Credit - Liebig's law of the minimum

"Capital as such is not evil; it is its wrong use that is evil. Capital in some form or other will always be needed." - Mahatma Gandhi

Looking at the acceleration in M&A activity in recent days (DELL, AB InBev, etc.), which amounts to us, as yet another indication of us being in the last inning in the credit cycle, it appears evident that while credit corporate bond markets remain wide open, the last two months have shown clear signs of some form of "exhaustion" in the cycle, particularly for High Yield. It remains to be seen which next M&A deal or LBO will fall through, but, when it comes to our chosen analogy, we decided this week to leave out the "explosive" references and steer towards a principle developed in agricultural science by Carl Sprengel (1828) and later popularized by Justus von Liebig.  The Liebig's law of the minimum states that growth is controlled not by the total amount of resources available, but by the scarcest resource (limiting factor). For us, this important factor is "capital", particularly in the light of ZIRP and repetitive QEs hence this week's title analogy. 

Liebig's law of the minimum concept was originally applied to plant or crop growth, where it was found that increasing the amount of plentiful nutrients (liquidity via QEs) did not increase plant growth (Economic growth). Only by increasing the amount of the limiting nutrient (the one most scarce in relation to "need") was the growth of a plant or crop improved (preventing mis-allocation of "capital"). This principle can be summed up in the aphorism, "The availability of the most abundant nutrient in the soil is only as good as the availability of the least abundant nutrient in the soil." Or, to put it more plainly, "A chain is only as strong as its weakest link."

In similar fashion, if we take biotechnology itself being totally dependent on external sources of natural capital, capitalism and CAPEX expenditures also depend on efficient market allocation of "capital". Obviously QEs and ZIRP, to that extent do not help whatsoever the process, on the contrary the distortions have been immense hence our Liebig's law of minimum analogy.

Also when it comes to our analogy and the "law of a minimum", we think investors should more and more focus on the return of "capital" as a "minimum" rather than focusing on the return of "capital" as a "maximum". Yes, there has been a strong rebound in inflows in recent weeks particularly in High Yield ETFs, but, looking at our much discussed "CCC credit canary" bucket and the dip in new issuance for the latter, it is a harbinger of trouble ahead we think, hence our recent call for moving higher in the ratings spectrum. If we would like to tweak slightly the previous aphorism we would state the following: "The credit cycle is only as strong as its weakest link, namely the CCC credit canary". 

While there has been a positive momentum in credit and equities alike, leading to strong inflows, with "bad news" on the macro side with weaker China GDP growth, leading to somewhat "good news", at least on the credit side, we think that financial system vulnerabilities have risen, thanks to the commodity down cycle in conjunction with the sharp depreciation of currencies in Emerging Markets (EM), particularly for commodity exporters such as Brazil. These developments have clear implications for foreign-denominated debt particularly for the corporate ones as discussed recently. There is a heightened risk for EM and DM banking systems alike for significant loan defaults and banking system losses in 2016.

In this week's conversation, we will look again at the consequences positive correlations have had on idiosyncratic risks and why in the current tightening mood, you should this time around avoid getting "carried away", meaning stretching for yield and risk given the lateness in the credit cycle.

Synopsis:

• Positive correlations means idiosyncratic risks are rising
• More on the credit cycle turning - don't get "carried away"
• Final charts - In a zero-inflation and borderline deflationary environment, the quality of the carried asset ultimately is more important than the cost of carry 

• Positive correlations means idiosyncratic risks are rising

While in August we voiced our growing concerns on the rise in positive correlations and the instability it was generating in our short conversation "Positive correlations and large Standard Deviation moves", the recent significant price movements we have witnessed on numerous occasions, indicates clearly to us that this instability is leading to sudden bursts of volatility and large standard deviations move. We would not call that a "new normal" environment but, we think it is akin to the "law of minimum" in a ZIRP central banks induced world. 

This rise in idiosyncratic risks has been confirmed by Bank of America Merrill Lynch in their latest Credit Derivatives Strategist note from the 14th of October entitled "Refocusing on the big picture":

"The rise of idiosyncratic risksThe EM driven volatility is here to stay. Names with significant sales exposure to EM have borne the brunt during the recent sell-off. Additionally the consequent commodity price sell-off has triggered an increasing pressure on metals and miners. But on top of the global growth headwinds, we have also seen a significant rise of pure idiosyncratic risk recently both in high-grade and high-yield market. Multiple single name stories have been popping around. The VW story is casting a shadow on the autos and auto parts sector. Abengoa has also been on the fore over the past couple of months. Matalan recently saw their bonds down ~10pts.
Our Plunging bonds index is reflecting exactly that; the rise of idiosyncratic risks. Note that the number of bonds that dropped more than 10pts in a month spiked to the highest level in September.

However, the performance in the month of September was not that catastrophic across the board. After all not many European companies are either exposed to EM or have been affected by the VW story.
A way to illustrate the diverging performance across high-grade cash sectors is by tracking the standard deviation of their excess returns. In chart 3 we present the standard deviation of monthly excess returns for a number of non-financial sectors over time.

We find that the level of dispersion in September has been the highest since the 2008/09 global financial crisis, and far worse than the one experienced during the European sovereign crisis in H2-2011.

Note that while autos and industrials were the ones that dropped by c.4%, the rest of the market was down by ~1% on average (chart 4). These two sectors represent only ~10% of the entire high-grade market.

Record low financing costs…default risks should be contained…Default rates have historically been highly correlated to companies’ financing costs. We find that the loan interest rate cost is a good leading indicator of default rates (in the following 12 months, chart 5). 

With the ECB likely to expand/extend QE beyond September 2016, financing costs are likely to remain low for longer. Should this trend continue the currently low financing costs should support low default rates suppressing systematic default risks. 

The recent EM-driven weakness has driven spreads significantly wider, decoupling from lower loan rate costs for European companies (chart 6).

This provides more attractive levels to selectively add risk in credit instruments that have a cushion to first losses. 

Fundamentals improving…no re-leveraging despite enticing financing rates

Inflation and financing costs have been ticking down over the past couple of years. Corporate fundamentals are clearly improving. Over the past six quarters, leverage has fallen due to an improvement not only in earnings, but also thanks to lower debt overhang. Chart 7 shows that European corporates have not embraced more leverage (more in our dedicated HY fundamentals note), despite enticing record low financing costs."

- source Bank of America Merrill Lynch

We agree with Bank of America's take when it comes to European valuation being relatively more attractive compared to the US thanks to lower overall "leverage". This what we argued in our conversation "The overconfidence effect", US "releveraging" has been fast and furious which is not yet the case in European credit (far less "leverage" and "buybacks").

But, we cannot agree with Bank America Merrill Lynch's use of loan interest rate cost as a good leading indicator of default rates. This is misleading we think in this credit cycle. This time, it's different!

Why so?

In September 2014 in our short note "US High Yield issuance and debt outstanding" we indicated the following:

"In Europe, the situation is different, where the explosion in growth in the High Yield market comes from substitution from corporate loans to bond issuance due to the disintermediation on the back of bank deleveraging (which by the way is way behind the US). Existing loans in Europe are getting refinanced therefore via new High Yield issuance in the bond market, which implies that there is no significant releveraging as seen in the US so far.
Credit wised, the Loan-to-bond refinancing, or disintermediation, is another growth driver in European High Yield markets as European banks tighten lending conditions. According to Bloomberg, analysis shows 50% of funding in Europe from loans vs 40% in U.S. so while banks are in retrenching mode, companies are switching to the bond market rather that asking banks for loans with the stringent covenants normally attached to bank loans"

- source Macronomics, September 2014, graph Morgan Stanley, March 2013.

Europe is an on-going story of "deleveraging" when it comes to its banking sector. Banks are not making that many new loans, particularly in peripheral countries because weaker banks are still capital constrained! If you think banks have completed their deleveraging, then watch German banks and in particular Deutsche Bank. More pain to come, more assets to be offloaded, more jobs to be cut.

Using again our Liebig's law of the minimum analogy, the limiting nutrient (the one most scarce in relation to "need") for European banks is "capital". 

As a reminder credit growth is a stock variable and domestic demand is a flow variable. Central-bank induced liquidity is pointless without the real economy borrowing and the issue at the heart of the problem is that most Southern European banks are in fact "capital constrained" and plagued by NPLs (Nonperforming loans) and their "core capital " has been artificially boosted by Deferred Tax Assets (DTAs). DTAs are like "Aspartame", an artificial, non-saccharide sweetener used as a sugar substitute in some foods and beverages but, when it comes to European banks by no means it can be considered true "capital". DTAs currently represent c42% of tangible equity in southern Europe and contribute a median of c300bp to core capital ratios. This is significant!

With loans you have covenants as an alert system, even less so in the US with the return of Cov-Lite loans,  and with bonds, not that much covenants, hence the significant increase in "idiosyncratic risk".

Furthermore, we agree with our Rcube friends recent take on "bonds" being now a more serious indicators than "loans":

"We have been highlighting for months now that the combination of redemption and rising cash levels would be equal to a serious tightening of bank’s lending standards. This is because the share of corporate financing now achieved through capital markets has massively increased over the last 10 years. Bond funds have taken over loan officers as the main credit providers to corporations around the world. Only watching banks’ lending standards to evaluate the health of credit flows is a serious mistake in this cycle. In the US alone, the ratio of bond issuance vs. loans is 5 to 1. For risky assets to drop, negative sentiment is a prerequisite condition. It is now the case." - source Rcube

While we might be sounding like a broken record but, in the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger, even for European Issuers, regardless of their EM exposure, or not.

