart 1). The recent move higher in BTPs vs Bunds has not been unprecedented; it has been experienced before the PSPP-era, but also briefly in late November 2016. The common ground in both cases was that credit spreads were a lot wider. Even compared to last November levels, credit spreads were ~10bp wider, when Italian 10y yields were at the wides vs Germany. We feel that the move in rates is under-priced in credit spreads at these levels. This is also taking place as Greek government bond yields are rising again over the past couple of days.

Rising rates and credit performance

The world economy is in sync mode. Global QE across the Fed, ECB, BoJ and BoE, have resulted in a well synchronised rebound in economic data. Surprise indicators are also pointing to the strongest rebound globally. The reflation trade is strong across Europe and US with rates moving higher. The global QE is reaching “peak strength” this quarter. However, the reflation knock on effect is ultimately negative for credit, according to our analysis. Credit spreads tend to react negatively in periods of rising inflation. Fund flows are also pointing to the downside, as higher rates hit high-grade fund flows more than flows into government bond funds and high-yield debt. Barbelling your portfolio in risk-terms can be the solution. High yield credit tends to beta-outperform its high grade counterpart.

Can a policy mistake be the driver of a trend shift?

Inflation is picking up; but unfortunately it is not the core inflation trajectory that is trending higher. Headline inflation is picking up over the past months on the back of higher commodity, and more importantly oil prices. As our economics team has been highlighting this is the “bad” inflation that is decoupling and surprising to the upside. Low and sticky nominal wage growth means that purchasing of consumers suffers again very soon; and populism continues to rise. 

The recent ECB meeting highlights the discrepancy between a very dovish message and a hawkish monetary policy (QE tapering from April), we think. Should headline inflation keep trending higher on the back of higher energy prices; we see higher risks of another policy mistake.

The credit market has historically been very well correlated to inflation trends.
• In chart 7, we find that the year-on-year changes in core inflation across Eurozone countries and the year-on-year changes in iTraxx Main non-fins 5y spreads are well synchronized. This has been the case especially in the period since the GFC were the central banks started unleashing their quantitative easing programmes.

• The same stands for headline inflation trends. However, should one look at the trend of headline inflation, there is a clear decoupling over the past year from that of credit spreads (chart 8).

 

It is notable that the credit market is still focusing on core rather than headline inflation. But at current levels, we fear that a policy mistake, like the one of the forthcoming April tapering decision, will ultimately be negatively received by credit investors.

Credit is mispricing the current headline inflation pick up

Chart 8 is depicting the decoupling between inflation and credit spreads trajectories.

To normalise these moves we employ a z-score analysis, presented in chart 9.

We find that the current “richness” of credit spreads trend vs. that of headline inflation is the highest it has been in almost a decade.

Looking back in times when this dislocation - between credit spreads and HICP - has been that strong, we find that the future credit market performance was not that positive. The previous peaks in “richness” have been in October-07, March-10 and March-11, as per chart 10. Remember that subsequently post reaching these peaks, credit spreads have always moved wider over the following months.

Downside risks on credit flows as rates move higher

The forthcoming “peak” of the QE positive backdrop is not our only source of concern. Fund flows into high-grade funds are negatively impacted amid a rising rates environment too. In our analysis we find that the higher the yield one can source from the government bond market - deemed as “risk free” - the lower the need to hunt for “quality yield” via the IG credit market.

We compare cumulative flows trends in high-grade and government bond funds vs. the level of “risk-free” rates. For the fund flows we use EPFR data as per our weekly Follow the Flow publication, and we use the 5y bunds generic yield to track the trends in the European rates market.

Historical evidence shows that:

• Fixed income investors embrace higher yielding (with same quality/rating) instruments when rates decline. This has been the case over the past decade according to our analysis (chart 11).

Note that there is a strong leading indication (6 months) of the rates trajectory vs. the flows differential between high-grade and government bond funds (in relative terms, % of AUM).

• There is a critical level in the rates market that prompts a shift into “quality yield” (i.e. high-grade credit) we think. This force kicks in when 5y bunds dip below the 1% handle (chart 12) it seems.

At the end of 2011, at the heights of the sovereign crisis, the lack of yield in the “risk-free” market (i.e. bunds) and the subsequent OMT moment, six months later, prompted a strong reach for “quality yield” and inflows accelerated into IG bond funds. We are still far from that level, but the trend is clear from here.

The solution to higher rates = barbell your portfolio

In 2016 we saw the lowest in yields and spreads. We doubt that we will see these levels again, especially post the recent strengthening of economic data across the globe. We expect that as rates will continue higher from here in the years to come (more in the latest Global Rates weekly) this will have a strong effect on flows across fixed income pockets. We think that flows  into govies and HY credit funds will fare better than flows into high-grade ones." - source Bank of America Merrill Lynch.

While both the Fed and the ECB might continue with their Sokal hoaxes, it appears to us that the recent shift from investors towards shorter duration is clearly a manifestation of a defensive stance, which could be further validated by the weakness in the support from overseas investors such as Japanese investors. Where we slightly disagree with Bank of America Merrill Lynch's take is that, if indeed there is some short term correction in equities, it is hard for us to expect that a move wider in European High Yield could be avoided thanks to its inherent strong correlation to stock movements. Though, from a convexity perspective, High Yield should be less immune than Investment Grade with rising sovereign yields, should equities remain stable in the coming weeks.

As a reminder from our August 2013 conversation "Alive and Kicking":

"Moving on to the subject of convexity and bonds, how does one go in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":

"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

Convexity measures how duration changes as yields change. For a positively convex bond, the duration increases as the yield declines, and decreases as the yield rises. Positive convexity means that the price increase for a given decline in yields is greater than the price decrease for the same rise in yields. Non-callable bonds are positively-convex. Bonds with traditional call options, such as preferreds, and mortgage-backed securities, or some specific callable high yield notes are generally negatively convex. If you expect yields to rise, you should avoid bonds with long duration, such as those with longer maturities and lower coupons, and favor bonds that have shorter duration and higher yields. In periods were you can expect higher volatility in yields, you should avoid low or negative convexity bonds such as callable bonds in the High Yield space.

The downside protection offered by the CDS market as well as the better liquidity provided by the CDS market can indeed mitigate the damages.

