Macro and Credit - Empire Days

"No one is free who has not obtained the empire of himself." - Pythagoras

Looking at the misery inflicted to battered German banking giant Deutsche Banks, emerging art getting trounced and the collectible car markets getting frothy (as we predicted back in July in our conversation "Who's Afraid of the Noise of Art?") , with luxury watches sales continuing to be under pressure in Asia, in conjunction with sabers rattling in the unresolved Syria situation and a tense election period in the United States with nationalist pressure on the rise globally, we reminded ourselves of this week title analogy of cold wave French-British group The Opposition's 1985 best album Empire Days. More and more we are convinced than the "statu quo" is failing and as we pointed out 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.

On a side note, while discussing the US elections outcome with some friends and there "Optimism bias" we reminded them our take on the subject around the time of the Brexit results and our contrarian stance which was indeed prescient:

"While assisting in Paris to the "Brexit conference" set up by our friends at Saxo Bank, one of the members of the audience during the Q&A session pointed out the "accuracy" of the bookmakers for the remain to "prevail". We could not resist but intervene to rebuke that statement by using as an illustration how bookmakers got it so wrong when offering 5000/1 odds at the beginning of the season for FC Leicester to clinch the British football Premier League and still having the odds at 500/1 around October. The biggest liabilities for the bookmakers were accrued at around 100-1 to 500-1. To quote Mike Tyson: "Everyone has a plan 'till they get punched in the mouth". Since that "FC Leicester punch" the longest odds that can now be placed on any event will be 1,000-1 to ensure that the betting company Ladbrokes is less exposed in future to 'black swan' events. We reminded also the Saxo crowd the Nash equilibrium concept, us playing on this occasion the "Devil's advocate". In fact not a single time did the bookmakers anticipated a victory for "Brexit" yet another display of the "Optimism bias"" - source Macronomics, June 2016

To that effect we argued with our friends about how irrelevant the results of the first television confrontation between Hilary Clinton and Donald Trump were and how low were their predictive nature when it comes to finding out about the potential "outcome" of the upcoming US elections. Therefore, given we like to put our money where our mouth is and our  long standing contrarian stance, we decided this time around to place a "friendly" bet with our friends as we argued that Donald Trump has a much higher probability of getting elected (in similar fashion to the "Brexit" base case) as the Mainstream Media (MSM) would like to "spin it". To that effect we bet on a nice bottle of wine for the winner, two friends deciding to take us on so that it's a nice 2 versus 1 situation for the time being.

But, when it comes to our analogy and this week's conversation, whereas everyone and their dog are focusing on Deutsche Bank, we would like to steer our attention to what lies beneath, namely, a dollar squeeze of epic proportion as we mused in our conversation "Singin' in the Rain" back in 2013:

"Why are we feeling rather nervous?
If the Fed starts draining liquidity, some "big whales" might turn up belly up. Could it be Chinese banks defaulting? Emerging Markets countries defaulting as well due to lack of access to US dollars?
It is a possibility we fathom." - Macronomics - June 2013

It might be that indeed "Deutsche Bank is one of these "big whales" turning belly up, there are indeed increasing signs in Asia and Europe that point to caution given Euro/dollar 3-month FX basis swap widest in 4 years on Deutsche Bank's troubles (-62 basis points). There is something nasty lurking we think. In similar fashion to 2011, regardless of the liquidity provided by the ECB, a widening of Euro/dollar basis swap should always be taken seriously.

Synopsis:

• Macro and Credit - Deutsche Bank woes is the tree hiding the forest of dollar illiquidity
• Macro and Credit  - Loan growth under NIRP - The case of Japan
• Final chart: Market’s growing dependence on central bank stimulus means more 
  prone to “corrections”

• Macro and Credit - Deutsche Bank woes is the tree hiding the forest of dollar illiquidity

Back in 2011, increasing bank stress during the summer led not only to a widening of credit spreads but as well to a significant widening of Euro/dollar FX basis swap. To that effect, dollar illiquidity was manifesting itself in the FX basis swap market as well as in the CDS space with the European financial sector credit spreads significantly widening until the launched at the end of 2011 of LTROs by the ECB which was followed by the establishment of swap lines between the Fed and the ECB. Many pundits are pointing towards the upcoming reform for Money Market funds in the US as the prime culprit for this impressive spike in the Euro/dollar FX basis swap market. We think there is more to it as per our 2013 worries. As shown by the BIS in its latest quarterly report released this month, "ultra-loose monetary policies" have increased global dollar shortage. The "crowding out" effect from lower yielding Euro denominated assets is pushing investors towards the US dollar in drove such as Japanese Life Insurers as we have shown in various musings. Also we argued in our July conversation "Eternal Sunshine of the Spotless Mind" that Bondzilla, the NIRP monster is more and more "made in Japan" as for Japanese Lifers, US assets remain preferred. Therefore there is a potential "crowding-out" effect we are seeing with rising yields in Europe with an acceleration of their allocation towards the US meaning effectively additional demand for US denominated assets and rising costs for hedging FX exposure. Remember you need to follow "Japanese flows" as they matter a lot.

So when it comes to Deutsche Banks woes and the attention it is garnering, to paraphrase our Rcube friends, when everyone is thinking alike, no one is really thinking. As a reminder, under the zero lower bound (ZLB), monetary policy isn’t just about the price of money, but also its quantity. When it comes to quantity, the surge of the significant Euro/dollar FX basis swap market is displaying in earnest, a dollar shortage. 

"When a wise man points at the moon the imbecile examines the finger." - Confucius

To that effect, rather to continue musing on European banking woes, deleveraging and "Japanification" this week given we have long been touching on these issues in numerous conversations, to paraphrase Confucius, we would rather steer you towards the moon, namely issues brewing in Asia in general and China in particular. As of late was as caught our interest is the acceleration of ebt-equity-swaps (DES) and defaults in China as reported by Nomura in their note from the 20th of September entitled "Both DES and defaults likely accelerated":

"According to local media today (Caixin, 20 September), the first debt-equity swap (DES) in this round (vs the c.RMB400bn DES in 99s) has been approved, in which half of Sino Steel’s RMB60bn debt could be converted into a six-year convertible bond (ie, c.RMB30bn), while the other half remains debt at a relatively low interest rate, likely at a discount vs the one-year benchmark loan rate of 4.35% pa. For the c.RMB30bn CB, according to the same news article, the first three years would see no conversion, and the conversion would come in the fourth year at the pace of 30/30/40% until the sixth year. 