This brings us to our second point namely that in a context of deteriorating "credit metrics" for High Yield issuers (and no it isn't only bound to the "Energy" sector...), we think that investors should focus on return of "capital" rather than return on "capital" because  increasing amount of plentiful nutrients (liquidity via QEs) did not increase plant growth (Economic growth) so far, although we keep hearing from the "snake-oil" pundits that's the "recovery" is just around the corner:

US Labor force: For the first time since May 1990 the Ratio Not in Labor Force / Civilian Labor Force has topped 60%:

- source Macronomics

• More on the credit cycle turning - don't get "carried away"

Whereas cheap credit has enabled some "extend" and "pretend" game, one of the major consequences has been to allow the extension of the "Maturity wall" to a later stage as illustrated by Bank of America Merrill Lynch in the below graph displaying the maturity profile for US High Yield bonds and Leveraged Loans:

- source Bank of America Merrill Lynch

In similar fashion, for some distress issuers in Europe, the game has been extended to "overtime" but in no way has altered the necessity for some form of "restructuring" as illustrated recently by the situation of Norske Skogindustrier ASA, a Norwegian pulp and paper company based in Oslo as reported by DataGrapple on the 16th of October:

"So NSINO (Norske Skogindustrier ASA) eventually paid their 2015 bonds. The company has apparently decided to buy some time in order to find a suitable solution to manage their considerable debt pile. Their next maturity falls in May 2016, but once these junior bonds will have been paid, there will be very little cash to redeem other maturities. It is therefore no surprise that holders of longer dated bonds are mulling restructuring plans. A group of investors holding NSINO’s 290mln euros of senior bonds due 2019 allegedly met with the company to discuss a possible debt for equity swap. Holders of junior bonds due 2017 approached management with an alternative plan that included extending their claims until after 2019. The company is conveniently in blackout period ahead of its results on October 22nd. They should expect a grilling then regarding their intentions. But in the meantime, as their willingness to kick the can down the road was evidenced by the payment made yesterday, investors have steepened the risk premium curve of NSINO on the short end. The 1 year CDS closed today at 29pts upfront, 10pts lower than 2 days ago." - source DataGrapple

Of course, in similar fashion, the "lunatics" running the "central bank" asylums have also played the "buying some time" game to say the least. They seem to be oblivious to Liebig's law of the minimum but we are ranting again.

We think it is high time investors start thinking about "playing" defense", this means going higher into the "ratings" spectrum. As goes our second point, do not get "carried" away, meaning stop "selling "beta" for "alpha" (though we do know that the first source of "alpha" are fees to quote one of our Hedge Fund manager friend...) because the cycle is running out of steam. 

On that note, we could not agree more with Bank of America Merrill Lynch's High Yield Wire note  from the 19th of October entitled "Fool me once, shame on you, fool me twice…":

"All credit cycles come to an end. This one’s no different.We’ve said for a while now that the benefits of low rates have long been sapped from the market, and we are in no rush to change our tune on the back of a two week rally. As we look at the fundamentals of the market, our strategic view on high yield remains crystal clear: the market is in its 7th or 8th inning and still needs to cheapen substantially before valuations become attractive. With the risk for 100s of billions of investment grade downgrades, our view that defaults will soon be increasing, and that Fed stimulus is no longer a tailwind to the market, our expectations are for wider spreads in 2016. This is not to say we expect a massive default wave next year, but do wonder whether the lack of liquidity and general direction of the market creates an attractive entry point anytime soon. 

Spread compensation not enough for what matters: ReturnsAs we have been traveling across the US and Europe the last 6 weeks we have heard two arguments why investors may find value in high yield. First, there is a lack of alternatives. Second, with the recent widening, spread compensates you for the default expectations priced into the market. We don’t agree with either. Investors need to demand return, not yield. A 7% coupon does not yield a 7% return and with the potential for low average returns for some time, we think alternatives do in fact exist. Additionally, traditional measures of spread compensation are flawed in our view, and need to be seen in the context of alternatives and default risk over the life of a portfolio." - source Bank of America Merrill Lynch

When it comes to Liebig's law of the minimum and "return" of capital, we also agree with Bank of America Merrill Lynch's take on the need for looking for "quality" rather than yield:

" All credit cycles come to an end. This one’s no different.
Over the last couple of years, the market has frequently been fooled by assuming a new old world where bad news is bad news and good news is good news, only to be whipsawed by risk on sentiment where fundamentals matter less than easy monetary policy. At the risk of being fooled again, we say the tide has turned, and low rates and pushed out hike expectations matter less in a world where sentiment has shifted, fundamentals are poor, and investors are not being compensated for default and
liquidity risk.
It is interesting how so few disagree with us that fundamental metrics in HY are quite poor and unlikely to take a turn for the better any time soon and yet so few agree with our thesis that this is highly problematic. The effectiveness of central bank policy in boosting asset prices over the last few years has created a blind spot when it comes to fundamentals. This is apparent when the only counter to our argument is “where else will the money go?”
The steadfast belief that low rates and the central bank put will continue to mean a reach for yield, never mind it’s quality, seems absurd and contrary to evidence. It’s been six years since the recession; we’ve had numerous rate cuts and quantitative easing programs the world over, we’ve seen all-time high stock prices and we’ve witnessed all-time low bond yields, and yet neither the market, nor it seems the economy is allowing the Fed to hike rates. As Thanos wrote recently, we should have known something was wrong when bad news was greeted more cheerfully than good news.
Ok, so what has changed now you say; if central banks continue to remain so accommodative, why not more of the same? Because the last six years have also borne witness to the fastest growth in corporate debt that we’ve ever seen and re-leveraging to a scale comparable to the worst moments in HY’s history.  

This has occurred in conjunction with mediocre revenue growth, disappointing capex spending and earnings burnished by buybacks and acquisitions. And just as credit quality started a turn for the worse, risk aversion has set in quite firmly within the market. The flight from Energy and the reluctance to step back in even at today’s highly distressed levels amongst investors has been stark, as they anticipate many HY E&Ps to raise priority debt ahead of existing bondholders and potentially file for bankruptcy. Even the erstwhile “safer” places to hide may not make the cut going forward. We have already seen some unraveling in the traditionally defensive pharma market with stock and bond prices of drug makers taking sizable hits on the prospects of drug price caps. Lately, the risk aversion has spread to mainstream hospitals too- case in point HCA equity down 23% since August 4th.

In the same vein BBs, which have outperformed Bs and CCCs all year (BBs -0.93%, Bs -2.67%, CCC -7.14% YTD), face headwinds from falling angels once rating agencies begin downgrades ahead of the default cycle. In the past two migration cycles, an average of 10% of the starting IG universe was downgraded to HY over the course of the cycle (Chart 3). 

This translates to as much as $300bn worth of par value in cumulative downgrades over the next 3 years if the rating agencies begin to shift their expectations in 2016. Should history repeat itself, these downgrades will expand the current BB universe by a whopping 63% and the overall size of the high yield index by nearly 25%.
Of course, existing BBs today will also suffer attrition by way of downgrades to Bs, and Bs to CCCs, but the overall indigestion to the market could prove massive. We hear so much about the potential for outflows, but very little about the potential for new paper through downgrades. The latter dwarfs the former.

Finally, the re-pricing in the primary market as issuers bow to investor demands is just another reminder of waning risk appetite. Never before has access for CCC issuers, even non-commodity ones, been so poor post crisis. The proportion of low quality issuers accessing the market on an annual basis has now dipped below 20%, a far cry from the 50% at the top of the cycle. It doesn’t take much to see what this means for the survivability of low quality issuers going forward. In fact the previous times we were at these levels and heading in the wrong direction was in 1989, 1999, and 2008, right at the heels of default waves (Chart 5). 

Of particular interest is that once CCC issuance (as a percentage of all existing triple C issuers) falls below 20%, the default rate tends to spike north of 10% within a year and a half on average. In the late 1980s/early 1990s, the time to double digit defaults was 20 months, in the late 1990s/early 2000s it was 22 months and in 2008 and 2009, it was just 14 months. Assuming a similar pattern today, one would expect the current risk aversion to lead to a significant pickup in defaults sometime in mid-late 2017, consistent with our previously published estimates. 

The idea that once again bad news is good news and good news is bad news has no merit in our view, especially in the context of all the late stage indicators we are seeing. We’ve said for a while now that the benefits of low rates have long been sapped from the market, and are in no rush to change our tune on the back of a two week rally. In fact, we would argue that we have witnessed nothing but a dead-cat-bounce in HY, and a price action which has little if anything to do with the expectation for rates or improved fundamentals, and everything to do with ETF buying and short covering. The $2bn+ that flowed into ETFs in the week ended Oct 9th was the highest on record for HY ETFs (Chart 6). 

This was the same period over which the HY index staged a dramatic 70bps of spread tightening, but has since given back some gains. In contrast, actively managed retail funds saw a meagre inflow of $140mn over the same period.
Note that the market was pricing an impossibly low probability for a hike before September’s meeting and that the market sold off all summer despite treasury yields falling. In fact, after Yellen’s press conference, where she discussed the lack of inflation and weak global growth as the main reasons for keeping zero interest rate policy, the market sold-off. Yet, we are meant to believe that when the same concerns were expressed in the minutes, everyone had changed their mind that these issues were now a good thing? We don’t buy it.

As hard as it is to accept that this glorious run for credit has come to an end, in our view it is time to acknowledge that valuations do not justify the risk-reward profile in HY, and no amount of QE or easy monetary policy is likely to change the story for an extended period of time. The market is in its 7th or 8th inning and without a substantial increase in earnings- a prospect that will require fiscal policy changes more than monetary stimulus, in our opinion- we think high yield will have a difficult time sustaining rallies. And to substantiate that view, we attempt to counter the most frequent arguments we’ve heard from those who disagree. 