Nota bene: Liquidity in the CDS market tends to be greatest at the 5 year point, making the 5 year single name CDS contract a more viable alternative than other CDS maturities.

Conclusion:

With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. 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... " - source Macronomics, August 2013

Therefore you now understand why Bank of America Merrill Lynch prefer to be long European high yield via synthetics more than via cash bonds, post the recent underperformance of Itraxx Crossover. We totally agree on this and it makes perfect sense.

Finally for our final chart, rising populism has gone hand in hand with protectionism (that 30s feeling we talked about...) hence renewed inflows into the "barbaric relic" aka gold which, we hinted, we had been adding since late December.

• Final charts - Deglobalize me

In numerous convcrsations we have mused around the rise of populism in conjunction with protectionism, which represents clearly a negative headwind for global trade and is therefore bullish gold. The rhetoric of the new US administration has gathered steam and there are already mounting pressure to that effect. Our final charts come from Bank of America Merrill Lynch from their European Credit Strategist note from the 2nd of February and entitled "Unwinding globalization". The first chart displays the eerie calm in the VIX index while gold inflows have been surging. The second chart shows the growing theme of protectionism in Developed Markets (DM):

"Unwinding Globalization

Protectionism has been the buzzword over the last few weeks, and much of the narrative has been emanating from the US. Since President Trump’s inauguration, executive orders have been signed to repeal free trade deals and to temporarily restrict certain forms of US immigration. Add to this the growing comments from the Republican administration around foreign countries’ weak currencies, and perhaps the post-Lehman vision of globalization has never felt more challenged. And as the rest of the world looks on, the risk of retaliatory protectionist rhetoric – or actions – grows.

While stocks and corporate bonds have rallied year-to-date, we see a very “incongruous” kind of calm in the markets at present. Note, that while equity volatility is still hovering around record lows, inflows into gold funds year-to-date in Europe have surged (chart 1).

In reality, the trends of protectionism – or “deglobalization” – have been bubbling for a while. Plenty of protectionist measures have in fact been put in place by countries around the world in the aftermath of the Global Financial Crisis – albeit ones not as dramatic as directly repealing free trade agreements. Rather than just tariffs and trade defense measures, governments appear to have become more imaginative in avoiding WTO disciplines. And over the last few years, more overt trade spats and protectionism have been seen (such as the EU’s and China’s issue over solar panels in 2013).

Chart 2 shows the countries that have implemented the most protectionist measures since 2005. Note that the US and the EU head the list. Moreover, the WTO’s trade monitor from June last year highlighted that for the 2015-2016 reporting period, trade restrictive measures had jumped to the highest monthly average on record.

Yet protectionism, in our view, is inherently inflationary in nature. As Chart 3 shows, just as globalization is being challenged by leaders, the world is more “connected” than ever at present.

Corporate supply chains have branched out across the globe over the last 10 years. And free movement of goods, services and labour have been an additional boon for corporate profit margins.

But if protectionism cuts back the tentacles of global supply chains – be it through higher tariffs, border checks or restricting worker migration – then corporates stand to be made less efficient via a rising cost base. Thus to preserve corporate margins, output prices will need to rise…" - source Bank of America Merrill Lynch

So, all in all, regardless of the Sokal monthly hoaxes from our central bankers, can you spell "stagflation"? Because we certainly can...

"Truth emerges more readily from error than from confusion." -  Francis Bacon

Stay tuned!

Credit - The Battle of Berezina

"The whole art of war consists of guessing at what is on the other side of the hill." - Arthur Wellesley, 1st Duke of Wellington

While monitoring the on-going onslaught in the commodity sphere with significant credit repercussions on Emerging Markets corporates and sovereigns spreads alike, marking the return of strong deflationary forces we think (particularly with the latest PBOC move on the Yuan and yes we are long US duration again...), we remembered for our chosen title analogy the Battle of Berezina which took place from the 26th to the 29th of November 1812 between the French army of Napoleon, retreating after his invasion of Russia and crossing the Berezina, and the Russian armies. During the course of the battle, the French suffered very heavy losses but managed to cross the river and avoid being trapped and annihilated. Since the famous battle, the name "Berezina" has been used in French as a synonym for "disaster". The unfolding commodity bloodbath appears to us as a "Berezina" and if the art of war consists of guessing what is on the other side of the hill, looking at credit in particular it spells a lot of trouble and potential defaults ahead of us, hence our title.

On a side note, looking at EUR/CHF heading toward its highest close in 5 months and the significant $50 bn losses for the first half of 2015 for the SNB, when it comes to our analogy, one has to remember that the four Swiss infantry regiments acted as a rearguard to enable Napoleon troops to cross the Berezina river (of the original 8000 men only 1300 were left by the time of the retreat). The Swiss, in similar fashion to today's SNB actions, suffered terrible losses and out of the four Swiss Regiments of Oudinot's corps, only 300 survived but, nevertheless, they managed to cover the retreat of Napoléon's invasion army. The Swiss heroic stand saved most of the French troops. We wonder if the latest SNB heroic stand saved most of the Euro's retreat but we ironize again...

In continuation to our previous conversation where we indicated that EM credit spreads and oil prices were highly correlated, this week we would like to further our analysis on the ripple effects the commodity market is having on credit as well as the growing discomforting and contagion risks at hand meaning that credit investors should not stay too long on the Berezina side of the CCC bucket or they might indeed face the same fate as the Swiss mercenaries at the famous battle of 1812...

Synopsis:

• Rating agencies oil related price downgrades and more credit troubles ahead in EM corporates land
• Is credit in earnest starting to see some significant headwinds?
• The immediate consequences of a Chinese "devaluation"
• Final chart: Divergence between US and China - How long can it last?

