Macro and Credit - White noise

"The real man smiles in trouble, gathers strength from distress, and grows brave by reflection." -Thomas Paine

Watching with interest, the return of volatility and consequent rise in Italian Government bond yields, in conjunction with trouble brewing yet again in Spain, following the continuous pressure and Turkey and other Emerging Markets, when it came to selecting our title analogy we decided to go for a signal processing analogy namely "White noise". In signal processing, white noise is a random signal having equal intensity at different frequencies, giving it a constant power spectral density. The term is used, with this or similar meanings, in many scientific and technical disciplines, such as physics, acoustic engineering, telecommunications, and statistical forecasting. White noise refers to a statistical model for signals and signal sources, rather than to any specific signal. White noise draws its name from white light, although light that appears white generally does not have a flat power spectral density over the visible band. White noise is as well interesting thanks to its statistical properties. Being uncorrelated in time does not restrict the values a signal can take. Any distribution of values is possible and even a binary signal such as the ones currently being given by European Peripheral bond markets (risk-off). In statistics and econometrics one often assumes that an observed series of data values is the sum of a series of values generated by a deterministic linear process, depending on certain independent (explanatory) variables, and on a series of random noise values. Then regression analysis is used to infer the parameters of the model process from the observed data, e.g. by ordinary least squares, and to test the null hypothesis that each of the parameters is zero against the alternative hypothesis that it is non-zero. Hypothesis testing typically assumes that the noise values are mutually uncorrelated with zero mean and have the same Gaussian probability distribution – in other words, that the noise is white. If there is non-zero correlation between the noise values underlying different observations then the estimated model parameters are still unbiased, but estimates of their uncertainties (such as confidence intervals) will be biased (not accurate on average). This is also true if the noise is heteroskedastic – that is, if it has different variances for different data points. While causation of Emerging Markets sell-off can be attributed to  "Mack the Knife" aka rising US dollar and positive US real rates, it doesn't imply correlation with the sudden surge in Italian government bond yields, following the rise of a so called "populist" government at the helm of Italy. It is not that Italian issues went away, it is that there were just hiding in plain sight thanks to the strong support of the ECB with its QE program. Now that a less accommodative government has been elected in Italy, the status quo of the sustainability of the European project and European debt are being questioned again. The constant power spectral density of the ECB's QE is fading, hence the aforementioned reduction in the "White noise" and stability in European yields we think. We recently argued the following on our Twitter account: 

"Both rising US dollar and Gold may mean we have entered a period where non-yielding assets are preferable to assets such as some sovereign debts promising a yield yet future size of payment and or return of principal are starting to become "questionable". - source Macronomics, 24th of May.

As the central banks put is fading, what basically has been hiding in plain sight, has been the sustainability of the European project. Investors are therefore moving back into assessing the "return of capital" rather than the "return on capital". It seems to us that the "White noise" which in effect had hidden the reality of "risk" thanks to volatility being repressed thanks to central banking meddling is indeed making somewhat a comeback to center stage yet again given the recent bout of volatility seen on Italian bond prices and yields. When it comes to Italy's latest political turmoil we have to confide that we are not surprised whatsoever. We warned about this playing out exactly last year during our interview on "Futures Radio Show" hosted by Anthony Crudele:

"The biggest risk in Europe is still Italy because the growth is not there" - source Macronomics, May 2017 on Futures Radio Show.

On the anniversary of us voicing our concerns on Italy in this week's conversation, we would like to look at debt sustainability with rising rates as well as the risk of deceleration we are seeing in global growth as of late. 

Synopsis:

• Macro and Credit -  Solvency of the issuer ultimately determines allocation of capital 
• Final chart - Decline in PMI's doesn't bode well for the US bond bears

• Macro and Credit -  Solvency of the issuer ultimately determines allocation of capital 

The latest ructions in both Emerging Markets and Italian Government bond yields are a reminder that once "White noise" starts to dissipate with QT and a fading central banks put, then indeed solvency issues can return with a vengeance, such is the case with Turkey and fears on Italian debt sustainability. It is a subject we already touched in a long conversation we had back in September 2011 in our post "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portolio Theory and more!". In this conversation we quoted the work of Dr Jochen Felsenheimer, prior to set up "assénagon" and now with XAIA Asset Management, was previously head of the Credit Strategy and Structured Credit Research team at Unicredit and co-author of the book "Active Credit Portfolio Management:

"Competing systems between countries in a world of globalisation and fully integrated capital markets restrict a country's room for manoeuvre in that mobile factors of production seek out the state infrastructure which give them the best possible reward. The state can only counter the migration of workers and relocation of whole production sites with economic measures, for example the creation of an effective infrastructure (e.g. education) or tax incentives. Accordingly, a government's outgoings - and also its income - are not just determined by domestic economic developments, but also by other countries' economic strategies. Countries are in competition with each other - just like companies. And this is particularly true within a currency union, which is fully reflected in the different tax policies of the individual member states." - Dr Jochen Felsenheimer.

At the time we added that the name of the current game was maintaining, at all cost, rates as low as possible, to avoid government bankruptcies hence the ECB's QE. Dr Jochen Felsenheimer which we quoted at the time also made the following comments in the letter we quoted extensively in our conversation in 2011:

 "In terms of global competing systems, we can view countries like companies. The difference is that they only refinance through debt. Even if this refinancing option does not appear unattractive in view of the low interest rate, even cheap money has to be paid back sometimes. And that is exactly what is becoming increasingly unlikely." - Dr Jochen Felsenheimer

The ECB has been able to provide protection against a run, alas temporarily. While the ECB acted as a lender of last resort, doing so exacerbated political tensions and is not a lasting solution as we can see unfolding right now in Italy. 

