Macro and Credit - The Zeigarnik effect

"Both poker and investing are games of incomplete information. You have a certain set of facts and you are looking for situations where you have an edge, whether the edge is psychological or statistical." -  David Einhorn

Looking with interest at the continuation of the rally in both equities and credit, including the high beta space while looking at the continuation in worsening macro data coming out of Europe, when it came to selecting our title analogy, thanks our fondness for behavioral psychology, we decided to go for the "Zeigarnik" effect given most investors are focusing these days on the uncompleted task of the Fed's balance sheet reduction. In psychology, the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks. In Gestalt psychology, the Zeigarnik effect has been used to demonstrate the general presence of Gestalt phenomena: not just appearing as perceptual effects, but also present in cognition. If a task is interrupted, the reduction of tension is impeded. Through continuous tension, the content is made more easily accessible, and can be easily remembered. The Zeigarnik effect suggests that students who suspend their study, during which they do unrelated activities (such as studying unrelated subjects or playing games), will remember material better than students who complete study sessions without a break (McKinney 1935; Zeigarnik, 1927). The results of the study of the "Zeigarnik effect" suggest that a desire to complete a task can cause it to be retained in a person’s memory until it has been completed, and that the finality of its completion enables the process of forgetting it to take place. In similar fashion the desire of the Fed to complete its balance sheet reduction could generate we think, a "Zeigarnik effect" in investors mind. After all it seems to us that the Fed's balance sheet contraction is more influential on assets prices than rates hike, hence the importance of the "Zeigarnik effect" but we ramble again...

In this week's conversation, we would like to look at the state of credit markets and US in particular given the significant rise in leverage in recent years versus Europe, as well as the state of the US consumer. 

Synopsis:

• Macro and Credit - R is for "recession" and D is for "deleveraging". 
• Final charts - Central banks to markets: let's be friends again...

• Macro and Credit - R is for "recession" and D is for "deleveraging". 

The central banking cavalry came late to the rescue with both the Fed and the PBOC coming to support risk assets in general and high beta in particular. Given the even weaker tone coming out of Europe we think it won't take long until we see more support coming from the ECB particularly given the grim growth outlook for the likes of Italy and its continuing ailing financial sector. Given that the European Banking Union remain "unfinished business", it is we think another case of "Zeigarnik effect" as the "doom loop" aka the nexus between the sovereign and the banks is yet to be meaningfully addressed. 

In our previous conversation we pointed out to the more pronounced slowdown affecting Europe including France as well. With French Services PMI at 47.5 in January, at the lowest level in the last 4 years versus 49 in December it doesn't bode well for French GDP going forward:

- graph source Bloomberg

This is what we had to say about France in our last conversation about France:

"The situation for French corporate treasures when it comes to cash flows from operations is deteriorating to a level close to 2012-2013 follow the Euro crisis. This we think, warrants close monitoring, given we think that the ongoing "attrition warfare" between the French government and the "yellow jackets" is taking its toll on the French economy as a whole, which as we reminded you last week is very much "services" orientated relative to other countries of the European Union (80% for France vs 76% of GDP on average)." - source Macronomics January 2019

Sure there is global weaker tone when it comes to macro data, but it is no doubt more pronounced in some places and in Europe in particular hence our concerns and the use of the dreaded "R" word, "R" for recession when it comes to Europe, with Germany coming close to it recently.

But, the latest dovish tone from the Fed is very supportive for high beta, bearish US dollar, bullish Emerging Markets equities, bullish gold and gold stocks as well.

With global "easing" on its way back, following investors fears of a policy mistakes and with a Fed more S&P 500 dependent thanks to the wealth effect, credit could see a return of "goldilocks" thanks to low rates volatility. 

The "R" word has been rising as of late thanks to the global deceleration in global trade on top of a flattening yield curve, but when it comes to credit markets in general and US credit markets in particular, it seems that the "D" word, "D" for deleveraging is staging a comeback as indicated by Bank of America Merrill Lynch in their Situation Room note from the 29th of January entitled "The (soft) floor on credit fundamentals":

"The (soft) floor on credit fundamentals

Our view is that large capital structures in the corporate bond market will go to great length to defend their IG ratings as it could become prohibitively expensive to operate in high yield. That (soft) floor on fundamentals remains one of the reasons we are overweight BBB-rated names. We make a couple of timely observations. First, although the situation remains evolving, we note that General Electric – the 6th largest BBB-rated issuer - is now again trading like the BBB-rated name it currently is, which is a remarkable turnaround after trading in line with BB-rated names during its weakest period last October/November (Figure 1).

Second, when Verizon – the second largest BBB - reported earnings this morning they managed to disappoint and the stock declined more than 3%. However with the company’s emphasis on deleveraging credit investors where not disappointed as spreads tightened about 2bps. AT&T – the largest BBB – was downgraded to BBB-flat in June last year. We would argue that for very large issuers BBB-flat is effectively the floor on ratings, as with further downgrades Fallen Angel risk would be too high for many investors. Since June 30, 2018 – when AT&T became BBB-flat rated in the indices – credit spreads in the Telecom sector, which is dominated by Verizon and AT&T, have tightened 12bps even as the overall IG market widened 10bps (Figure 2).