Meanwhile, Guangxi Non-Ferrous Metals announced its bankruptcy per court release on 19 September, being the first on China’s interbank bond market. On the same day, Dongbei Special Steel also announced a potential default due 24 September, the latest warning after a series of bond defaults. 

The DES ratio reportedly is up to the cash flow coverage of relevant debt, thus it varies for different banks 

Sino Steel has faced default risks since 2014 and the regulators called a meeting to resolve the company’s debt issue, which was chaired by BOC as per the news article above. The debt restructuring plan was finalised early this year, and now reportedly the DES has been approved for implementation. 

Despite an overall c.50% DES ratio for the entire debt of RMB60bn for the Sino Steel group and its subsidiaries, this swap ratio varies according to individual banks, given that cash flow coverage over individual banks’ debt exposure differs, per the media coverage. It seems that loans well covered by collateral and/or cash flow of projects would remain as debt, and it is those loans primarily on credit or guarantee and not covered by cash flow that might be swapped into CB. Capital injections from SASAC were also expected in future, according to the media coverage. 

If the reports are accurate, DES through CB puts less pressure on banks’ capital and they could avoid material write-downs upfront; though debt burden remains in short-to-medium term 

DES triggers concerns over banks’ capital pressure, given that equity investments carry 400-1,250% risk weight vs 100% of loans (see DES: Trade-off between capital and provision, 6 April), and the swap through CB could likely alleviate banks’ capital pressure in the short to medium term, although in the long term capital pressure remains if such investments cannot be disposed of in a timely manner. 

Meanwhile, direct DES of potential bad debt requires either a bailout (like the DES in 1999-2003, Fig. 1) or material write-downs upfront.

Since a bailout for DES has been ruled out this time (Re-rating may start as defaults accelerate, 21 July), banks conducting DES may face material write-downs upfront if the loans convert into equity directly. DES through CB could have given banks more time vs direct swap into equity, and thus could facilitate progress.
For a company involved in DES, however, debt burden likely remains before equity conversion, and when conversion starts, it seems to be selective (eg, just the credit/guaranteed loans, with no underlying cash flow for Sino Steel). 

Reiterate our estimate of limited-scale DES this round 

With a full government bailout, the last round of DES digested c.RMB400bn in NPLs (non-performing loans) from banks, equivalent to c.30% of RMB1.4trn NPLs sold to AMCs (asset management companies) at par value. This time around, we see no government bailout, which makes DES a less attractive option both for banks and for companies, in our view. DES through CB may increase the feasibility of the swap, but long-term capital pressure remains for banks and debt burden remains for companies in the short to medium-term, as analysed above. We reiterate our view that DES is one of the options for NPL digestion in this credit cycle, but it is unlikely to be a primary tool for banks, compared with measures of cash collection, write-offs and sales to AMCs. 

Bond defaults expected to accelerate 

Compared to bank loans, the bond market is seeing a normalisation of risks, with this first bankruptcy case coming through on the interbank bond market today. We still see c.RMB50bn bonds on the watch list, all of which are bonds that have announced defaults but are still trying to work out repayment plans to avoid ultimate defaults, including Dongbei Special Steel as mentioned above. We believe that defaults are positive for the risk normalisation in the bond market, which we hope could lead to better risk pricing and higher liquidity efficiency. 

We see a change in the landscape, though we are cautious, with volatilities likely coming through as well 

As banks turn risk-off in 2Q16, DES were launched to start addressing the SOE debt issue (and may be a prelude to other more marketised deleveraging measures in future), as well as risk normalising on the bond market, we see the landscape change discussed in our 2016 outlook (see Changing the playbook in 2016, 2 November 2015) happening. However, fundamental volatilities may come together in this structural change, and we recommend booking profits on vulnerable banks, like mid-caps. In comparison, ICBC (1398 HK, Buy) remains our top pick, given its tighter risk control and stronger loss-absorbing capacity with decent capital ratios (12.5% CET1 by 1H16). CCB (939 HK, Buy) is the other fundamental pick, for similar reasons (13.0% CET1 by 1H16)." - source Nomura

Whereas prompt restructuring is a welcome feature when dealing with nonperforming loans (NPLs), as posited by Nomura, long term capital pressures will remain. Furthermore, the significant surge in Chinese property prices leading to many pundits talking about a large bubble, means that China needs no doubt to rein in credit growth at the time where credit continues to outpace nominal GDP growth!

Yet in another important report published as well by Nomura, it shows that all isn't that quiet on the Eastern front for some countries. in their September special report entitled "The party is getting crazier – stay close to the door":

"China is borrowing growth from the future 

1. China needs to adjust to the new normal of a persistent slowing in potential growth, as the working population shrinks and the low-hanging productivity gains diminish.
2. China has reached the point where the rubber hits the road: The problems of overcapacity, over-leverage and keeping zombie companies afloat have become so large that they are bearing down on growth via falling returns on capital and rising debt-servicing costs. Leaving it so late, rebalancing away from investment is being forced upon China, and is fraught with risks.

1. Rebalancing and restructuring is likely to hurt growth in the short run, including negative spillover effects on consumption and services. Unsurprisingly, the hardest supply-side reforms – restructuring SOEs, deleveraging and banks properly pricing credit risk – have been left to last. Monetary and fiscal stimulus can buy some time, but they are losing efficacy and can fuel bubbles.

1. For new engines of growth, the economy must be opened up to market forces, but as China is discovering, this is hard at the best of times, let alone when economic fundamentals are weak. History in EM shows that financial liberalisation often precedes credit crunches, banking crises and capital flight.

• We find it striking that the distribution of the latest 2017 growth forecasts display no fattening tail risk of hard landing (i.e., exactly 50% of forecasts are below the median).

• The downside risks to our growth forecasts of 6.5% in 2016 6.1% in 2017 and 5.5% in 2018 include a mass exodus of capital by Chinese residents and snowballing corporate defaults. Upside risks are mega policy stimulus (but this risks creating bigger bubbles) or window-dressing reported GDP (ultimately undermining policy credibility and the chance of policy mistakes).