The concept of "solvency" is very sensitive to the government’s cost of funding (Turkey), and therefore to swings in market confidence.  A government with even a very large level of debt can appear entirely solvent if funded cheaply enough, which is the case for various European countries we think. There is no reassurance that solvent government will always be kept liquid, forget "leverage", end of the day in credit markets "liquidity" matters and we should all know by now that "liquidity" is indeed a "coward". We commented at the time in 2011 that liquidity, matters, because the major implication of the disappearance of risk-free interest rates is that it weakens in the process the quality of the "fiscal backstop" enjoyed by banks, particularly in peripheral countries which have extensively played the "carry trade". Therefore the sovereign/banks nexus has not been reduced by the ECB's actions, on the contrary. Net Interest Margins (NIM) for peripheral banks has been replaced by "carry trades" thanks to the ECB. There is a direct relationship between the credit quality of the government and the cost and availability of bank funding. You probably understand more our Twitter quote from above regarding the risk for the "return of principal" when it comes to some sovereign debt which again are starting to become "questionable" hence the "repricing" for some Emerging Markets and Italy as well.

If indeed we are moving towards a repricing of risk on the back of "solvency" issues it is because the "risk-free" status of some European government bonds is coming back into center stage. We can see it in the credit markets as pointed out by Bank of America Merrill Lynch European Credit Strategist note from the 24th of May entitled "Corporates safer than governments":

"The not so dolce vita

2017 was a year of “buy the dip” galore in Euro credit markets. Few of the risks that bubbled to the surface last year caused spreads to sell-off for any notable length of time. In fact, the longest consecutive streak of spread widening in 2017 was a mere 3 days (Aug 9th – 11th). What held the market together so well? The constant stream of retail investor inflows into European credit (IG inflows in 49 out of 52 weeks).

This year, however, it’s been more of an uphill struggle for spreads. “Buy the dip” behaviour has been decidedly absent whenever risks have weighed on the market (note that spreads widened for 7 consecutive days in March). And new issuance continues to knock secondary bonds, something that was rarely seen last year.

What happened to TINA (There Is No Alternative)?

What’s changed, then, from 2017 to now? Simply, that the retail inflows in Europe have been much more muted over the last few months…and these were the “glue” of the credit market last year. What about TINA…and the reach for yield? We think the Euro credit inflow story is partly being disrupted by the attractive rates of return available on “cash” proxies in the US market. As Chart 1 shows, given the cheapening in the frontend of the US fixed-income market, US bill yields now offer more attractive returns for investors than the dividend yields on US stocks – something that has not been the case for over a decade.

Accordingly, we think some European retail inflows may be leaking into the US market at the moment, especially given the recent USD strength.

QE…and a classic liquidity trap?

But we don’t think this dynamic will stymie the inflow story forever. In fact, we remain confident that retail inflows into European credit funds will pick up steam over the weeks ahead.

As Chart 2 shows, domestic savings rates across major Euro Area countries have been rising noticeably of late, while declining in other countries such as the US and UK. Even with all the restorative work that Draghi and the ECB have done, European consumers’ penchant for conservatism and saving has not moderated.

In a classic “liquidity trap” scenario, we wonder whether low/negative rates in the Euro Area may simply be encouraging a greater effort by consumers to save for the future (and note that the Fed and BoE never cut rates below zero).

Whatever the driver, more money is being saved in Europe, and yet the prospect of material rate increases by the ECB remains a distant thing: the market has pushed back lately on rate hike expectations, with cumulative ECB depo hikes of 40bp now seen in over 2yrs time.

In this respect, Draghi is still fighting a “war on cash” in Europe. We believe this was the pre-eminent reason retail inflows into credit were so consistent last year…and we believe that this story is far from over.

The not so Dolce Vita

The ructions in Italy have contributed to another dose of high-grade spread widening over the last week: 8bp for high-grade and almost 20bp for high-yield. Testament to the weaker inflows at present, the move in credit is larger than that seen last March, pre the French Presidential election. Back then, the market was also on tenterhooks given Marine Le Pen’s manifesto pledge to redenominate France’s debt stock into a new currency, and to hold a referendum on EU membership.

5% of high-grade

For now, the ink isn’t yet dry on Italy’s first populist government – there are still the hurdles of designating a Prime Minister (at the time of writing), the President’s “blessing” on the government programme, and confidence votes in the Italian parliament. But assuming a 5-Star/Lega coalition government takes power, is this a source of systemic risk for Euro credit? We think not for the high-grade market. While Italy has a larger outstanding stock of sovereign debt than France, the picture is much different when it comes to high-grade. In fact, Italian IG credit represents just 5.4% of the market now…and that number continues to shrink as Italian corporates remain focused on deleveraging.

Where systemic risk from Italy may be of greater concern is in high-yield, as Italian credit represents 17% of ICE BofAML’s Euro high-yield index (we elaborate more on this here).

The plunge protection team

And true to form, the sell-off in the corporate bonds over the last week has been a much shallower version of what historically one would have expected to see. Chart 4 shows corporate bond spreads for peripheral financials versus 10yr BTP spreads.

They have been well correlated since early 2011. But credit spreads have moved much less over the last week than the move in BTPs would imply (and see here for a similar picture for Itraxx Main).

Populism…for real

The Le Pen populism experience quickly came and went for credit markets last year. Her insistence on drastic ideas such as “Frexit” appeared to stymie her support heading into the first round of the French Presidential elections. Her policies did not resonate with a French electorate that were broadly in favour of the EU and its institutions.

But political uncertainty, and populist sentiment in Italy, is likely to have longevity in our view. The hallmarks of populism – voter frustration and wealth inequality – are clear to see. Strong and stable governments have not been a hallmark of Italian politics since the proclamation of the Italian Republic in 1946: the country has had 65 governments.

The hallmarks of populism

Although the Italian economy has returned to growth over the last few years the magnitude of the recovery is still tepid. The IMF forecast Italy to grow at 1.5% this year, one of the lowest growth rates among Advanced Economies (the UK’s projected growth rate is 1.6% this year and Japan is forecast to grow at just 1.2%, according to the IMF).

In fact, the Italian electorate has seen little in the way of wealth gains since the creation of the Eurozone. Chart 5 shows GDP per capita trends for Italy and Germany. While GDP per capita is much higher in Germany, for Italy it remains marginally below where it was upon the creation of the Euro.

According to Eurostat, almost 29% of the Italian population were at risk of poverty or social exclusion in 2015 (and almost 34% of children were at risk). Hence the Citizenship Income mentioned in the 5-Star/Lega Government Contract.