While we appreciate the longer term challenges to the Telecom industry from technological change, for the next several years we are comforted by relatively stable cash flows and the financial flexibility to support BBB ratings afforded by high dividend yields in the 4.5%-6.6% range. Hence our overweight stance on the Telecom sector." - source Bank of America Merrill Lynch

If there is indeed a slowly but surely rise in the cost of capital, yet at more tepid pace thanks to the latest dovish tone from the Fed, then indeed, this could be more supportive for credit, if companies choose the deleveraging route in the US to defend their credit ratings. In this kind of scenario, it would be more "bond" friendly than "equity" friendly from a dividend perspective we think.

In addition to a potential "D" for deleveraging story playing out for the US, Europe as well could also see a more defensive balance sheet stance coming from CFOs given the weakening growth outlook more pronounced on European shores. On that very subject we read some interesting additional points made by Bank of America Merrill Lynch in their note mentioned above:

"Credit Strategy/Equity Strategy: Who are the refi “losers”?

From the era of hubris… to the reality check

Between 2012 and 2017, European corporates basked in ever-declining debt costs, thanks to unprecedented support from the ECB. The result was a steady boost to Earnings Per Share estimates. Buoyant credit markets thus led equity markets higher. But now the tables have turned, and the equity market should be prepared for a reversal of this symbiotic relationship. European credit spreads have doubled over the last year and companies are finding that they must now pay large concessions on bond deals to attract the requisite demand. Moreover, bond refinancing is a pressing need for a number of companies that failed to term-out their debt maturities during the good times. We think that credit markets now signal that EPS downgrades lie ahead.

A walk into the future - who are the refinancing "losers"?

Table 1 screens for European issuers that could see the greatest EPS downgrades from refinancing their 1-5yr debt. Based on today's credit landscape, we calculate EPS hits of up to 4%. Which names tend to be captured by our screen? Those with plenty of frontend debt still, and those where credit markets have already priced-in steep credit curves.

While Table 1 highlights a variety of names, reflecting these mix of themes, (peripheral) utilities, autos, industrials and telecoms feature prominently. And while there may be mitigants to EPS hits for utilities (regulatory regimes) and autos (financial debt), if debt costs continue to rise in Europe, these sectors would be impacted in other ways.

The canary in the credit mine for stocks

At the height of ECB QE, interest costs for European companies had dropped to 20yr lows. However, interest expenses returning to pre-QE levels will likely become a reality, and will be a further headwind to an already slowing profit cycle. EPS Revision Ratios have been trending down since 2017, when credit spreads turned, and our top-down profit cycle model is predicting 0% EPS growth this year. While operational leverage is undoubtedly the key profitability driver, a 100bps rise in interest costs could lead to a ~2% hit to European EPS. Our strategic view on equity styles and sectors is to focus on quality companies with higher profitability and lower leverage - names that we think will be less vulnerable to rising interest cost and widening credit spreads.

Defend the debt…not the dividend

Companies manage to shareholders, not bondholders. That is the unspoken rule. But we believe that this narrative may no longer hold in today's world of tougher debt rollovers. Equity investors should be prepared for companies to "defend" their debt more than their dividend going forward. Equity investors should therefore be mindful of companies with a high quantum of front-end bonds, and with high dividend payout ratios.

Who are the refi "winners" still?

The silver lining for equity investors is that while debt costs are rising everywhere, some companies have been relatively slow to refinance their bonds over the last few years, and are thus paying higher-than-market coupons on their existing debt. When refinancing time comes, we believe these companies (Table 2) will likely see a small EPS boost.

- source Bank of America Merrill Lynch.

Whereas 2018 was not a good vintage for European stocks, then indeed there might be more additional pain for some equities holders should CFOs in Europe as well embrace a more defensive balance sheet stance, though, leverage in Europe has been creeping up at a much slower pace with the exception of France, being the outlier when it comes to corporate credit leverage overall.

We pointed out in our previous conversations that corporate treasurers in France were becoming more cautious given the deterioration they were seeing in their operating cash flows and slowdown in activity. We could therefore see more dividend cuts coming from French local players, if indeed CFOs adopt a more credit friendly approach when it comes to their balance sheet. The French "leverage" is highlighted in the below Barclays chart from their European Equity and Credit Strategy report from the 30th of January entitled "How worried should we be about Credit?":

- source Barclays

In relation to the European situation we read with interest Bank of America Merrill Lynch's Credit/Equity Strategy note from the 29th of January entitled "Who are the refi losers":

"Canary in the credit mine for stocks

The end of all-time lows on interest charges, as QE ends Since the inception of ECB QE in 2015, corporate borrowing costs have been falling up until 2017, when we saw the Euro cost of debt drop to all-time lows (Chart 5).

With ECB QE coming to an end, we have seen widening corporate credit spreads amid a widespread economic downturn and trade tensions. In periods of declining macro conditions, although safe-haven government bond yields tend to fall amid expectations of looser monetary policy, corporate credit spreads tend to widen due to the perception of rising default risks.

Interest expenses returning to pre-QE levels becomes especially important when EPS Revision Ratios in Europe have been trending down since May ’17 (chart 6) and our topdown earnings model predicts 0% EPS growth in Europe over the next 12 months (chart 7).