Four reasons not to overburden monetary policy

1.  Easing monetary policy risks inciting even stronger capital outflows.
2. Aggressive monetary easing risks creating even bigger financial imbalances, since debt and asset prices are interest-rate sensitive. The inflation-adjusted bank deposit rate is near zero.
3. Monetary policy is a blunt instrument affecting the overall economy; it can be less useful when the economy’s performance is more uneven. In 2014, only one of China’s 31 provinces had sub-3% nominal GDP growth; in 2015, eight did, with a total population of 304mn. Also, China’s large manufacturers had a PMI reading of 51.8 in August 2016, compared with 47.4 for small manufacturers.
4. It may be wise to save some interest rate ammo to ease the pain of eventual deleveraging." - source Nomura

One might wonder if indeed it is a case of "Big Trouble in Little China" or "Small Trouble in Big China" but we ramble again. Of course while everyone is focusing on Deutsche Bank, we would like to point out to Nomura's very valid points regarding a potential credit crunch unfolding in Asia at some point from their very interesting special report:

"There is a high risk of a credit crunch in Asia

• The combination of rapid private debt build-up and elevated property prices is worrying: when they inevitably reverse, the negative feedback loops can activate financial decelerator effects.

• Cheap credit has weakened productivity by misallocating capital (e.g., property speculation), reducing pressure for supply-side reforms and kept zombie companies alive. Potential growth is slowing across most of Asia. 

• Debt-service ratios are high and rising in many countries, at a time when interest rates are at, or close to, record lows.

• Potential triggers: faster than expected Fed rate hikes; sharp USD appreciation; large RMB devaluation; a major EM corporate default prompting global asset managers to pull out from the region en masse, causing market liquidity to evaporate; inflation shock in Asia; politics.

- source Nomura

Of course, we agree with the above from Nomura that the seeds for a credit crunch have been sown and the rising private debt in conjunction with already high elevated real estate prices particularly in Hong Kong warrants close monitoring. As a follow up on our HKD take from our  December conversation "Cinderella's golden carriage", where we pointed out our concerns relating to the HKD currency peg, and its exposure to China tourism which so far have been moving in drove to Tokyo to benefit from cheaper luxury goods priced in Japanese yen, it appears to us that both the credit gap and the property price gap have been quite stretched in Hong Kong. While we won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg back in December last year,we might have been early for 2016, we would not rule it out eventually as pressure mounts on China. maybe it will be for 2017 after all. As we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the Yuan and in effect the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:

"The amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

It seems to us that speculators, so far have not been able to gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals. For a short strategy to succeed, it is much better to hunt as a pack than to be a lone wolf or at least to cry wolf on a specific situation. When it comes to the fate of the HKD peg, Nomura has been solacing again our concerns in their note:

"HK stuck between a rock (Fed hikes) and a hard place (ebbing China)

• Hong Kong has large credit and property market bubbles. Since 2008, real property prices have risen 109% (the recent correction is reversing), and the ratio of private non-financial credit to GDP has surged to 278%.

• The real effective exchange rate has risen 21% since 2011. The current account surplus/GDP has shrunk from 15% in 2008 to 3% in 2015, and is no longer a larger buffer to net capital outflows.

• Foreign assets and liabilities have surged since 2008. This leaves significant scope for capital outflows which, via the currency board, would likely lead to a spike in Hibor rates. Official reserve assets, at 10% of total liabilities, are a limited buffer.

• Economic hardship could ignite further political and social unrest, or vice versa, ahead of the selection of a new chief executive in March 2017. We would not rule out rising pressures on the HKD peg regime.

HKD re-pegged to the RMB? The HKD peg to USD could face its most trying time since it was adopted 32 years ago. Hong Kong imported US QE due to the peg, which has fueled what seems to be a bigger property market bubble than in 1997, while its economy and markets have rapidly become more integrated with China’s. Hong Kong would be stuck between a rock and a hard place if the Fed were to accelerate hiking and China’s growth keep slowing. Also, if Hong Kong were to face capital flight, the currency board system means that short-term interest rates would automatically rise, increasing the risk of a property market crash. Ideally, it is too early to re-peg to the RMB as it is not yet a fully convertible currency, nor have China’s financial markets developed to the point where interest rates are the primary tool of monetary policy. However, China is making progress on both these fronts and re-pegging would be a shot in the arm for RMB internationalisation. An out-of-the-blue Swiss-franc style regime change is not out of the question." - source Nomura.

Back in September 2015 in our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen.

It remains to be seen, if the recent spike in Hibor rates will not once more put yet again some end of the year additional pressure on the currency peg. We might have been early but, after all, we might not be wrong eventually. We will of course continue to monitor this interesting trend rest assured. End of the day currency pegs like "empires" are not eternal as a reminder:

- source Société Générale

When it comes to Asia, while Japan has been at the forefront of Quantitative Easing for many years, they recently joined the NIRP club in early 2016 on the footsteps of the ECB, in our next point we will look at the impact the policy has had on loan growth and what it entails.

• Macro and Credit  - Loan growth under NIRP - The case of Japan

While we have long been indicating that QEs and NIRP in no way on their own were sufficient enough to trigger a material change in "credit impulse" which would therefore entail a significant change in real economic growth, we find that Japan's recent experiment with NIRP in the footsteps of the ECB is as well a confirmation of the broken credit transmission which has plagued Southern Europe in recent years thanks to bloated banks balanced sheets and the insufficient rapidity with which these NPLs were addressed in both instance but has as well impacted the Japanese economy.

On this particular subject of loan growth under NIRP, we have read with interest yet another note from Nomura from the 17th of September entitled "Loan growth has not changed materially in

real terms":

"The BOJ expects its negative rates policy to boost borrowing by companies and households as loan rates fall, spurring capital investment and housing investment. In this report, we examine changes in loan balances since the negative rates policy was introduced, trends in loan rates, changes in loan demand by companies and households, and changes in financial institutions’ lending stance.We found that growth in bank lending seems to be falling. However, this was largely due to changes in currency exchange rates (stronger JPY reduces the amount of foreign currency lending in nominal terms), while actual lending growth is almost unchanged. Financial institutions appear to have become more aggressive in lending, but corporate loan demand has not changed much, and the increase in loan demand from households was largely attributable to refinancing, with few signs of accelerated loan growth.