Successive governments, of late, have focused on the fiscal side of the economy with less emphasis on structural reforms to unlock Italy’s growth potential. This has hindered private entrepreneurialism and the expansion of the corporate sector. As Chart 6 shows, Italy still has a large number of SMEs (and “micro firms”) making up its industrial base.

Sluggish long-term investment has partly contributed to this state of affairs. As Chart 7 highlights, capex intensity in Italy remains well below the levels seen between 2000- 2005, while the capex recovery has been a lot healthier in France and Germany.

A vibrant banking sector – that supports SME lending – is of course a prerequisite for greater levels of credit growth in Italy. And while Italian banks have made a lot of progress in reducing their NPLs recently (especially over the last few quarters), Chart 8 shows that there is still work to be done.

Italian banks continue to have the largest stock of non-performing loans across the European banking space. For more on the structural challenges facing Italy see our economists’ in-depth note here.

Such a backdrop is fertile ground for populist politics. Unlike in France, however, populist narratives are likely to fall on more receptive ears in Italy. As the charts below show, the Italian electorate is much less enamored with the EU than in other Eurozone countries.

Companies safer than governments?

The unknown in all of this will be the ECB. QE has been a powerful tool at controlling spreads and yields in the European fixed-income market over the last few years. But Draghi has not had to buy debt securities when Euro Area member countries have been less committed to fiscal consolidation.

And as Chart 11 shows, the ECB has been almost the only net buyer of Italian sovereign debt over the last 12m. Their impetus remains crucial.

Will higher political uncertainty in Italy alter the balance of the ECB’s asset purchases from here until year-end? Time will tell. However, in the credit market we’ve been struck by the extreme relative value gap that’s opened up between Italian credit and Italian sovereign debt during the last week. Italian credit spreads have held up incredibly well vis-à-vis BTPs, amid the volatility.

Chart 12 shows the volume of French, Italian and Spanish credits that are currently yielding less than their respective, maturity-matched, sovereign debt. Notice for Italy that close to a staggering 90% of credits now yield less than BTPs.

And while in periods of political uncertainty the market has often taken that view that corporates are “safer” than governments, this is by far a historical high for Italy (and for any Eurozone country for that matter). Moreover many Italian companies are actually “domestic” and thus have little in the way of a safety net from foreign revenues.

CSPP > PSPP?

How has there managed to be such a substantial outperformance of Italian credits over the last few weeks? We believe a large part of this is because the ECB has upped the intensity of its CSPP purchases lately, especially with regards to Italian issuers. This gives us confidence that the ECB remains committed to buying corporate bonds for as long as politically possible. See our recent note for more of our thoughts on CSPP, the “stealth” taper, and the programme’s longevity.

Yet, Chart 12 also suggests that credit investors should tread carefully with respect to Italian credits at present. While corporate credit richness versus government debt can persist, we learnt during the peripheral crisis of 2011-2012 that eventually tight credits will reprice wider vs. govt debt (the best example of this was Telefonica).

As a guide for investors, Tables 1 and 2 at the end of the note highlight which Italian credits trade the richest versus BTPs.

Respect the law

For the last year, the Euro credit market has not had to worry about the risk of Eurozone breakup. That ended last week, as the first draft of the 5-Star/Lega Contratto contained a reference to a Euro exit mechanism. However, in subsequent versions this was removed.

Nonetheless, as the front-page chart highlights, the market still appears nervous with regards to Eurozone break-up risk. Note the spread between 2014 and 2003 sovereign CDS contracts (The ISDA “basis”) remains high for Italy, and has ticked up again for Spain and France lately.

The 2014 sovereign CDS contracts provide greater optionality for protection buyers, relative to the 2003 contracts, both in terms of whether the CDS contracts trigger upon a redenomination event and also in terms of their expected recovery rates.

Know your bond

If redenomination concerns remain, what should credit investors look for in terms of Italian corporate bonds? In the charts below, we run a simple screen from Bloomberg on the governing law of corporate bonds in our high-grade and high-yield indices. Chart 13 shows the analysis by country and Chart 14 shows the analysis by Italian credit sector.

We rank Chart 13 by the country with the highest share of foreign law bonds (to the left) to the lowest share of foreign law bonds (to the right).

For Italy, the Bloomberg screen suggests that just 10% of Italian corporate bonds (IG and HY combined) are domiciled under domestic law (Chart 13). This is a very different situation to last March when around 60% of French corporate bonds were domiciled under domestic law.

While a legal analysis of the redenomination risks of Italian corporate bonds is outside the scope of this note, what we learnt from the Greek crisis in 2011 and 2012 was that investor focus gravitated towards the governing law of bonds (where foreign law bonds were perceived by the market to be more secure)." - source Bank of America Merrill Lynch

Of course, as everyone know and given the latest news on the Italian front, the European technocrats in Brussels have shot themselves in the foot by interfering with Italian democracy which will led to bolster even more anti-european sentiment. In October 2016 in our conversation "Empire Days" we pointed out that the statu quo was falling in Europe and we also reminded ourselves what we discussed in our November 2014 "Chekhov's gun" the 30's model could be the outcome:

"Our take on QE in Europe 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?
Of course our "Hopeful" equation has a very low probability of success given the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which has in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015)" - source Macronomics November 2014

It seems to us increasingly probable that we will get to the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…) hence the reason for our title analogy as previous colonial empire days were counted, so are the days of banking empires and political "statu quo" hence our continuous "pre-revolutionary" mindset as we feel there is more political troubles brewing ahead of us." - source Macronomics, October 2016

Obviously the path taken has been the road to growth / disillusion / social tensions and short-term road to heaven for financial assets as well as goldilocks period for credit. Now we are moving towards longer-term violent social wake-up calls in various parts of Europe. 

We really enjoyed our friend Kevin Muir latest excellent musing on Italian woes on his blog The Macro Tourist. He made some very interesting points in his must read note and we really enjoyed his bar-fighting economics analogy:

"Total French, Italian and Spanish assets are multiples of German assets. Italian Government BTPs are almost 400 billion and there are another 200 billion of other Italian debt securities. 600 billion represents almost 20% of German GDP. And that’s only Italy. What are the chances that an Ital-exit is confined to one nation?

Remember back to the 1930s. Nations that devalued early and aggressively generally did better economically during the ensuing depression - I like to call this bar-fighting economics - hit first and hit hard.