Unsurprisingly, investors are increasingly demanding that companies preserve cash to pay down debt rather than spend it on dividends or capex (chart 8).

We prefer more defensive High Quality names with lower relative quantities of frontend debt (or flatter credit curves). These are names that are less likely to see a hit to EPS from future debt refinancing, we think. Also similar to the list, we are strategically overweight the Food & Beverages equity sector in Europe.

European stocks dropped 18% last year, peak-to-trough, but have recovered the majority of December’s losses this year. Recent Fed action has clearly brought short-term relief, but so far has failed to generate large inflows back into Euro corporate credit. The key question is whether we can see a repeat of 2016, when the Fed took a long pause – and helped credit markets. However, in Europe, we think the ECB are unlikely to be able to offer new big stimulus, given the political constraints of QE.

We would note that equities have 88% correlation with credit spreads. But credit markets can also serve as useful leading indicators for equity investors. Large declines in EUR HY credit spreads have reliably signaled major troughs in equities in the past. With global growth in question, central banks are the only game in town (chart 9).

The credit market-equity market nexus

Note as well, that our analysis shows that a rise in European high-yield spreads of 100bp leads to an approximate 2% hit to market EPS in Europe (from the current levels). Given that our top-down model for European earnings suggests 0% EPS growth in 2019, we think that this is quite a meaningful number." - source Bank of America Merrill Lynch

If indeed the Fed's dovish pattern has been more positive for US equity holders including the high beta space, we do agree with Bank of America Merrill Lynch that, in Europe, the story might play out differently, with equities benefiting less from the ECB than credit markets overall. With slowing growth we continue to dislike European banks equities. From a credit perspective, it is more on a case by case basis we think but we would rather own selected credit from European banks than their stocks as far as we are concerned regardless of the high beta/cheap valuation put forward by some pundits or "confidence men" out there. 

So does it mean a return for "goldilocks" for credit? Sure they are many external factors such as Brexit and other geopolitical factors that come into play but, given the Fed has been in the driving seat in the most recent "risk-on" mood, there is a potential for a continuation of the rebound but probably not as significant as the one we saw during the second part of 2016 thanks to the rally in oil prices. We have touched this subject before on numerous occasions but when it come to a sustained rally for US High Yield, oil prices do matter a lot given the exposure to the Energy sector. 

With a notable slowdown in global growth on the back of rising angst surrounding the outcome of the trade war between the United States and China, with central banks coming to the rescue there is indeed a potential for credit to continue to perform on the back of the stabilization of fund flows in the asset class. In relation to US corporate credit's potential for pushing the United States into recession, as we stated before, earnings will be essential in 2019. On this subject we read with interest UBS's take from their Global Macro Strategy note from the 28th of January entitled "Credit Perspectives - US Corporate Credit - What we worry about and what we don't":

"While US growth is coming lower, rest of the world growth is still falling even quicker. Much as we think that at the aggregate level there are mitigating factors that imply US corporate debt won't itself lead to a US recession, there seems to be little doubt higher leverage means the US economy is more vulnerable to a profits slowdown, even one that has its origin abroad. The lack of willingness and ability from China to give a major stimulus this time has compromised growth both in Asia and Europe. Given that Asia has been a big driver of the demand for both tech and energy, key sectors for the US LL and HY markets, a slowdown here could have a big impact on US spreads. Energy issuers are still amongst the most vulnerable, even if the breakeven price for shale has fallen to USD 40-50 per barrel on WTI (Figure 24).

At those levels HY energy spreads could rise to 800-1000bps, we estimate. For the IG space, the big risk is European financials, to which US financials display a very tight correlation (Figure 25), and which have widened but less than would have been expected in the face of a sharp growth slowdown in Europe.

However, the decline in credit market liquidity means a sign of relative calm should not be read as a signal of health. Things could change dramatically with a few downgrades, or an uptick in NPLs." - source UBS

Given the significant rally in European credit since the inception of QE in Europe and with the ECB purchasing directly corporate credit, should a new TLTRO materialize in the coming months to continue to support the European financial sector, we do not think the upside will be as significant as seen before. We do have to agree with UBS namely that the "Zeigarnik effect" of our "generous gamblers" will probably be less potent than previously in engineering a significant rebound in credit markets à la 2016.

Moving back to the subject of earnings and risk-on/Goldilocks, we think there is limited upside in 2019 and we did warn in 2018, that when it came to earnings estimates, analysts were being overly optimistic in their outlook. December has clearly set the tone for vicious EPS revisions and cuts in many instances. If indeed CFOs become much more defensive of their balance sheet, then we could see more dividend cuts in 2019, which would be more credit positive, no wonder we suggested to seek higher quality in US Investment Grade versus high beta credit, performance wise, it has been more supportive to play quality (ratings) over quantity (high beta/yield) as highlighted in the below charts from Bank of America Merrill Lynch from their Credit Market Strategist note from the 25th of January entitled "High grades to IG":

"High grades to IG

While equities and high yield ended this week roughly flat (Figure 1) the strong rally in investment grade continued with credit spreads tightening at a roughly 5bps weekly pace (Figure 2).

This makes sense as the key economic data release this week – Jobless Claims – at the best level since the 1960s (Figure 3) confirms recession risk remains remote. Moreover, the Fed remains clearly on hold for an extended period of time (Figure 4) on the negative GDP impacts of tighter financial conditions and uncertainties surrounding trade war and the government shutdown.