Implications and points to watch for in comprehensive assessment 

As noted above, loan rates have fallen since the BOJ adopted negative policy rates, but loan growth has not picked up, which suggests that BOJ policy has only a limited impact on the real economy.
The BOJ cites an increase in the issuance of super-long corporate bonds and subordinated loans as a result of its adoption of negative policy rates, but we believe this has had only a limited impact on the economy overall. The BOJ should also look at the impact that a stronger stock market and weaker JPY could have on the economy.
The BOJ’s main concern has been a deterioration of the financial intermediary function, which could occur if banks tighten their lending (i.e., extending fewer loans, raising loan rates) as loan margins narrow. This has not yet been the case.
The BOJ should quantitatively assess the negative impact of its policy on financial institution earnings and their net capital, and determine how much policy rates can fall before destabilizing the financial system." - source Nomura

As loan margins will continue to narrow, there is a heightened risk that banks could decide to extend fewer loan due to lack of demand or poor profitability, in effect triggering a credit crunch in a context where there is subdued demand for credit overall. This is as well highlighted in Nomura's report:

"According to a survey on major loan trends, loan demand was unchanged for companies (5 in June from 7 in December) and rose sharply for households (9 in June from 0 in December). However, lending to households may have included substantial refinancing demand.
In fact, the key factor cited by financial institutions in explaining the increase in individuals’ demand for capital is the drop in loan rates, not growing housing investment and higher personal spending. Moreover, we believe slow growth in corporate lending likely reflects weak loan demand in the corporate sector, and not so much financial institutions’ stance on lending. " - source Nomura

Weak loan demand means that at the Zero Lower Bound (ZLB) and now NIRP, there is very little monetary policies can do. Now that we have a case of broken monetary transmission to the real economy, there is very little in that context for additional unconventional policies from the Bank of Japan to work their magic on the real economy.

We have already touched on this subject in April in our long conversation "Shrugging Atlas" where we discussed Japan and the kite string theory:

"That is the very difficult situation that lies with "easy policy", there is an easy way in, but no easy way out. So as goes the the kite string theory, you can control a kite by pulling its string, but not pushing it. Once you reach the ZLB and implement NIRP on top of QE, it seems to us monetary policies become ineffective." - source Macronomics, April 2016

We keep hammering this but it seems to us that central banks do not understand clearly the difference between stock and flows. Aggregate Demand (AD) as well as "credit growth" are flow variables, NPLs are stock issues. That simple. Despite aggressive monetary policy easing, the ability of central banks to boost bank lending and hence economic growth is been limited at the ZLB or NIRP level. The basic problem, both with monetary expansion and NIRP, is that the primary transmission channel is via the commercial banks, and that channel has, for a variety of reasons, is broken as we have pointed out in numerous conversations.

Maybe "The Cult of the Supreme Beings" aka central bankers should Bank of America Merrill Lynch's recent primer entitled "How European Banks work" from the 26th of September to fully grasp the stupidity of NIRP in a difficult deleveraging environment akin to adding fuel to the fire they have set up:

"Bank profits leveraged to economic cycle 

Bank profits are naturally leveraged to the economic cycle. Net interest income accounts for c.50% of bank revenues. Increasing this revenue generally involves growing the loan book, which relies on a combination of economic growth and product penetration. Fee revenue also depends on economic activity. On the other hand, economic downturns cause banks to increase provisions for credit losses.

Summary

• Credit risk has a pro-cyclical effect on profits. Credit losses are higher ineconomic downturns
• Credit provisions cumulate on the balance sheet as a negative asset and reduceboth shareholders’ equity and regulatory capital

Banks lend money on the expectation that the full amount is paid back. However, borrowers cannot always pay back all of the money they have borrowed, nor can they always meet their monthly loan costs.
Payment difficulties typically increase during times of economic stress: Individuals may lose their jobs, see a sharp fall in incomes and not be able to cover their repayments. Companies may find reduced demand for their products, affecting revenues and their debt obligations.
Banks are exposed to potential losses, as they may not get back the full amount they initially lent. Once a borrower misses a payment they are said to be “in arrears”. Once they are 90 days behind, the outstanding portion becomes a non-performing loan, (NPL).
Banks must set aside provisions for such losses. These provisions can be large and reduce profits, equity and regulatory capital. While critical to a bank’s health, such provisions are a non-cash item. This undermines the usefulness of cash flow statements for banks.
Loan growth and revenues are linked to the economic cycle. Credit losses are also linked to the cycle. Bank profits can therefore be highly cyclical. 

• Credit risk has a pro-cyclical effect on profits. Credit losses are higher in economic downturns
• Credit provisions cumulate on the balance sheet as a negative asset and reduce both shareholders’ equity and regulatory capital

- source Bank of America Merrill Lynch

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings. And, to say the least, one thing for sure, NIRP marks the end of Banking Empire Days rest assured. Also like we posited before, the problems facing Europe and Japan are more acute than in the United States because they are driven by a demographic not financial cycle. So, when it comes to low loan growth under NIRP, in the case of Japan, thanks to unfavorable demography, it marks we think the end of the "Empire Days" and the sun is setting, not rising.

Finally, as we have been commenting as well on various occasion, central banks meddling with asset prices is not only pushing cross-asset correlations higher but it is as well brewing instability and triggering more significant large standard deviation movements overall.

• Final chart: Market’s growing dependence on central bank stimulus means more prone to “corrections”

While we have shown in various conversations the instability created by "The Cult of the Supreme Beings" aka central bankers thanks to rising correlations, the impact can be seen in our final chart coming from Bank of America Merrill Lynch's The European Credit Strategist note from the 20th of September entitled "QE’s merry-go-round" from the 20th of September which displays the number of 4 plus SD (Standard Deviations) movements across markets over time:

“Corrections” par for the course 

"More broadly, because of the market’s growing dependence on central bank stimulus, we think assets are generally becoming more prone to “corrections”. Chart 1 highlights our Correction Counter: the number of 4 SD moves registered across markets over time. Brexit (June ’16) and China (August ’15) were clearly powerful events that drove market reversals. Yet, we think chart 1 also shows a general rise in the number of “corrections” since mid-2014 – interestingly, a time when the ECB first embraced negative rates." - source Bank of America Merrill Lynch

So there you go, what is indeed NIRP accelerating is the end of the statu quo and end of the low volatility regime which will of course end many "Empires" including banking Empires we think but, that's a story for another day...

"All enterprises that are entered into with indiscreet zeal may be pursued with great vigor at first, but are sure to collapse in the end." - Tacitus

Stay tuned!