The ECB’s balance sheet expansion has put Germany in an extremely difficult place. They cannot afford to cut back on the expansion for fear of another Euro-crisis, yet the more QE they do, they more Germany is on the hook.

I hate to break it to Germany, but it’s even worse than it looks.

Don’t forget that ECB balance sheet expansion is only one the methods that imbalances within the European Union are stabilized. There is another potentially even more scary mechanism that occurs behind the scenes without much fanfare. Although the ECB is Europe’s Central Bank, each member nation still has their own Central Bank. Since monetary policy is set for the Union as a whole, there are times when capital leaves one European nation in favour of another. Individual Central Banks cannot raise rates to counter these flows, so the ECB stands in as an intermediary.
Let’s say capital flees Italy and heads to Germany, to facilitate the flows, the Italian Central Bank borrows money from the ECB while the German Central Bank deposits excess reserves with the GDP, thus allowing it all to balance. The individual country net borrowing/lending amounts are known as Target 2 Reserves." - source  The Macro Tourist, Kevin Muir

Target 2 issues have been a subject which has been well documented and discussed by many financial pundits. We won't delve more into this subject. But, as pointed out by Kevin Muir in his very interesting note, as a creditor Italy and being a very large one, Italy is in a much better position than the arrogant technocrats in Brussels think it is. In our book, it is always very dangerous to have a wounded animal cornered, it's a recipe for trouble. The latest European blunder thanks to the Italian president most likely instructed by Brussels to muddle with the elections result will likely lead to a more nefarious outcome down the line. Charles Gave on French blog "Institut des Libertés" made some very interesting comments when it comes to Italy's macro position:

• Italy now runs a current account surplus of 3.5% of GDP, 

• Italy has a primary surplus of 2 % of GDP, 

• Italy has extended the duration of its debt in the last few years and so is less vulnerable to a rise in long rates, 

• 72% of Italian debt is now owned by Italian entities

There has never been a better time for Italy to quit the euro. Come the autumn a fresh euro crisis is possible." - source Institut des Libertés - Charles Gave

Another expression we could propose relating to the excellent bar-fighting economics analogy from Kevin Muir and Target 2 would be as follows:

 "He who leaves the bar early doesn't pick up the bar tab" - source Macronomics

It is always about first mover advantage anyway, hence our previous positive stance on Brexit from a macro perspective when everyone and their dog were predicting a calamitous fall in growth following the outcome of the referendum.

When it comes to credit and Italian troubles, European High Yield needs to be underweight as it is at risk as pointed out by UBS in their Global Macro Strategy note from the 23rd of May entitled "How big a risk to EUR, credit and stocks":

"Credit: HY more exposed than IG to Italian stress

Italy is a risk but more so for HY cash vs. IG, in our view, where the Italian exposure is about 20% vs. 5%. As long as the risk of Italy challenging the integrity of Eurozone remains low (i.e. higher risk premium but no crisis scenario), we think the disruption in credit should remain mostly contained to Italian corps.

In a scenario of modest additional stress (c. 40bps BTP spread widening), we estimate that EUR IG and HY should widen 5-10bps and 25-30bps respectively from here, based on our fair value models and the recent performance. Our models are based on multi-linear regressions which also take into account other factors such as global growth, credit risk and conditions, as well as the ECB's CSPP.

In fact, peripheral spread widening of 30-40bps is likely the threshold when the relationship between corporate credit and peripheral spreads becomes non-linear, in our view (see Figure 5 and Figure 6). This is the threshold beyond which Italian risk should also affect EUR corporate credit markets more significantly outside of Italian issuers.

Given the uncertainties, we shift our preference for EUR HY vs. IG to neutral and prefer exposure to HY via its CDS index (Xover) which has a much lower Italian exposure at 7%. We recommend investors underweight Italian corps in IG and HY financials (largely Italian banks) and move up the HY curve from single B names to BB non-fins." - source UBS

We have recommended in our recent musings to reduce your beta exposure and to adopt a more defensive stance. If high beta is a risk and you don't like volatility, then again you are much better-off favoring non-financials over financials and you should probably maintain very low exposure to subordinated debt from peripheral financial issuers. At our former shop, a large European Asset Manager we recommended launching a Euro Corporate Bond Funds ex Financials. While the fund unfortunately did not gathered much attention AUM wise, performance wise it has been very good thanks to its low volatility profile and solid credit management. It is still boasting 4 stars according to Morningstar most recent ranking. Should Italian woes escalate high beta exposure will be hit much more, particularly financials. In that instance, for a long term credit investor, having less exposure to financials makes much more sense and we are not even discussing recovery values at this stage.  

Don't ask us about our opinion on having exposure to European banks equities again, because you will get the same answer from us. From a risk-reward perspective and long term investment prospect, it's just doesn't make sense whatsoever to get exposed to them regardless of the cheap book value argument put forward by some snake-oil sell-side salesman. You have been much more rewarded by sticking to credit exposure on European banks, rather than equities in Europe. End of the rant.

As well, we also pointed out in recent conversations that US cash had made a return into the allocation tool box and given the rise in political uncertainties and volatility, one should think about rising its cash level for protective measure. Cash can be "king" particularly with rising US yields and a strengthening US dollar marking the return of "Mack the Knife". Gold continue with it's safe harbor status. As we indicated in our earlier quoted tweet, both the dollar and gold can rise when we move in a situation where investors are moving from being more concerned about "return of capital". One would also be wise to seek refuge again in the Swiss franc (CHF) we think particularly versus the Euro (EUR). As well, a short covering on 10 year US Treasury Notes could be in the making (in size...). Watch that space because we think long end is enticing even zero coupon 25 years plus (ETF ZROZ) should we see an acceleration in the "risk-off" environment.

