Credit - The Monkey's paw

"'It had a spell put on it by an old fakir,' said the sergeant-major, 'a very holy man. He wanted to show that fate ruled people's lives, and that those who interfered with it did so to their sorrow.'" - The Monkey's paw - Horror short story by W.W. Jacobs published in 1902

After some R&R (Rest and Recuperation), our reconnection to the credit markets validated even further our long standing assertion of a "japonification" process taking place in the credit space in particular and in world growth in general (IMF lowered its 2014 US growth prospect forecast to 2% from 2.4%). 

Of course, all of this is part of the deflationary pressure we have been discussing and highlighting throughout our numerous posts. For illustration purposes we have used the shipping industry to support our deflationary stance and used what was happening with the Drewry Container Rates as an illustration of the tremendous deflationary forces at play. Container lines have made eight general rate increases and one peak season surcharge totaling $3,000 on Asia-U.S. routes since June 2013 and there have been four general increases this year - graph source Bloomberg:

Every single time, the increases have failed to hold because of excess capacity and a sluggish global economy. The benchmark Hong Kong-Los Angeles rate has fallen 7% this year through June 4 and is down 11% yoy. In our Bear Case scenario, slack capacity will continue undermining efforts to raise rates during 2014. Rates have been below $2000 in 16 of the past 17 weeks.

Looking at the growing build up in liquidity concerns which have been stressed on many occasions by market practitioners, it is interesting to see that finally some of the "omnipotent" deities in central banking are waking up to the wonders of the "practice" of their magician tricks given that Federal Reserve officials have discussed whether regulators should impose exit fees on bond funds to avert a potential run by investors, underlining concern about the vulnerability of the $10tn corporate bond market as reported in the Financial Times.

While we previously used many references to the magic tricks used by a "Central Banks" world which was dominated by the "Sorcerer's apprentice" aka Dr Ben Bernanke before his replacement by Janet Yellen, and our "Generous Gambler" aka Mario Draghi in Europe, we thought this time around in continuation to "failing magic trick" references and on-going deception we would use in our title a reference to the Monkey's paw. 

The story is based on the famous "setup" in which three wishes are granted. In the story, the paw of a dead monkey is a talisman that grants its possessor three wishes, but the wishes come with an enormous price for interfering with fate (deflation). In similar fashion the wishes of our central bankers have come with an enormous price tag for interfering with the most important price of all, the price of money with their ZIRP experiment. Of course the recurring liquidity risk in credit markets has been amplified by the acceleration in disintermediation as well as the reduction in market making activities due to regulatory pressures, deleveraging and balance sheet constraints, leading of course to a growing sense of a nasty build-up in "instability" in true Minsky fashion but we digress.

So in this week conversation we will look again at liquidity constraints as well as interesting development in the subordinated space which so far has been disregarded by credit investors given the appetite for yield has clearly made them forget the notion of "risk".

The "japonification" process and the growing risk posed by "positive correlations" is a subject we touched in our conversation "Misstra Know-it all" back in September 2013 and we referred to Martin Hutchinson's take on these correlations:

"Negative real interest rates are correlated both with a rise in stock valuations (because dividend yields decline) and with a rise in earnings themselves, as the corporate cost of capital declines. Earnings are now at record levels in relation to US GDP, two or three times the deflated level that would be suggested by the current anemic rate of growth. However valuations continue to increase in relation to these inflated earnings, driving stock prices into the stratosphere. 

Since central banks worldwide are now pursuing the same easy-money policies as the Bernanke Fed, the same correlations are appearing elsewhere, with the exception of the majority of emerging markets, where economic reality remains in play." - source Asia Times, Martin Hutchinson

We commented at the time that the credit markets and equities markets were no exception to "rising forced correlations". In recent years, credit and equities have correlated closely, but, as credit has moved towards a lower bound, Investment Grade for instance have become even more sensitive to interest rates movement, making it incredibly likely that any rate rises will have a large impact given the disappearance of the interest rate risk buffer in the asset class given the on-going spread compression supported by large inflows into the asset class. An illustration of the "positive correlations" we are discussing can be seen, we think in the strong convergence we have seen between the CDX index in the US representative of Investment Grade credit risk and its European counterpart the Itraxx Main Europe 5 year CDS index - graph source Bloomberg:

In August 2013 in our conversation "Alive and Kicking" we argued the following:

For us, there is no "Great Rotation" there are only "Great Correlations" and we have to confide that we agree with Martin Hutchinson's recent take on "Forced Correlations":

"The lack of a major banking crash and major job losses from the LTCM debacle, and the Fed's insistence on goosing the stock bubble yet further by reducing interest rates when LTCM collapsed, produced the moral hazard from which we are now suffering, and in the long run the correlations from which the more leveraged and better connected are currently profiting. 

However, the new correlations are - like LTCM's correlations in 1996-8 - entirely artificial and capable of reversing at any time. As we are seeing in the bond markets, where the Fed in spite of all its efforts is proving incapable of keeping interest rates to the level it wants, even the Fed does not have access to large enough printing presses to keep these correlations going once they start to turn negative. As with LTCM, the eventual reversal of the current correlations will within a few months cause gigantic losses and a major market crash. 

Only this time the loser will not be a single albeit bloated hedge fund but more or less the entire universe of investors, all of whom have become overextended in a market far above its fundamental value. With a crash so widespread, the losers will not be just too big to fail, they will be too big to bail out - an altogether more perilous state." - source Asia Times, Martin Hutchinson

It seems to us the central bank "deities" are in fact realising the dangers of using too much the "Monkey's paw" in the sense that the Fed paved the way for "mis-allocation" and the rise in inflows into the credit space, but that even the Fed's generosity cannot offset the rising risks of a broad exit in a disorderly fashion in credit funds given that the Fed's role is supposedly one of "financial stability". To illustrate further the growing liquidity risks posed by central banks actions, please see the below graphs from Bank of America Merrill Lynch recent situation room from the 16th of June entitled "Geopolitical risk in the Middle-East" displaying the evolution of the capacity for market makers in providing two way markets since 2005:

- source Bank of America Merrill Lynch

Another illustration of the growing risk posed by the gigantic growth of the credit space can be seen in another graph coming from the same Bank of America Merrill Lynch report:

- source Bank of America Merrill Lynch

In this note Bank of America Merrill Lynch made the following interesting comments:

"Just to re-iterate our concern – the Fed’s rate hiking cycle tends to be associated with wider credit spreads (Figure 9). 

Three developments make us concerned that it may actually be much worse this time. 

1) The Fed’s zero interest rate policy has led to an unprecedented reach for yield for more than five years – when the Fed hikes rates the “un-reach” for yield is going to be unprecedented as well. 

2) Dealers have little ability to act as buffer in a sell-off this time, as balance sheets have collapsed due to new regulation (Figure 5 above ). And finally 

3) The mutual fund/ETF ownership share of the corporate bond market is much higher than we have seen in the past – and this is the “hot money” in the corporate bond market (Figure 6 above). However, in the short term we still view the initial increase in interest rates over the past two weeks as modestly bullish for credit spreads, as institutional investors come out and retail flows react to returns only with a lag." - source Bank of America Merrill Lynch

Higher interest rates so far in June have indeed highlighted rising interest rate risk for US high grade spreads and the lack of a significant buffer to counteract rising rates. Back in August 2013 in our conversation "Alive and Kicking" we argued the following when it comes to convexity and bonds:

Moving on to the subject of convexity and bonds, how does one goes in hedging convexity risk in credit in a rising rate environment? The use of CDS can mitigate the duration risk as indicated in a note by Barclays on the 9th of August entitled "An Alternative to Negative Convexity":
"CDS benefits from positive convexity. For CDS, spread duration declines as spreads widen and increases as spreads tighten, generating positive convexity for the protection seller." - source Barclays

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

We concluded at the time:

"With positive convexity from using CDS, the sensitivity of the price to yield changes (i.e., duration) works in your favor whereas with negative convexity, duration works against you as the price of the bond is becoming more sensitive to yield changes. The greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger..."

Of course another issue to take into account is the liquidity in the CDS space which has been affected as well by the new regulatory environment.