Macro and Credit - Superstition

"The root of all superstition is that men observe when a thing hits, but not when it misses." - Francis Bacon

Looking with interest our anticipated weakness in USD/JPY coming to bear fruit from 107 since our last post to 109.11, and given we decided to start writing our conversation on Friday the 13th of May, which, for some people, is clearly of "significance", particularly for Stevie Wonder given it is birthday and that we share the 13th as the day, not the month or year for our respective birthdays, we could not resist but pay homage to this great singer once again (see our previous related Stevie Wonder 2013 reference "Misstra Know-it-all") by making a reference to his 1972  "Superstition" song in our title analogy. The song was Stevie Wonder's first number-one single since the live version of "Fingertips Pt. 2" topped the Billboard Hot 100 in 1963. The song's lyrics are chiefly concerned with superstitions, mentioning several popular superstitious fables throughout the song, and deal with the negative effects superstitious beliefs can bring:

"When you believe in things that you don't understand,
Then you suffer" - Stevie Wonder, Superstition lyrics

Obviously our "superstitious" beliefs since early 2016 have not been that "negative" from a P&L perspective rest assured given we have been advocating going long the 30 year US Treasuries as well as gold and gold miners for a while since the end of 2015, meaning for us that, when you believe in things you actually do understand such as "The return of the Gibson paradox" as per our 2013 rambling you do not suffer, on the contrary, you thrive:

"Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which has been the case with the rally we saw in the 10 year US government bond getting close to 3% before receding, then of course, gold prices went down as a consequence of the interest rate impact." - Macronomics, October 2013

Whereas some people have been rightly "Superstitious" over time when it comes to "Sell in May and go away", from the latest raft of "flow data" it seems that there is a continuation in the "Great Rotation" from "equities" into "bonds", particularly in "Investment Grade" credit, confirming our recent musings on the subject. 

When it comes to "Mathematics" and "Superstitions" relating to Friday the 13th, the interval between two Friday the 13th is respectively 27, 90, 181, 244, 272 or 426 days. Therefore they can be an interval of more than a year between two Friday the 13th. Interestingly enough it happened on the 13th of August 1999 and the 13th of October 2000. What we find amusing is that the infamous "Dot-com" bubble saw the NASDAQ peak on Friday the 10th of March 2000 at 5132.52, very close to the middle of this rare interval and the birthday of yours truly which was on the following Monday. Given next Friday the 13th will be next January, could it be that we will experience the "peak of the market in the middle of both dates therefore on Monday the 12th of September this year? We wonder and yet it seems we ramble again, this time towards "Superstition" and are left "guessing".

In this week's conversation, we would like to look at the narrowing gap between US and European Investment Grade Credit as well as the impact of the ECB's global corporate bond buying binge programme aka CSPP (Corporate Sector Purchase Programme) is having to "credit quality". We will also as well "revisit" our US CCC "credit canary" indicator.

Synopsis:

• Macro and Credit - When the ECB starts playing with "credit quality"
• Macro and Credit  - The "CCC credit canary"is still pointing towards "exhaustion" in the credit cycle
• Final chart: The world was poorer in terms of yield in the government space, thanks to the ECB it's spreading into Euro denominated corporate credit

• Macro and Credit - When the ECB starts playing with "credit quality"

One of the prime effect of the "buying corporate credit binge" from the ECB has lead to a significant increase in effectively "zero coupon issuance" in the Investment Grade space such as the latest 2020 issue from Unilever as per our most recent conversation:

"To paraphrase du Pont de Nemours, in forcing credit investors to exchange an interest-bearing proof of debt for another which bears no interest (recent issues in the European Investment Grade land are zero coupons...), you will have borrowed at the sword point of the ECB." - source Macronomics, May 2016

We also added at the time:

"The recent decision by the ECB will no doubt boost the rally into credit in Europe into "overdrive" and as expecting we are already seeing more and more large corporate issuers issuing de facto "zero coupon" thanks to our "Generous Gambler" aka Mario Draghi. As we pointed out in our previous missive before going for our R&R, it seems to us that the ECB is failing because it is enticing the money "uphill" namely into "bond speculation" where all "the fun is",  not downhill, to the real economy. Flow wise this exactly what is happening. The "fun" is in the bond market and particularly in the European investment grade market" - source Macronomics, May 2016

What is of interest is that thanks to its global corporate program, not only EM Corporate will benefit from the ECB's "generosity" which will no doubt trigger "mis-allocation", but, US issuers have been coming in drove to European shores thanks to "Reverse Yankees" issuance.

When it comes to issuance, obviously from a "flow perspective", at least in Europe, Investment Grade credit has been the prime beneficiary of the latest policy as indicated in UBS Global Credit Comment note on EUR credit from the 10th of May entitled "Who's issuing and what are they doing with the capital?":

"Euro IG issuance strong, HY weak 

The ECB CSPP has given the Euro IG primary market a kick start in March. We have since seen a pick up in BBB and BB issuance coupled with a tightening of spreads and smaller new issue premiums. Issuance in the Auto and Telco sectors YTD is already above the total issuance for 2015. There have been surprisingly few debut issuers in IG and we do not expect a radical change in issuer behavior on the back of CSPP. HY issuance has failed to benefit and is lagging far behind IG and last year's issuance. 

What is being done with capital? 

Issuance programs and borrowing needs are usually pre-determined, so we don’t expect CSPP to radically alter issuer behaviour. We will probably have to wait until these recent borrowings filter through the cash flow statements to find a real trend.
We have looked at the cost of capital of corporates refinancing themselves via bonds compared to dividends yields. Here, we see that the majority of 2016 issuers have a much higher dividend yield than bond yield." - source UBS

As expected, the "yield hunters" have been front-running the ECB's move which have led to a significant compression in credit spreads in the process.

What is also of interest to us is that given the on-going deleveraging of the European banking sector, there is of course a transformation of the "corporate funding process" given that thanks to banks bloated balance sheets and on-going reduction of assets, issuers have to rely more on the bond market rather than on the traditional loan market, which in some way marks an "Americanization" of the European corporate bond market as indicated by UBS in their note:

"The slow transformation of capital structure in Europe from bank loans to credit continues. Although about 79% of funding is still from banks (Figure 2) the trend toward a more US-like funding model is clearly underway after an acceleration in 2009.  

Structurally this transition could be helpful for growth in the Eurozone as bank balance sheets could be freed up to fund SMEs rather than mid- to large-cap firms (for example see this speech by Yves Mersch in 2014). The ECB is therefore likely to remain supportive of this structural transformation.

The structural trend is clear, but how are we doing so far in 2016? There is good news and bad news: IG is keeping track with 2014 and 2015 (Figure 4) whereas HY is lagging far behind (Figure 5).

Euro IG issuance over the first four months of 2016 was €191 bn, the second highest figure on record for the first four months of the year. Issuance in April was the largest in any April since 1999. Up until early March, 2016 issuance was below last year for the same period. Then came the announcement by the ECB to include non-bank corporate bonds into the QE programme, which proved to be a game changer. Issuance picked up sharply and the week following that announcement was the largest week of issuance on record at ~€30 bn. For more information on the ECB CSPP please refer to our earlier publication (ECB CSPP: Additional details). In contrast HY lags far behind previous years, with €9.8 bn printed to the end of May which is just a fifth of issuance to end of May in 2014 (€46.1 bn) and 2015 (€50.6 bn).