For IG, the material decline in rate hiking risks in reaction to just some tenths cuts to economic growth is a good tradeoff. Being relatively more sensitive to economic growth for high yield and equities the tradeoff is a bit different.

The most likely scenario for how this year plays out, in our view, is continued improvement in the macro – US government reopens, Brexit resolves, US–China relations de-escalate and the US economy continues to grow above trend. As financial conditions ease this environment eventually puts the Fed in a position to resume its rate hiking cycle – probably sometime in the middle part of the year – which is going to be a more formidable challenge for IG. For now, we expect tighter credit spreads – although obviously the first big step has already been taken – but over time IG outperformance fades and turns to underperformance. We remain overweight IG corporate bonds." - source Bank of America Merrill Lynch

So yes, clearly, there is room for slightly more tightening with the Fed's dovish tilt and lack of interest rates volatility with falling inflation expectations. In terms of upside, it is a question of not having "great expectations" and being very selective hence the return of global macro and active management at this stage of the cycle with continued rising dispersion. 

Our final charts below clearly highlight the importance of central banks and in particular the Fed in driving asset prices, with its balance sheet policy reduction being the most important factor at play when it comes to the "Zeigarnik effect".

• Final charts - Central banks to markets: let's be friends again...

With the most recent dovish tilt coming out of the US Federal Reserve, no surprise "risk-on" lives on. It is all about after all a question of "growth sensitive assets" as indicated in our final charts from Bank of America Merrill Lynch The Inquirer note from the 30th of January entitled "Wanted: Monetary easing, not Verbal flexibility":

All indicators point to weak global growth, and suggest EASING monetary policy

1) Only 5 out of 38 economies are seeing rising OECD leading economic indicators (LEI). The net proportion of countries with rising LEI is in the bottom decile of its history since 1988. 2) The world's monetary base shrunk 1.7% YoY in November, only the sixth time since 1980. All prior five occurrences of a shrinking monetary base were associated with recessions in Asia/emerging markets, and ALL were eventually associated with global monetary easing. The Fed's plan to "watch paint dry" and shrink its balance sheet by USD50bn/month this year, is likely to shrink the global real monetary base by 5% YoY by end-2019. Global central banks are implying a massive rise in the money multiplier to counteract this, and/or a rise in monetary velocity to keep nominal GDP growth humming. We think these assumptions are heroic. 3) The global 1m earnings revisions at 0.5 (i.e. for every upward revision there are two downward revisions) is in its bottom decile. 4) Asset prices that have an opinion on global growth (Dr Copper, Dr Sotheby's, Dr. Halliburton etc.) are in their lowest decile. Again, prior instances of such analyst pessimism and weak asset prices were followed by monetary easing. Policymakers seem to be flexible, and the markets like this flexibility if data weakens. Next stop easing?" - source Bank of America Merrill Lynch

Given the "Zeignarnik effect" states that people remember uncompleted or interrupted tasks better than completed tasks, it seems that markets are more than happy to remember an incomplete balance sheet reduction from the Fed at this stage but, we ramble again...

"An educated person is one who has learned that information almost always turns out to be at best incomplete and very often false, misleading, fictitious, mendacious - just dead wrong." - Russell Baker, American journalist.

Stay tuned!

Macro and Credit - Le Chiffre

"If you spend a week at a casino you will very easily see that people have a certain way of behaving in a casino." - Mads Mikkelsen, Danish actor (who played Le Chiffre in the recent Casino Royale).

While observing the rapid, yet severe pain inflicted to the "short crowd" so far in October thanks to the "relief rally" in risky assets "High Yield" and equities included, supported as of late by the PBOC double rate cuts and the return to the front stage of our "Generous Gambler"  aka Mario Draghi, we decided this week given our eagerly anticipation of the release of the 24th opus of James Bond's adventure Spectre to steer towards a "Bond" related analogy when it comes to choosing this week's title for our musing. While we could have simply elected to go for "Casino Royale", the character Le Chiffre appears to us more interesting from a central banking "gambling" perspective given the latest actions of the PBOC and promises made by Mario Draghi. Le Chiffre after all was the main villain of the official 2006 James Bond film "Casino Royale". In order to win the money back lost during the summer, one could argue that Le Chiffre aka our main European central banker has indeed set up and entered a new high-stakes Texas hold 'em tournament in similar fashion he did at the Casino Royale in Montenegro in the movie. In the movie Casino Royale Bond eventually beats Le Chiffre in the game of poker by catching his bluff. In the start of the movie Bond tells Vesper: "in poker you never play your hand...you play the man across from you". 

While in the movie Le Chiffre pretty much made a game out of it with nothing on his cards in the first game, in similar fashion Mario Draghi made a game out of it with his "OMT" and "Whatever it takes" July 2012 moment. In the movie it made Bond surmise that Le Chiffre was in desperation to get the money and resorted to bluffing (It was exactly our thought at the time). Le Chiffre and Mario Draghi share the same trait, both are poker prodigies hence our title analogy.