Moving on to the subordinated space which has been a pet subject of ours in recent years (as we predicted in timely fashion skip of calls, bond tenders, and debt to equity swaps in the European banking space - see our conversations "Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"), the new TLTRO set by the ECB is preventing additional liability management taking place in the subordinated space. As we argued in our previous conversation, what European banks lack is not liquidity but lack of capital. Liability management exercises meaning buying back or exchanging subordinated debt usually well below par value took place before the introduction of the LTRO in December 2011. These exercises provided some support for subordinated bond prices at the time. On the back of the ECB's support most prices of Tier 1 subordinated bonds rallied hard closer to par for most in 2013 given the liability exercises took place in 2011 and 2012 and for some peripheral banks took place at a later stage in 2013. 

What has been interesting indeed is the convergence we have seen between the Itraxx Financial Senior 5 year CDS index with the Itraxx Financial Subordinated 5 year CDS index - graph source Bloomberg:

This convergence can indeed be explained by the central banks support which has so far prevented further liability management exercises by providing more than enough liquidity to provide additional support in the on-going deleveraging process and capital raising exercise taking place in the European banking space.

Again, the use of the Monkey paw by central bankers has indeed clearly created mis-pricing and induced mis-allocation as indicated by the induced compression between financial senior risk and subordinated risk we think. For instance a recent example of the mis-perception and mis-pricing of risk in the subordinated space has been highlighted by the threat of the Austrian government towards subordinated creditors of Austrian distressed real estate bank Hypo Alper-Adria-Bank (HAA). The Austrian government in this specific case is trying to pass a law to impose haircuts on investors who thought were insured given the bonds have deficiency guarantee from the state of Carinthia in Austria. This is in effect putting into a new perspective regional government guarantees. The spillover effect of the HAA story had of course some impact on the Austrian financial sector and led S&P on the 10th of June to put the ratings of seven Austrian banks and four Austrian states under review for downgrade. As reported by CreditSights in their Euro Financial Movers report of the 15th of June:

"The government is also proposing to cancel loans of €800 mn provided by the bank's former owner Bayerische Landesbank (BayernLB), while a further €1.5 bn of loans from BayernLB will not be repaid or paid interest until June 2019 at the earliest. BayernLB has reacted angrily, not unexpectedly (see Bayerische Landesbank: HAA Bail-in Challenge), as this move could hit its capital ratios and potentially might require it to take further provisions or impairment charges." - source CreditSights

This illustrates not only the unpredictability of government action but also the mis-pricing of risk in the subordinated space we think, particularly in the light of the upcoming revamp of the CDS market in September 2014 with the new design for CDS contracts which should lead to a significant widening of subordinated spreads to reflect the changes in the new contracts. The lower recovery rate expectations in the new European bank CDS contracts will widen spreads but should end of the day benefit the protection buyer as the sub-level events given successor provisions which will be introduced mean that senior and sub debt will be tracked separately to determine successors meaning it reduces orphaning risk (lack of deliverable bonds). As a reminder in the experience of Bankia/BFA sub debt moved to BFA, but the majority of senior debt and sub and senior CDS moved to Bankia.

In relation to the widening expected, Barclays in their note from the 6th of June 2014 entitled "Implied valuations of '14 bank CDS definitions" expect a widening of 50 bps:

"We expect sub CDS to be up to 50bp wider, on average, with senior CDS 15bp tighter. Though September is a few months away, two trading implications that are relevant right now are to sell sub protection in names with positive CDS-cash basis and to own (or not be underweight) LT2 bonds in tier 2 banks." - source Barclays

Therefore the Bloomberg graph above displaying the on-going relationship between Itraxx Financial Senior with Itraxx Financial Subordinated 5 year CDS index is somewhat an anomaly which has been induced by investors once again over-reaching for yield in their buying spree.

On a final note as always, regardless of the final melt up in asset prices, credit prices will indeed be giving clues for a stock market correction as indicated by Bank of America Merrill Lynch in the below graph from their recent Thundering Word note from the 12th of June entitled "The Greatest Risk of All":

"We are a buyer of vol into fall when correction risks rise significantly: either Q3 growth is +3% confirming recovery and cause rates to rise or speculative excesses appear causing central banks to start "talking down" asset prices. Clues to stock market correction include rising gold prices and decline in credit prices (as in 1987 –Chart 1)." - source Bank of America Merrill Lynch

The Monkey's paw story is as follows:

" The story involves Mr. and Mrs. White and their adult son, Herbert. Sergeant-Major Morris, a friend of the Whites who has been part of the British Army in India, introduces them to the monkey's paw, telling of its mysterious powers to grant three wishes and of its journey from an old fakir to his comrade, who used his third wish to wish for death.

Sergeant-Major Morris, having had a bad experience upon using the paw, throws the monkey's paw into the fire but White quickly retrieves it. Morris warns White, but White, thinking about what the paw could be used for, ignores him.

Mr. White wishes for £200 to be used as the final payment on his house. The next day his son Herbert leaves for work. Some time later, the young man is killed by machinery at the factory where he works, and the couple receives compensation of £200 from his employer.

Ten days after the funeral, Mrs. White, almost mad with grief, asks her husband to use the paw to wish Herbert back to life. Reluctantly, he does so. Shortly afterwards there is a knock at the door. Mrs. White fumbles at the locks in an attempt to open the door. Mr. White knows, however, that he cannot allow their revived son in, as his appearance will be too hideous. Mr. White was required to identify the body, which had been mutilated by the accident. It has now lain buried for more than a week. While Mrs. White tries to open the door, Mr. White makes his third wish, and the knocking stops. Mrs. White opens the door to find no one there." - source Wikipedia

Maybe Mr Central Banker, in similar fashion to Mr White knows that he cannot allow a fast revival of normal interest rates as the re-appearance will be "too hideous" for risky asset prices as a whole.

As far as we are concerned we have our doubts in the much vaunted "recovery" story but do agree that vol's cheapness is indeed inversely correlated to the rising "complacency" making new highs on a regular basis in the market place.

From Monkey's paw to Monkey business...

"An American monkey, after getting drunk on brandy, would never touch it again, and thus is much wiser than most men." - Charles Darwin

Stay tuned!

Credit - The Shrinking pie mentality

"I am neither bitter nor cynical but I do wish there was less immaturity in political thinking." -Franklin D. Roosevelt

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

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

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

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

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

Of course we all know what happened next, from the same article:

"By the end of 1989 the Nikkei average stock price had climbed to 389,000 yen, expanding two times in four years! While during 1998 alone the land price around Japan's three major metropolitans rose by 43.8 percent, the Tokyo Rim rising even by 65.3 percent. 

In early 1990s, the economic bubbles created by the yen revaluation suddenly blew up, plunging the nation into an unprecedented recession, from which the country has been trying to struggle out till today. During the recession lasting longer than a decade, almost all the important economic indexes registered the worst post-war record. By then Japan had completely lost its long-term advantageous position held in the after-war pattern of western economic growth, especially that over the US. To some degree we should say, after years of efforts as set out at the "Plaza Agreement", America finally has defeated its biggest rival in the field of international trade." - People's Daily, September 23 by Professor Jiang Riuping, Chairman of the Department of International Economics, Foreign Affairs College, Beijing.

On another point the demise of the Japanese rival was a "blessing" for the US economy which had been under duress due to the Saving & Loans crisis of the 80s. In similar fashion, the US would thrive on a strong revaluation of the yuan, which would no doubt precipitate China into chaos and trigger a full explosion of the credit bubble in China, putting an end to the "controlled demolition" approach from the Chinese authorities. A continued devaluation of the yuan, would of course be highly supportive of the Chinese attempt in gently deflating its credit fuelled bubble, whereas it would export a strong deflationary wave to the rest of the world, putting no doubt a spanner in the QE works of the Fed, the Bank of Japan and soon to be ECB. As we pointed out, the Chinese have learned their "Japanese lesson" unfortunately for the US Treasury and there are no US military bases in China (like the United States have in Japan...). Given the raging "Shrinking pie mentality" in the world today, the US economy won't benefit like it did in the 90s from Chinese committing "economic seppuku" as the Japanese did, as they have learned their "Japanese economic lesson" but we ramble again...