Spread compensation not enough for what matters: ReturnsYield does not equal returnThis may be stating the obvious. But we find it necessary to say so anyway. The most vociferous argument for HY seems to rest on the fact that it indeed provides a high yield; more importantly a higher yield than Treasuries, high grade and perhaps even expected stock returns. But what good is a high coupon if enough price loss and defaults occur to wipe away any cash inflow? We would think investors would search for return, not yield, in which case, in our view compensation is not commensurate with the alternatives.
In late December last year, the yield on our HY index was over 7%, the highest it had been in over two and a half years. Just a few weeks back it was over 8% and year-todate returns stand at -0.6%. High yield or higher yield than recently observed did not by themselves preclude an even higher yield or negative returns. Why opt for 2-3% returns in HY with its volatility, defaults and liquidity challenges when HG paper yields 3.3%, has less volatility and virtually non-existent default risk?" - source Bank of America Merrill Lynch

Exactly!
Given the "holding" pattern of the Fed, we believe as well, that US Investment Grade has become somewhat attractive again. On that matter of "quality", we have read with interest Bank of America Merrill Lynch's Situation Room note from the 20th of October entitled "It’s what you don’t see that hurts you":

"Cash gets no credit
High quality industrial spreads are attractive relative to their lower quality HG counterparts. This is because currently single-A and BBB-rated industrials offer similar spread levels per turn of gross leverage (ex. energy, materials, utilities) – see Figure 1. 

This means that investors give A-rated industrials little credit for their superior liquidity positions, with higher quality industrials holding about twice as much cash on their balance sheets as BBBs (Figure 2). 

In other words, current valuations assign close to zero value to the much lower net leverage of high-quality companies compared to their lower rated peers. With corporate releveraging expected to slow we think credit market valuations should become more aligned with net than gross leverage. While a significant portion of corporate cash could be overseas, it would still be available and useful to repatriate - after a tax haircut - in situations of distress. 

The trend in gross leverage for both high quality and BBB-rated industrials has been similar, with the median leverage rising since 2012 (Figure 3). 

In contrast the higher cash balances actually pushed the net leverage down for single-A rated issuers, while net leverage increased for BBBs (Figure 4). 

In fact, about 40% of single-A issuer in our credit universe (ex. energy, materials, utilities) have negative net debt as of 2Q-2015." - source Bank of America Merrill Lynch

"Quality" indeed in Investment Grade credit is once more a "compelling" argument, we think, given the lateness in the "credit cycle".

While in September we would confide we have been adding on our US long duration exposure, it seems to us that in a "deflationary" enclined world, "quality" credit Investment Grade is still good value for your money, US High Yield doesn't appear to us like it and this bring us to the main reason we have also discussed in recent weeks is the rise in the cost of capital and global tightening financial conditions (think about our CCC Credit Canary and its issuance "issues"...).

This brings us to the final "inning" of this week's credit conversation, namely that in Liebig's law of the minimum, what matters in a D for Deflationary world more and more is the return of your capital, not the return on capital.

• Final charts - In a zero-inflation and borderline deflationary environment, the quality of the carried asset ultimately is more important than the cost of carry 

While we recently boasted on the attractiveness of "deflation floors" for US Tips as compelling in a "D" world, there has been as well as of late, some evidence of the rise in the cost of capital hence a slowdown in buybacks and US corporates starting to become more defensive of their "balance sheet". We would like to point out David Goldman's comments which can be found on Reorient Group's website from their note from the 18th of October: 

"Part of the reason for lower per-share profits is the decline in equity buybacks. Factset reports, “Companies in the S&P 500 spent US$134.4 bn on share buybacks during the second quarter. This represented a 6.9% decline in spending from the first quarter. At the sector level, six out of eight sectors saw a sequential (quarter-over-quarter) decrease in share buybacks at the end of Q2 (excluding the Telecom and Utilities sectors, which have each averaged less than US$2 b in quarterly buybacks since 2005).” 

Buybacks, in turn, have declined because the cost of financing them has risen. The spread to Treasuries paid by medium-grade corporate borrowers rated Baa/BBB has risen by a full percentage point since July 2014.

In a zero-inflation and borderline deflationary environment, 5.4% interest on term debt is real money, and corporates are getting reluctant to lever their balance sheets in order to show higher per-share earnings. During the past five years, the 100 members of the S&P 500 with the highest proportion of share buybacks (the S&P 500 Buyback Index) outperformed the rest of the index by 20%.

Source: Bloomberg

During the July-September correction, though, the S&P Buyback Index underperformed, losing 4% against 1% for the S&P as a whole.
That’s an important signal that the quality of the carried asset ultimately is more important than the cost of carry. If earnings continue to deteriorate, carry trades will start to resemble the conclusion of the Stephen King film with the homophonous name. " - source Reorient Group - David Goldman - 1§th of October

While it isn't yet "Nightmare" on "Credit Street", it looks to us that while leverage matters, earnings matter even more when it comes to "default" risk as we posited back in November 2012 in our conversation "The Omnipotence Paradox" which is in effect, yet another manifestation of "overconfidence" by our central bankers, at the time we argued the following:

"We believe the biggest risk is indeed not coming from the "Fiscal Cliff" but in fact from the "Profits Cliff". The increase productivity efforts which led to employment reduction following the financial crisis means that companies overall have reached in the US what we would call "Peak Margins". In that context they remain extremely sensitive to revised guidance and earnings outlook" - Macronomics, November 2012

One thing for sure, don't get "carried" away, preserving "capital" sure is the law of the minimum...

"Words have no power to impress the mind without the exquisite horror of their reality." - Edgar Allan Poe

Credit - Optimal bluffing

“It's funny. All you have to do is say something nobody understands and they'll do practically anything you want them to.” - J.D. Salinger, The Catcher in the Rye

Listening amusingly to the positive "spin" put by the French government on French economy smashing expectations, expanding by 0.6% in the first quarter following zero growth in the previous quarter, as well as learning about Benoit Coeuré from the ECB giving Hedge-Fund players an extra "edge" on the central bank's "front-loading" move, we reminded ourselves of  the "Optimal bluffing" strategy in the game card of poker for our chosen title analogy. David Sklansky, in his book The Theory of Poker, states "Mathematically, the optimal bluffing strategy is to bluff in such a way that the chances against your bluffing are identical to the pot odds your opponent is getting." 

We remembered the "whatever it takes" moment of our "Generous Gambler" aka Mario Draghi, which was no doubt a display of "Optimal bluffing" as it requires that the bluffs must be performed in such a manner that opponents cannot tell when a player is bluffing or not. To prevent bluffs from occurring in a predictable pattern, game theory suggests the use of a randomizing agent to determine whether to bluff. Of course, the continuation of the high stake Greek poker game, in our mind is yet another display of "Optimal bluffing". But, the on-going Greek saga is also a perfect illustration of our August 2012 conversation's analogy "Banker's Algorithm". In our computational reference previously used, "The Banker's algorithm" is run by the operating system (OS) whenever a process requests resources. The algorithm avoids deadlock by denying or postponing the request if it determines that accepting the request could put the system in an unsafe state (one where deadlock could occur):

"When the system receives a request for resources, it runs the Banker's algorithm to determine if it is safe to grant the request. The algorithm is fairly straight forward once the distinction between safe and unsafe states is understood.

1. Can the request be granted? If not, the request is impossible and must either be denied or put on a waiting list

2. Assume that the request is granted

3. Is the new state safe?
-If so grant the request-If not, either deny the request or put it on a waiting list. Whether the system denies or postpones an impossible or unsafe request is a decision specific to the operating system."

Looking at the "modus operandi" of the European Commission, or put it simply it's OS, it appears that the Greek request will not be granted for the moment but we ramble again.

Rest assured that when it comes to applying "Optimal bluffing", the US Fed is as well an astute poker player as well in this high stake poker game with global investors, given their latest FOMC comment:

"FED OFFICIALS GENERALLY DIDN'T RULE OUT RATE RISE AT JUNE FOMC"

Perfect illustrations of "Optimal bluffing" given of the chances against the Fed's bluffing are identical to the pot odds the market is getting we think.

In this week's conversation we will look at the challenges facing the Euro area which are indeed more challenging that of the Japan of the 1990s. We will also look at the deterioration of all the indicators in the latest survey from French corporate treasurers, depicting yet another bleak picture for unemployment given the decay in the overall cash position which had been on an improving trend since 2011 but has now turned more negative overall. Finally, we will look at liquidity in US credit with clear signs of vacuum in unexpected places thanks to the effects of central banks meddling aka "Cushing's syndrome" and overmedication.

Synopsis:

• Euro-area is worse than the Japan of the 1990s.
• The deterioration of the latest survey from French corporate treasurers warrants close monitoring
• The liquidity in US credit markets shows clear signs of vacuum in unexpected places
• Final note: Applying the US definition of U-6 under-employment shows Southern Europe is in the doldrums

• Euro-area is worse than the Japan of the 1990s.