• Rating agencies oil related price downgrades and more credit troubles ahead in EM corporates land

While in our last conversation we discussed around the exposure of sovereigns and quasi sovereigns to the oil sector  which meant that their credit spreads have moved in conjunction with oil prices, that is wider for spreads, and lower in prices, the updated price assumptions with a significant cut at Moody's which could be followed by S&P could indeed mean trouble down the line, not only for the High Yield sector but as well for Investment Grade credit as described by Bank of America Merrill Lynch in their European Energy note from the 8th of August entitled "Moody's oil move spells potential trouble":

"Oil price assumptions cut at Moody’s; S&P could follow
Moody’s has reduced its base case Brent price assumptions to $55, $57 and $65 in 2015, 2016 and 2017 (from $60, $65 and $75, respectively) and WTI price assumptions to $50 and $52 for 2015 and 2016. Moody’s has also lowered its stress-case scenario oil price assumptions for both WTI, at $40/bbl, and Brent, at $45/bbl. The updated price assumptions represent baseline approximations Moody’s uses to analyse credit conditions of companies in a number of industries and oil exporting countries and are used to calculate future financial metrics. Most vulnerable on the back of this move, in our view, are: (1) OMV hybrids (Baa3 Stb); (2) Origin Energy (Origin) (Baa2 RfD) senior bonds and hybrids; and (3) Repsol’s (Baa2 Neg) senior bonds; hybrids and CDS. It remains to be seen if S&P will follow. This is possible and would be a particularly negative technical for Origin and Repsol, which are both rated ‘BBB-‘ at the agency." - source Bank of America Merrill Lynch.

While indeed these "high-beta" names and bonds are first in the line of this "repricing" oil exercise from the rating agencies, there has indeed been some additional ripple effects from the commodity meltdown to other sectors in the market such as peripheral Telecoms and financials having exposure to the likes of Brazil as indicated by Laurent Beruti on the Datagrapple blog on the 6th of August:

"Yesterday, TITIM’s ( Telecom Italia Spa ) Brazilian subsidiary reported weak results, mainly due to a tough macroeconomic environment. And with mobile penetration rates now over 138% in the country, competition for subscribers will only get tougher. That put TITIM’s 5 year risk premium under a bit of pressure, and it widened by 3bps to 145.5bps. But the real casualty was PORTEL (Portugal Telecom), as retail investors, who had arguably little understanding of the structure under which PORTEL bonds trade since Oi bought the company, are finally realising that they are not Portuguese risk but in fact Brazilian risk, and have been selling them over the last few sessions. TITIM’s results appear to have been the catalyst for more aggressive selling because of the poor outlook for Brazil in general and this drove the bonds 5 to 8pts lower and the 5 risk premium CDS 3.875pts higher to 11.13%." - source Datagrapple blog.

In the CDS space Spanish banks continue to underperform on the back of the ongoing weakness in Latin America.

Brazil is no doubt at the "Battle of Berezina" when one takes into account the latest PMI read from the 7th largest world economy. Brazil's PMI for services was down from 41.0 in June to 40.8 in July, the Brazil Composite Output Index is now at its lowest mark since March 2009. At the same time, Brazil's manufacturing activity contracted for the sixth time in July although at a slightly slower pace than in June: 47.2 in July from 46.5 in June. 

A good illustration of "Berezina" credit wise comes from Brazilian Steel Companies. The tough dynamics of the basic material meltdown continues to weigh heavily on the sector as illustrated by Bank of America Merrill Lynch Emerging Market Corporates note from the 5th of August entitled "Brazilian Steel Companies: The Storm Continues":

"Tough conditions for domestic steelmakers
Brazilian steelmakers continue to face tough dynamics in 2015. YTD (Jun-May), domestic demand is down -11% (flat -13% and long -8%). We believe flat steel demand could fall -15%+ and long steel demand -10%+ in the full year Continued collapse of domestic demand, increasing imports, a higher export mix (low margin), weak pricing (discounts of 5- 10%) and the erosion of EBITDA from iron ore sales have combined to drive leverage on the path to unsustainable levels. Results are also impacted by lower fixed cost dilution and higher energy costs. We expect these forces to persist in 2016. It appears that new equity is needed across the sector to reach sustainable leverage levels, and that debt covenants are at risk at Gerdau and Usiminas. We expect downgrades of credit ratings. We assume a sustainable net leverage level of 3.0x.
Needs are most substantial at CSN and then Gerdau. We estimate that CSN needs R$15.6bn of equity (three times its current market capitalization; 8/4/15 R$4.36/share); Gerdau R$2.8bn (30.6% of current market capitalization; 8/4/15 R$6.04/share), and Usiminas R$1.7bn (25.0% of current market capitalization; 8/4/15 R$4.17/share). Equity injections would be positive for bonds, but negative for stocks. However, we believe that they would be difficult to execute, particularly under the current sector environment and given the amounts required. We also think existing shareholders would be loath to issue such substantial amounts of equity due to the impact on share value and their ownership interest.
As a result, we remain negative on all three names and expect spreads to continue to widen as investors price in weaker results in 2H15, and a continued negative demand and pricing environment in 2016. Spread widening accelerated in mid-June and escalated in mid/late July with CSN’s bonds widening up to +557bp (to spreads as wide as +1,373bp; the CSN-19s), and Gerdau’s bonds widening up to +93bp (to spreads as wide as +617bp; the Gerdau perp’s). CSN has widened most at the short end (on heightened refinancing risk), while Gerdau has widened most at the long end.

We omit Usiminas’ bonds from our discussion as they are limited in size and liquidity. Our recent meetings with over 50 investors in the UK and Europe indicated that bearish sentiment is high and increasing.

Leverage and financial debt covenants
We currently forecast CSN to end 2015 with net leverage of 6.94x, and 7.36x at spot (versus forecast) iron ore prices. We forecast CSN’s net leverage to rise to 7.10x in 2016. We forecast Gerdau’s net leverage to be near flat at 3.61x in 2015 as the company generates cash (3.70x in 2016), and Usiminas’ net leverage to rise to 3.99x (4.45x in 2016). The companies have LTM1Q15 net leverage of: CSN 4.76x/5.51, Gerdau 3.69x and Usiminas 2.89x. While CSN has no leverage covenants, Gerdau has a net leverage covenant of 4.0x that applies to 22% of its debt. Usiminas has a net leverage covenant of 3.5x that applies to 80% of its debt (potentially in danger of breach as soon as 2Q15)." - source Bank of America Merrill Lynch

CSN has no leverage covenant, meaning, there is no limit to it and no warning sign either for the "macro tourist" carry players, who, we think should think about crossing rapidly the "Berezina" bridge or face "annihilation" à la Swiss mercenaries...