As an illustration of the lack of the Fed progress we think in recent years has been no doubt in the Employment to population ratio as displayed in the below Bloomberg graph:

Does the recent uptick is indicative of the recovery finally taking shape in the US? The jury is out there and the next employment figures to be released in the coming months will be key particularly hourly wages data when it comes to validating the "escape velocity" plight of the US economy. But, as Roosevelt, we are neither bitter nor cynical, we are just merely economic observers and when we see that the US housing market which saw sales of previously owned properties tumbling in March by 7.5% from a year earlier to the slowest pace in 20 months while purchases of new houses sank 14.5% from February as reported by Bloomberg, we have our doubts on the "escape plan".

As we indicated last week, US Family Housing Starts has been falling in conjunction with US Furniture sales, as well as the Baltic Dry Index pointing, to some important "crosswind" in this much vaunted US recovery.

One of the prime reason of our disbelief in the much hyped global recovery has been indicated by our regular observation of the shipping space where, for instance the Drewry Hong-Kong-Los Angeles container rate benchmark has been displaying clear lack of traction for 10 straight weeks despite numerous rate increases due to overcapacity still largely plaguing the container shipping industry - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles container rate benchmark fell to $1,900 for the week ended April 23. Rates declined 3.3% after a general rate increase of $300 per 40-foot container implemented April 15 failed to hold due to slack capacity. The three general rate increases ytd have not been sustainable. Rates have remained below $2,000 for 10 straight weeks. Container rates are down 10.4% yoy." - source Bloomberg.

Given the annual rate of inflation in the euro zone was 0.5% in March, well below the ECB’s target of just under 2%, and it has been less than 1% since October, many pundits are tentatively analysing the various forms of QEs which could be attempted in Europe as well as pondering the benefits. Therefore, in this week's conversation, and given the glaring "Shrinking pie mentality" taking place in the world today, we will look closely at this very subject and the potential impact it could have.

In terms of our take on the Euro currency's strength, in our conversation in early January 2014 entitled "Third time's a charm" we argued the following:

"As we move into 2014, our chosen title reflects the third time strategists put forward the case for a weaker euro. So could indeed 2014 see finally the much anticipated weaker euro forecasted by so many pundits?

In terms of our prognosis in both 2012 and 2013, we did not believe in a weakening of the Euro versus the dollar and we reiterated our stance in numerous occasions such as in our conversation from April 2013 "Big in Japan":

"In terms of the EUR/USD, we still think in the second quarter that it should remain in the 1.30 region versus the US dollar, which were our views for the 1st quarter. As we posited in January 2012, when most strategists were bearish on the EUR/USD, the Fed swap lines in conjunction with the FOMC decisions at the time did put a floor to the euro and are delaying a painful adjustment in Europe. The latest decision by Japan will as well prolong the European agony. In the process the European recession can only be prolonged and the European economy will continue to suffer (unemployment rate now at 12%)."

We also added:

"Unless Mario Draghi unleashes in Europe QE to fight off the growing deflationary risks we have been tracking and warning about, we do not see a weakening of the Euro in 2014."

Arguably in recent months, thanks to the US Fed tapering, the 1 year/1 year forwards for the US dollar and the Euro have significantly diverged as displayed in the below Bloomberg chart:

This seems to indicate that the market clearly anticipates at some point some "nuclear" action from the ECB and also indicative of the tapering effect on the US dollar versus the Euro we think.

But, as shown by the "Japanese experience" the Euro strength may not simply be reversed by the "nuclear" QE option as indicated by Bloomberg:

"The impact of quantitative easing programs on currency is not clear, based on the experience across the U.S., U.K. and Japan. While initial announcements in both the U.S. and U.K were followed by a weakening of domestic currency, Japan's approach failed to stem currency appreciation, which instead followed Premier Shinzo Abe's 2013 reform announcements. The scale of program and type of assets purchased will determine the impact on currency and inflation across the euro zone." - source Bloomberg.

We do agree with Bloomberg, when it comes to QE "size matters".

In particular when one relates to the "japanification" of Europe and the deflationary risk we have been mentioning on a regular basis in our conversations. We did read with interest the comments on this very subject from Mansoor Mohi-uddin from UBS in the Financial Times back in November 2013:

"During Japan’s two lost decades, domestic banks were too weak to cut non-performing loans and absorb the losses. That prevented them from supplying fresh credit to the economy. Only when Tokyo began substantially recapitalising the financial sector – a full 13 years after the country’s bubble burst in 1990 – were Japanese banks able to start expanding their loan books.

Deflation risk

The eurozone’s banks are in a similar position to Japan’s in the 1990s. Six years after the credit crunch began in the western economies, eurozone banks have only hesitantly shrunk their balance sheets. Loans-to-deposit ratios remain roughly 110 per cent, at levels comparable to Japan’s ratios during its first lost decade. In contrast, US banks, forcefully recapitalised by the US Treasury in 2008, have been able to reduce bad credit and now only have loans accounting for 75 per cent of deposits. That rapid deleveraging has allowed the financial sector to provide stronger credit growth to the US economy.

Tokyo’s inability to strengthen quickly its banking sector led to Japan’s economy falling into recession frequently throughout the 1990s and 2000s. In addition, the country suffered entrenched deflation for most of the past decade.

Likewise, the eurozone has already endured two recessions since the credit crunch started in 2007, with the second downturn lasting six consecutive quarters until this year. Furthermore, the eurozone’s latest inflation data show consumer prices are increasing only 0.7 per cent year on year, increasing fears that the region will also fall into deflation.

Paradoxically, such economic weakness has been accompanied by persistent exchange rate strength. In both economies faltering gross domestic product growth has constrained demand for imports. Until the 2011 earthquake, Japan ran consistently large trade surpluses. That year the yen hit an all-time high of Y75 against the dollar. Similarly, the eurozone’s trade balance has become strongly positive over the past couple of years, pushing the euro up to a two-year high of $1.38 last month." - "ECB must act to prevent euro aping strong yen" - Financial Times, Mansoor Mohi-uddin, UBS.

Of course many see the continuation of the strong euro as a catalyst of QE in Europe as indicated by Bloomberg:

"Mario Draghi's April 12 assertion that "a strengthening of the exchange rate requires further monetary stimulus. That is an important dimension for our price stability" suggests the likelihood of quantitative easing is increasing. According to Bank of France Governor Christian Noyer, inflation would be running at 1% absent the exchange rate's strength, twice March's 0.5% figure. Implementing a QE program would boost liquidity, and likely profit, at euro-area banks." - source Bloomberg.

Yes, implementing QE would no doubt boost liquidity but would, in similar fashion to the LTROs amount to "Money for Nothing" we think unless proper unconventional measures were taken such as helping out the deleveraging process of the private sector in peripheral countries. On that point we do not think that the Euro Sovereign-Loan Yield link may be restored as the LTRO runs down as posited by Bloomberg:

"A key goal of future ECB activity is to reopen lending channels to small and medium-sized enterprises across southern Europe. While attempts to invigorate the combined $2 trillion corporate loan markets of Italy and Spain have failed to drive new business loan rates lower, some sovereign and asset yields are at record lows. Until 2009, the correlation between sovereign yields and corporate loan pricing was meaningful. Re-establishing this would lower borrowing costs." - source Bloomberg.

No matter how large QEs where in the US, we have yet to see the transmission of credit for small businesses, which are essential for a strong recovery scenario in employment figures as shown in the below graph from a recent note from Bank of America Merrill Lynch entitled "When the tide turns" from the 25th of April 2014:

Of course the big beneficiaries of a QE in Europe would be the pure high beta play namely banks as posited by Bank of America Merrill Lynch in their recent European Banks Strategy note entitled QE without a real AQR:
"QE makes risk assets go up

There is a lively debate as to what Quantitative Easing actually is but we believe the market has a rule of thumb that is being applied to the euro area QE debate, which is that QE makes risk assets go up. Riskier assets tend to go up by more. Banks are risk assets and have behaved according to this rule YTD. Using a low starting price-to-tangible book multiple as a proxy for a bank being riskier, Chart 3 shows the riskier banks have strongly outperformed (bottom ten vs top ten by 23 percentage points YTD)"

- source Bank of America Merrill Lynch

European banks have already benefited from the "whatever it takes" carry trade which they set up following Mario Draghi's July 2012 comments and have purchased large quantities of peripheral government bonds, boosting their earnings in the process thanks to the central bank's generosity and of course not severing the link to the sovereign but increasing it drastically in the process.