In our February 2015 conversation "The Pigou effect", we argued that government bonds had replaced private sector lending on European bank's balance sheet with the significant effect of "evergreening" bad loans in Europe à la Japan. We also touched recently in April 2015 in our conversation "The Secondguesser" on the unattractiveness of the European banking sector particularly Southern European banks due to extensive use of on DTAs (Deferred Tax Assets) in their capital base:

"When it comes to "capital", what matters therefore is the "quality" of the capital. In the case of some Spanish banks, the capital levels made up mostly by DTAs are not sufficient regardless of the AQR. Given in the case of Spain, these DTAs constitute a "credit" against the Spanish government and are exchangeable for Spanish public debt we doubt this marks the end of the banks/sovereign nexus" - source Macronomics, April 2015

In continuation to the Euro-area comparison to Japanese woes of the 1990s we read with interest Nomura's take from their 19th of May 2015 Economic Insight note entitled "Euro area outlook more challenging than that of Japan in the 1990s" showing that indeed the Euro-area failed to learn its fast enough its Japanese lessons compared to the United States:

"Contrary to the US, the euro area failed to draw early lessons from the Japanese experience as it continuously rejected the analogy. But what put the euro area in a more challenging situation to that of Japan is in our view related to factors which are more idiosyncratic to the region (Figure 2). 

Our analysis of how the euro area is faring in comparison to the challenges that Japan faced in the 1990s – which is presented in detail below – suggests that the magnitude of the shocks has been on average less pronounced than in the case of Japan (see Figure 1). 

The area where we find that the euro area has been particularly badly hit relative to Japan is the banking sector, where problems cumulated in a number of countries across the region have been worse than in Japan and the slow policy response in the euro area will likely be remembered as the most important failure to draw lessons from the Japanese crisis. Europe did have the lessons of Japan to draw upon which Japan never had. We believe that there are still major issues in the banking sector that need tackling in earnest if the region wants to turn the page decisively away from the NPL and DTA issues that continue to plague a large swathe of the sector.

On labour markets, while downward nominal rigidities might have prevented the region entering a deflationary spiral for now, the adjustment has taken place on the unemployment side with under-employment today in the region around 20%, twice as much as Japan and the US. On a multi-year basis this will exercise fundamental downward pressures on wage growth of an order of magnitude which we believe is still underestimated by policy makers (the so-called “pent-up” deflationary process as described by Akerlof et al and Daly et al). Some of the symptoms behind the breakdown in nominal rigidities that took place at the end of the 1990s in Japan are also present in the current labour market developments in the euro area, arguing that on the aspect of nominal wages, the jury is still out." - source Nomura

Of course the main reason we had a much vicious recession with an explosion in unemployment in Europe was the ill-fated decision of the EBA to impose banks to reach a core tier one level of 9% by June 2012 which led to an epic credit crunch in Southern Europe.

We have also long argued there was an on-going "japanification" process in Europe. This was as well highlighted by Nomura's report:

"The euro area’s major underperformance

There has been a lot of debate over the past few years on the potential Japanification of the euro area, but most observers and policymakers have concluded that the euro area was unlikely to face a repeat of Japan’s experience and that the region has a higher chance of lifting nominal growth than Japan did. The ECB in particular has provided reasons for thinking that the euro area is in a different place than Japan was in the 1990s and that, while Japan provided some important lessons, the euro area was unlikely to face a similar outturn to that of Japan1.
As shown in Figure 3, euro area GDP was about 2% below that of Q1 2008 at the end of 2014 while Japan was down less than 1%.

Also, when looking at Japanese performance in the seven years following its own banking crisis, which reached its peak in 1997, output was 3% higher than at the beginning of the period and so grew by 5 percentage points more than the euro area over a comparable period (see again Figure 3).

The underperformance is also apparent when looking at other economic measures over different time periods. Figure 4 provides a comparison of productivity growth in Japan and the Big-4 euro area countries as measured by GDP per capita. With the exception of the 1990s and of Germany, productivity growth has been higher in Japan since the beginning of the 2000s.

Consumption per capita (in real terms, see Figure 5) in Japan rose on average by 2.6% per year between 1970 and 2013, higher than any of the Big-4 euro area countries.

Since 2009, Japanese consumption per capita has increased by 1% per year on average in line with the German consumer and higher than the other three countries in the Big-4. The euro area has outperformed Japan to date on nominal variables such as nominal GDP or nominal wage growth, but that is no reason for optimism in our view.

Based on the recent underperformance of the euro area, we believe the question should not be about the risks of Japanification but about whether the euro area can return to a sustainable path of growth that would put it at least on a par with Japan." - source Nomura

Exactly, and we do not think the euro area can return to a sustainable path of growth particularly when one looks at France and the lack of structural reforms recently highlighted by the IMF. 

In earnest, do not expect any major changes given French President François Hollande is already on the campaign trail for 2017. 

France remains in our views the new barometer of risk for core Europe. Back in August 2014 in our conversation "Thermocline - What lies beneath", we discussed the "Optimal bluffing" of the French government in its forecasting skills:

"French Minister Sapin is talking about budget deficit being above 3.8% in 2014, rest assured it will be North of 4%. If you have 0.5% of growth it should equate to 4.3%" - Macronomics, August 2012

For 2014, the budget deficit for France was in fact 4% but debt to GDP increased from 92.3% to 95.6%. We were not that far off in our estimate. The issue in the game of poker when a player bluffs too frequently like French Minister of Finance Michel Sapin, at Macronomics we just had to "snap off" his bluffs by re-raising our budget deficit estimate.

A symptom of European woes has been the very weak aggregate demand caused by the European crisis and the credit crunch triggered by the EBA in 2012 which accelerated the deleveraging of European banks and the lack of credit transmission to the real economy. This can be ascertained by the different trajectory taken between the United States and Europe also highlighted in Nomura's report:

"Leaving aside the Japanese comparison, it is also worth emphasising the extraordinarily weak performance of final demand (as measured by real consumer spending + nonresidential capex) in the euro area both relative to its own past (Figure 6) and relative to the US (Figure 7).

Assuming that euro area private sector demand picks up from now on and follows an uninterrupted recovery path comparable to the one experienced by the US over the past six years (i.e. with the growth rate 16% higher than its previous trend rate), it would take seven years for the euro area to resorb part of the private sector gap that has built up since the onset of the crisis and shrink it to 7%. Even assuming an extraordinary deterioration on the supply side, it is hard not to believe that there is a substantial amount of slack in that economy." - source Nomura

In our conversation "The Secondguesser" we also highlighted the difference between Europe and the US:

"In the US QE was more effective for a simple reason: stocks vs flows as highlighted earlier. The problems facing Europe and Japan are driven by a demographic not financial cycle. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment." - source Macronomics

After all, credit growth is a stock variable and domestic demand is a flow variable. We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe:

"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012.

Of course, the availability of credit is only beginning to be restored in Peripheral Europe and has been encouraged by the ECB's recent QE but it is by no means dealing with the stock on Southern European banks impaired balance sheets!

Also, private demand due to high unemployment levels continue to weigh significantly in the euro area private sector as indicated by our musings from our November conversation "Chekhov's gun":

"If domestic demand is indeed a flow variable, the big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.

QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.

In textbook macroeconomics, an increase in AD can be triggered by increased consumption. In the mind of our "Generous Gamblers" (aka central bankers) an increase in consumer wealth (higher house prices, higher value of shares, the famous "wealth effect") should lead to a rise in AD.

Alternatively an increase in AD can be triggered by increased investment, given lower interest rates have made borrowing for investment cheaper, but this has not led to increase capacity or CAPEX investments which would increase economic growth thanks to increasing demand. On the contrary, lower interest rates have led to buybacks financed by cheap debt and speculation on a grand scale.

 In relation to Europe, the decrease in imports and lower GDP means consumer have indeed less money to spend. We cannot see how QE in Europe on its own can offset the deflationary forces at play." - source Macronomics, November 2014 

Put it simply, credit growth is a stock variable and domestic demand is a flow variable. Central-bank induced liquidity is pointless without the real economy borrowing and the issue at the heart of the problem is that most Southern European banks are in fact "capital constrained" and plagued by NPLs (Nonperforming loans) and artificially boosted capital by DTAs.

When it comes to the comparison with Japan in the 1990s, Nomura's report makes an important point relating to the size of the problem which has not been dealt with in Europe:

"Figure 14 shows that banks’ conditions in many euro area countries are significantly worse than at the worst point of the Japanese banking crisis between 1997 and 2002, when NPLs peaked at 8.4%.

In particular, NPLs in Cyprus, Greece and Ireland are above 20%, even higher than Japan’s NPLs subject to self-assessment and after the implementation of bad banks in some of these countries. More worryingly, NPLs in Italy and Spain are above the Japanese levels.

The IMF finds in its latest GFSR that banks with a higher ratio of non-performing loans have tended to lend less: for 60 euro area banks over 2010-13, those with the lowest NPLs (1st quantile) expanded their loan supply by six times the national average growth rate, while the credit of those with the highest NPLs (the 4th quantile) contracted at the pace of four times the national average growth rate. This negative relationship is believed to arise because the non-performing assets decrease banks’ profitability, use more capital (to absorb the bad assets), and damp banks’ intention to lend to borrowers with borderline credit quality.

DTA might be another potential risk to the banking sector
Bank equity, or net asset value (NAV), always acts as the first line to defend the financial entity in an adverse event. However, not all the equity is of the same quality as some can quickly lose their value in face of negative shocks and pose significant risks to the financial system. One example is a bank’s “goodwill”. Another important asset whose quality is generally recognised of being of a lower standard is the “deferred tax assets” (DTAs).
A deferred tax asset is an asset used to reduce the amount of tax due in the future. It mostly arises when a bank makes losses, for example by writing off bad loans. The losses, although processed as expenses in corporate accounting, are not tax deductible under tax law. As such, an “overpayment” of taxes emerges. It is then booked under deferred tax assets in the assets section, which correspondingly requires an increase in the bank’s equity. In theory, DTAs can reduce banks’ liability in the future but this only materialises if the bank can make enough taxable profits. That said, for banks that overestimate future earnings, their equity is inclined to be overvalued by DTAs.