Moving back to "solvency" risk and sustainability of debt, namely "return of capital", as pointed out corporate credit in many instances could be "safer" than "sovereign" risk. Back in our conversation  "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portolio Theory and more!" we quoted again Dr Jochen Felsenheimer on macro and credit (our focus):

"In the end, all investors face the same problem - the whole world is a credit investment. And it is difficult to negotiate this problem with the classical theory of economics. Short selling bans, Eurobonds and ratings agency bashing will not provide a remedy here either." - Dr Jochen Felsenheimer

We added at the time that confidence is the name of the game and the perception of the risk-free interest rates, namely a solvency issue is at the heart of the ongoing issues. This brings us to the trajectory of European debt in general and Italy in particular. On this very subject we read Deutsche Bank's Euroland Strategy note from the 25th of May entitled "Pricing debt (un)sustainability" with great interest:

"Default risk pricing and bond relative value

Rising concerns over Italy’s debt sustainability can also be seen in the spreads between high coupon and low coupon bonds on the BTP curve. Over periods of stress, high coupon bonds which typically trade at a higher cash price tend to underperform lower coupon neighbours. One potential explanation for this is the risk that upon a hypothetical default the recovery rate will be based on the par value of the bond rather than the cash price an investor paid. Related to this, lower coupon, more recently issued bonds are also more likely to have CAC clauses compared to neighbours issued pre-2013.

Moreover, in times of stress participants seeking to release cash (for example insurers or pension funds with broad portfolios) might prefer to reduce holdings of higher price bonds (high coupon). Finally, even in normal times higher cash bonds may trade at a slight discount, reflecting the lower liquidity in some of these issues.

This effect is apparent in the charts below showing the positive correlations of z-spread (left) and yield differentials (right) between high and low coupon bond pairs and the IT-DE 10Y spread (which proxies for market pricing of BTP risk). As the BTP Bund spread has widened, high cash bonds across the curve (but particularly from 10Y+) have underperformed.

The non-linear dynamics of some of the bond pairs as spreads have widened are noteworthy. At the the 30Y point, the 44s-47s spread had remained elevated into the latest stress, with the 44s only beginning to underperform after the initial widening move. This may partially reflect the relatively large maturity gap between the two bonds, with 10s30s flattening at first outweighing the high cash price/low cash price effect on the bond spread.

- source Deutsche Bank

From a convexity perspective we find it very amusing that "yield hogs" when facing "redenomination/restructuring risk" see their high coupon bonds underperforming lower coupon neighbours, or to put it simply when non-linearity delivers a sucker punch to greedy investors...

While the "risk-off" mentality is prevailing thanks to Italian woes, confidence matters when it comes to "solvency" and debt "sustainability" yet, given the overstretched positioning in US Treasury Notes, if there is a continuation of troubles in European bond markets, then again, it will be interesting to see what our Japanese friends will do when it comes to their bond allocation. Our final chart deal with the current slowdown in the global economy which represents for us a clear threat to the US bond bears current positioning.

• Final chart - Decline in PMI's doesn't bode well for the US bond bears

While we have been reluctant so far to dip our toes back into the long end of the US yield curve, given the most recent surge in European woes and extreme short positioning, we think there is a potential for a violent short covering move. Our final chart comes from CITI Global Economic and Strategy Outlook note from the 23rd of May and displays the decline from recent peak in Manufacturing PMI pointing towards a slowdown:

There is more evidence that global economic growth is slowing. Some of the drags are likely temporary, such as some payback from unusually fast growth in H2 2017 (e.g. real retail sales in the US grew by 8% annualized in Q4), and adverse weather impacts across Western Europe, Japan and the US, while the positive effects of fiscal stimulus in the US will ramp up over the course of the year. But declining business sentiment, some tightening of financial conditions and the rise in oil prices are likely to have a more persistent (if moderate) dampening effect on global growth, notably on moderating momentum in business capex (Figure 2)." - source CITI

As far as White Noise is concerned, being uncorrelated in time does not restrict the values a signal can take (Italy back in crisis mode + slowing global economic growth). Any distribution of values is possible and even a binary signal such as the ones currently being given by European Peripheral bond markets (risk-off) can makes confidence turn on a dime. For financial markets as well as consumers, end of the day "confidence matters" for credit growth. Have we reached peak consumer confidence?

"What we obtain too cheap, we esteem too lightly; it is dearness only that gives everything its value. " - Thomas Paine

Stay tuned!

Credit - Quality Street

"Quality is not an act, it is a habit."- Aristotle

While mesmerizing at the velocity in the fall in core government bonds including our beloved US 30 year exposure, and the aforementioned flight to "quality", we reminded ourselves of the individual sweets first produced by Mackintosh's in Halifax, West Yorkshire, England in 1936:

"In the early 1930s only the wealthy could afford boxed chocolates made from exotic ingredients from around the world with elaborate packaging that often cost as much as the chocolates themselves. Harold Mackintosh set out to produce boxes of chocolates that could be sold at a reasonable price and would, therefore, be available to working families. His idea was to cover the different toffees with chocolate and present them in low-cost yet attractive boxes. Rather than having each piece separated in the box, which would require more costly packaging, Mackintosh decided to have each piece individually wrapped in colored paper and put into a decorative tin. He also introduced new technology, the world’s first twist-wrapping machine, to wrap each chocolate in a distinctive wrapper. By using a tin, instead of a cardboard box, Mackintosh ensured the chocolate aroma burst out as soon as it was opened and the different textures, colors, shapes and sizes of the sweets made opening the tin and consuming its contents a noisy, vibrant experience that the whole family could enjoy." - source Wikipedia

In similar fashion, our title is a reference to the rapid surge in ETF inflows in 2014 which broke numerous records in terms of inflows as reported by the Financial Times in their article entitled "ETF industry booms in record-breaking year":

"Numerous records for ETF inflows were set in 2014 by providers, and across asset classes and geographies. This was helped by a massive surge in December, when investors allocated $61.5bn of new cash, a monthly record.  The December surge pushed 2014’s net inflows for ETFs (funds and products), to $338.3bn, up 36.1 per cent on the previous year and surpassing the $272.2bn record for inflows set in 2008, according to ETFGI, the consultancy. Deborah Fuhr, founding partner at ETFGI, called 2014 a “truly amazing” year for the industry.
 BlackRock, the world’s biggest fund manager, cemented its position as the leading ETF provider globally after gathering record inflows of $103.6bn, two-thirds more than in 2013.  Mark Wiedman, global head of iShares, the ETF arm of BlackRock, says more investors around the world are embracing the versatility of ETFs, whether for strategic buy-and-hold investments or as precision exposures to express views on virtually any market. Vanguard, the third-largest ETF provider by assets, also enjoyed a record-breaking year, with inflows of $88.7bn in 2014, up almost 47 per cent on the previous year. A variety of other providers including Amundi, Lyxor, FirstTrust, Charles Schwab, UBS and BMO of Canada also had record-breaking inflows." source Financial Times

It is no surprise to read from the same article that when it comes to "Quality Street", investment grade matters:

"Two BlackRock ETFs linked to investment-grade corporate debt were among the best-selling products in Europe, gathering a combined $5bn." - source Financial Times 

One could indeed infer when it comes to our analogy that, in similar fashion to Harold Mackintosh's boxes of chocolates, when it comes to the investment world the surge of the ETF complex is akin to the rapid success of "Quality Street" sweets but we ramble again.