As an illustration of the significance of the performance from the beta play set up by the ECB can be seen in French bank BNP's stock price performance as displayed by Bloomberg:

"Since Mario Draghi's July 2012 "whatever it takes" pledge, the correlation between falling Italian and Spanish yields and appreciating bank stocks has strengthened. While there may be some scope for further falls in rates, much of the recovery in confidence has now taken place, questioning the extent to which further declining yields can act as a catalyst for bank stock appreciation. BNP, only 7% of the Euro Stoxx 600, moves in tandem with the index, offering a good proxy." - source Bloomberg.

The European Banking Union was sold to the public on the premises it was supposed to break the link between sovereigns and financials and reignite lending. It looks to us, it hasn't happened and won't happen any time soon as displayed by the below graph from Bank of America Merrill Lynch's note on QE and the AQR:

- source Bank of America Merrill Lynch

The recent Portuguese auction is reflecting a return of confidence thanks to Mario Draghi's magical talents as displayed in the below Bloomberg graph:

"The Portuguese republic has successfully placed 10-year debt for the first time since January 2011, with an accepted yield of 3.575%, very nearly half the level required last time a placement was made. A bid-to-cover ratio of 3.5x underlines investor interest, a key positive as Portugal has 37 billion euros ($51 billion) of debt maturing by end-2015. A key read across for periphery banks is likely to be cheaper access to liquidity, which can help kickstart lending." - source Bloomberg.

Kickstart lending...

It has not happened in the US for small businesses and from a conversation with a friend who is a small business owner in Tokyo it hasn't happened there either. Small businesses in Japan cannot easily get credit lines to fund expansion. Only large corporates are able to access credit it seems.

When it comes to loan growth in the Euro area, we agree with Bank of America Merrill Lynch's take on QE in their recent European Banks Strategy note entitled QE without a real AQR:

"Capital works better than QE

We see the AQR as an opportunity for the ECB to jump-start bank lending more effectively than QE, if it were to be used to drive bank recapitalisation. The evidence to date is not reassuring in this regard. 

Less effective this way

We believe that QE without something to accelerate banks becoming confident enough in themselves is likely to be significantly less impactful on the real economy than one stapled to bank recapitalisation. While share prices would in our view likely respond positively to QE, banks’ behaviours are set to be slower to change. As a result, euro area growth is set to remain well below that of other major economies through 2015 (Chart 13)" 

- source Bank of America Merrill Lynch

The reason for the continued divergence in funding terms for corporates loans in the European space is due to the pace of deleveraging and the loss recognition process and rising nonperforming loans hence our "japonification" stance when it comes to assessing European woes and our well documented deflation bias. The below chart from Bloomberg highlights the difference in funding terms in various European countries:

"The disparity in cost of and access to corporate credit between north and south Europe was cited by Mario Draghi at the time of the ECB's November statement as a reason for the need to cut. New business rates and gross loan flows will remain a vital indicator that will inform policy decisions. If and when the ECB manages to reinvigorate the asset-backed market to unlock corporate credit, the differential between northern and southern rates will also be a key determinant of success." - source Bloomberg

To that effect, cleaning up banks' balance sheet would not be purely accelerated by QE in Europe, but banks recapitalization needs would be "reduced" by rising share prices in the financial space. When it comes to capital needs for European peripheral banks and rising nonperforming loans the race is on as displayed in the below graph from Bloomberg:

"Aggregate bad debt across the banks of Greece, Ireland, Italy, Portugal and Spain exceeded $925 billion at the end of 2Q13, 300% higher than in 2008, according to IMF data. As banks continue to prepare for the ECB's asset quality review in late 2014, and levels of restructured loans and various foreborne assets come under new scrutiny, many of these loans may be considered for sale. Italy and Spain will likely be a focus for private equity and distressed debt investors." - source Bloomberg.

As we pointed out last week, Europe is indeed for sale on a "fire sale" mode at least for banks.

"The deleveraging for Italian banks has hardly run its course and in similar fashion to the Italian government shedding real estate and its car fleet, Italian banks are as well busy shedding non-performing loans backed by real estate" - Macronomics 

"The non-performing loan ratio for all domestic EU lenders tripled on average to more than 4.5% at the end of 1H13, from full-year 2007. The coverage ratio (provisions as a percentage of bad debt) also fell by a third to 43%, as income statement charges failed to keep pace with ballooning bad debt. The imminent ECB asset quality review in the euro zone may require banks to reclassify more loans as bad debt, prompting pre-emptive portfolio sales." - source Bloomberg

In similar fashion to what we wrote about Japan in general and credit versus equities in particular in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets":
"Financial credit may be the next big opportunity

The build-up of corporate leverage in the 2000s was confined to financials which, unlike other corporates, had escaped unscarred from the 2001 experience. However, this changed in 2008. Judging by the experience of G3 (US, EU, Japan) non-financial corporates, there should be significant deleveraging in banks going forward. Indeed, regulatory pressures are also pushing in that direction. All else being equal, this should be bullish for financial credit." - source Nomura

Credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities. No wonder the riskiest part of CLO have returned 16% in 2013 as indicated by Kristen Haunss in Bloomberg in her article "CLO Returns at 16% for Risky Slices Buoys Loans":

"The riskiest portions of specialized loan funds that have helped finance the biggest buyouts in history are luring investors with returns that exceed even junk bonds.

The equity slices of U.S. collateralized loan obligations, which get whatever money is left-over after more senior investors are paid, returned an average 16 percent last year, according to JPMorgan Chase & Co. data on funds raised since the end of 2008. That compares with 7.4 percent for the Bank of America Merrill Lynch U.S. High-Yield Index of bonds.

Investors say the prospect for above-average returns remains, even as the Federal Reserve starts to flag that it will raise interest rates as soon as next year. Demand for the equity slices of CLOs is helping fuel issuance, providing money for the neediest borrowers." - source Bloomberg

Of course thanks to these stellar returns as per the same article, the asset class has been booming:

"Investors poured a record $61.3 billion into leveraged loan mutual funds last year, according to Morningstar Inc. data, as they sought protection against rising rates. CLOs were the largest buyers of high-yield loans in 2013, with a 53 percent market share, according to the New York-based Loan Syndications and Trading Association.

Sales of CLOs reached $82 billion in 2013, the third-largest year on record, and have topped $32 billion in 2014, according to RBS." - source Bloomberg.

When it comes playing credit, we have to confide that, indeed we did participate and bought some junior subordinated debt from a French bank in October 2011 at a cash price of around 94.5 for a perpetual bond paying a nice 12.5% coupon seeing it rise meteorically to 138 cash price, a 46% appreciation with limited volatility, hence applying our lesson learned from the Japanese experience thanks to our continued study of central bank magic...

In the case of credit, if indeed the ECB does indeed embark on QE, another big beneficiary will no doubt be in the financial bond space as indicated by Citi in their credit weekly commentary entitled "How would ECB impact credit":

"So if the ECB wanted a serious percentage of any QE programme to be made up of private assets, then it seems quite probable that that would have to extend beyond secured assets.

Unsecured bank debt would seem the most obvious candidate for them to turn to next. The rationale for lowering bank funding costs is obviously that: 1) it would facilitate further recapitalization (now that revenues from the periphery-sovereigndebt-carry trade are fading), 2) it would lower the rate at which is it efficient for banks to lend without distorting the market-based allocation of credit, and 3) that the ECB through its comprehensive assessment should have a decent insight into the quality of the collateral that it would implicitly be buying into.
Although more probable than we previously thought, we still think it is less likely that the ECB would extend any purchases to regular non-financial bonds. It might suit a political purpose, but from an economic perspective we struggle to see much merit in lowering what are already record low funding levels for the large investment grade non-financials.
That said, even if the ECB chose not to buy them directly, by purchasing assets which fund managers hold interchangeably with non-financial bonds, the impact on non-financial spreads would be significant even at these tight levels." - source Citi

Given last week we indicated that Italian banks have relied more on debt issuance for their funding needs and given the significant rise in nonperforming loans on Italian banks balance sheet, should the ECB embark on a QE spree, you should rightly expect a strong outperformance of Italian financial bonds which be prime beneficiary of the central bank's renewed generosity. 