This was the case for Japan back in the late 1990s: in 1998 when banks’ other sources of regulatory capital had been depleted, Japan introduced the rule of deferred tax assets and allowed them to be accounted for as regulatory capital. DTAs then became an important source of regulatory capital for Japanese banks. For example, in 2002 the major banks’ DTAs totalled 60% of bank equity (Skinner, 2008), rising quickly from 45% in 2001 and from 29% in 1998. This increase in weak forms of capital is thought to have prolonged the financial crisis (Skinner, 2008).

In the euro area, currently the CRR (Credit Requirements Regulation) allows competent authorities to set the percentage for the deduction of DTAs relying on future profitability at 10% in 2015 for DTAs that existed before 1 January 2014. The deduction rate will increase by 10% each year until 2023. For DTAs created after 1 January 2014 and relying on future profitability, a phase-in approach is applied, i.e. minimum of 20% in 2014, 40% in 2015, 60% in 2016 and 80% in 2017 and 100% in 2018.

For the moment, the ratios of net DTAs to bank equity in some countries are at similarly high levels as in Japan back in 2001-02 (Figure 15).

In particular, the ratio in Greece is higher than the peak level in Japan and that in Portugal is above Japan’s 2001 level. Although for Spain and Italy DTAs have a lower share in total bank equity, 30% is still big enough to pose significant risks in adverse scenarios, in our view." - source Nomura

Exactly! DTA amounts to us as "dubious" capital. As we have shown in our conversation "The Secondguesser" many Southern European banks are still capital impaired  and their banks' capital basis are made up for a large part of Deferred Tax Assets (DTAs).

• The deterioration of the latest survey from French corporate treasurers warrants close monitoring

One particular important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest survey published on the 18th of May points to a deterioration in the Terms of Payments, which indicates that the improving trend since mid 2012 has turned decisively negative:

The monthly question asked to French Corporate Treasurers is as follows:

Do the delays in receiving payments from your clients tend to fall, remain stable or rise?

Delays in "Terms of Payment" as indicated in their May survey have reported an increase by corporate treasurers. Overall +18% of corporate treasurers reported an increase compared to the previous month (+22.8%), bringing it back to the level reached in October 2014 (17.9%). The record in 2008 was 40%.

Overall, according to the same monthly survey from the AFTE, large French corporate treasurers indicated that they are still facing an increase in delays in getting paid by their clients. It is therefore not a surprise to see that the overall cash position of French Corporate Treasurers which had been on an improving trend since 2011 has now turned more negative overall according to the survey:

The monthly question asked to French Corporate Treasurers is as follows:

"Is your overall cash position compared to last month falling, remains stable or rising?"

Whereas the balance for positive opinions was 17.9% in November 2014 and still at 6.3% in January 2015, February saw it dip to -5.2% and March's came at -13%, April at -0.5% but provisional May came at -9.5%.

We will restate what we mentioned back in our March 2015 conversation "Zugzwang":

"This warrants significant monitoring in the coming months we think from a "corporate monitoring health" perspective."

The French government policy is based on "hope" and their strategy is based on "wishful thinking". No matter what, we do not see unemployment falling with these deteriorating conditions.

Furthermore, in our March conversation, we indicated the following:

"While the international scene is watching with caution the rise of the French National Front, the political story, we think is the slow dislocation of the unity of the left." 

As we indicated in our conversation as well is that there was a large contingent of public servants supporting François Hollande representing 22% of the working population compared to 11% in Germany. The slow dislocation of the unity of the left is currently being tested given there was a significant demonstration of teachers in France this week. French teachers’ unions, which routinely protest any changes, complained about reforms relating to secondary education. France’s 840,000 teachers have traditionally been a strong base of support for President François Hollande, but the proposed reform has turned many against him and his ruling Socialists. Furthermore the growing rift has been increasing given the proposed reforms where pushed through a decree without consultation during the night, following the day of the demonstration. Given President François Hollande is already on the campaign trail for 2017, it will be interesting to see most of structural reforms requested by the IMF put on the sideline.

Given the on-going negative trend from the AFTE surveys, it will be interesting to both monitor the micro data from a corporate health perspective as well as the evolution of the political mood in France and the lack of progress in the unemployment front in the coming months.

• The liquidity in US credit shows clear signs of vacuum in unexpected places

We share the growing concerns of the lack of liquidity in the fixed income space. On numerous occasions we have indicated our uneasiness with the "yield hunt" and dwindling liquidity in the secondary space thanks to banks deleveraging as well as mounting regulatory pressure on market makers.

A good illustration for the hunt for yield has been happening in the high yielding space such as MLPs, REITS, dividend funds and High Yield as displayed in Bank of America Merrill Lynch's chart from their Thundering Word note from the 17th of May entitled "The Twilight Zone":

"High Yield
Investors are positioned heavily in high yield, high dividend yield and high PE strategies (Chart 15). The quest for high yield (relentless multi-year inflows to dividend funds, MLPs, REITS & HY bonds - $415bn inflows since Mar’09) remains the biggest Achilles’ Heel for positioning, in our view." - source Bank of America Merrill Lynch

What we find of interest from a "Twilight Zone" perspective is that when it comes to the Fixed Income space, the liquidity deterioration is not what it seems and has not been where one would have expected it to be. On this specific matter we read with interest Deutsche Bank's US Credit Strategy note from the 20th of May entitled "Signs of Liquidity Vacuum in Unexpected places":

"Liquidity deterioration has not been uniform across fixed income
While liquidity has deteriorated in all parts of fixed income, the extent of such deterioration has not been uniform, and this represents another area where consensus view is often misguided, in our opinion. Figures 1 and 2 below present trading volumes in HY, IG, and Treasury markets, expressed in a percent of market size terms. 

The scale here is showing us the proportion of each respective market that changes hands on a daily basis, measured as a trailing 12-month average value. In other words, HY traded 0.7% of its market size on an average day in the past year; IG traded 0.4%, and Treasuries traded 4.0%. The degree of deterioration in these metrics since their pre-crisis levels amounted to a 30% loss of trading depth in HY, 50% in IG, and 70% in Treasuries! We are doubtful that most investors realize the presence of this distribution in that the higher quality segments of the fixed income universe have in fact been impacted by liquidity withdrawal to a greater extent. Treasuries still maintain their position as the most liquid set of securities in the world; they are just not nearly as liquid as they used to be pre-crisis.
This last point is critical to properly understanding the current liquidity environment and its implications. While most investors perceive HY liquidity as being inherently poor, and drying up even more around turning points in the market, this in fact has been the normal state of affairs in our asset class. Few investors realize that IG has become a more illiquid portion of the credit universe, even though somewhat misleadingly a given IG cusip usually trades more deeply than a given HY one.Deutsche Bank Securities Inc. Page 3
These findings have significant implications as to how investors should be positioning themselves to take advantage of liquidity vacuum points that undoubtedly await us in the future. Instead of watching HY market for the signs of cracks, they should be spending more time monitoring higher quality portions of the market going all the way up to Treasuries. The experience of last year’s October 15 is very important in this respect in that it serves as a preview of what a liquidity vacuum experience is likely to feel like. The 10yr Treasury yield experienced a seven-sigma intraday move during that session, triggered by temporarily thin volume at some point, and exacerbated by dealers pulling a plug on their electronic trading systems on early signs of volatility. While that particular experience has not registered as much in credit, given its extremely short duration measured in minutes, it is reasonable to assume that it could have more pronounced implications in the future, if it lasts longer than that or repeats itself more frequently.
Furthermore, and we cannot overemphasize the importance of this point, most investors tend to think about the potential impact from reduced liquidity in the context of Fed’s raising of short-term rates and a resulting back up in longer-term Treasury yields. The key lesson from October 15 however is that Treasury yields gapped down, and not up, in seven sigma moves in a perfect example that illiquidity-driven volatility could happen on lower rates as well. We could not have come up with a better example than this to drive home our most important point: it is a point of debate how far and how fast the Fed is going to be able to raise short-term rates, given the prevailing weak macro environment and a potential for negative side-effects of higher volatility. But volatility itself could, and most likely will, materialize from their attempt of doing so, even if a lesson from this experience is that six-plus years of zero rates would make it incredibly difficult to raise rates in early stages of a liftoff without disrupting the market. The point is that failure to raise rates materially does not by itself protect us from higher volatility impacting the Treasury market first and IG/HY market next. In fact such a failure would probably mean that volatility was just too high for the market and the economy to be able to cope with it." - source Deutsche Bank

In this high stake poker game with investors, we hope the Fed will be able to play its "Optimal bluffing" strategy given its bloated balanced sheet and reduced liquidity in the Treasury market.

• Final note: Applying the US definition of U-6 under-employment shows Southern Europe is in the doldrums

Whereas many pundits are expecting a gradual recovery in Europe thanks to the ECB's QE support, we beg to differ and as we indicated previously, in our conversation "Chekhov's gun" back in November 2014:

Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).
“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?

Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)

When it comes to the damages inflicted by the "credit crunch" in Europe, again as a final point, we would like to point out Nomura's interesting replication of the US BLS methodology to construct broader measures of unemployment in the euro area focusing on the so-called U-6 from their 19th of May 2015 Economic Insight note entitled "Euro area outlook more challenging than that of Japan in the 1990s":

"We also believe that the level of so-called labour under-utilisation, a concept which has recently attracted a large amount of attention in the US, is in the euro area at levels that no advanced economy has seen since the great depression. The rising share of nonregular contracts has been a feature of the Japanese (see Kuroda & Yamamoto 2013) and German (see Toshihiko, 2013) labour markets. This structural change is generally understood as having helped diminish the bargaining power of wage-setters and thus to the surprisingly low wage dynamics in those economies.
Measures of labour under-utilisation in the euro area are not readily available, which is probably the reason why there so little attention has been devoted to this topic.