European credit has benefitted from an increase in popularity this year amongst ETF investors. Fund flow data shows that ETF investors returned to European credit funds in March, following nine months of flat AUM. The €1 bn March inflow into European HY ETFs was the largest on record.

At the same time, the concession on new paper has been eroding given this sharp increase since March. Yields have fallen and the gap between corporate and government bond yields has been squeezed. We have seen A1/A+ rated corporate issuers print paper with a 0% coupon and 0.08% yield in April.
Although issuance terms are clearly better since CSPP was announced, we have not seen a radical change in issuer behavior. Issuance programs and borrowing needs are usually pre-determined, and we do not think this will lead to a substantial increase in debut issuers." - source UBS

Whereas we indicated in April in our conversation "Paradise Lost" and also in early March in our conversation "The Paradox of value", that, the US investment grade market was no doubt the only game in town when one looks at the performance of the asset class relative to US High Yield, it seems to us that, relative to European Investment Grade, it has lost some of it appeal as clearly indicated in the gap closing between US and European Investment Grade as per UBS's note:

- source UBS

This is most likely due to global issuers such as US issuers conceding to the siren call of the ECB which thanks to the current level of the strong negative EUR/USD basis seems to be irresistible as per UBS's note:

"US issuers benefitting from low European rates 

At the moment the EURUSD basis swap is strongly negative, but given the yield differential between the US and Europe it is still relatively cheap for US issuers to swap their liabilities from EUR back to USD (Figure 9).

Combined with a central bank that is not only keeping risk-free rates low but also offering to buy the bonds of foreign issuers (assuming they meet eligibility requirements) this makes a compelling case for US issuers. It also allows for diversification of funding.

Over the last three years reverse Yankee issuance has been around a fifth to a quarter of all IG EUR issuance. This year the reverse Yankee issuance year to date is close to the total issuance for the whole of last year so it looks like US issuers are making use of the favorable conditions in the Eurozone.

These issues could also qualify for the CSPP provided the criteria is met, including issuing the notes in euros through a local European subsidiary." - source UBS

So not only is the ECB continuing to support the "deleveraging" process of the financial sector in Europe and providing "cheap financing" to both European Governments and Corporates alike, it is now as well providing "cheap funding" to the rest of the corporate world! It seems that the terms we used last week about an "epic credit bubble" forming are nowhere close to just "superstition".

From a "flow perspective" as we pointed out last week, the "fun" continues to flow "uphill", leading to a "frenzy" in bond market speculation, but for now, not really flowing "downhill", to repeat ourselves, to the real economy. This buying spree is materializing in "flows" as indicated by Bank of America Merrill Lynch in their Follow the Flow note from the 13th of May entitled "IG credit in the limelight":

"The X factor 

High grade credit has definitely got the X factor, as the ECB embarks on corporate- QE from next month. Flows into the asset class saw a strong U-turn over the past nine weeks. Outflows seen over the first weeks of the year are now almost erased.
On the contrary outflows continue from equity funds, as investors struggle to see inflation or earnings picking up any time soon. Moreover, on the other side of the high quality fixed income spectrum, government bond funds have barely seen any inflows in the same period as high-grade credit is in the limelight.
High grade funds had yet another week of inflows, the ninth in a row. On the other hand, high yield fund flows turned negative, erasing the gains from the previous couple of weeks. This was the highest outflow from the asset class in six weeks.

Government bond fund flows remained volatile, recording an outflow over the past week (after a brief week of inflow), the highest in nine weeks.
Away from QE eligible assets, equity fund flows recorded their fourteenth week of consecutive outflows, the longest streak since 2007. Last week’s outflow raised the total outflows for the year to over $31bn." - source Bank of America Merrill Lynch.

From a "flow perspective" and "leverage cycle" and "relative value", European High Yield boast more favors from investors although it offers lower credit spreads (but less leverage than US High Yield) as well as strong support from retail inflows into ETFs. It seems the "Great Rotation" from equities to bonds is running unabated making so far "flow wise" Investment Grade" the big winner of this "flow process", no superstition there, just plain facts.

But if indeed ECB is playing the "pumping up the issuance volume" game in the credit space, then something is going to give, and that is credit quality given in most recent years CFOs in Europe have been more "defensive" of their balance sheets compared to the US and its "buybacks bing" financed by "cheap credit" (hence a faster rise in leverage and deterioration of credit metrics). When it comes to the "quality risk factor", we have to agree with UBS's take from their recent note:

"Deterioration of credit quality 

As the European credit market has matured and grown since 2004 the quality of credit issuance can be broken into three phases. From 2004 to 2009 average credit quality improved slightly from A, peaking at AA- in 2009. In the next phase from 2009 to 2014 average credit ratings fell to BBB. In the third phase since 2014 credit quality has been on a slowly improving trend. But as we have noted above after the ECB's announcement of the CSPP quality has ticked downwards slightly to an average of BBB+. This recent trend is also visible in Figure 20 which shows issuance broken down by rating in the form of a heat map. Please refer to our recent piece on the credit quality of the iBoxx universe; European Credit: Fallen angels or rising stars?.

Which sectors are lagging/leading issuance in 2016? 

We are wary of a situation in which new issues are concentrated in one sector, as we saw in the US with energy producers over the last few years. This often signals a mis-allocation of capital and may end with a sharp correction as business conditions change adversely for that sector and capital is withdrawn, as occurred in the energy sector in the US. European sector issuance seems to be fairly well diversified. In Figure 16 is YTD issuance for each sector (excluding Financials) vs the average amount issued per year from 2010-2015.

Figure 17 shows the sectors sorted as a ratio such that 100% means we have reached the year total average issuance already in March.

- source UBS

Thanks to NIRP and its QE, the ECB is now following the same FED path in encouraging "oversupply" and a "credit bing" which will no doubt entice further "mis-allocation" of capital in conjunction with a deterioration in credit quality and credit metrics it seems, no "superstition" there either we think.

Moving on to our "CCC credit canary" indicator which we have discussed on numerous occasions, whereas High Yield in Europe is still supported by "flows", particularly in ETFs as discussed above, the fall in issuance in this bucket, in conjunction of a significant drop in CLO issuance point, we think towards exhaustion in the credit cycle.