As per Nomura's take in our April 2012 conversation "Deleveraging - Bad for equities but good for credit assets" remember this:

"Unlike corporates, financials have just started what is likely to be a long deleveraging process, suggesting opportunities in financial credit.

-As dealers, they will carry lower inventories. As investors, they will have less demand for assets. And they will be supplying assets to the market." - source Nomura

On a side note, those who listened to us have done well so far in 2014 given we hinted  a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed":

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

In fact, US thirty-year debt has gained 10.3 percent from Dec. 31 through yesterday, the most for the period based on Bank of America Merrill Lynch data that go back to 1988 as reported by Bloomberg by Wes Goodman in his article entitled "Treasury Long Bond's Record Year-to-Date Return Four Times S&P:
"A rally in 30-year Treasuries has pushed returns past 10 percent in 2014, the best start to a year in at least two and a half decades.
“It’s going to continue for some time,” said Yusuke Ito, a senior fund manager in Tokyo at Mizuho Asset Management Co., which has the equivalent of $39.1 billion in assets. “The pace of the recovery is not enough to generate inflationary pressure.”
Long bonds climbed 10.3 percent from Dec. 31 through yesterday, the most for the period based on Bank of America Merrill Lynch data that go back to 1988. The broad market rose 2.1 percent and the Standard & Poor’s 500 Index returned 2.3 percent. While bonds gained on the outlook for slow inflation, shorter notes lagged behind on speculation the Federal Reserve will raise interest rates in the years ahead." - source Bloomberg.
We have to confide we have also been playing this game via ETF ZROZ (we do indeed learn a lot from our central bankers and their magic tricks...).

On a final note, when it comes to the "Shrinking pie mentality", exporting deflation  and China, given that in a Pareto efficient economic allocation, "no one can be made better off without at least one individual worse off", we have interestingly noted that China's services have recently replaced manufacturing and construction as per Bloomberg's recent Chart of the Day from the 22nd of April:

"Services have replaced manufacturing and construction as the biggest part of China’s economy, a sign that the Communist Party’s goal of getting people to spend rather than just make cheap exports is working.
The CHART OF THE DAY tracks contributions from services, industry and agriculture to gross domestic product since 1992, with sectors such as real estate, retailing and finance overtaking manufacturing last year for the first time since at least 1978, with a 46 percent to 44 percent proportion. In 1996, the breakdown was 48 percent industry and 33 percent services. Agriculture’s contribution fell by half in the period to 10 percent, according to National Bureau of Statistics data compiled by Bloomberg.
“It’s an irreversible trend that the share of services in the Chinese economy will keep growing,” said Chen Xingdong, the Beijing-based chief China economist at BNP Paribas SA. “The days are gone when everything is manufactured in China,” partly because the younger generation is more demanding and better-
educated, he said.
The lower panel compares urban and rural populations, with cities taking the biggest share starting in 2011, the data show. As recently as 1998, the rural population was twice as big as its urban counterpart, the data show. Of China’s 1.36 billion residents as of 2013, 54 percent lived in cities.
The shift toward services marks a milestone for the government and Premier Li Keqiang, who has made a priority of moving people from farms to cities to spur domestic demand as people accumulate more wealth and spend their money on homes, electronics and entertainment. There is room for more growth: China’s urbanization rate compares to 80 percent in developed nations like the U.S.
“In the past, a Chinese worker basically ate and prepared for work, but now they are pursuing a better lifestyle,” said Chen, who previously worked at the World Bank. Shifts in habits and demographics will put pressure on traditional industries like cement and steel and bring new opportunities to consumer, health-care and education businesses, he said." - source Bloomberg

The winner takes it all. Period.

"We are neither bitter nor cynical but we do wish there was less immaturity in macroeconomic thinking." - Macronomics

Stay tuned!

Credit - Too Big To Fall

"Risk comes from not knowing what you're doing." - Warren Buffett

Watching with interest the ever compressing credit space with the Europe High Yield CDS risk gauge Itraxx Crossover tighter by 30 bps to 290 bps since the new series launched on the 20th of March, we are indeed feeling the same nervousness around the rapidity of the spread compression we experienced firsthand in 2007. We also reminded ourselves lately of the epitome of the financial crisis namely the expression  "Too Big To Fail" which led to the definition of systemic importance for some banks. We decided this time around to play along this famous or infamous expression (whichever you prefer) in our chosen title given the abandon and frenzy with which investors seems to be seeking whatever is on offer in the credit space with a decent coupon, regardless of the risk (or covenant protection in some instances), but more importantly disregarding the growing "liquidity" risk we have often warned about, leading us to our chosen title, as we believe credit markets are indeed becoming "Too Big To Fall" given the shrinking balance sheet of  banks has led to paltry dealers book to accommodate any major selling pressure should it materialise in the near future.

On the subject of liquidity and credit markets, we could not agree more with Axa's recent take on the subject as reported on the 21st of March by Roxana Zega in Bloomberg:

"Regulatory change imposed on banks to make them safer may ironically end up sparking systemic risk, with current spreads failing to compensate for greater illiquidity, Mark Benstead, global head of SmartBeta Credit at Axa IM says in 2014 outlook.

 -Regulation has stopped market makers from being either willing or able to supply former levels of market depth for corporate credit

 -Central bank liquidity has engineered falsely low default rates

 -Axa says there’s a mismatch between size of credit market and the ability to trade it

 -Carry will be the main source of return for credit as capital appreciation is unlikely this year, with yields barely expected to budge

 -“Credit events” could dent returns, so careful selection is needed to dodge isolated risks

 -Expects central bank policy to be more divergent in 2014 than at any other time in past 5 years

 -Axa IM managed ~EU547b as of end 2013

 -Note: BNP said March 13 that low liquidity is main risk to credit" - source Bloomberg

A good illustration we think of risks coming from "not knowing what you are doing", from a credit perspective, can be ascertained from the growth of convertibles under ETF format in the US in assets under management (AUM), particularly when one looks at the growth of CWB US, the US convertibles ETF (SPDR State Street) which includes convertibles and preferred, leading it to be highly "equity" sensitive. Please keep in mind that when it comes to convertibles issuance, the US market has seen a strong pick-up in issuance from the technology and biotechnology sectors.

The surge in AUM has indeed been staggering - graph source Bloomberg - ETF Market Capitalisation:

- graph source Bloomberg

Of course the surge in the AUM has been closely following the surge in the price of the aforementioned ETF:

- graph source Bloomberg.

As we indicated recently there is a great article in Forbes by Bill Feingold on the high price being paid on some convertibles:

"A wise trader once said, “There are no bad bonds, only bad prices.”

If you’ve been following this space, you know that I’ve been trying to encourage companies to take advantage of a historic opportunity to issue convertible bonds on favorable terms.  The opportunity has come about for the same reason most things get more expensive:  increasing demand and limited supply.

Here’s a statistic that should get your attention. I mentioned it the other day but once was not enough. The only significant exchange-traded fund dedicated to U.S. convertible bonds, CWB, has seen its assets explode over the past 12 months. Barely over $1 billion a year ago, the fund now has nearly $2.5 billion under management.  It’s a passively managed fund designed to track Barclays BCS +0.45%’ index of large U.S. convertible bonds (each component must be over $500 million, or about twice the size of an average convertible).

That growth should tell you all you need to know about how demand for convertible bonds has been expanding. It’s understandable—investors and their advisors are worried about rising interest rates but want to stay with an asset class that, unlike stocks, promises principal repayment.

However, companies haven’t been issuing convertibles nearly enough. New issuance in the U.S. bottomed at $20 billion in 2012, compared with around $100 billion annually in the years leading up to the financial crisis. 2013 was a lot better, with almost $50 billion, but that was barely enough to replace maturing deals.  Current issuance is simply nowhere near enough to keep up with demand.

Unfortunately, this means that in many cases, investors who are just now putting their money into a generally terrific asset class may be getting on the wrong side of value. In some cases, this can be rather severe."  - source Forbes, Bill Feingold.