When it comes to CSN, the weakest player in the Brazilian Steel Company illustrations, we read with interest Bank of America Merrill Lynch's take, which, we think is illustrative of the "Private Equity" mentality of "maximizing" dividends regardless of the outcome for bondholders à la TXU Corp, a subject we touched in our January 2013 conversation "The return of LBOs - For whom the Dell tolls":

"The paroxysm of the mega-buyout deals of the period was Energy Future, formerly known as TXU Corp which was taken private by KKR and Co. for a cool 43 billion USD in 2007. The deal did not evolve favorably for bond holders given Energy Future is now seeking an extension of maturity for the portion of Texas Competitive's revolving loan that matures in 2013 (2.1 billion million USD of revolving credit facility used in total).  Energy Future Holdings is loaded with 37.4 billion USD worth of obligations whereas Texas Competitive is saddled with 32.2 billion USD in debt, 700 million USD of which is due in 2013, and with 2.7 billion USD in interest payment due in 2014 according to Bloomberg. 
KKR and Co., TPG Capital and Goldman Sachs Capital partners paid themselves 528.3 million USD in fees while TXU Corp is moving towards bankruptcy and restructuring." - source Macronomics, January 2013.

In their note, Bank of America Merrill Lynch clearly illustrate the similar mentality that prevails in the Brazilian Steel Industry:

"In addition, to deteriorating results, companies also have controlling shareholder demands that require dividends and share buybacks. Whereas, in the typical stress situation we would expect a company to eliminate dividends and share buybacks to conserve cash flow and control leverage, we expect these items to be a continued drain, especially at CSN, and to a lesser degree at Gerdau and Usiminas. (See BofAML’s equity report: Brazilian Steels: Controlling shareholders (and companies) need cash. What now? 27 July 2015.)
CSN: SH demands for dividends and share buybacks, cash and weaker results CSN’s controlling shareholder Benjamin Steinbruch (and family) indirectly owns 54.62% of CSN through holding companies. Holdco debt totals nearly R$3.0bn and is serviced primarily with cash flows (dividends) from CSN. Estimated interest expense on holdco debt is approximately R$400mn a year. As a result, holdco debt service pressures CSN to distribute approximately R$720mn in dividends to shareholders each year. We note that CSN paid R$1.67bn of dividends in 2013, R$425mn in 2014, and R$550mn in 1Q15, while results deteriorated and leverage increased. Dividend payouts by CSN have averaged over 70% of net income in the last 10 years.
A substantial portion of holdco debt has been collateralized with holdco-owned shares in CSN. As the value of CSN shares has diminished, lenders have required additional share collateral. This situation has compelled CSN to continue to use cash to execute share buybacks (thereby supporting CSN or collateral share value). Share buybacks totaled R$909mn in 2014 and R$9mn in 1Q15. Management has declined to give share buyback guidance for 2015.
Further the amount of cash reported by CSN in its press release, and which the company calculates net leverage includes cash at Namisa (its iron partnership with Japanese and Korean steel companies). The cash amount used by CSN in calculating net debt and net leverage is R$12.251bn. However, CSN’s balance sheet reports just R$9.071bn of cash, indicating CSN’s proportional share of R$3.180bn of cash at Namisa. CSN calculates net leverage of 4.76x (including the cash at Namisa). Using balance sheet cash, net leverage is 5.51x. The Namisa iron ore assets are planned to be merged with CSN’s iron ore assets by year-end. However, there is risk that substantial cash could be dividended out before the assets are merged. We note Steinbruch’s needs for dividends and share buybacks, as well as the potential that the Namisa partners may also want to withdraw some their proportionate cash.
In 2Q15, we forecast CSN’s EBITDA at R$836mn, up 7.6% QoQ (on better iron ore volumes and slightly better realized iron ore prices), but down -35.8% YoY. We expect FY EBITDA to fall -31.4% to R$3.245bn, and net leverage to increase from 4.48x in 2014 to 6.94x in 2015. Compare forecast 2015 EBITDA to LTM1Q15 interest expense of R$3.046bn and our expected capex of R$1.3bn. On top of these demands, we expect dividends and share buybacks.

Asset sales are also a potential source of cash (and debt pay down) for CSN. We estimate that CSN could realize R$5-7bn from potential asset sales: (1) its 17.5% interest in Usiminas (R$1.0bn), (2) SWT (a 1.1mn ton long steel plant located in Germany) (R$1.0-1.5bn), (3) its 1/3 interest in MRS Logistica (R$1.5-2.0bn), (4) Tecon (a container port terminal located in Santos, Brazil) (R$400-700mn), (5) Metail and Prada (metal packaging and distribution assets (R$250-500mn), and (6) non-core real estate (R$1.0bn). Asset sales could comprise 1/3 or more of potential equity needs in order to reduce leverage to sustainable levels but are not sufficient by themselves. Compare CSN’s equity requirements of R$15.6bn. We caution that CSN could be loath to sell assets at current valuations. Local sentiment in Brazil is that CSN is reluctant to sell assets and may favor a different strategy.
We note that CSN’s debt does not have any financial covenants. Management could pursue a strategy to maintain high cash liquidity and obtain sufficient credit facilities to repay or refinance debt maturities due in the next few to several years. It could secure those facilities (to the detriment of unsecured bondholders) to obtain lower interest rates and longer maturities. We think that this is likely an interest with federal or state banks. If CSN could successfully execute this strategy, leverage (and were bonds trade) could be more or less irrelevant to management in the next couple years." - source Bank of America Merrill Lynch

Can you spell default/restructuring for CSN? Because we can. This is going to be a "Berezina".

This is clearly illustrative of maximizing the dividends payout through leverage (without due covenants) à la TXU and will end up in tears in similar fashion. It is all about "greed" in the end using buyback and poor dividends strategies to maximize the payout for shareholders which in the end will be detrimental to bondholders.