Whereas in the last couple of weeks, we have mused around the deterioration of credit metrics particularly in High Yield land,  with renewed M&A marking what we think signs of exhaustion in the "credit cycle", in this week's conversation, we would like to highlight the weakening effects of the various iterations of QEs have had on risky assets, showing in essence that Le Chiffre is probably "overplaying" it particularly when one looks at the poor effects on "credit growth" in Europe and "inflation expectations".

Synopsis:

• QEs and the law of diminishing returns
• Europe's "Japanification" process is still supportive of European credit
• Final chart - Bonds have been the only game in town when it comes to "over-allocation"

• QEs and the law of diminishing returns

In last week's conversation we used Liebig's law of the minimum concept as an analogy for our title given it 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). Last week we read with interest that the ECB indicated Credit Standards improved as QE Program supported lending as reported by Bloomberg:

"Credit standards on loans to companies eased for the sixth consecutive quarter, the ECB’s Bank Lending Survey showed on Tuesday. Terms for mortgages tightened, with banks citing national regulation as the primary cause. A small majority of lenders reported an increase in profitability over the past six months as a result of the central bank’s quantitative-easing program, though a deterioration is seen over the next two quarters." - source Bloomberg

Obviously what we find of interest from Le Chiffre's team at the ECB is that, once more the reality of the data counters their wishful thinking as indicated by Reuters in their article from the 27th of October entitled "Euro zone bank lending sluggish despite tsunami of QE and cheap cash":

"Growth in loans to the private sector slipped to 0.6 percent in September on a year ago, lower than August’s 1 percent rate and nowhere close to the near double-digit numbers clocked before the global financial crisis.  Loans to non-financial corporations grew just 0.1 percent in September from 0.4 percent the month before, the first monthly slowdown since June 2014.That data also are at odds with ECB’s Bank Lending Survey findings released last week, which showed banks reported increasing demand for business loans." - source Reuters

QE on its own is not leading to credit growth, because as we have repeatedly pointed out in our musings, a lot of European banks, particularly in Southern Europe are capital constrained and have bloated balance sheet due to impaired assets.

We would have to agree with Reuters, namely that  no matter how charming Le Chiffre's bluff is, we are not falling for it and you should not. From the same Reuters article:

"ECB President Mario Draghi last week signaled more easing is coming in December, and that has already become the consensus among economists. 

But more than six months of QE – 60 billion euros of bond purchases in each – and years of cheap long-term cash auctioned by the ECB has so far yielded lacklustre results despite the extraordinary amount of stimulus along with interest rates at or below zero.

More stimulus will not necessarily give banks the incentive to start lending to businesses.

Instead, European banks are lending a lot for house purchases, which does not suggest there will be a spurt broader consumer prices, which the ECB targets.

Consensus forecasts for euro zone inflation at the end of 2015, 2016 and 2017 have either stayed constant or been downgraded in each Reuters poll since May, even as it slipped back below zero last month." - source Reuters

We will repeat ourselves again: QEs have no impact on the "real economy". This a subject we already discussed at length in our November 2014 "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

When it comes to the change in "credit growth", we agree with Kit Juckes from Société Générale in his recent takes on the impact of QE on lending growth in his View From The Hill from the 27th of October:

"QE doesn’t boost bank lending: I have two problems and one question. The first problem is economic: I can’t see how further ECB ‘QE’ can really help boost economic activity and specifically, how it can help boost loan growth. The second problem is a market one: I have no idea how to judge how far German Bund yields can fall as growth loses momentum and investors project zero (or negative) rates further onto the future and settle for less and less yield in their portfolios. The question, which I shall attempt to answer, is what that means for the Euro. Whatever else it means, of course, it isn’t good news.

The chart shows (In my opinion) the key part of the ECB’s monthly money supply release: the growth of loans, adjusted for securitisations. This slowed to an annual rate of just 0.4% in September, from 0.8% and from a recent peak of 1.4% in July. That’s a severe loss of momentum. I plotted it against the annual rate of change in the ECB’s balance sheet, although I could have plotted it against almost any other measure of QE and got the same answer – QE does not appear to be doing anything to boost loan growth in Europe.
We don’t know (what would have happened to bank lending or economic activity if the ECB hadn’t embarked on its bond-buying programme but ‘QE’ has supported peripheral bond markets, narrowing spreads and preventing a crisis of confidence, and it seems have supported equity and increasingly, property markets across Europe. But it hasn’t supported lending. QE + the shift to negative interest rates meanwhile, have as a combination weakened the Euro, which has hopefully helped exports (though a 9% year-to-date fall against the dollar is only a 5 ½% fall on a trade weighted basis).

The issue at stake is the different path taken between the Fed and the ECB when dealing with the impaired balance sheet of their respective banking sector. After all, the "Growth divergence between US and Europe? It's the credit conditions stupid...", it is all about Stocks versus Flows as we pointed out in May 2012:

"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."

What is depreciating at a very slow pace are the impaired liabilities on banks' bloated balance sheet hence the on-going support of the financial sector via LTROs first and then QEs, but in no way finding its way "meaningfuly" into the "real economy".