We think there are growing risks of seeing liquidity vortexes where the lack of bid will make prices gap down violently, hence our chosen title. New Basel regulations have pushed banks to re-assess their balance sheets and are less in a position to absorb secondary offerings when markets turn South. Like others, such as Matt King from Citi, we have been warning about the fact that spreads reflect less and less "liquidity" risk in the current environment, convertibles being no exception, as clearly indicated by Bill Feingold in his Forbes article. 

As posited more recently by Matt King from Citi, liquidity is indeed a growing concern because it is extremely fat-tailed:

Citi Matt King - Investing in fake markets - March 2014 - How is the distribution in markets?

- source CITI - Matt King - March 2014 - Investing in fake markets.

Highly leveraged funds in the case of a sell-off will be particularly hit hard in that case. The issue of course would be to hold a higher proportion of cash to mitigate the redemption risk, unfortunately, cash buffers have been going down in many cases. Negative convexity risk in callable bonds for instance can be as well mitigated by increasingly playing credit via the CDS market. Recent hybrid calls at 101 for Telecom Italia and Arcelor Mittal are stark reminder of the need of pricing "optionality". Another advantage of the CDS market is the added liquidity on the credit exposure you want to add to your portfolio. Of course you are somewhat switching liquidity risk for counterparty risk. It is never a zero sum game but we ramble again. For illustrative purposes, the graph below from Matt King from Citi, illustrates further the liquidity issue, volatility and risk you run between cash bonds and CDS:

 "The vol you see is not the risk you're running"

- source CITI - Matt King - March 2014 - Investing in fake markets.

When we talk about investors getting outside their comfort zone and adding risk they might not perceive, the Junk-Loan ETF space is growing at a very rapid space in an environment which is becoming more and more reminiscent of 2007 as indicated by Sridhar Natarajan in his Bloomberg article from the 26th of March entitled "Junk-Loan ETF Asset Surge Heralds Higher Rates":

"Investors just can’t get enough of exchange-traded funds that buy junk-rated loans.
After more than tripling their assets in 2013, the loan funds are now growing four times as fast as the rest of the $262 billion market for fixed-income ETFs, according to data compiled by Bloomberg. The biggest leveraged-loan ETF, Invesco Ltd.’s $7.4 billion PowerShares Senior Loan Portfolio, has already amassed almost a billion dollars in new money this year.
The popularity of speculative-grade loans, which have rates that rise with benchmarks, has soared with debt investors seeking shelter from higher borrowing costs as the Federal Reserve moves up its rate-increase projections. While the demand has been a boon for ETFs that invest in loans to the neediest companies, it’s also prompted regulators to warn that excesses which contributed to the credit crisis may be creeping back." - source Bloomberg

As Warren Buffet quote goes, risk does indeed comes from not knowing what you are doing given that single-B rated loans now make up the largest portion of the junk-loan market compared with 2007, when double-B rated loans were the most popular. As a reminder, during the credit crisis, loans were the worst performers among the major credit asset classes, losing 23 percent in the last quarter of 2008.

Loan ETFs are yet to be tested, by our "liquidity" fat-tail concerns but they are sure becoming "Too Big To Fall", and if indeed selling pressure does materialise, they will probably sell-off fare more than the index because they might not be in position to redeem the assets at the pace of the money being pulled out. Caveat investor...

In a world of increasing "positive correlations" where convertibles ETFs as well are getting even more sensitive to "equities", last year's sell-off in the credit ETF space for High Yield (ETF HYG) and Investment Grade (ETF LQD) illustrate, we think the "redemption" risk - graph source Bloomberg:

Another illustration of the "Cantillon Effects" at play and outside the credit space has been the London real estate market courtesy of Central Banks' generosity as indicated by Bank of America Merrill Lynch in their Thundering Word note from the 27th of March entitled "Hey Crude, don't make it bad":

"London...the last great EM “speculative fervor”
Prime London real estate is up 2X since 2006, 3X since 2000 and 4X since 1998.
And yet UK rates are the lowest they have been in 300 years. In our view, London property is a classic outcome of the Max Liquidity-Min Growth backdrop of the past seven years. We believe the risk of "speculative fervor" remains high. The UK could prove a useful early warning system.

Prime London real estate has doubled since 2006, tripled since the 2000 and quadrupled since the last great Asia/EM crisis of 1998 (Chart 3). 

And yet the Bank of England's policy rate is at its lowest level in 300 years (Chart 2)."

- source Bank of America Merrill Lynch - The Thundering Word - 27th of March 2014

As per our conversation "Cantillon Effects", we too, have an our own useful warning system, being the art market in general and Sotheby's stock price versus world PMIs since 2007 - graph source Bloomberg:

We have argued previously that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months.

As a reminder, why did we choose art as a reference market in describing "Cantillon Effects" and asset bubbles you might rightly ask?

Well, as posited by a very interesting study by Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":

"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.

Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

Nota bene: Classical equation of exchange, MV = PQ, also known as the quantity theory of money. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.

-Endogenous money, PQ => MV (Hume, Wicksell, Marx)

-Exogenous money, MV => PQ (Keynes, Monetarist)

In our Cantillon Effects, we get:

Δ M  => Δ Asset Prices

Sales of art and antiques increased 8 percent from a year earlier to 47.4 billion euros ($65.9 billion), according to a report compiled by Arts Economics and published on the 12th of March as reported by Bloomberg by Katya Kazakina on the 12th of March in her article "Art Market Nearing Record as Global Sales Reach $66 Billion":  

"The results fell just short of the record 48 billion euros in 2007. The value of postwar and contemporary art transactions increased by 11 percent from 2012, reaching its highest-ever auction sales total of 4.9 billion euros as records were established for artists such as Francis Bacon, Roy Lichtenstein and Andy Warhol." - source Bloomberg.

Yet another example of "illiquid asset" such as London real estate to monitor closely in the near future and another illustration of our 2007 feelings we think.

On a final note and relating to our deflationary monitoring stance, we have been tracking with interest the shipping space as you know and looking at the recent Asia to Europe container shipping rates, it continues to fall and has indeed fallen to a 21 week low:

"Shipping rates for 40-foot containers fell 5.1% to $1,684 for the week ended March 27, marking the ninth-straight weekly decline and the lowest price since mid-December ($1,660), according to World Container Index data. None of the major trade lanes increased. Rates from Shanghai to Rotterdam (11.9% lower) and to Genoa (down 5.7%) declined the most for the fourth consecutive week, as rates for both lanes dipped to the lowest levels since October." - source Bloomberg.

The latest reading from the Drewry Hong-Kong/Los Angeles container rate benchmark tells a similar story - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5% to $1,886 for the week ended March 26, reversing last week's gain and the eighth week in 2014 below the $2,000 mark. Slack capacity continues to pressure prices, with rates 13.4% lower yoy and 25.1% below the July 2012 peak of $2,519. Carriers are expected to implement a $300 general rate increase per 40-foot container from Asia to the U.S., effective April 15." - source Bloomberg.

What is of course of interest is the additional rate increases to counter the deflationary forces at play still wreaking havoc on the shipping industry as a whole. As a reminder, Containership lines have announced 13 rate increases, totaling $5,450, on Asia-U.S. routes since the beginning of 2012.

So what is the new trick to offset deflationary forces, you might rightly ask? It is called "Container Liner Alliance" by the U.S. Federal Maritime Commission (FMC) when it should be called "Oligopoly" or more simply a cartel:
"The U.S. Federal Maritime Commission (FMC) approved the alliance of the three largest containerliners Maersk, Mediterranean Shipping and CMA CGM, dubbed P3, on March 20 to set sail in 2Q.
The alliance of 252 vessels (2.6 million 20-foot equivalent units) represents 42% of Asia to Europe, 24% of Trans-Pacific and 40% to 42% of Trans-Atlantic capacity, according to the FMC. P3 may help reduce costs and manage excess capacity, stabilizing rates." - source Bloomberg.