When it comes to Brazil corporates, year to date 13 EM corporates including 6 from Brazil have "paid the piper" compared to only 3 in the first seven months of 2014 according to Bank of America Merrill's EM Corporate Monthly note from the 6th of August 2015 entitled "Between a rock and a hard place":

"Tonon’s default in July takes YTD total to 13
Brazil’s Tonon Bionergia defaulted in July after going through a distressed exchange of $300mn of unsecured notes due in 2020 for new unsecured notes. However, S&P upgraded Tonon to CCC- (from D) 4 days after the closure of the exchange offer, since the refinance achieved more than 95% of bondholder’s acceptance and most of the short term debt was refinanced. S&P now sees upside potential and relieved liquidity pressures in Tonon. The trailing 12 month EM HY default rate ended July at 3.7%, unchanged from the end of June.

YTD, 13 EM corporate issuers have defaulted, which compares to only 3 defaults in the first seven months of 2014. On a trailing 12mo basis, there have been 19 EM HY defaults. Regionally, LatAm accounts for 8 defaults (6 from Brazil alone), while there have been 6 defaults in EEMEA (4 from Ukraine) and 5 defaults in Asia (4 from China). The regional LTM HY default rates as of the end of July were: LatAm HY 4.6%; EEMEA HY 3.4%; Asia HY 3%." - source Bank of America Merrill Lynch

Brazil and Colombia HY were the worst performers in July particularly in the light of heightened downgrade risk on Brazil's sovereign rating on the back of very weak macro data. Whereas 1998 was all about "Asian risk", current tensions clearly shows that the on-going "tapering tantrum" and commodity rout is putting clearly more pressure on LatAm corporates (Energy sector, Materials, Real Estate). As a side note YTD EM HY outstanding corporate debt expanded by 30% due to massive migration from Investment Grade status to High Yield in Russia and Brazil when new supply is down by -43% y/y according to Bank of America Merrill Lynch's note:

"Of the 283 bonds downgraded YTD, 100 came from Russia, 75 came from Brazil, and 29 came from China (combined, 72% of all bonds downgraded YTD came from these 3 countries). There have been 10 upgrades in Russia YTD, 8 in Brazil, and 18 in China (43% of all bonds upgraded YTD)." - source Bank of America Merrill Lynch

When the trend, is not your friend, credit wise, that is...

This brings us to our next bullet point namely the increasing pressure from credit and not only from the previously mentioned CCC bucket, the "credit canary" mentioned in numerous conversations including our previous one.

• Is credit in earnest starting to see some significant headwinds?

We touched in July in our conversation "A Cadmean victory" on the recent underperformance of credit particularly in the Investment Grade space, with US underperforming Europe overall: 

"From a positioning perspective in an environment impacted by dwindling liquidity and rising "convexity" risk from both a duration and credit quality perspective, we believe in a defensive position in H2 on US investment Grade, meaning lower duration exposure in credit as well as higher credit quality. This brings us to our third point, namely that given the disappearance of interest rate buffers in the credit space, thanks to central banks "meddling" and "overmedication", investors have no choice but to take on more credit risk hence our credit "mousetrap" reference." - source Macronomics, July 2015.

What is interesting of course is that finally 2015 really is a story of the "Great Rotation" when it comes to the outperformance of equities relative to credit as displayed in Société Générale's Credit Strategy Weekly from the 31st of July 2015 highlighting the Total Return performance of equities versus credit:

"Total returns see mixed performance:

This is clearly the year of the European equity markets, which continue to dominate the total return performance table. This week, equities in Europe were a touch lower by Thursday and total returns were down from a week ago, although they remain well ahead of any other asset class (in local currency). US equities improved further but are well behind, and fixed income asset classes had a mixed performance, with most still struggling to get back into positive territory. The Euro IG market remains the laggard at -0.56%, although it has been outperforming its US counterpart recently." - source Société Générale.

But is there something rotten in the Kingdom of Credit one might rightly ask to paraphrase Shakespeare's Hamlet "Equities players" should pay attention to?

Flow wise, it seems that finally the "convexity" pain (namely over extended duration and credit risk investors) continues to bite as indicated by Bank of America Merrill Lynch in their Situation Room note from the 6th of August entitled "Outflows from duration and risk":

"Outflows from duration and risk. For the third week in a row mutual funds and ETFs reported outflows form risky asset classes such as stocks and high yield bonds. At the same time the flows for high grade last week were out of duration and into the frontend as the flows for long-term high grade funds turned negative while short-term funds swung to the largest inflow since November. Long-term high grade funds reported a $0.58bn outflow last week following a flat -$0.01bn reading the week before. More generally flows outside of short-term funds (which also include intermediate and total return funds) declined to +$0.37bn from +$0.92bn the week before. Short-term funds reported a $0.79bn inflow after a $0.54bn outflow in the prior week. This makes last week’s inflow the largest since the start of the fairly consistent outflows from short term funds outflows in December 2014.

The risky asset classes reporting outflows last week included stocks, high yield, loans and EM bonds. Outflows form stocks accelerated to $3.62bn from $2.64bn the week before, while outflows form high yield slowed down to $0.82bn last week from $1.31bn in the prior week. EM also funds continued to report outflows ($0.26bn last week and $0.39bn the week before), while leveraged loan funds turned to outflows (-$0.43bn) following a flat reading the week before (-$0.06bn). Muni funds remained muted with a $0.04bn inflow. The net result was a small $0.27bn outflow from the all fixed income category, which also includes government and mortgage funds. Finally, money market funds reported a $15.03bn inflow." - source Bank of America Merrill Lynch

Of course this should not come as a surprise to us, given that to avoid paying negative rates, investors have either taken more duration risk and/or more credit risk thanks to our "generous gamblers" policies aka our beloved central bankers and their omnipotent powers.

Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:

"In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..." - source Macronomics, August 2013.

As a reminder on how "convexity" can impact the price movement in credit, we followed with interest the situation of Abengoa SA (ABGSM) the Spanish company involved in the Renewable Energy sector which is particularly exposed to Brazil. S&P Capital IQ has an assumed recovery rate of only 30%. As we told you before, we expect recovery rates in the next downturn to be much lower making the 40% overall recovery rate assumption for senior CDS dubious at best. The price action in the bonds are indeed illustrative of how price movement lower can be larger in our days and ages (h/t Credit Macro PM / Bloomberg graph source):

- source Credit Macro PM - 4th of August Twit - Graph source Bloomberg.