When it comes to credit, one may just look at the latest EPFR data to see that in our "Quality Street", Investment Grade is leading with 56 straight weeks of inflows as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 16th of January 2015 entitled "Positioning for ECB QE":

"Credit flows (week ending 16th January)
HG: +$1.7bn (+0.3%) over the last week, ETF: +$440mn w-o-w
HY: -$755mn (-0.3%) over the last week, ETF: +$132mn w-o-w
Loans: +$9mn (+0.1%) over the last week
Inflows strengthened into high-grade funds, with the strongest pace in 7 weeks, and the 56th consecutive week of inflows. High-yield registered another outflow, marking a continuation of the flight to perceived relatively safe assets amid an eventful previous couple of months. ETF fund flows into credit remained buoyant for another week in IG space, while flows in high-yield through the ETF door were the highest in 11 weeks, perhaps suggesting that ECB QE could reverse the recent negative
momentum.
Looking at duration, the trend is back to what it was at the end of last year; with unloved short-term funds seeing outflows while mid-term funds continue to remain popular with an inflow of +$1.6bn. Long-term funds are not attracting much attention thus far but the flows are still positive - albeit marginal." - source Bank of America Merrill Lynch

As we were typing our new market musing, came, not the proverbial "sucker punch" which we discussed in August 2012 in our conversation "Sting like a bee - The European fight of the century", but more akin to a nuclear strike on the market with the removal of the Swiss peg.

The SNB punch, EUR/CHF's 30% intraday range picture following the nuclear 10 sigma strike - graph source Bloomberg:

Of course it is of no surprise to hear that after such a massive shock and awe move the demise of some small fishes which are already turning belly-up, in the likes of some FX retail brokers meeting their maker.

"Boxing is the only sport you can get your brain shook, your money took and your name in the undertaker book." - Joe Frazier

No offense to the memory of boxing legend Joe Frazier, but, there is another "leisure" activity that seems to fulfill the above quote we used back in August 2012 we think: "FX Retail brokerage is an activity where you can get your brain shook, your money took and your name in the undertaker book".

So while we are already seeing the small dead fishes resurfacing, we wonder when a big whale will turn up. Rest assured that the SNB's brutal move has had some major financial impact somewhere apart from the FX retail broker space.

In this week's conversation, we will therefore muse around the notion of "Quality".

As a starter, in relation to the Swiss move and the lack of reaction of gold in the process, we read with interest Deutsche Bank's take from their Behavioral Finance Daily Metals Outlook entitled "Gold is still a currency without central bank":

"There are some sections of the gold market where observers are puzzled by the rally in gold prices yesterday. The surge in the value of the Swiss franc, after the SNB abandoned the euro peg, confirmed for them that it was the relatively safer haven, not gold. However, one might also question at what price will come the SNB’s attempt to dissuade safe-haven seekers from coming to Switzerland. Already deposit rates stand at minus 0.75 percent. Ten-year yields, which had halved since the start of the year, halved again yesterday to stand at just 7bp. International competiveness has been eroded and disinflation looks set to be the country’s largest import. Of course, the alternatives might have been worse: after the ECJ backed the principle of ECB sovereign bond purchases, the SNB might have been faced with having to print francs in order to buy many of the euros the ECB might print. This would have proved unsustainable and carried huge economic risks. It is precisely this convoluted relationship that is proving so worrying. Global central banks have continued to set key prices in the financial system, some six years after the crisis – zero benchmark rates, low bond yields, competitive FX rates, and buoyant stock prices. The effort has now become so expansive that the policy of one central bank has undone that of the other. For investors who yearn for a market with less official intervention, gold is once again entering the discussion." - source Deutsche Bank

Exactly, what we posited in our previous conversation when we looked at the "Global Credit Channel Clock". Not only long vol, long government bonds have been rewarding in the early days of 2015, but, gold again is surging again.

What we find of interest is that, for some pundits, the SNB has lost some of its credibility. On the contrary, we think the SNB has in fact regained some credibility by removing the peg and let the market drive freely the level of the CHF currency. As we mused in our November conversation "Chekhov's gun", there are indeed different types of central banks:

"Indeed, when it comes to the ECB we have a case of "Chekhov's gun, whereas when it comes to the Fed and the Bank of Japan it is more akin to Tuco's philosophy: "When you have to shoot, shoot. Don't talk"

In the case of the SNB, we remind ourselves also the points made by Richard Koo quoted in our November conversation:
"The problem is that treating monetary policy like currency intervention also has side effects. Over the last decade it has become standard practice around the world to conduct monetary policy with a minimum of surprises based on careful dialogue with market participants.
Until the mid-1980s, monetary policy decisions tended to be made in closed rooms, something then-Fed chairman Paul Volcker was very good at. In Japan, it was even considered “acceptable” for authorities to openly lie in the lead-up to decisions on the official discount rate (or the timing of snap elections).
Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members."- source Richard Koo, Nomura Research Institute

To some extent, both the Bank of Japan and the Fed have been fast QE gun drawers, but the fastest gunslinger is no doubt the SNB. The move of the SNB clearly shows a shift towards the mid-1980s kind of monetary policy described by Richard Koo. Some pundits have deemed unacceptable for the SNB to openly-lie in the lead-up to the decision of the removal of the peg, calling in question its credibility. Obviously the violence of the movement should be a stark reminder for "complacent" investors of what to expect when markets cease to be "financially repressed" and manipulated by our central bank deities. What has actually happened, we think, is that the SNB has decided to "defect" from the central banks cartel of "money printers". The SNB has indeed broke rank with the "easy money" gang and decided to shift back to a more 80s orthodox view of conducting monetary affairs. Interesting thing happens during currency wars, currency pegs like cartels do not last eternally. One might therefore wonder if the SNB has not indeed decided intentionally to shift towards "Quality Street" regardless of the deflationary environment rather than continue to embrace the lax monetary policies embraced by many, preferring therefore the short term pains for long term gains.