So in the competition of survival of the fittest, the set-up of a de facto "cartel" in the shipping space  with the benediction of US authorities has no doubt "boosted" the probability of survival of the big three. This latest "intervention" does indeed validate our January 2014 musing "Shipping and Deflation - Only the strong survive":
"In a Bear Case scenario, only the strong survive such as Maersk. The world's largest container shipping line with 15% of the world's market share, did report an 11% increase back in November in third-quarter profit after cutting costs by 13% in the quarter helped as well by its new line of triple-E ships being introduced which has been countering the deflationary trend in freight rates." - source Macronomics, 9th of January 2014

Looks like the containers industry is like the banking industry after all, it's "Too Big To Fail".

"If my survival caused another to perish, then death would be sweeter and more beloved." - Khalil Gibran, Lebanese poet

Stay tuned!

Credit - The Thin Red Line

"If we take the generally accepted definition of bravery as a quality which knows no fear, I have never seen a brave man. All men are frightened. The more intelligent they are, the more they are frightened." - George S. Patton

Watching with interest the events in Crimea, after having spent some time wondering about the raft of "good" economic data (PMIs, nonfarm payrolls,...), and the recent geopolitical events we thought we ought to use a reference to a military action, given we quoted the maverick George S. Patton earlier on. 

This time around we decided to pick a military action by the red-coated Sutherland 93rd Regiment of Highlanders at the battle of Balaclava on the 25th of October 1854 during the Crimean War. In this event the 93rd backed back a small force of Royal Marines and some Turkish soldiers routed the Russian cavalry charge, earning the fiery Scots more Victoria Crosses than at any other time:

"The Times correspondent, William H. Russell, wrote that he could see nothing between the charging Russians and the British regiment's base of operations at Balaclava but the "thin red streak tipped with a line of steel" of the 93rd. Popularly condensed into "the thin red line", the phrase became a symbol of British sangfroid in battle." - source Wikipedia

The Thin Red Line became an English language figure of speech for any thinly spread military unit holding firm against attack. The phrase has also taken on the metaphorical meaning of the barrier which the relatively limited armed forces of a country present to potential attackers. 

You must therefore be already wondering where we are going with our chosen analogy. Colin Campbell, 1st Baron Clyde, the commanding officer of the "Thin Red Line" had such a low opinion of the Russian cavalry that he did not bother to form four lines but two lines, although military convention dictated that the line should be four deep. 

When ones look at the growing sense of "impunity", in both the equity space with the S&P breaking records after records and in the credit space with the Markit CDX North American Investment Grade Index touching the lowest intraday point of 61.6 basis point, the lowest level since the 1st of November 2007, we are left wondering in this replay of "Balaclava" if investors are not too "complacent" by not bothering to protect their portfolio, preferring, like Colin Campbell, to hold two lines of defense, rather than the conventional four (volatility being currently very cheap).

Credit wise, we reminded ourselves that dealers' books have shrunk from $256 billion in 2007 to $56 billion today. So, when and not if, the market turns, mind the gap because, as goes one of our favorite quote which we have used repeatedly:

"Liquidity is a backward-looking yardstick. If anything, its an indicator of potential risk, because in liquid markets traders forego trying to determine an assets underlying worth  - they trust, instead, on their supposed ability to exit." - Roger Lowenstein, author of When Genius Failed: The Rise and Fall of Long-Term Capital Management. - "Corzine Forgot Lessons of Long-Term Capital"

So dwindling dealers' books and rising bond offerings might make DCM bankers put on a huge smile but if the market turns, everybody will cry, much more than in 2008.

In this week's conversation, the metaphorical meaning in our title is that of the relative "limited" protection offered in terms of "liquidity" due to the relatively limited dealers book present to potential "redemptions" on the downside for credit investors. But we ramble again...

For us "The Thin Red Line" is how thinly liquid credit markets are today relative to 2007. Valuations wise in segments of the technology space are akin, we think to 1999, and credit markets looks more eerily familiar to 2007. We could indeed be looking at 1999+2007 for both equities and credit. 

In this week's conversation, we wanted to convey our thoughts and some of the "Red Flags" we have seen as of late, not justifying the on-going complacency when it comes to assessing the replay of "Balaclava". We are not too sure the "Scots" (USA and Europe) can hold the line this time around versus Russia but we digress slightly.

More and more, investors are not getting compensated for the credit risk they expose themselves to in the High Yield space. For instance, a recent example of the complacency we think is illustrated by the new HeidelbergCement 2019 new issue in Euro, offering 2.40% of yield, for an annual coupon of 2.25%. It isn't much being paid out for a BB+ 5 year bond when you think that the Iboxx Euro Corporate All benchmark index commonly used in investment grade mutual funds is offering a yield of 2.12% for a modified duration of around 4.5 years.

This growing disconnect is clearly illustrated we think with the evolution of the Itraxx Crossover 5 year CDS index (European High Yield risk gauge based on 50 European entities) and Eurostoxx volatility (1 year 100% Moneyness Implied Volatility) - graph source Bloomberg:

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

The evolution of the US Vix index and its European counterpart the V2X tells as well a similar story of volatility being contained by the sea of liquidity. Evolution of VIX versus its European counterpart V2X since 18th of April 2011 - graph source Bloomberg:

As we already posited in our conversation "All that glitters ain't gold" in December 2013, 2014 is indeed the year of the "Carry Canary" in particular in the convertibles space given M&A and buyback activity are always a catalyst for issuance as illustrated by the below chart from Bank of America Merrill Lynch displaying the proportion of high yield issuance used for acquisitions:

Another point which indicates a "Thin Red Line" has been in the loan space with the significant rise in high loans without covenants as indicated by Caroline Salas Gage and Kristen Haunss in their Bloomberg article from the 6th of March entitled "Banks Enriched by Junk Resist U.S. Regulatos Standards for Loans":
"For the first time, more than half of the junk-rated loans made in the U.S. during the fourth quarter and so far this year lacked standard protections for lenders such as limits on debt relative to cash flow, Bloomberg data show. Such so-called covenant-light loans amounted to a record $84 billion in the fourth quarter. That was followed by another $57 billion since December.
The exclusion of “meaningful maintenance covenants” is a sign that “prudent underwriting practices have deteriorated,” the Fed, OCC and Federal Deposit Insurance Corp. said in a March 21 statement accompanying the release of their underwriting guidelines.
The advisory said debt levels of more than six times earnings before interest, taxes, depreciation and amortization, or Ebitda, “raises concerns.” Underwriting standards should also consider a borrower’s ability to repay and “delever to a sustainable level within a reasonable period,” the regulators said." - source Bloomberg

It reminds us of the buyout of TXU in 2007 for $48 billion which came at the peak of the private-equity boom which ended up in tears. Energy Future will probably end up  being the biggest failure of a private equity-backed company since Chrysler Group LLC in 2009.

Another "Thin Red Line" we have been looking at has been in the convertible space with the gigantic Tesla convertibles issue upsized from $1.6 billion to $2.3 billion has also made us revisit the hay days of 2007, given most the latest issues in the convertibles are offering a zero coupon with an "ambitious" premium, such as Akamai which in February announced a $500 million Senior Convertible Note with 0% coupon and 45% premium, giving you an interesting negative yield of -0.2% / -0.3% and 50% premium:
"Akamai intends to use the remaining net proceeds of the offering for working capital and general corporate purposes, including potential acquisitions and other strategic transactions. Repurchases of common stock from purchasers of notes in the offering, as well as any additional repurchases of common stock by Akamai, could increase, or prevent a decline in, the market price of Akamai's common stock or the notes." - source Akamai offering.

In relation to that 1999 feeling for equities, we noted the following as reported by Bloomberg by Leslie Picker and Ari Levy on the 6th of March from their article "IPO Dot-Com Bubble Echo Seen Muted as Older Companies Go Public":
"Last year, 208 companies went public, raising more than $56 billion in the U.S., the most since 2007, data compiled by Bloomberg show. Companies seeking more than $100 million in their U.S. IPOs surged an average of 21 percent on their first day of trading, the biggest annual increase since 2000.
People who argue that this time is different “have a vested interest to ensure the investing trend continues,” said Ian D’Souza, an adjunct professor of behavioral finance at New York University who co-founded a technology-focused equity fund." - source Bloomberg

When it comes to stretched "valuations" and echos from the 1999-2000 era, we have been monitoring a specific stock which appears to us strongly reminiscent of the 2000, namely Salesforce.com, which displays many prior accounting similarities with Microstrategy.