Things have escalated quickly since Friday 31st of July poor senior management call with analysts as indicated by Laurent Beruti on his Datagrapple post on the 3rd of August:

"The call between ABGSM’s management and analysts on Friday left the latter scratching their head as the company which previously appeared committed to de-levering announced out of the blue a capex increase and reduced FCF guidance. The communication around how the €500mln bonds due in 2016 will be managed was not very convincing either. Investors pushed the 5 year risk premium 12pts higher to 48.25pts (insuring $1 of ABGSM’s bond against a default costs 48.5cts spot and 5cts per year afterwards) and the 1 year risk premium to 30pts upfront. " - source Datagrapple blog.

In this case while the price movement of the bond is lower, the price of CDS protection against potential default is significantly higher to say the least.

On the 3rd of August Abengoa announced an "out of the blue" rights issue of €650mn, or 30% of market value prior to the announcement (market cap on the 4th of August €1,335mn). This "market surprise" or credit "sucker punch" was reflected by CITI's take in their 4th of August note on the issuer:

"Understanding the right issue:

On 31 July after market close, Abengoa released its 1H15 results, the first set of results under the new management team (both CEO and CFO recently changed). While the underlying business performance operationally looked promising, it was a disappointing performance in terms of credibility on the most important factor for this stock – the balance sheet and in particular, liquidity levels. The company has made enormous progress over the last two years in laying out and delivering on its asset and capex-light deleveraging strategy. However, the significant reduction in FCF guidance as a result of heavily increased capex, has caused the markets (both debt and equity) to once again question the liquidity situation of the group. 

Having expressly stated on the call that the company would not need to come back to the markets (equity and credit) this year, and that liquidity was ‘comfortable’, the group then announced a material rights issue (€650mn or 30%+ of the equity value prior to the announcement) on the next trading day following its results (today, 3 August 2015). The company’s view that liquidity was comfortable was backed up by a detailed disclosure on its €1,330mn of cash and short term investments that was not linked to suppliers (total cash and STFI was €3,095mn). These cash and STFI balances, combined with the (increased) expectations for disposals, and the expected reversal in working capital, inevitably raises the question as to why the rights issue should be necessary if there is not a liquidity situation. 

Moreover, not only did the company state that it did not intend to come back to the market and that liquidity was comfortable, but the company also included a slide in its results presentation showing its assessment of what it considered to be a prudent valuation of the equity, at €8 per share. Accordingly, undertaking a material rights issue at what is likely to be an extremely large discount to that assessment of value (the shares are currently trading post today’s 30% drop at €1.42) once again calls into question those views on liquidity.

We spoke to the company today (investor relations), who stated that while they were indeed confident in their liquidity situation on Friday, they received significant feedback over the weekend from bondholders and investors that a rights issue would calm the speculation over liquidity. However, judging by the reaction of the bonds (and shares) today, it appears that the announcement of the capital increase has in fact had the opposite effect, in making it appear that there is indeed a liquidity situation, hence the need for a rights issue. The company believes that the reason for the negative reaction is that some investors feel that the capital raise may not go ahead, and others that it is not large enough. The company was adamant that the reason for the rights issue was NOT because banks had demanded it. Accordingly, the only reason (short of a genuine liquidity crunch) for the rights issue, is that the company thought that this was what markets wanted." - source CITI

No offense taken on Abengoa liquidity situation given we have heard similar denials before in other circumstances:

"Our liquidity is fine. As a matter of fact, it's better than fine. It's strong." Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002. 

In the case of ABGSM, between Q1 and Q2 has seen a significant increase in CAPEX coming from a major Brazilian T&D project representing a total amount of €2,696mn as shown in CITI's report:

"The key shift in this table is that debt has dropped materially, being replaced by an additional €761mn of equity from Abengoa, hence the significant increase in equity capex laid out at the 1H15 results, partially offset by increased disposals, which led to the significant reduction in FCF guidance." - source CITI

The rub, lies when it comes to "tightening" financing conditions due to higher inflation in Brazil thanks to deteriorating macro as well CAPEX financing difficulties facing further BRL depreciation which will no doubt negatively impact project costs in local currency.


What is of course of interest for us "credit players" versus "equities players" is once again the disconnect between the two markets, particularly given that as indicated by the team behind the Datagrapple blog, when ABGSM announced it had won a €600 million contract for a biomass power station in the UK, the stock surged by  a cool 20%, meanwhile the CDS was unmoved and the price closed on the 10th of August at a nice 60% upfront +5% running spread over 5 year.

You can probably decide who is right when it comes to "pricing the risk" but we ramble again as it seems credit players are more wary of a potential "Berezina" for the bondholders while "equities players" seems oblivious to the market signals reflected in the 5 year CDS prices and the fast deteriorating macro picture in the 7th largest economy of the world.

But, apart from the overly exposed "high beta" peripheral issuers, there is indeed some significant headwinds building up in credit, particularly in the light of the recent weakness in Media shares which saw a significant widening in CDS 5 year spread as displayed by S&P Capital IQ graph below from the 11th of August:

"Media shares fall due to downfall in Disney. Movers include Disney, Comcast, Timewarner and CBS"-  source S&P Capital IQ

The disappointment in earnings seems to have led to the selloff and the credit widening in 5 year CDS spreads. But one indeed might rightly ask if the tone in credit is weakening and not turning sour? On that point we agree with Datagrapple's take from the 7th of August:

"Have tables Started To Turn?

Since the beginning of the summer we have been used to seeing the commodity related sectors underperform consistently the rest of the market. The fall of the commodity prices severely impacted the likes of RIG ( Transocean LTD ), ABX ( Barrick Gold Corp ), or FCX ( Freeport-McMoRan Inc ) and the risk premia of these high beta names were under severe pressure. Since the beginning of the week, there is a new cohort of names which joined the ranks of battered credits: media companies. It started with DIS ( Walt Disney Co ) which reported disappointing earnings raising concerns about subscriber erosion and the long term viability of the cable model, and rapidly spread to CBS ( CBS Corporation ), TWX ( Time Warner Inc ) and today BSY ( SKY pLc ). All of a sudden, it is no longer all about the widest credits, and low beta names appear vulnerable as well." - source Datagrapple blog.