• Macro and Credit  - The "CCC credit canary"is still pointing towards "exhaustion" in the credit cycle

As we pointed out in October 2015 conversation "Bouncing bomb", low quality speculative grade net issuance has fallen sharply in a replay of late 2007 as the stimulative effects of past Fed quantitative easing wears off as shown in a recent chart from Bank of America Merrill Lynch's monthly chart book:

- source Bank of America Merrill Lynch

As we pointed out last week in our conversation "Sympathetic detonation":

"Every single time the "CCC Credit Canaries" have been less and less "able" to tap the primary markets, the High Yield default rate went significantly upwards. As we have told you before, cost of capital, "hiking" or "not hiking" by the Fed is going up in an environment where issuers have weaker fundamentals, falling EBITDA and higher leverage which is not a good "credit recipe" for "total return players" (which by the way have a significant exposure in dollar terms) as well as for "forward returns" on the asset class itself." - source Macronomics

While the rally seen as of late as been "significant" in terms of performance as shown in the below table from Bank of America Merrill Lynch displaying the month to date returns for the month of April, "flows" in US High Yield are indicating further deterioration ahead and one would be wise to starting taking his chips out of the proverbial poker table we think, us not being "superstitious" but, you might be running out of "luck" soon:

- source Bank of America Merrill Lynch

"Flow" wise, apart from Europe, as far as US High Yield is concerned, is showing "contagion" from the ETF sphere (The iShares iBoxx High Yield Corporate Bond ETF HYG, the largest high-yield ETF, had $3.6 billion in redemptions in six days ending May 6) to the mutual funds sphere according to Bank of America Merrill Lynch High Yield Flow Report from the 12th of May entitled "Outflows spread to open-ended funds":

"HY non-ETFs see first outflow since Feb 17th 

US HY recognized its second consecutive weekly outflow, again led by ETFs which lost $691mn or -1.8%. As was the case last week, the ETF redemptions were limited to HYG with other notable HY ETFs not experiencing equivalent outflows. As such, we believe these redemptions were used to gain exposure to the underlying bonds making up the ETF and do not consider it an overly bearish signal for the market. However, open-ended funds also experienced net redemptions last week with a $91mn (-0.1%) outflow, their second negative print since February and third consecutive weekly decline. In our opinion, the outflows from open-end funds are a much more negative sign and provide yet another reason why we believe the recent rally may have already seen its end." -  source Bank of America Merrill Lynch

Given the significant performance of High Yield during the month of April, it would be reasonable, we think to start booking some profit.

Also, the latest Senior Loan Officer Lending survey points towards additional tightening. Deterioration in non-bank lending standards illustrate an overall tightness in US financial conditions and therefore signal a downside growth risk to the US economy. At least this exactly what the flattening of the US 2-10 yield curve is telling you as of late! The tightening in lending conditions can be seen below in another chart from Bank of America Merrill Lynch:

- source Bank of America Merrill Lynch

With tighter lending conditions default rates may rise materially through 2016, which will continue to weigh significantly on US High Yield and the issue is not confine only to the Energy sector.

But, as pointed out in our October 2015 conversation, simply tracking bank lending standards is not sufficient to gauge how the corporate credit cycle is evolving hence our "CCC credit canary" issuance indicator. Also, in our conversation "The False Alarm" in October 2013 we stated:

"If we take CCC Default Rate Cyclicality as an early indicative of a shorter credit cycle, then it is the rating bucket to watch going forward
Why the CCC bucket? Because there has been this time around a very high percentage of CCC rated issuers accessing the primary market in High Yield.
A rise in defaults would likely be the consequences of a deterioration in credit availability. Credit ratings are in fact a lagging indicator." - source Macronomics

We will re-iterate our 2013 advice for credit investors, watch CCC default rate going forward. Because it matters, more and more.

In relation to our "CCC credit canary" concerns, we read with interest UBS's take from their Global Credit Comment note from the 10th of May entitled "Decoding the US triple C debt concerns":

"Decoding the US triple C debt concerns 

The amount of lower quality, risky corporate debt is a crucial input to assessing the inherent structural risks in global credit markets. In rating agency parlance this is synonymous with the proportion of triple C rated debt, and the bulk of which lies in the US. Our prior research has flagged the substantial rise in triple C issuers outstanding since the 1990s, peaking last year at 42% of all issuers, up from 14% and 18% in 1999 and 2006, respectively (Figure 1).

That said, investors have consistently pointed to lower estimates in the mid double digits and inquired about how to reconcile the stark divergence. Below we decode the discrepancies and discuss the key takeaways.
In short, the current estimates are lower if one considers only the high yield bond universe, utilizes index (or average) ratings and weights the universe by debt outstanding. This mosaic suggests triple C concentrations in the 15% context, above the 12% and 9% observed in 2006 and 1999, respectively, but below the 30% peak in 2008. We attempt to build on to that lower estimate using different permutations around the calculation for triple Cs to illustrate the components; i.e., we can perform a rough sum-of-the-parts analysis to build up from 15% to 42%. 

First, calculating triple Cs based on issuer versus debt weightings accounts for roughly 8% of the difference. This likely reflects the reality that abnormally low yields and robust credit inflows allowed more issuers to tap speculative grade bond and loan markets; given rating agencies assign ratings based on business and financial risk profiles, smaller firms by nature suffer more on the business risk profile assessment. However, we do not take much comfort in this fact in that we struggle to envision an environment where smaller defaults do not cascade or coincide with larger defaults. We view the surge in smaller lower quality issuers as consistent with commensurate increases in other non-index eligible corporate funding such as private placements, P2P and like non-traditional issuance that has manifested itself to satiate the reach for yield. And historically, issuer and debt weighted default rates have been fairly highly correlated (Figure 4).

Second, our analysis suggests about 8% of the differential is due to index or average versus Moody's ratings. How can Moody's ratings suggest nearly 50% more triple Cs than that of S&P/Fitch (on a debt weighted basis)? Macroeconomic assumptions do not appear to differ materially; neither is particularly non-consensus in their economic or profit assumptions. It is not the case of one industry or sector (e.g., energy, metals/mining) that largely explains the discrepancy; in aggregate, commodity-related industries only comprise about 30% of all triple Cs (and the result is similar whether we use index or Moody's ratings). Nor do differing recovery ratings appear to be a key factor. In short, Moody's may take a more conservative approach, but it appears broad-based and not unwarranted. Perhaps they are closer to in-line with market expectations, but by nature rating agencies are never ahead – but rather typically woefully behind. 

Third, the remaining 11% is due to inclusion of HY bonds and leveraged loans versus HY bonds alone. The LL universe expanded aggressively in the prior cycle driven by LBO activity, and the space grew substantially again driven by sponsor-led M&A and releveraging actions. In practice, many leveraged loans rated single B effectively encompass issuers with triple C default characteristics offset by secured collateral to lower the loss in default.