As a reminder, our take on QE in Europe from our "Chekhov's gun" can be summarized as follows:

"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

We also quoted at the time Nomura's Richard Koo on the subject of lending growth, QE and liquidity:

"Central bank-supplied liquidity has nowhere to go without real economy borrowingAs I have repeatedly pointed out, the central bank can supply as much base money (liquidity) as it wants simply by purchasing assets held by private-sector banks.But a private-sector bank cannot give away that liquidity, it must lend it to someone in the real economy for that liquidity to leave the banking sector." - Nomura, Richard Koo

If Le Chiffre is again promising more "generosity" it is because, contrary to some beliefs in its effectiveness in triggering "real economic" growth via the lending channel, all is not well in the European banking world.  We noticed that on the 12th of October, 3 small Italian banks Banca Marche, Banca Popolare dell'Etruria and Cassa di Risparmio di Ferrara (Carife) had to be bailed out by the Italian Central Bank due to a "small hole" of €2.2 billion euros. There are 650 small and medium banks in Italy, you  can therefore expect more consolidation and more "support" from the ECB.

Of course, when it comes as well to Le Chiffre and "inflation expectations", QE has been as well a failure as displayed in the below Bloomberg graph - H/T Holger Zschäpitz

- source Bloomberg / Holger Zschäpitz on Twitter

While Le Chiffre has been a prodigious  Poker player when it comes to "bluffing" his way out out of the "bond vigilantes" in Europe setting their sights on weaker European government bonds, when it comes to both "credit growth" and "inflation expectations", we think Le Chiffre has indeed been "overplaying" it.

In similar fashion to Liebig's law of the minimum, the law of diminishing return means that at some point, adding increasingly more fertilizer (liquidity via QE) improves the yield by less per unit of fertilizer (QE), and excessive quantities can even reduce the yield (check out 2 year Italian and Spanish government yields...). 

Back in December 2014  in our conversation "The QE MacGuffin" we quoted Société Générale in relation to the law of diminishing return from QE:

"Life below zero. At the ZLB, central banks do what they know: they print money. But such policy seems to follow a law of diminishing marginal returns. It has worked well for the US, because the Fed had a first-mover advantage, and the support from pro-growth fiscal policy and a swift clean-up of the household and bank balance sheet. The BoJ and ECB aren’t as lucky. Let’s consider three transmission channels: 1) The portfolio channel. By pushing yields lower, central banks force investors into riskier assets, boosting their prices. But trees don’t grow to the sky. And the wealth effect on spending is constrained by high private and public debt. 2) The latter also gravely impairs the lending channel. And with yields already so low, it’s questionable what sovereign QE can now achieve. 3) The FX channel. This is where the currency war starts, as central banks try to weaken their currency to boost exports and import inflation. It however is a zero-sum game that won’t boost world growth.-The battle to win market shares highlights a fierce competitive environment, which tends to depress global inflation. Adding insult to injury, oversupply in commodities, especially oil and agriculture, currently add to the deflationary pressure. That leads central banks to get ever bolder, when instead they’d need to be more creative (e.g. a bolder ABS plan from the ECB would be far more effective than covered and government bond purchases) and get proper support from governments (fiscal policy, structural reforms)." - source Société Générale, December 2014 - Macronomics

Indeed, in December we expect Le Chiffre to get even bolder.

When it comes to Le Chiffre and QE, we would have to agree with Société Générale's Forex Weekly note from the 22nd of October, "QE is losing is Mojo" and so is Le Chiffre:

"Dubious QE impactThere’s a belief in the foreign exchange market that ‘QE’ - bond-buying by central banks - can continue to weaken currencies and boost asset prices, pretty much ad infinitum. This argument feels more and more dubious to me. In particular, I am doubtful that increased conventional QE (bond-buying) by the ECB or the BOJ will weaken the yen or the euro significantly further from their recent lows. Indeed, I’m not sure how much of the weakness in either currency to date can really be attributed to QE in the first place. I think we have learnt enough from the experiment in glowing central banks’ balance sheets to understand more about how this works in practise. The Fed went first and, by buying bonds, forced a portfolio switch on US investors, out of Treasuries and into more exotic assets, first into mortgages, then corporate bonds and then on into domestic equities and foreign assets. Up went the S&P500 and down went the dollar as outflows to EM grew. US QE was turbocharged by intervention to limit the rise of the ruble, real and perhaps most of all the renminbi
(Chart 1). 

As central bank reserves grew across EM, which created more demand for Treasuries, magnifying the effect. And it also spilled over, through diversification, into demand for euros, Australian dollars and even sterling. I wouldn’t want to argue that Fed QE didn’t undermine the dollar. But what about BOJ and ECB action? Well, these moves weren’t turbo-charged in the same way, yet the yen and euro weakened. I put that down in large part to the other policies undertaken by these ‘excess saving’ central banks. The BOJ started with FX intervention after Mr Abe’s election and the next big phase of yen weakness came about as a result of a deliberate asset allocation switch into equities, including foreign equities by the public sector pension fund. The ECB generated euro weakness not through QE but later, when QE was compounded with negative interest rates in 2015. Driving yields down, on its own, isn’t always enough to persuade investors in savings-rich, low inflation countries to move money overseas - just look at the Swiss.

If conventional QE wasn’t what weakened the euro and yen as much as combining QE with other more potent policy adjustments, it seems to me wrong to assume that another simple round of QE by the ECB or BOJ will have much impact on the euro or yen in the coming days/weeks. Maybe there’s still an effect on peripheral bonds spreads in Europe, and perhaps on equities in both Europe and Japan. Or maybe, as in the UK, the most visible effect now will be on the property market. But in FX, perhaps not so much.