We concluded our November conversation with the following remarks at the time:

"While it has been easy to somewhat front-run the QE cowboys thanks to "Pascal's Wager", the end of QE in the US coincide with a renewed period of weaker global trade, historically high asset price levels and record low bond yields making it more likely we will see a return of higher volatilities regime in the near future making future equities return questionable and long bond US Treasuries enticing (we are keeping on our very long duration exposure via ETF ZROZ)."

No doubt, that we have indeed seen a return to a higher volatility regime in 2015 but when it comes to future equities return, they are indeed questionable, particularly in the light of Société Générale's recent report on Risk Premium from the 13th of January entitled "High is not always better":

"US equity risk premium – High is not always better
The US equity risk premium (4.3%) is still in attractive territory (above its long-term average of 3.9%) relative to government bonds. However, the internal rate of return on US equities (6.4%) has continued to fall and is now materially below the long-term average (8.9%). This means that US equities are likely to deliver below-average returns going forward. Furthermore, US equities have limited capacity to absorb higher bond yield:

Internal rate of return on US equities is near its lowest level since 1990 The internal rate of return on US equities currently stands at 6.4%, i.e. materially below its historical average of 8.9%. Clearly, the high US equity risk premium is largely due to stubbornly low government bond yields. Our analysis indicates that a 10-year US government bond yield of above 2.55% would make switching from equity to government bonds attractive from a valuation perspective

US long-term growth (3.7%) is also near multi-decade lows. Any recovery in the long-term growth prospects of the US should have a positive impact on US equities. However, our analysis indicates that part of the growth recovery is already reflected in the current valuation." - source Société Générale

When it comes to equities and their performance relative to credit risk in the European space, no doubt "Quality Street" has played out and will continue to perform has indicated by Kepler Cheuvreux in their latest Cross Asset Research note entitled "Crisis and Continuity":

"Higher quality equity continues to outperform. Stocks with high sensitivity to credit continue to under-perform."

The defensive bias in stock behaviour is still apparent. Higher quality equity continues to out-perform. Stocks with high sensitivity to credit continue to under-perform. In particular, we would like to point out two aspects of the recent behaviour of European equity that are especially significant. The first is the differentiation within Europe’s universe of higher quality, lower risk stocks. The second is the under-performance of Europe’s banks and of the compartment of large cap value since last October. The recent improvement in the relative performance of smaller caps is largely the consequence of the weakness of Europe’s category of large cap value stocks" - source Kepler Cheuvreux

Kepler Cheuvreux made also some very interesting remarks when it comes to our "Quality Street" analogy in their report:

"The benefit that Europe’s lower risk equity has derived from the bull market in high quality duration has declined quite notably, indicating the emergence of a deflation risk premium.
In the second place, only the portfolio of lower risk quality stocks out-performed in 2014. The lower risk growth portfolio did not out-perform. The difference relates to two criteria: debt and growth. Stocks with low debt and low expected growth performed best in 2014.
Generally speaking, low risk stocks with high expected growth and comparatively high debt did not perform well. Moreover, the divergence in question has become more apparent in recent months.
The decline in expectations of nominal growth in Europe produced a premium for balance sheet quality in the course of 2014, with particular reference to indebtedness. It also gave rise to the expectation of Central Bank intervention, accelerated by the effects of the collapse of oil prices. The consequence in the credit space since last October is a premium for the liquidity of the IG and quasi-IG beneficiaries of Central Bank intervention.
The behaviour of Europe’s banks is a barometer of the balance of advantage between the forces of deflation and reflation because bank balance sheets are evaluated by reference to the incentive to leverage or deleverage. The investment consensus tends to assume that all forms of Central Bank intervention are good for Banks. However, excess liquidity does not necessarily ensure the expectation of reflation. Precisely, the contradiction of the investment consensus is the conviction that the ECB must engage in GB-QE but that it will fail to raise the rate of nominal growth in the euro zone. The relative performance of Europe’s banking sector, especially that of the cheaper, lower quality EZ banks, has deteriorated since last October even though Central Bank liquidity is driving down bank funding costs and their lending rates.
The equity investor should take note of the message delivered by divergences within the credit space since last October. A collapse in the value of an asset as strategically important as oil produces the expectation of credit stress in the commodity-emerging space which translates into a risk premium for the banking system. There is a link between the under-performance of the banks and of energy stocks. We cannot yet say that the price of oil has bottomed. There is no sense yet of genuine capitulation with respect to oil within the commodity investment community.
The under-performance of large cap value in Europe identifies a crucial weakness of the bullish consensus. In current circumstances the premium for liquidity and for quality benefit lower risk, non-bank equity, including many of Europe’s insurers. We cannot say that the reflation trade in Europe is effective until Europe’s banks begin to out-perform bond proxies in the equity space (see chart 11). 

The performance of Europe’s banks will improve when expectations of the rate of nominal growth in the region begin to revive. We have no yet reached that point." - source Kepler Cheuvreux

This validates our long standing view that a bank is the second derivative to the growth of the economy. A bank is a leverage play on the economy. This is why it is so important to track economic activity, as banks are at the heart of the economic system when it comes to providing the means to its development.

Furthermore, since the European financial sector stress of 2011 which first started in the credit space, financials senior and particularly low beta credit have clearly outperformed financial equities in Europe. This can be ascertained by looking at the Eurostoxx Banks vs Itraxx Senior Financial index (roll adjusted) particularly since late 2013 whereas European banks stocks have been trading sideways - graph source Bloomberg:

- source Bloomberg

We continue to view European Investment Grade credit particularly in the financial space to be more appealing than equities (QE might change this view and boost banks equities). We expect further earning headwinds and surprises with additional goodwill writedowns particularly for European banks having significant Eastern Europe exposure. US banks earnings have erred so far on the weak side. We expect a similar picture in Europe.