But will the theory work in practice? There are some reservations. First, realized recovery rates are already disappointing expectations. Trailing 12-month secured loan recoveries are averaging $57 (versus $70 modelled), while unsecured bond recoveries are $25 (versus $40 assumed) even absent a high default, recessionary environment. Part of this is due to peak earnings and multiples facilitating excessive corporate leverage, a phenomenon we have documented previously which ultimately depresses recovery rates based on normalized firm values. Second, the number of covenant-lite loans has risen from 20% to 70% in this cycle. These structures are largely untested, but they typically lack proper covenant and collateral packages. The risk is that these loans recover more akin to secured bonds (averaging $47) than secured loans (averaging $57, Figure 5). 

Third, the number of loan-only leveraged loans have risen from 5% to 30% post-crisis. These are loans without bonds to absorb losses below them and, in turn, could suffer lower recovery rates. Fourth, we believe leveraged lending and other regulations will tighten funding requirements for distressed borrowers in a downturn. The basic premise is banks are crucial providers of liquidity in stress as they are less mark-to-market sensitive; conversely, many new capital providers stepping in will not have such a luxury. And finally, recovery rates are strongly negatively correlated with default rates, which we expect to be near record levels given the higher proportion of lower quality bonds and loans and high degree of default correlation (Figure 6).

Distressed supply will come not only from advanced, but increasingly from emerging markets given structural risks in EM corporates.

In short, most metrics of lower rated debt in this cycle are above to materially above that witnessed in prior cycles at this stage. Investors analyzing the lower versus higher estimates should largely dismiss differences due to semantics such as rating agency selection or default weightings, in our view, which account for roughly three-fifths of the total. While it is true that roughly two-fifths are due to the surge in (lower quality) leveraged loan issuers, we do not take too much comfort in trading higher default risk for lower losses in default as we feel the latter will likely disappoint versus expected recoveries – akin to what is precisely happening now." - source UBS

It is not a question about being "superstitious" but given the "size" of our "CCC credit canary" in conjunction with Cov-lite loans, and we would like to repeat what we said in our conversation from May 2015 entitled "Cushing's syndrome":

"On the subject of "Overmedication", for us it means that the fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets meaning that in the next downturn, we expect the recovery rates to be much lower than in previous cycles!" - source Macronomics, May 2015 

Furthermore the strong "relief" rally in the High Yield Energy sector doesn't change our opinion in the lateness of the stage we are in the credit cycle. We can also point to another chart from Bank of America Merrill Lynch that clearly shows the deteriorating trend in US High Yield. For instance the chart below shows the trailing 3 month migration rate for US Investment Grade and US High Yield:

- source Bank of America Merrill Lynch

So one might rightly ask, where do we go from here with your "CCC credit canary"? We would like to point out to Bank of America Merrill Lynch's take from their recent High Yield Strategy Chartbook note from the 4th of May entitled "Back to where we started":

"Where do we go from here? 

Perhaps nothing illustrates the irony of this rally better than recent bankruptcies of EXXI and MPO. These issuers ultimately succumbed to the oil glut, filing for Chapter 11 protection in April, even as their bonds rallied hard, with their single B bonds springing up 20 points from their Feb 11 lows until default. Other defaulters such as CHK too saw their exchanged bonds jump up to 60 points. Note that virtually nothing has changed in the context of default probabilities in the Energy space, as it would perhaps require oil sustainably above $50/bbl to alter any of their fates. Which begs the question, how long can a rally based on recoveries alone last? Not much longer in our opinion. Having said that, rising oil could continue to push even ex-energy spreads tighter. However in the absence of solid fundamentals (more below), we think that this too will be short lived and the high correlation of non-commodity HY with oil will ultimately fade.
An early read of Q1’16 suggests more deterioration of HY balance sheets. With a little over 100 reporters, YoY revenue growth is -0.3% (5th consecutive –ve quarter) while YoY EBITDA growth is -7.0% (6th consecutive –ve quarter). Ex-energy, YoY revenue growth is nearly flat while YoY EBITDA growth is slightly positive. Adjusted EBITDA YoY growth numbers too are underwhelming, with US HY posting its 3rd consecutive –ve quarter, and ex-energy growth turning negative for the first time since Q1 2013.

We are back to where we were in HY spreads four months ago, but our message hasn’t changed. In the context of poor HY fundamentals, lack of liquidity and rising defaults, central banks are the last remaining pillars of support for risk assets. Yes, they have surprised us so far this year in their ability to remain dovish, but even so, plenty headwinds remain and risk assets have more reasons to sell off than rally, especially from these levels. As such we view this rally as temporary and believe we could retest 9% yields on an ex-energy basis again this year." - source Bank of America Merrill Lynch

So, when you believe in things you actually do understand, therefore, you are not being "superstitious", you can indeed sidestep upcoming "risk-off" in the US High Yield space we think.

As far as credit is concerned in general and with the ECB's backstop in particular pushing you to invest in "zero-coupon" investment grade credit at the point of the sword, as per our final chart, negative yields are not only spreading into the European Government Bond space, it is as well spreading into the Corporate credit space.

• Final chart: The world was poorer in terms of yield in the government space, thanks to the ECB it's spreading into Euro denominated corporate credit

While in our previous conversation we started indicating how pandemic the NIRP virus had become in the Fixed Income world and in particular in the Government bond space in Europe, the ECB's CSPP is indeed accelerating the spread of the Negative Yield virus now to the Corporate sector as indicated by the below chart from Bank of America Merrill Lynch displaying the impacted on Euro denominated credit from their EM Credit Global note from the 9th of May entitled "ECB buying is positive for EM corporates":

"ECB says ‘go’ to more negative yielding corporate bonds 

How low can spreads for IG corporates go? Chart 3 below shows that already, about 10% of Euro-denominated corporates are negative-yielding, or close to EUR200bn. This number could move meaningfully higher once buying begins.
The quantity of negative yielding assets globally has reached almost EUR10trn, or about 24% of global EUR assets. The figure was about 13% at FYE15 and 11% at FYE14. This figure includes sovereign debt eligible for purchase (see BofAML index GFIM).

- source Bank of America Merrill Lynch

Just because we wrote this conversation on Friday the 13th and born on a "13th" day, for us, it isn't a question of being "superstitious" but, we do think this "epic bond bubble" will end badly...

"I had only one superstition. I made sure to touch all the bases when I hit a home run." - Babe Ruth

Stay tuned!