If words from the ECB and QQE from the BOJ this month fail to weaken the euro and the yen meaningfully, there’s a risk of the FX market adding two and two together and making four - concluding that QE ‘doesn’t work in FX’ and challenging the idea of a stronger dollar. EUR/USD at 1.20 and USD/JPY under 115 are not at all inconceivable outcomes this autumn. All it takes is for US Treasury yields to remain anchored." - source Société Générale

Combining QE with other more potent policy adjustments such as the ones described above in our "Hopeful equation" would have indeed a more meaningful impact on the "real economy", but, the free-ride given to European politicians by the ECB is ensuring that structural reforms are either postponed or not implemented. France for instance is a basket case for slack in implementing structural reforms.

While we have long been ranting on our strong deflationary bias, nonetheless, the "japanification" process is still supportive of European credit.

• Europe's "Japanification" process is still supportive of European credit

In a market where recent bad news is still seen as good news (as it leads to more QE), the reality of QE’s failure will become at some point "bad news" as we once more lean towards deflation. While we have during the summer touched on the lateness in the US credit cycle and in particular through the view of our "CCC Credit Canary", European, which is still an expanding universe thanks to dis-intermediation from the banking sector and new players issuing bonds rather than loans, the on-going "Japanification" process and the increase in "Reverse Yankee" (US corporates issuing in EUR) is still supportive of the asset class, but, as we are indeed getting late in the credit cycle, there is limited upside we think.

As we indicated when quoting Nomura in April 2012, "Deleveraging - Bad for equities but good for credit assets":

"As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns" - source Nomura

But, while Le Chiffre is promising some additional "unconventional" card tricks in December, the law of diminishing return means that as we are getting late in the credit game in the US, we could indeed have a spillover effect on European High Yield, should the Fed proceed with some form of normalization in December as expected by the markets following the latest FOMC statement.

When it comes to European High Yield, we would have to agree with Société Générale's take from their Credit Market Wrap up of today:

"Additionally, whatever (in)action the central bank takes today, the markets are likely to react one way or another. However, hike or no hike, we believe that the reality in Europe will remain largely the same. That means low inflation, poor economic growth, high unemployment and the need for more structural reforms and ongoing QE. In that environment, don’t expect corporates to start reckless releveraging processes any time soon, and that means, as we mentioned already this week, low to non-existent defaults and supportive credit metrics in general. The end result is a constant pressure on spreads to head tighter as credit, particularly HY, remains a more attractive alternative to other fixed income asset classes." - source Société Générale

Once more, Central Banks are indeed in the "driving seat" given the non-existing strong economic growth prospects, which makes this "Japanification" process "Goldilocks" period for "credit investors". Even more so in Europe if indeed Le Chiffre in December goes far more "unconventional and extending the already finite bond buying list of some Corporate issuers further. This would of course provide an additional "boost" to European credit. This was a well highlighted by Société Générale in their Credit Market Wrap up from the 25th of October entitled "Where did the defaults go?":

"Highlights: Credit yields are heading lower again, a trend that looks unstoppable for the coming months, even though they are much more attractive than equivalent sovereign bond yields. Still the upside of credit is again increasingly limited and the downside is growing. The good news is that spreads remain very wide by historical standards and compensate amply for the risk of defaults which are simply not happening. 

The ECB continues to prepare the ground for an increase in its QE program, most likely for the duration of it (extending it well beyond next September), but we suspect for the size and scope as well with the central bank gearing up to buy non-financial corporates next year. But even if the ECB confines its purchases to sovereign bonds, the ultra-low yield environment (not just sovereigns but corporates too) is set to remain in place for a very long time. And that means that funding conditions for both governments and corporates will remain extremely attractive for the time being. 

And we can already see some of the benefits of the favourable funding conditions. Coupons in IG of 1% are no longer rare, and only corporate hybrids offer 3%+. In HY, coupons can vary substantially depending on the rating but the average of new issues this year stands at 5.08% or 5.4% since the end of the summer. And this low funding, added to the ongoing disciplined approach to spending, means that defaults globally seem to be a negligible worry. As we can see in the chart below, it’s been around four years already with very low levels of defaults despite a very difficult recession and a very slow economic recovery.

In Europe there were only two defaults in September, Privatbank and Savings Bank of Ukraine, both Ukrainian banks, which is not too surprising given the situation in the country, and to a certain extent this pushes the European default rate higher than it should be under normal circumstances. Still, spreads continue to price in a higher level of defaults to come.
The iBoxx Corporates index is currently around B+157bp, better than where it ended September but still very wide compared to the current level of defaults. The iTraxx indices are a cleaner way to look at the pure credit risk which is in the end a reflection of the risk of default, given the greater liquidity in the synthetic contracts but even these continue to show a very high level of implied default rates. Currently, the iTraxx Main implies a default rate of 1.15% in a year’s time for IG which is excessive as the actual default rate remains at 0.0% and IG defaults tend to be very rare. The X-Over implied a default rate of 4.86% which also looks high versus current and forecast default levels.