Make no mistake, with China finally joining the currency war, the deflationary forces are indeed more potent than ever making us significantly increase our long US bond exposure. From a contrarian stance, we are also looking at adding from a medium term perspective some Norwegian government bonds in local currency, the rational being that from their macro fundamental long term perspective, NOK seems oversold given Norway can balanced its budget with oil  at $40 USD versus $106 for Saudi Arabia and Russia, but that's another subject we will deal with at a later stage.

This brings us to our third bullet point, namely the immediate consequences of China's latest currency move.

• The immediate consequences of a Chinese "devaluation"

Back in April 2014 in our Conversation  "The Shrinking pie mentality" we argued the following:

"Reading with interest the latest take on China by both Russell Napier from CLSA in his latest Solid Ground opus as well as Albert Edwards on the similar subject of a potential Chinese devaluation risk which would push the world further into outright deflation, we reminded ourselves of the "Shrinking pie mentality" in relation to our chosen title. Indeed, when the economic pie is frozen or even shrinking, in this competitive devaluation world of ours, it is arguably understandable that a "Winner-take-all" mentality sets in. Shrinking economic growth resulting from the financial crisis means that, from a demographic point of view in Europe with a shrinking working age population, low birth rates and a growing population of older people, it means to us that Europe does indeed face a critical choice: meet their unfunded pension liabilities and go bust, or cut drastically in entitlements in order to compete with emerging countries that don't have these large "legacy" costs associated with aging developed countries. 

When it comes to the benefits of "Quantitative Easing" program which went on in various countries (Japan, United States and the United Kingdom), the possible gains of this uphill battle against strong deflationary trends for a small share of a shrinking pie rarely justify the risks in the long run we think.

In relation to the aforementioned Chinese devaluation, we do agree with both Russell Napier and Albert Edwards that a Chinese devaluation is a strong possibility given that the Chinese have studied carefully Japan's demise from its economic suicide thanks the fateful decision taken to revalue the yen following the Plaza Agreement of 1985 (a subject we discussed with our good credit friend back in March 2011 in our conversation "Fool me once, shame on you; fool me twice, shame on me..."). In its most recent commentary, the US Treasury states that the Yuan is “significantly undervalued” and suggests that it must appreciate if China and the global economy are to "enjoy" stable growth. Unfortunately for the US Treasury the Chinese are not stupid as indicated by this article displaying the Chinese view on the Japanese economic tragedy written in 2003:

"Revaluation of Japanese Yen, a historical lesson to draw: analysis" 

"Under US pressure, the Japanese government and banks "honestly" carried out the "Plaza Agreement", starting to interfere the yen exchange market on a large scale together with the US. As a result the exchange rate of yen against US dollars skyrocketed, exceeding 200:1 by the end of 1985, going beyond 150:1 at the beginning of 1987 and nearing 120:1 in early 1988. This means that the Japanese yen had doubled its value against US dollars in less than two years and a half!" - People's Daily, September 23 by Professor Jiang Riuping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing." - source Macronomics, April 2014

What we have argued at the time as well is that devaluating the RMB has much more to do with "Information cascade" rather than pure economic justification:

"The issue we have with Société Générale's EM strategists case that devaluating the RMB would have little economic justification in the current "rebalancing" act, is that increasing disinflationary pressures from outside China might indeed lead it to succumb to "Information cascade" as a cascade occurs when a person observes the actions of others and then—despite possible contradictions in his/her own private information signals—engages in the same acts." - source Macronomics, April 2014

China has indeed finally decided to join the ranks of the currency wars players we think. At the time we also sided with Nomura's take on the probability of a Chinese devaluation to put our position in context:

"The problem is, however, that the headwinds of deleveraging and the property market correction are so powerful – domestic demand is at its weakest since 1997 – that the economy is unlikely to be stabilised on piecemeal easing measures. Moreover, the potency of stealth-like, piecemeal targeted easing on the real economy has weakened significantly, in our view, even for the sectors (e.g. small enterprises) that the targeted measures are supposed to support.

Should this time window for more traditional wholesale monetary policy loosening be missed, the authorities may eventually be forced to ease more aggressively when the economy is slowing more sharply and edging closer to deflation, adding volatilities to the economy." - source Nomura

This is indeed a materialization of the above mentioned "Shrinking pie mentality". Global demand is weakening and slowing hence the growing temptation in preserving at all costs one's position by using the "devaluation" tool and exporting therefore further deflationary pressure on the rest of the world and Europe in particular. On that case our recent musing on "shorting" the 3 large German automakers as described in our conversation "Ominous Decade" seems more and more relevant in the light of the recent actions from the PBOC.

The 3 Big  German automakers have already conceded significant price discount to revive sales and increased subsidies with affiliates. While luxury brands and their high margins might absorb more easily a drop in the Chinese currency, we think it is therefore going to be more headwinds going forward for automakers and particularly European ones.

As an immediate consequence to the Chinese "sucker punch" move with their currency, our fellow blogger "Sormiou" at Macronomics made a very interesting point when it comes to the widening of the fluctuation band from of the Yuan (CNY) and its impact for exporters to China:

"With rising doubt on future further widening of the fluctuation band for CNY, hedging strategies  for exporters to China (Carmakers, luxury brands, etc.) will have to be "reviewed". One might wonder if we are going to move from a market with zero demand for FX options (cf. CHF market prior to the removal of the peg to the Euro) to a new "real" market for CNY FX options"

CNY 3 month volatility:

 - graph source Bloomberg

An interesting "development" indeed, given that Exporters will have to more and more "mitigate" the fluctuations of the CNY in order to "smoother" their earnings and lower their volatility in the future.

When it comes to EM exposure to China and the "Shrinking pie mentality", with Korea biggest trading partner being China representing at least 25% of their exports, they are indeed in the receiving end of the latest joiner in the "currency wars". While MSCI Emerging Markets is showing some clear downward pressure, we would not be surprised to see the Korean Kospi index seeing increasing downward pressure as well in the coming weeks/months particularly after 6 months of exports contraction. This is well clearly illustrated in Bank of America Merrill Lynch note from the 22nd of July 2015 Korea in Focus entitled "Exports: looking beyond the surface":

"Cyclical export challenges for Korea
Exports, the key driver of Korea’s economic growth, remain challenging from both a cyclical and structural standpoint. The long-awaited tailwind from better external demand remains elusive, as the global economy failed to muddle through hurdles including the jittery Greece. Accordingly, nominal exports contracted 5.0% yoy in 1H15, following two semi-annual growth of around +2.3% yoy in both 1H14 and 2H14 (Chart 1). 