The underperformance of equities versus credit in Europe for the banking sector is not surprising given the deleveraging and continued consolidation of the bloated sector as highlighted by Société Générale in their European Banks note from the 9th of January:

"€600bn of lost corporate lending
The European corporate loan book has shrunk by €600bn since 2009, the point at which corporate credit volumes began to retreat. Around €450bn of this shrinkage has taken place in the last three years – the period of austere governments and regulators. Almost all of this correction is down to three banking systems: Spain (€400bn lost from peak), Italy (€100bn lost) and Greece (€30bn lost).

Over this same period, outstanding debt securities issued by non-financial institutions have increased by c.€200bn, from €850bn to €1,050bn. This has plugged some of the gap, but of course it has been more geared to the core eurozone markets. The periphery has seen less replacement of the banking balance sheet by debt markets.
Corporate credit levels have been in decline. They also remain in decline in 9 out of 18 of the eurozone lending markets we outline below.

However, it is not all gloom. In Germany and France, corporate loan books have actually been growing very modestly since 2013. The volume increase is still slight (1-2%), but the cycle has at least turned.
€7tn of lost assets and 800 lost banks
Shifting up from loans to overall balance sheet, the trend is just as clear. The total euro area banking system has shed €7tn in assets since 2008. The first chunk of assets fell away in 2008-09 (typically non-lending assets – subprime, etc.). The second chunk of assets has been falling away since 2011.
At the total balance sheet level, it is actually Germany that has seen the lion’s share of the balance sheet decline. This is largely linked to the non-lending assets that fell away in 2008-09.

As well as the €7tn in lost assets, the banking system has lost 800 banking institutions. Obviously this takes us well into the tail of banks, with the 150 banks lost in Germany (to 1,734 institutions in 2013) generating few headlines. 

However, consolidation is a theme that cannot be overlooked." - source Société Générale

We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth.

Indeed, consolidation will carry on and pain will be inflicted on subordinated bondholders in the European banking space. On a side note we have yet to hear about the fate of Italian fallen giant Banca Monte dei Paschi di Siena which fell today another 2.4% to 45.25 cents. MPS has fallen around 66% in the past six months, leaving the third Italian bank with a market value of just 2.35 billion euros.

It is not surprising to see that there has indeed been a correlation with the severity of the contraction of credit with the rise of unemployment and economic disarray in peripheral countries, which was precipitated by the stupidity of European regulators as we discussed on numerous occasions in our posts when relating to the fateful decision of the EBA:

"What accelerated the "credit crunch" was the EBA's decision for banks to reach a certain capital threshold by June 2012 (for the EBA June 2012 core tier one capital target of 9%, banks needed to raise at least 106 billion euros according to the EBA's calculations)

On a final note, to conclude our note, we would recommend you stay on "Quality Street" (your are less likely to be mugged...) as indicated by this chart coming from the Kepler Cheuvreux report quoted above indicating the evolution of the premium for Quality and Liquidity in particular since October:

"We emphasise the reinforcement of the premium for quality and for liquidity in both the credit and equity space since last October." - source Kepler Cheuvreux

 "Quality is never an accident. It is always the result of intelligent effort." - John Ruskin, English writer

Stay tuned!

Markets update - Credit - Rates - Equities - Kneecapped...

Another day in the trench and not even the better than expected employment figures at 9.1% and Nonfarm payrolls (NFP at 117K versus 85K)have been able to sustain a strong rally in the equity space.
The intraday move on some European indices made everyone fill dizzy, or sick. It was fast and furious. In these markets you can clearly age in dog years as in 2008...
In relation to the NFP numbers, while June had come in at a horrible 18K jobs, it was revised upwards to 46K. Very slight improvement but nothing great about it. The average duration of unemployment increased to 40.4 weeks from June's 39.9 weeks as it continues to make a new high each month. 44.4% of those unemployed and still looking for work have been searching for 27 weeks or more. This is not a recovery.

The US economy looks like muddling through but the worries in the European space in relation to the ongoing contagion to Spain and Italy, make the outlook for 2012 look grim, if the situations spiral out of control in 2012.

Credit got whacked kneecapped (the joys of rebranding) and while there was some small relief in the peripheral government space, it started off with the usual flight to quality mode in the morning with German 10 year government bonds even touching 2.22% then bouncing back up to close at around 2.35%.

Here are some markets updates:
10year German Government Bond:

Greek 2 year bonds:

Creeping up again.

Vix index shooting up:

Credit Markets:
Itraxx Financial Sub 5 year CDS index reaching a new record:

Itraxx Crossover 5 year CDS, going up fast:

"In Europe, the cost of insuring corporate debt rose to the highest since June 2010. The Markit iTraxx Crossover index of credit-default swaps linked to 40 companies with mostly high-yield credit ratings increased 29 basis points to 545.5, according to JPMorgan Chase Co. at 10 a.m. in London" - source Bloomberg.

EUR/CHF, the trend is your friend and the Swiss National Bank is powerless:

Intraday volatility on the CAC40 index, you bet!

CAC40 index, that European stock index sinking feeling...

Some serious risk indices are flaring up, OIS/Libor spread and our friend TED, it is a short-term indicators of bank liquidity:

OIS/Libor spread:

We will need to monitor closely these two indicators in the coming days and weeks. Given the market is currently shut down for both Italy and Spain, their banks might need as well to curtain lending, because, like their sovereign issuer, the access to the market is as well shut down for these banks.
According to Bloomberg, the five biggest banks in each of the two countries have about 240 billion euros of debt maturing by 2013. It appears as the two graphs displayed above that the interbank market is freezing up again, as it did in 2008.
At the same thime, the average yield on high-grade corporate debentures fell
to a record 3.45 percent yesterday, according to Bank of America
Merrill Lynch index data. Investors are seeking the relative safety of corporate bonds, but we are talking about A rated companies and above, particularely high quality industrials companies in the US.

I have already discussed the issue of the wall of maturity in the following post Crowding Out. Banks and countries alike are competing to raise money. Banks will have to go to the ECB for their funding needs for the time being.

All of this means that the cost of funding will rise significantly in the years to come.