Moody’s forecasts a speculative default rate of 3.2% in 12 months’ time, the highest forecast in a long time but even this is lower than what the X-Over is pricing. Furthermore, Moody’s universe is very broad and includes very vulnerable names (the two Ukrainian banks for instance), while the X-Over is made up of the 75 strongest names in the HY universe, companies that have easier access to the capital markets. Additionally, we believe funding conditions for corporates will remain very attractive throughout the life of the ECB’s QE as sovereign yields remain ultra low (and are probably falling) with spreads tightening gently in the coming months. With the economy growing even at a slow pace, it is difficult to see a wave of defaults on the way." - source Société Générale

What of course could but a "spanner" in the current "overconfidence" in Le Chiffre's ability in driving further "credit" into "overtime" for us are two factors, first one being a Fed December normalization process when liquidity will be very thin, second factor is that the EPS momentum continues to slump. As per our conclusion of last week's conversation,  companies overall remain extremely sensitive to revised guidance and earnings outlook. This was clearly illustrated in an another interesting note from Société Générale from their Global Equity Market Arithmetic series from the 26th of October entitled "While equities celebrate central bank actions, EPS momentum continues to slump":

• Global equity markets continued their resurgence with the MSCI World up 1.4% last week, up over 10% from the recent lows. Interest rate cuts from the PBOC and dovish comments from the ECB pointed to a continuing downward trend in global interest rates.
• The ECB's words undoubtedly had the intended effect of weakening the euro and as such, in local currency terms, it was the eurozone equity markets that were the better performers last week with the MSCI Eurozone index up 4.6% and the DAX gaining 6.8%. The DAX has rebounded strongly from the correction, having bounced back 14%, but it is still 8.0% off this year's high. With the Eurozone and Chinese central banks having made their intentions clear, all eyes will no doubt shift to Japan.
• Away from the central banks, the US reporting is in full swing and there have been some impressive price moves, particularly in the large cap tech stocks, in response to positive earnings surprises. The message remains the same though, revenues are disappointing and despite some Herculean efforts to deliver EPS surprises, US earnings momentum is awful, with 70% of all revisions to 2016 numbers coming through as downgrades. Interestingly European and Japan EPS momentum is suffering the same fate, with the direction firmly negative. Only Emerging Markets and Pacific ex Japan are seeing a rebound from lows.

- source Société Générale

So while Société Générale is right in pointing out the "low default rate" in Europe, it is we think "oversimplistic", leverage matters more and so does earnings when it comes to High Yield. Looking at default rates is like looking at the rear view mirror. It tells you what has happened, not what is going to happen and maybe indeed looking at the iTraxx CDS credit indices is a cleaner way to look at the pure credit risk, given the greater liquidity in these synthetic contracts versus cash. We like mostly as an early indicator, the ability of our "CCC credit canary" to tap the primary market when it comes to using an early warning indicator in rising default risk and exhaustion in the credit cycle.

As we posited in our September conversation "The overconfidence effect", when it comes to credit spreads and default risks and leverage, end of the day, earnings matter!

Finally, for our final chart, we would like to point out that both the Fed and Le Chiffre have been great benefactors to bond speculators who continue to have a field day. Bonds have been the only game in town when it comes to "over-allocation".

• Final chart - Bonds have been the only game in town when it comes to "over-allocation"

The big benefactors of the Fed and Le Chiffre's gaming style, particularly since is brilliant 2012 bluff in the European Government bond poker game have been bonds. We came across this very interesting chart from Deutsche Bank (h/t Tracy Alloway from Bloomberg on Twitter) which clearly illustrates "overconfidence" and "over-allocation" to the bonds relative to the trend which are $755bn above the normal trend. This is entirely attributable to the distortions created by QEs:

- source Deutsche Bank (h/t Tracy Alloway).

But of course there is a caveat to the Fed and Le Chiffre "overplaying" it in this monumental poker game.  On that specific matter we will simply quote again Antal Fekete from our July 2014 conversation entitled "Perpetual Motion":

"Moving back to the important notion of the difference between stocks and flows we do agree with Antal Fekete's take in May 2010 in his article "Hyperinflation or Hyperdeflation" being akin to a Black Hole and the possibility of capital being destroyed thanks to ZIRP (as it is mis-allocated towards speculative endeavors) hence the risk of pushing too far the "Perpetual Motion" experience":
"Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it the Black Hole of Zero Interest. When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively. Deflation is the measure of wealth in the process of self-destruction -- wealth gone for good. The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators." - Antal Fekete

While Le Chiffre is indeed in the process of trying to mesmerize us once more in December with his astute poker abilities, if bond investors continue to observe Le Chiffre, they will at some point find out his physical tell (A tell in poker is a change in a player's behavior or demeanor that is claimed by some to give clues to that player's assessment of their hand).

In the movie Casino Royale, Bond knew he could beat Le Chiffre as he was confident that he would catch his tell and get an insight into his game and strategy (bluffs included). This is what happens at the end!

Why? Because Le Chiffre used to place his left hand near his wounded eye at times during play. That was his physical tell. It ended up very badly for Le Chiffre but that's another story...

"When people are taken out of their depths they lose their heads, no matter how charming a bluff they may put up." - F. Scott Fitzgerald

Stay tuned!