We have replicated the US BLS methodology to construct broader measures of unemployment in the euro area focusing on the so-called U-6 definition of unemployment (a measure that includes people marginally attached to the labour force, part-time employment for economic reasons, and unemployed).

The results shown in Figure 23 indicate that the euro area U-6 rate averaged slightly above 20% in 2013 (the latest year we have) compared with 13.6% in the US. The last reading for the US which is available on a monthly frequency was 10.9% in March 2015, down from its March 2010 cyclical peak of 17.1%.

The picture across the region is extraordinarily varied, with the German U-6 already below 10% in 2013 and below its 2002-04 average and countries like Spain, Greece and Italy with U-6 levels at or above 30% and more than twice their 2002-04 averages." - source Nomura

QE on its own, rest assured will not cure European woes and particularly the difficult employment situation in Southern Europe, no matter how "Optimal" the ECB thinks it is "bluffing".

"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

Stay tuned! 

Credit - The Secondguesser

"Do not try to second-guess or master-mind our military officials. Leave this for established military analysts and experts, who are experienced enough to await the facts before drawing conclusions." - Broadcasting magazine, December 1941

While playing with interest the Hang Seng Index rally game given we have taken some exposure since the 30th of March and enjoying the ride so far, we reminded ourselves the definition of "second-guess" for our title analogy, as it can be of two folds:

1. To criticize and offer advice, with the benefit of hindsight.
2. To foresee the actions of others, before they have come to a decision themselves.

Of course when it comes to our "Asian allocation", we have indeed played number two and decided to "front-run" somewhat the appetite for Chinese investors moving from Shanghai towards Hong-Kong when it comes to their regional "appetite". As far as our title is concern and the choice of allocation, it stems from learning from the wise Charles Gave of Gavekal research for whom we have great respect: 

"if there is more money than fools then market rise, and if there are more fools than money markets fall"

In the case of the HSI, there is indeed more money than fools, whereas when one look at the European government bond markets and in particular the state of the corporate Hybrid debt market we touched on last week, there are indeed more fools than money in Europe. This ties up nicely to definition number 1 for "second-guess" and the benefit of hindsight, given that the "bond" risk in Europe doesn't justify anymore the reward we think.

A commonly used meaning of "to second-guess" is to criticize the actions of others, after the event. On this blog, we try to criticize the actions before the events. When it comes to choosing our title we also reflexionated around the meaning and the origin of the expression as defined by Gary Martin:

The umpire in a baseball game used to be called, rather unkindly, 'the guesser'. People who were continually telling the guesser, the manager or the players what they were doing wrong were known as 'secondguessers' and were so defined in the Sporting News Record Book, 1937:
"Secondguesser, one who is continually criticizing moves of players and manager."

Therefore one could unkindly define us as being "Seconguesser" when it comes to assessing the macro and credit environment and the decisions taken by our brazen central bankers, but we ramble again. Although one could indeed unkindly defined as "Secondguessers" with these few examples:

• we have been short yen since November 2012 when the Japanese yen was trading around 80 as described in our conversation "Cold Turkey" (partly via ETF YCS) guessing that the Bank of Japan had a lot of catch-up to do when it came to QEs and expanding its balance sheet .
• Following the BOJ move, in early 2013 we went long Nikkei but in "Euros" via a quanto ETF (currency hedged).
• Of course our biggest 2014 call has been to go long US duration in January (partially via ETF ZROZ).

As per our January 2013 conversation, "If at first you don't succeed...", we have repeatedly broken our Magician's Oath:
"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

We have to confide, that we have continued to become clear "Seconguessers" as per definition number 2 above when it comes to "second-guessing" the "Black Magic" practices of our magicians of central bankers and their "secret illusions".

So never mind the practices of our "dark sorcerers apprentice", as in this week conversation, while we will briefly touch on the attractiveness of Asia versus Europe, we will look at the supposed end of the European banks/sovereign nexus particularly in the light of the latest Icelandic proposal, namely the Sovereign money proposal which we think is a must read.

Synopsis:

• Yes, for now Asia is a buy and it will continue to be so
• A large number of European banks still destroy value
• Many Southern European banks are still capital impaired
• Don't count on the end of the banks/sovereign nexus in Europe
• Final note: Flows have lagged performance in EM

• Yes, for now Asia is a buy and it will continue to be so

As me mentioned, playing our "Secondguesser" role has meant we have gotten on the HSI exposure since the 30th of March and we do believe in the compelling valuation story in Asia, regardless of the recent parabolic rise in the equity space.

So one might wonder why there has been such a rally in the equity space. It all has to do with the collapse in China money market rates as displayed by Bank of America Merrill Lynch in their recent Liquid Insight note from the 15th of April 2015 entitled "What's driving China rates":

"More to lower rates than just policy easing
The rally in the China stock market since March has been significant and in our view at least partly related to expectations of policy stimulus, as reflected in lower rates (Chart of the Day). In particular, there has been a lot of focus on China’s money market rate – the 7-day repo – which has dropped about 200bp to 3.0%. The decline should come as no surprise as market rates were high relative to inflation, and high real rates were probably the last thing the government wanted to see given the slowdown in investment and economic growth. The market move has been consistent with our view that 7d repo should come off to 3.0-3.5% in the short term.

But a closer analysis suggests banks’ liquidity management also played an important role in the decline of repo rates, over and above the PBoC’s policy guidance. The question is how fast and to what extent can money market rates fall from the current low level, in particular after the latest weaker-than-expected financing and economic data. We argue that the 7d repo rate could fall moderately further to an average of 2.5-3.0% in the coming months, but that the sharp decline of recent months seems unlikely to repeat itself." - Bank of America Merrill Lynch.

We are not the only one thinking about the China "reflation" trade as we see maverick money manager Stanley Druckenmiller recently commenting on this very subject on April 15th in Bloomberg article from Katherine Burton and Stephanie Ruhle entitled "Druckenmiller Bets on Market Surprise With China Boom, Oil Rise":

"Chinese stocks have soared with the Shanghai Composite Index doubling in the last 12 months.
“Whenever I see a stock market explode, six to 12 months later you are in a full blown recovery,” he said.
A recovery in China, the world’s second-biggest economy, would influence securities and commodities prices around the globe, said Druckenmiller. For instance, it would send German government bond prices lower, boost European exporters and lift the price of oil, he said in a separate interview." - source Bloomberg

When it comes to valuation, while the rally in Asia has been epic, when it comes to Europe, we would rather "cash in" given current valuation levels as displayed in the latest note by Louis Capital Markets from the 13th of April entitled "Three For The Price Of One" where one can see in their bonus chart the percentage of Stoxx Europe 600 members trading above their 200-day Moving Average:

 - source Louis Capital Markets

With the liberalization of personal account rules in China and a forward PE around half of the S&P500 and a free cash flow yield or around 20% according to Asia Times, Hong-Kong appears to us a better "value proposition" in these global inflated markets if we would need to second-guess investors' appetite.

• A large number of European banks still destroy value

When it comes to Europe and in particular many points to cheap valuation in the European banking space. As we have argued in our conversation "The Pigou effect" in February this year, we have argued around the "japanification" process of Europe:

"As we have stated on numerous occasions, when it comes to European banks, you are better off sticking to credit (for now) than with equities given the amount of "deleveraging" that still needs to happen in Europe."

This "japanification process can be seen with the rapid disappearance of "positive" yields in the European Government space with German Bunds closing on the zero bound.

We have also long argued that regardless of QE, ZIRP and AQR, European banks would be facing continued deleveraging and that both bondholders and shareholders alike would in many instances get punished for their holdings. The reason is that European banks, in many cases still destroy value. On this subject, we read with interest Nomura's EU banks strategy note from the 10th of April entitled "Why European banks still destroy value":

"Why do half Europe's banks not make a 10% cost of equity?
Even by 2016, Bloomberg consensus implies that half of Europe’s larger banks will not make a return on tangible equity above their historical 10% cost of equity. This contrasts with US banks where almost all exceed the hurdle.
In this report, we decompose profitability to identify the main drivers. Low ROE banks are mainly a result of higher costs, and to a lesser extent higher provisions and higher taxes. Margins (mix) and leverage together account for less variation between high and low ROE banks. Nordic and Benelux banks show the highest ROEs, while German and Italian banks are lowest, with UK, France and Spain around the 10% hurdle.
How and where can banks improve their profitability?
We show that cutting costs would deliver the biggest improvements in ROE, but given the consistency of national cost/income ratios, much of the differences in costs appear to be structural. Although most banks have some form of cost reduction plan in place, few target an absolute reduction in the cost base, suggesting it will take some time for banks in the least profitable countries to converge their ROEs (hence valuations) with the best in class." - source Nomura

Truth is most European banks offer poor value in terms of returns as shown in Nomura's report:

"Even by 2016, Bloomberg consensus implies that half of Europe’s larger banks will not make a return on tangible equity above their historical 10% cost of equity. This contrasts with US banks where the average ROTE of banks in the BKX index is just over 13% and where almost all exceed the10% hurdle."

- source Nomura

As pointed out by Nomura's note we were note surprise to read that US banks higher ROE was driven by fewer lower risk mortgages on balance sheets:

"The higher ROE of US banks is driven by higher revenue margins given fewer low risk mortgages on balance sheet. This (and to a lesser extent a lower cost of risk) helps compensate for a considerably better leverage (equity/assets), as well as a slightly higher cost/income ratio and tax rate."