Meanwhile, real exports excluding service produces also plunged into negative territory (-0.9% yoy) in 1Q15, the first merchandise exports contraction since 3Q09 (-0.1% yoy).

Shifting structure of China’s production and trade

Recall that exports to China are predominantly intermediate goods. More than 80% of goods exported to China are used as inputs to produce final goods in the country, be it for Chinese domestic consumption or re-exports from China. This implies that Korea's exports to China are cyclically very sensitive to growth in China, as well as its export destinations, as the demand for intermediates is more cyclically sensitive than the demand for final goods.

Even though China remains the top destination of Korean exports, advancement in China’s domestic manufacturing and technological capabilities continue to put pressure on Korean exporters. According to a report published by Korea Institute for Industrial Economics & Trade (KIET), overall Chinese imports of intermediary goods noticeably decreased from 63.6% of the total imports in 2000 to 48.8% in 2012. This is because both domestic and foreign manufacturers that are based in China are increasingly procuring the locally-made Chinese parts and materials. Accordingly, Korean exports to China of intermediary goods dropped from 84.4% to 72.3% over the same period. In our view, exports to China will proportionally decrease in the long term as the competitiveness of China’s intermediate goods continues to rise.

Another vivid impact of the structural change in China can be found in the change in processing exports. Influenced by the Chinese government’s policy to boost ordinary trade, Chinese ordinary imports have increased from 44.8% to 56.6% over 2007-13, while Chinese processing imports have decreased from 38.6% to 26.8% (Chart 2). 

Meanwhile, over the same period, reliance of Korean exports to China on processing goods barely changed, declining from 54.1% to 51.9%. As the share of processing exports in Korean exports markedly increased, expanding from 0.1% to 7.8% over 2009-14, this slowdown in Korea’s processing exports had a much greater effect on total exports. As Chart 3 shows, decline in Chinese processing imports has translated into a negative contribution in overall exports.

Searching for the silver lining

In 2H15, we see returning growth momentum in trading partners. Our economists expect the US and the EZ growth to expand by 3.2% saar and 2.2% saar in 3Q15, respectively (up from growth of -0.2% and 1.5% in 1Q15 for the US and the EZ). Meanwhile, China growth will likely stabilize at 7.0% yoy for 2H15. In line with these expectations, Korea’s leading indicator for exports is showing a better outlook in 3Q15 (Table 1).

In our view, swift depreciation of the KRW in both bilateral and multilateral terms will likely help boost the exporters’ price competitiveness. Moreover, the recently inked free trade agreement with China should help stimulate Korea's exports and GDP growth over the long term." - source Bank of America Merrill Lynch

Unfortunately we disagree with the above and cannot see a silver lining for Korea particularly in the light of most recent US data as well as the PBOC latest currency weakening move which does spell trouble for the highly export dependent Korea.

To ascertain the return of the "deflationary forces" at play, we read with interest Bank of America Merrill Lynch Connecting Asia note from the 3rd of August entitled "The rise and fall of Asia FX Reserves":

"The final broad implication is the risk of sustained capital outflows due to a Fed tightening cycle (explored in Economic Insight). This could help to reinforce the falling trend in Asia’s FX reserves and result in falling money supply – see front page chart.

This will add to pressure for some Asian central banks to ease. In China’s case it can be achieved only at the cost of a weaker CNY as maintaining a stable CNY implies a contradictory withdrawal of liquidity (as we have argued in Connecting Asia: Contradicting China. This also helps to explain the aggressive policy intervention in the stock market to prevent the amplification of outflows." -source Bank of America Merrill Lynch

This is what we posited in our last conversation "Mack the Knife" and our "reverse osmosis theory explaining our difficult it is for EM countries to currently stem capital outflows:

"Emerging Markets including China are in an hypertonic situation, therefore the tendency is for capital to flow out. In conjunction with capital outflows from exposed "macro tourists" playing the carry trade for too long, the recent price action in US High Yield and the convexity risk we warned about as well as the CCC bucket being the credit canary are all indicative of the murderous proficiency of "Mack the Knife" (King Dollar + positive real US interest rates)." - source Macronomics

We will have to watch closely how effective the latest PBOC actions are in stemming capital outflows but, if indeed our "reverse osmosis" theory is playing out and the Fed effectively starts raising rates in the near term, then you can expect additional capital flows pressure on EM countries, falling FX Reserves as well as weaker money supply growth, therefore weaker growth.

What is at play by China is a "Winner-take-all" strategy which can be illustrated as well by Korea's giant Samsung posting recently disappointing earnings as cheaper smartphones made by Chinese manufacturers are slowly but surely eating away at Samsung's share, like Lenovo is a well eating away Dell's pc market share.

A continuation of a weakening of the CNY will of course accelerate this long term trend which brings us to our final chart, namely the divergence between US ISM services with China PMI manufacturing.

• Final chart: Divergence between US and China - How long can it last?

Given the weakening tone coming from the Chinese economy compared to the US, as a final note we leave you with Bank of America Merrill Lynch chart from their Liquid Insight note from the 10th of August entitled "Where do we stand?":

"The decoupling trades

The Chinese and US economies have been on diverging paths over the past few months

(Chart of the day). Against this backdrop, it is not surprising that trades designed to profit from this divergence have performed generally very well. Whether it is buying DM equities against selling EM equities, buying S&P consumer discretionary against selling industrials, or buying G3 currencies against selling commodity currencies, these so called “decoupling trades” have generated strong returns with high Sharpe ratios since May." - source Bank of America Merrill Lynch

Given our propensity to be contrarian, hence us having jumped again in the last couple of weeks on the deflationary wagon again, we wonder if we are not going to see some strong rebound at least in the precious metals space and miners alike in the near term...

"Educate men without religion and you make of them but clever devils." - Arthur Wellesley, 1st Duke of Wellington

Stay tuned!