Salesforce.com  had a Q4 EPS of $0.07 beat by $0.01. Q4 GAAP loss per share was ($0.19), yes GAAP (all that matter for us). Salesforce previously introduced in 2012 a new metric called “unbilled deferred revenue,” a "non-GAAP" measure of the value of contracts. For us, more than a "Thin Red Line", a "Big Red Flag". Unbilled deferred revenue rose 29% Y/Y to $4.5B after growing 40% in FQ3.

 "Those who cannot remember the past are condemned to repeat it" - George Santayana

Fortunately for us, we do remember the past.

When it comes to the accounting similarities, the previous case of MicroStrategy Inc in 2000, was a case of Revenue Recognition Fraud or Error, as explained by Sudha Krishnan, assistant professor Loyola Marymount University:
"On March 20, 2000, MicroStrategy announced that it planned to restate its financial results for the fiscal years 1998 and 1999. MicroStrategy stock, which had achieved a high of $333 per share, dropped over 60% of its value in one day, dropping from $260 per share to close at $86 per share on March 20th. The stock price continued to decline in the following weeks. Soon after, MicroStrategy announced that it would also restate its fiscal 1997 financial results, and by April 13, 2000 the company’s stock closed at $33 per share." 

Basically, MicroStrategy stock tanked in 2000 because it had materially overstated its revenues and earnings contrary to GAAP not complying with SOP 97-2. So when we read that Salesforce.com tells the SEC it cannot quantify the revenue impact between new customers and additional subscriptions as indicated by Michael Blair in Seeking Alpha, we do indeed chuckle. Particularly when we know that in 2012, Salesforce introduced a new metric called “unbilled deferred revenue,” a non-GAAP measure of the value of contracts not yet booked as sales.

So we really do feel sorry but, in our world, sales growth without profit is pointless. From an equity valuation point of view Salesforce.com is overstretched. We do not know when this stock will crater in similar fashion MicroStrategy did, but eventually it will.

Another illustration of this 1999 feeling comes from the recent surge in China's Tencent Holdings Ltd, as displayed by Bloomberg's Chart of the Day:

"China’s Tencent Holdings Ltd., the best-performing major technology stock worldwide in the past five years, is mirroring gains by the biggest U.S. computer companies at the height of the dot-com bubble.
The CHART OF THE DAY compares Tencent’s 1,246 percent advance in Hong Kong trading since March 2009 against the rallies in Microsoft Corp., Cisco Systems Inc. and Intel Corp. before the stocks peaked about 14 years ago. The lower panel shows Tencent shares trade 10 percent higher than the average 12-month price target of 27 analysts tracked by Bloomberg.
Surging demand for Tencent’s online games, e-commerce platform and WeChat social-networking app in the world’s most-populous nation has helped the company boost earnings at a 48 percent annual rate since 2009 to become Asia’s largest Internet business. While ABCI Securities Co. says the advance is built on stronger profits than many U.S. stocks during the 1990s bubble, Shenyin & Wanguo Securities Co. says Tencent is becoming a riskier bet after its valuation reached an almost six-year high.
“A rally like this cannot go on forever,” said Gerry Alfonso, a trader at Shenyin & Wanguo in Shanghai. “There is upside on this stock, but it is clearly a more risky stock to buy than a few months ago.”
Shares of Microsoft, Cisco and Intel climbed between 1,078 percent and 3,432 percent in the five years through March 10, 2000 -- when the Nasdaq Composite Index peaked -- to become the world’s most valuable technology companies. The trio plunged between 55 percent and 81 percent over the next three years on concern valuations in the technology industry overshot the potential for earnings growth.
The gain in Tencent, the best performing technology company with a market value of at least $20 billion, left it trading at the biggest premium over analysts’ price targets among large-capitalization peers. The stock is valued at 60 times reported profits, the most among Asia’s top 100 companies. Cisco’s price-to-earnings ratio was 196 on March 10, 2000, versus 63 for Microsoft and 52 for Intel.
Jerry Huang, a director of investor relations at Tencent, declined to comment, citing restrictions before the company reports earnings on March 19." - source Bloomberg.

Of course of the main culprit for the "meteoric" rise of some stocks in the technology space, has been the generosity of the Fed and its QE as displayed by the below graph from Bank of America Merrill Lynch form their 18th of February note entitled "Pig in the Python - the EM carry trade unwind":

"Could the party go on? Yes, if for some reason – a significant deterioration in the US labor market, or a deflationary shock from China, or any other surprise that could lead to a cessation of the US tapering could prolong this carry trade. This is not the house base case. We believe it is better to start preparing for a post-QE world. As one of our smartest clients told us: “the main theme in the past five years was QE. If that is coming to an end, investments and themes that worked in the past five years must therefore be questioned.” We agree."- source Bank of America Merrill Lynch.

When it comes to the deflationary forces at play, they should not be underestimated we think, no matter how "rosy" the latest data appears to be. From our point of view, we have a hard time believing the US economic recovery is genuine and that US has finally reached "escape velocity" when we look at the trend for shipping as our favorite deflationary indicator. Container shipping rates continue to fall, highlighting no doubt the fragile state of global growth as displayed in the following Bloomberg table:

"Shipping rates for 40-foot containers fell 7% to $1,843 for the week ended March 6, marking the sixth-straight weekly decline and the lowest rate since mid-December when prices dipped below $1,700, according to World Container Index data. All major trade lanes declined, except Rotterdam to Shanghai, which rose 3.4%. Rates from Shanghai to Rotterdam declined the most, falling 15% for the seventh-straight decrease, to $2,166, the lowest price in 11 weeks." - source Bloomberg

As we indicated on numerous occasions, any change in consumer spending trends is depending on a more pronounced housing market revival and will directly impact container traffic.

But, when it comes to the housing market revival, we would have to agree with Bloomberg, namely that the housing-market prospects in the US seems shaky:

"Housing may slow the pace of U.S. economic growth this year even though home prices and sales of new single-family dwellings would indicate otherwise, according to Pavilion Global Markets Ltd.
The CHART OF THE DAY displays one reason for the firm’s conclusion, presented in a report yesterday. As the top panel shows, the annual rate of home resales fell 15 percent for the six months ended in January, according to data compiled by the National Association of Realtors. The decline contrasted with a 25 percent increase in new-home sales during the same period, according to data from the Commerce Department.
There were 8.7 existing homes sold in January for every new dwelling, the fewest since August 2008, as illustrated in the chart’s bottom panel. Yet about 90 percent of transactions for the month were resales, based on a sales-rate comparison.
“Housing is on a shaky pillar, and perhaps more than recognized,” Pierre Lapointe, head of global strategy and research at Montreal-based Pavilion, and two colleagues wrote.
The market presents “one of the largest real economic risks to U.S. growth in 2014.”
Smaller gains in home prices are another reason for concern, the report said. The Standard & Poor’s/Case-Shiller price index for 20 U.S. cities rose 13.4 percent in December, down from 13.7 percent in November. The change in the growth rate, called the second derivative, slowed earlier last year. The potential for reduced investment buying of homes, the lingering effect of foreclosures, and a reluctance among many banks to provide mortgage loans may also weigh on the housing market, the report said." -source Bloomberg.

In similar fashion, container shipping rates fell another 5% recently as shown by the latest reading from the Drewry Hong-Kong/Los Angeles container rate benchmark - graph source Bloomberg:

"The Drewry Hong Kong-Los Angeles container rate benchmark fell 5% to $1,886 for the week ended March 5, declining to the lowest rate since early January and marking the fifth week below $2,000 in 2014. Slack capacity continues to pressure prices, with rates 17.9% lower yoy and 25.1% below the July 2012 peak of $2,519. Carriers are expected to implement a $300 general rate increase on containers from Asia to the U.S., effective March 15." - source Bloomberg

So investors might indeed think that "The Thin Red Line" is enough to keep the deflationary forces at bay, but, given volatility remains cheap, we think investors would be wise to follow military convention  which dictates that the line  of "defense" should be four deep.

"Courage is what it takes to stand up and speak; courage is also what it takes to sit down and listen." - Winston Churchill

Stay tuned!