This is not a surprise for a "secondguesser" as we have highlighted on numerous occasions the very important concept namely the accounting principles of "stocks" versus "flows":

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

After all, credit growth is a stock variable and domestic demand is a flow variable. We have long argued that the difference between the FED and the ECB would indeed lead to different growth outcomes between the US and Europe:

"Whereas the FED dealt with the stock (mortgages), the ECB via the alkaloid LTRO is dealing with the flows, facilitating bank funding and somewhat slowing the deleveraging process but in no way altering the credit profile of the financial institutions benefiting from it! While it is clearly reducing the risk of banks insolvency in the near term, it is not alleviating the risk of a credit crunch, as indicated in the latest ECB's latest lending survey which we discussed in our last conversation." The LTRO Alkaloid - 12th of February 2012.

Of course, the availability of credit is only beginning to be restored in Peripheral Europe and has been encouraged by the ECB's recent QE.

The core of our macro thought process is based upon the difference between "stocks" and "flows", which we highlighted when discussing the growing difference between Europe and US growth (see our post "Shipping is a leading deflationary indicator"). The same approach can be applied in relation to the growing divergence between US banks versus European banks we think. 

This difference can be ascertained from the difference in return on assets for EU banks versus US banks as displayed in Nomura's recent report:

- source Nomura

Given the amount of deleveraging that still needs to occur in the European banking space, this divergence will continue to grow.

Although European banks have risen 16% YTD, they are still underperforming the market and when it comes to their peers in the global space they do stand out less cheap as indicated by Nomura in their report:

"EU banks stand out less as cheap vs global peers …
With the 16% rise in European banks YTD, the market capitalization weighted SX7P banks index trades at 1.2x 2015E TBV for a consensus 2016E ROTE of 11.7%, which limits aggregate re-rating opportunities (absent a sustained fall in the cost of equity).
At a global level within the banking sector, European valuations generally appear proportionate to forward ROE expectations, with some countries already implying further profitability improvements." 

- source Nomura

When it comes to a better "value" proposal, China stands out as having much better 12m forward ROE. It is also not a surprise for a "Secondguesser" to see Chinese banks listed on the Hang Seng China entreprises index rallying hard as well as indicated by Asia Times in their article from the 15th of April entitled "Chinese bank soar on valuations":

"Industrial and Commercial Bank of China led gains on the Hang Sang China Enterprises Index overnight, up 4.86%, followed by China Construction Bank (+4.39%), Bank of Communications (+4.31%), China Minsheng Bank (+3.93%), Bank of China (+3.56%) and Agricultural Bank of China (+3.50%). Banks rallied after ICBC reported mediocre 4th quarter earnings, with a big pop in loan loss provisions and a modest decline in YOY net revenue.
Mediocre is beautiful when stocks are cheap. Chinese banks non-performing loans were a mystery wrapped in an enigma wrapped in plastic explosive, and the market bid down bank stocks because of uncertainty about future write-offs. A year ago, ICBC traded at a multiple of just 4 to earnings. Now investors are convinced that banks can earn their way out their bad loss positions over time, and bank multiples have recovered–to just one-third their pre-2008 levels.
At the peak of the 2007 China equity boom ICBC traded at 21 times earnings, or three times its present valuation. The bank stock recovery reflects greater confidence in regulatory transparency under the ongoing financial reform regime. The banks have gone from distressed valuations to merely low valuations.
As global managers pile into the China trade, moreover, bank stocks are among the few vehicles with enough market capitalization and liquidity to meet the requirements of large portfolio managers." - source Asia Times

From a "second-guesser" perspective, there is indeed better value in Asia at the moment and particularly in the banking space we think whereas European banks doesn't offer that much value particularly when one takes into account the quality of capital in Southern European banks. This brings us to our next item

• Many Southern European banks are still capital impaired

Many Southern European banks' capital basis are made up for a large part of Deferred Tax Assets (DTAs) as reported by Nomura in their Southern European Banks report of the 7th of April entitled "Quality of Capital":

"Deferred tax assets (DTAs) under the microscope
European authorities are reported to be considering whether or not the legislation and guarantees on DTAs in southern Europe can be considered state aid (FT, 7 April 2015). This is in addition to the ECB looking for greater harmonisation of European capital ratios by attempting to correct for some of the different national definitions.

How big an issue are DTAs for southern Europe?
DTAs have increased significantly in southern Europe over the past few years (generated by the significant losses incurred by many of the banks). However, under Basel III’s definition, the bulk of the DTAs will be deducted from capital ratios (a change vs the previous regulatory environment). To minimise the impact of this regulatory treatment, many countries in southern Europe enacted legislation to limit the impact of this deduction. DTAs currently represent c42% of tangible equity in southern Europe and contribute a median of c300bp to core capital ratios.

Raise capital or improve quality over time? 

Given the extent and the size of the DTAs in southern Europe, and taking into account political considerations, we think it unlikely that the banks will be forced to raise capital specifically to address this issue. However, with the ECB increasingly looking to harmonise capital ratios, the banks could be required to continue to build and strengthen capital ratios over time. This issue could also be a hurdle to those banks looking to significantly increase dividends or payout ratios. For the moment though, the majority of dividend policies for southern European banks target moderate payout ratios of c40%- 50% (with Intesa the one major exception – targeting a payout ratio of c70% in 2015 and c82% in 2016)." - source Nomura

Hence our negative stance on European Banks and Southern European Banks in particular given the additional "real capital" that is needed to compensate for the "favorable" DTA treatment offered by the local regulators.

The exposure to DTAs while often overlooked when it comes to the quality of capital is not trivial as per the same report and is very significant in the Spanish banking system as indicated by Nomura in their report:

"Exposure to DTAs
As we can see from Fig. 1 banks in southern Europe have built up significant amounts of DTAs. In Spain alone total DTAs reached cEUR 77bn in 2013, although net DTAs (ie, net of tax liabilities) were cEUR 68bn. Low levels of profitability have meant that for the moment the amount of DTAs continues to increase.
Under Basel III, the treatment of DTAs is harsher vs the previous regulatory regime. However, in an effort to minimise the negative impact on capital from holding large levels of DTAs, governments in southern Europe have enacted legislation to reduce some, if not most, of this impact. In Spain, for example, the value of the DTAs is underwritten by the Spanish government. The DTAs that are not used up within 18 years are considered a credit against the Spanish government and exchangeable for Spanish public debt. Of the total amount of net DTAs in Spain, the government has guaranteed c 60% or cEUR 40bn. As we can see in Fig. 2, DTAs account for a significant part of the current capital ratios for the banks.

Our base-case scenario is that the banks do not have to raise capital to specifically address this issue. However, we do believe capital ratios could be raised to higher levels. The level of DTAs could also affect banks looking to raise payout ratios to high levels or significantly increase dividends, although most dividend policies are targeting a moderate payout ratio of c40%-50% (which we believe is achievable)." - source Nomura

When it comes to "capital", what matters therefore is the "quality" of the capital. In the case of some Spanish banks, the capital levels made up mostly by DTAs are not sufficient regardless of the AQR. Given in the case of Spain, these DTAs constitute a "credit" against the Spanish government and are exchangeable for Spanish public debt we doubt this marks the end of the banks/sovereign nexus discussed in our next bullet point.

• Don't count on the end of the banks/sovereign nexus in Europe

As highlighted by the DTAs issue in our last bullet point, the last couple of years have seen the banks/sovereign nexus increasing thanks to the "carry trade" financed by cheap LTROs allowing Peripheral banks to gorge on the domestic debt of their country (Italy and Spain). On the subject of the banks/sovereign loop in Europe we read with interest Bank of America's take on the subject in their Euro Area Economic Viewpoint from the 13th of April entitled "Towards the end of the banks/sovereign nexus":

"Banks/sovereign loop in the EA was worse, absent QEIn the Euro area, the impact of the banks/sovereign negative feedback loop was even more acute than in the rest of the developed world, given the tardiness in addressing the structural issues of the banking sector and more fundamentally because, in the absence of QE, banks played the role of marginal lender to the government - thanks to the ECB's generous liquidity policy - at the expense of funding the private sector.

But things are improvingHowever, thanks to progress in the capital position of banks and the new "presumption of bail-in" - which in our view could only come after the most acute systemic banking risks were actually alleviated thanks to government support (e.g. in Spain) - member states' exposure to the financial sector has now fallen. This liberates more room for manoeuvre for counter-cyclical fiscal policy. The recent shift, in the Euro area, from all-out austerity to a neutral, or even slightly stimulative, fiscal stance would not be sustainable, in our view, if government faced massive contingent liabilities.

And QE will help reduce the loop even further
At the same time, to wean banks off lending to the governments at the expense of the private sector without jeopardizing the governments' funding capacity - which would be equally detrimental to economic growth - the Euro area needed to find an alternative marginal lender. This is achieved by QE. In a nutshell, QE is the necessary complement to banking union and the Single Resolution Mechanism to break the banks/sovereign nexus. This is another, indirect, transmission mechanism of QE to the real economy. Under cover of QE, we think that the regulatory authorities will try to incentivize banks to reduce their exposure to sovereigns. This is the message that Daniele Nouy, head of SSM, sent in a recent interview in the Handelsblatt, in which she opined that holdings of government bonds should be limited to a quarter of banks' equity." - source Bank of America Merrill Lynch

We disagree with the aforementioned progress made in the capital position of banks, particularly in the light of the DTAs for Southern European banks. While QE will certainly try to incentivize banks to reduce somewhat their exposure to sovereigns, we have a hard time seeing most of these banks part with some of their highly collateral such as German government bonds due to bond scarcity with the German budget being balanced and the reduction in their debt to GDP level.

In the US the problem were dealt swiftly and differently as highlighted by Bank of America Merrill Lynch's note:

"In the US, vigorous monetary policy action - in the form of early QE - managed to offset much of the fiscal drag. To put things simply, if fiscal support is unavailable and sensitivity to interest rates is lower, then monetary policy needs to "go an extra-mile'. In our view, QE in the US has been instrumental in making sure the economy remained on the recovery track in spite of a i) effective fiscal drag and ii) unprecedented threats of "catastrophic withdrawals" in public spending, with the various "debt ceiling" and sequester episodes. The UK is another example of a country which managed to control the impact of a major fiscal drag - after a just as major public bailout of the financial system - thanks to extraordinary monetary support.

In the Euro area, in our view, the "banks/sovereign" nexus played a more acute role than in the US and the UK, not simply because monetary policy did not offer as much support, at least until very recently, but more fundamentally because the "banking issue" had a more durable, complex and pervasive effect on the economy and policy-making.

The banks/sovereign nexus is bad everywhere, but it's even worse in Europe
The reaction of the US authorities - after the initial "bail in" temptation on Lehman Brothers - was remarkably swift. Forcing a recapitalisation and imposing management decisions on banks complemented state support on liquidity. In Europe, while support came very quickly, there was comparatively little attempt at dealing with the structural issues surrounding the national banking systems. Probably to some extent because European policy-makers considered that this was primarily an "Anglo-Saxon crisis", the onus was on dampening the contagion effects of a New York born financial meltdown, without necessarily a clear awareness of the depth of the local difficulties.

This timing difference is plain to see in banks’ capital to asset ratio across the regions (see Table 3).

For simplicity of analysis, we look here at total assets, not risk weighted assets. This measure, which we take from the IMF’s financial stability report, is therefore close to a leverage ratio. Before the Great Recession, the ratio was already much higher in the US than in Europe (roughly twice as large), but what is striking is that within only three years, it had already improved by more than 2 percentage points. The best European performer during this period (France) managed an increase of only 1.2 pp, from a very low starting point.
The irony, then, is that the Europeans ended up spending slightly more government money on their banks than the Americans (4.9% of GDP instead of 4.5% of GDP for on-balance sheet expenditure alone) while triggering a much smaller improvement in their banks' capital position. To some extent, this mechanically reflects the difference in size between the two banking systems - the same public spending in % of GDP has a much lower impact on the financial position of the much larger European banking sector - but we also consider that, at least at the onset of the crisis, European governments failed to emulate their US counterpart in making public support conditional on significant and rapid efforts from banks under their jurisdiction to deal with their underlying problems.
Europe’s tardiness in dealing with the structural issues of the banking sector proved particularly toxic given the much more central role it plays in funding the economy, relative to the US. Indeed, in the US bank loans accounted for only 20% of the total liabilities of the corporate sector before the Great Recession, roughly half the proportion found in the Euro area (see Chart 2). 

It was not only a matter of quantities but also, as suggested above, of price. As we have argued before (see EEW), the health of the demand and particularly the supply of credit are key to understand the broken transmission of monetary policy, the very limited sensitivity of lending rates to policy rates in most of the periphery for most of the post-crisis period and the increased sensitivity of lending rates to sovereign yields.

Another consequence of the belated reaction of the European public sector was, that by the time the banking sector was blatantly on the brink of collapse in number of countries, the governments there had already lost market access – or at the very least was already paying crippling interest rates – precisely on account of the market’s anticipation of the bailout costs. Spain probably is the best example of this type of behaviour. Exactly at the time public sector support became crucial, its cost was impossible to shoulder.
This gets us to the second significant difference between the US and the Euro area as far as the "banks/sovereign nexus" is concerned: the "imperfect mutualization issue". In the US, even if various bodies compete in the regulation of the banking industry, two centers of decision matter: the White House and Congress, as it is ultimately a federal issue. In the Euro area, a major difficulty arose from a discrepancy, across member states, between banks' need for funds and fiscal capabilities. Ireland is the best example of this. As it can be seen in Table 2, the total of approved support to the financial sector there - on and offbalance sheet potential liabilities - amounted to 500% of GDP, while the effective cost of support exceeded twice local GDP."

   - source Bank of America Merrill Lynch

In the US QE was more effective for a simple reason: stocks vs flows as highlighted earlier. The problems facing Europe and Japan are driven by a demographic not financial cycle. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment. As shown above in our post in Nomura's chart,  the difference in return on assets for EU banks versus US banks improved much faster in the US thanks to the swift approach by the US in dealing with the crisis as well as their existing resolution framework absent in Europe at the time.

The main reason we had recession and credit crunch in Europe was the ill-fated decision of the EBA to impose banks to reach a core tier one level of 9% by June 2012.

Of course the 2011 debacle was avoided by LTRO 1 and 2 but what the "geniuses" at the EBA did not understand was that European banks were "capital" constrained hence the speed of the deleveraging and the epic credit crunch (Italy/Spain) that followed which led to a fall in "Aggregate Demand" a point which we agree with Bank of America Merrill Lynch:

"The political balance within the central bank - compounded by, until recently, the absence of clear deflationary pressure at the aggregate regional level - made it impossible to break this negative feedback loop via direct purchases of government bonds, which at the very least would have isolated sovereign funding costs from the consequences of the banking crisis.
Instead, the ECB approach - understandable from an emergency management point of view - added another layer to the banks/sovereign nexus by turning the banks into the lender of last resort of their local sovereign. Indeed, the ECB, by allowing access to long term cheap liquidity, through the LTROs, allowed banks to engage in safe carry-trade, parking liquidity into government bonds at a time when non-residents were leaving the periphery in droves.

Banks always tend to skew their asset allocation towards government bonds in bad cyclical times, as the demand for credit from the private sector diminishes while the quality of the banks' loan books deteriorates. Still, the ECB's generous approach to liquidity clearly was a facilitator. Italy in our view managed to avoid a recourse to the EFSF/ESM only because banks, which in 2009 held only 14% of the stock of public debt, ended up absorbing 75% of the increase in public debt between 2009 and 2014.

This was probably an acceptable "second best" to QE in terms of maintaining some funding capacity for embattled governments, as well as keeping the banking sector alive in the absence of clear progress on recapitalisation and balance sheet clean-up, but such approach presented the major risk of keeping the real economy into a recessive regime. Indeed, in this configuration, peripheral banks could make a more than decent living purely on the carry-trade, with little incentives for them to try to re-start lending to the private sector." - Bank of America Merrill Lynch

And of course the above approach, for any reasonable "Secondguesser" led the real economy into recessive regime thanks to the "crowding-out" effect mentioned in numerous conversations.

Where we slightly disagree with Bank of America Merrill Lynch is that while QE seems to be a necessary condition to alleviate the distortion created on Peripheral banks' balance sheet when it comes to their overall exposure to their sovereign, it is creating yet another distortion in "valuations" triggering in effect financial instability on a grand scale:

"Beyond institutional progress on banking union, QE is the necessary condition for breaking the banks/sovereign nexus
The two key institutional elements allowing the Euro area to deal with the banks/sovereign nexus are i) the Single Resolution Fund, funded by the banks and ii) the possibility, finally adopted on 8 December 2014, for the ESM to recapitalize banks directly, i.e. without leaving the financial cost, ultimately, on the balance sheet of the sovereign in the concerned banks' jurisdiction. These two instruments' capability is limited (1% of insured deposits for the first one and EUR 60bn for the second) but this is a first, important step towards a mutualization of the banking risk across the Euro area, which is in our view made possible by the federalization of banking supervision under the SSM framework.
In both cases, however, in principle mutualized support can be triggered only after a bail-in of the private creditors. This leaves the "financial stability" issue unanswered. Indeed, if the Euro area was faced with a major banking incident in which "burning" private shareholders and bondholders would trigger an unstoppable, generalized crisis, it remains unclear how a collective response would be organized." - source Bank of America Merrill Lynch

QE on its owned as we have argued recently is not enough to put Europe on the right track as we pointed out in our conversation "Chekhov's gun":

"Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).

“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?" - source Macronomics, November 2014 

QE without private demand for funds only generates bubbles. The liquidity it supplies will not enter the real economy as long as there are no private sector borrowers. From our take, as "secondguessers" the Icelandic proposal of Sovereign money would break this toxic nexus between banks and sovereigns. To explain further why the Icelandic proposal is very appealing we would like to re-quote Dr Jochen Felsenheimer from asset management XIAI we used in our conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!" in September 2011:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy." - Dr Jochen Felsenheimer

Looking at the current stalemate surrounding Greece in particular and Europe in general nothing has really changed from our "secondguesser" perspective.

• Final note: Flows have lagged performance in EM

While some EM markets have continued to post on stellar performances, there is indeed a disconnect between EM equity flows and EM equity performance as displayed in Bank of America Merrill Lynch's recent Flow Show note from the 9th of April entitled "EM Disconnect":

"Europe hogs the spotlight: $3.9bn inflows this week, extending inflow streak to 13…
…meanwhile EM can’t catch a bid: flows have lagged performance (Chart 3); 8 straight weeks of outflows from China equity funds (despite her being the best performing global market past 12 months) and LatAm equity funds only see a tiny $37mn after 9 straight weeks of outflows" - source Bank of America Merrill Lynch

As "secondguessers", we would expect flows to resume in the coming weeks/months.

"Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcome after-effects. Their precise nature is anyone's guess, though one likely consequence is an onslaught of inflation." - Warren Buffett

Stay tuned!